When investing too early isn’t ‘wrong’

June 29, 2011, 5:06 PM UTC

In venture capital, success is often predicated on failure.

By Jonathan Tower, contributor

I recently had an Twitter exchange with Mark Suster over the issue of being “too early” as a venture capitalist, and what that means in the current climate. While I genuinely like and admire Mark and am not usually one to publicize my disagreements with other investors over philosophical matters, I thought the content in the exchange was valuable and supported some re-examination.

Mark made what I would consider a somewhat sweeping statement: Namely, that investing too early was the same as being wrong. I responded that this entirely depended on the perspective being considered. Let me explain.

There scarcely exists a technology sector that became vibrant and consequential without first experiencing a great deal of stops, starts and stalls early in its evolution. Most of the “failures” (i.e., companies that had a piece of the solution figured out but perhaps not the entire solution) were venture-backed. Many of the same investors in those early failures learned from the experience and went on to back later entrants that became juggernauts in that given sector. Were those investors wrong? Would those investors have developed the insights, market knowledge and ecosystems critical to their becoming investors in the eventual market leaders without those early experiences? Would the sector have developed as it did without the flame-outs?

My answer to those rhetorical questions an emphatic “No.” As has been evident across technology markets for decades, advancement occurs in waves of innovation that beget other waves of innovation. The early failures provide formative experiences for both investors and future entrepreneurs, who can better see what worked and what didn’t for the previous class of market entrants.

Take, for example, the notion of pattern recognition among venture capitalists. Tangential to pattern recognition is the idea that a VC’s early forays into a sector provide a great education — wanted or unwanted — about what will ultimately be successful in the space and what simply doesn’t work. It also provides the investor with an ecosystem of supporting companies and entrepreneurs that will serve that investor well for years to come in his or her chosen area of investment, and even in other areas. This is called active cross-pollination and it is critical for long-term success as a venture investor.

To pull on that thread a bit further, venture capital is not a discrete, narrow vertical exercise. Good investors are constantly influenced by outside factors, parallel markets and advancements in technologies that appear unrelated until an epiphany occurs and interesting combinations can result. From the embers of a previous failed investment can come a dormant technology or a seasoned manager that can be re-potted into a new venture and can enable that venture to become enormously successful. The future success may not have happened without the early mis-step. I have several examples of this in my own career.

There is an oft-told piece of black humor in legal circles about a veteran attorney counseling a young protegé. The senior lawyer remarks, “When I was a young attorney like you I lost a lot of cases that I should have won. Now, with my years of experience, I win a lot of cases that I should probably lose.”

No one is suggesting that venture investors new to a sector should message to entrepreneurs that they are “learning” on their deals. That said, to maintain that experiences on early investments do not positively inform decisions made on later ones is simply folly.

So, can one be “wrong” by investing too early in a sector, as Mark suggests? Most definitely. This occurs when an investor develops an investment thesis, makes an investment in a company against that thesis, leaves the sector after that company fails and never leverages the lessons learned from that experience into other investments.

The mere statement that anyone invested “too early” in a sector implies that the given sector did ultimately develop into something substantial. With any luck, the earlier investors that helped shape the sector with early bets were able to prosper by participating in the eventual winners. Historical venture returns seem to bear that out.

Jonathan Tower is a Managing Director at Citron Capital, a global private equity and venture capital firm, where he focuses primarily on Consumer Internet, Software, Digital Media, and Web Services investments.

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