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In a recent post, I discussed the painful honesty of Silicon Valley tech VC Dave McClure’s much-discussed meditation, “Late Bloomer, Not a Loser.” I’ve since had a chance to read more about McClure’s unconventional investing philosophy, reflected in his firm, 500 Startups, and the approach seemed worth discussing as well – particularly in the context of whether it might be relevant to companies in the digital health space.
(As I mentioned in my previous post, I don’t know McClure either personally or professionally – I’m simply captivated by his thinking.)
What I find most intriguing about McClure’s investing approach is that he seems to be doing exactly what you’d do if you read Nassim Taleb’s “The Black Swan” (see my WSJ review here) and really took the key messages to heart. In particular: (a) make a lot of small bets with limited downside; (b) take advantage of the cognitive biases that lead investors to cluster for comfort.
“The logic is that most startups fail, but the winners can yield disproportionate returns – and you can eliminate most of the contenders without needing to sink more cash in.” -David Shaywitz, M.D.McClure’s approach seeks to make unusually small bets in a number of mostly tech start-ups – $50K-$250K, according to this recent, useful Gigaom profile. The logic is that most startups fail, but the winners can yield disproportionate returns – and you can eliminate most of the contenders without needing to sink more cash in. (Only an estimated 20% of the start-ups survive, and earn another round of investment, according to Gigaom.)
The math is appealing: rather than obsessing over whether one specific opportunity or another is likely to be groundbreaking, the way most VCs do, here, you try to eliminate the real dogs, and then simply roll the dice (and administer some TLC), hoping that a few of these bets yield an outsized payoff. The key premise is the humility to believe at the start that neither you nor anyone else really knows which opportunities will win big.
There are a few obvious problems with this approach, of course. For starters, you risk running out of money, and hence not realizing your payoff because you can’t afford to stay in the game. This is a classic dilemma faced by undercapitalized seed-stage investors – they put in a ton of sweat equity, but then can’t contribute adequately to subsequent financing rounds and thus get diluted out.
The second problem is that success for a venture investor may not depend simply upon the number of opportunities, but also upon the degree of involvement with each investment. Or not. Most VCs believe they add a significant amount of value this way, while most entrepreneurs I know have a more mixed view, at best. While the investment team of 500 Startups is known for their boundless energy, it’s still hard to envision it’s physically possible for them to devote the time and attention to each of their portfolio companies that a more focused VC could – at least in theory.
A related feature of McClure’s investments are that he specifically – and provocatively – states he’s not looking for groundbreaking innovations, companies that will “change the world” (in stark contrast to many other VCs, who may be running far larger funds). Rather, he seems to be looking for small wins in defined niches – narrow customer segments that larger players have overlooked. Of course, this probably also impacts the size of return a successful investment is likely to deliver (unless you really believe there’s absolutely no correlation between scope of original ambition and the size of the company that develops from this vision).
McClure’s investments also appear to be informed by a deep commitment to diversity (see this recent TechCrunch interview), for what I’d call all the right reasons. The idea – which I’ve also heard well-articulated by Dean Nancy Andrews at Duke University – is simple: most tech VCs (so it is argued) have a fairly similar idea of what an entrepreneur looks like and where to find him. For McClure and others, this represents what is effectively an outstanding arbitrage opportunity – by embracing a less restrictive view of what talent looks like (on parameters such as geography and gender), these investors in theory have easy access to a relatively untapped pool of exceptionally talented entrepreneurs who have been overlooked by traditional investors, but who can deliver substantial innovation nonetheless.
McClure is absolutely on target here, as I’ve touched upon in two different WSJ book reviews. In my discussion of Malcolm Gladwell’s Outliers, I note that the book,
“offers an implicit message for companies as well: There is great competitive advantage for the organization recognizing that the work environment can nurture talent – and also suppress it. The best companies will not only seek to provide their employees with enrichment but will also have the insight – and courage – to identify and recruit exceptional though neglected talent that could flourish under the right conditions.”
Similarly, in my WSJ review of George Anders “The Rare Find,” I write, “The real challenge may not be so much identifying talent as getting serious about seeking it.” Clearly, McClure is both serious and expansive in his pursuit of talent – and it’s difficult to envision this as anything but great.
The last question to think about is whether McClure’s approach has implications for investments in digital health, an area he has placed only a handful of bets (and that’s counting generously).
First, the bad news: McClure’s approach seems very poorly suited for the one area I can think of where it is most needed: biopharmaceuticals. It’s incredibly difficult to know whether an emerging compound, or an emerging company (frequently the same thing) is going to succeed or not, and unfortunately, it takes scads of money and a lot of time to find out – even if you employ the lean and/or virtual approaches that proponents advocate.
The truth is that what you really would like to do in early stage drug development is place a lot of small bets, and quickly kill all but the most promising products – and everyone knows this. Moreover, all consultants recommend this approach – and then invariably blame leaders for their unwillingness to kill favored programs.
The reality, unfortunately, is a lot more messy. In most cases, I don’t think you can make intelligent and accurate early decisions about which compounds are clearly going to fail, and which might eventually succeed – it’s just not that obvious. Most blockbuster drugs that I know of – including Lipitor – could easily and rationally have been killed for one reason or another at some point in their development.
Hopefully, and through improved science, we can get smarter about killing drugs earlier, but at least right now, the truth is you have to do a lot of work to figure out what will work and what won’t – and it’s expensive and time consuming.
I’m considerably more optimistic about the prospects of McClure’s approach for digital health. To date, my sense is that the thinking around digital health bounces between a laudable but abstract vision to “disrupt everything,” and a number of pretty trivial apps that are technically clever but which don’t really address an unmet need.
I suspect that a McClure-style approach that preached a relentless, iterative focus on the customer, and which was comfortable concentrating on a narrowly-defined segment of customers, could ultimately be extremely impactful, and represent a compelling way to channel entrepreneurial passion into improved health.
Addendum (July 21): Readers might also enjoy my WSJ review of “Little Bets” (by Peter Sims); this recent, thoughtful discussion of small bets in the context of science funding, by Jason Hoyt; and this Atlantic piece I wrote addressing the need for design thinking in health care, but also questioning whether this would be enough to drive new cures.
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