In Part 1 of this blog, I wrote about why so many angels, venture investors and even entrepreneurs continue pouring resources into investment lemons well after they should have pruned them and moved on. It is well known in the venture business that the deals investors most regret are not those that crash and burn quickly, but rather those that never get anywhere worth going but never completely fail either: the proverbial land of the living dead. These are the deals that take, and ultimately waste, the most time and capital. One of the less understood talents of the best venture investors – and I don’t think anyone gets a perfect score on this one – is the ability to recognize a deal that is headed for zombie land and kill it off before it gets there.
In the age of the lean startup, when pivoting is all the rage (and often the right thing to do), lemons that need pruning rather than pivoting are harder than ever to spot. Be that as it may, there are clues that investors should watch for and be ready to act on. The first is at the very place where most good investments start – with the team.
In looking back at my own experiences in zombie land, by far the most common regret (the most common “I should have seen this coming” epiphany) was realizing that the deal lived beyond the point at which confidence in the team had materially slipped from the initial investment. Most venture investors believe the quality of the team is the single most important factor in the investment decision equation. Nevertheless, from my experience as an investor, entrepreneur, and counsel to one or the other, I am struck how investors will throw more resources into a deal after their confidence in the quality of the team has fallen below the level at which the initial investment would never have been made. So, my first rule of lemon pruning: don’t throw more resources at a deal unless, after a fresh evaluation, you still have the kind of confidence in the team that would support an initial investment. The test is not whether the team has made any mistakes, but rather, if you were seeing this team for the first time, with the current lemon experience behind them, would you consider them worthy of backing in their next deal?
The next place to look for a lemon is in the “day late and dollar short” aisle. A lot of the zombies that I have seen are deals that missed the market or technology wave and, rather than wait for the next wave (i.e. bail on the existing business), think that if only they paddle hard and fast enough can they catch back up. Alas, it almost never happens that way. As long as you are not too far out in front of a wave, you can plausibly think about waiting for the wave to catch up; but, once you are looking at the back of the wave, forget it. Thus, my second rule of lemon pruning: don’t lose sight of the market and technology wave you are riding. If at some point you find yourself on the back side of it, swim – briskly – to the nearest beach.
Also, in the age of the pivot, too many folks are too quick to think that just because you have a great team to attack market opportunity X, you can (when market X does not pan out) just pick another attractive market opportunity, say Y, and go for it. While that can happen, you have to be very careful to honestly ask yourself whether you and the team have any right to go after market opportunity Y. Recognizing a good market opportunity (and let’s say Y is in fact a good market opportunity) is not the same as being able to capture it. A pivot only makes sense if the post-pivot team really knows enough about the dynamics (distribution channels, competitive landscape, business models, etc.) of that market to knock off the people already immersed in the market (at least some of whom you have to assume are competent) and has the connections and capital to execute. Thus, my third rule of lemon pruning: avoid pivots that take you to markets you don’t know much about and/or don’t have realistic access to the capital and other resources you need to successfully attack.
In the interests of full disclosure, over the years I spent a lot of time thinking about why investors don’t timely prune more investment lemons. Most of my thinking focused on what makes pruning a lemon so hard to do. More recently, it has occurred to me that more timely lemon pruning would happen if lemons were not so hard to recognize. In that regard, it would be great to hear what others are thinking in terms of timely recognizing investment lemons.