When a doctor examines a patient and comes up with a diagnosis of a very rare condition, another doctor might look at the first and say: “you’re finding a zebra there, but it’s really just a horse.” The guiding principle there is that rare diseases are rare, so you have to find extraordinary evidence to support the finding. Most hoof prints you see, at least here in America, are left by horses, not zebras.
Well, it turns out that most companies are also horses, not zebras. And amazingly few of them are unicorns! But angel investors and VCs are all out hunting zebras and unicorns, despite the fact that many of the horses are actually quite valuable.
In the Boston angel group community we tend not to look for unicorns – it’s just too expensive to feed them and too often the early investors get washed out somewhere along the way. We’re out hunting zebras, and I’m afraid we’re easily fooled by a few stripes painted on. Looking over my own portfolio, I think there are probably 20-25% that were really horses that my colleagues and I convinced ourselves were zebras. Some of this is certainly 20-20 hindsight, but I think many instances could have been foreseen.
Why do we do this? Well it’s largely because we can’t fund horses with our current model, so we grab out the stencil and paint and try to make a zebra. And pushing a company that’s really not a zebra to try to be one is actually detrimental to the companies that can’t make that transformation. Forcing hyper-growth onto a linear growth opportunity will usually end in disaster as the company constantly overspends its income to fuel growth while expecting the next round. And when the growth falls even a little short, the funding is likely to dry up very suddenly. When that happens the company is forced to seek profitability instantly, which usually means layoffs and general belt tightening.
When I hear from a portfolio CEO that they’re trying to achieve profitability after years of chasing explosive growth, I can read between the lines that they have not hit sufficient milestones to satisfy existing and new investors. At that point I drop my estimate of their market value from some multiple of my investment to 1x (get my money back) or 0, depending on how I feel about the remaining opportunity.
What does it take to make a zebra? Well, the main thing is to have a disruptive opportunity that will change a market space, as well as some kind of a “moat” to make it more difficult for others to compete. And you have to have the team that executes so well that you capitalize on the opportunity. Sufficient funding helps. And finally, luck helps. A lot of luck.
We too often ignore our own parameters and invest in companies that have no “unfair advantage” over their competition. These might be very fine companies that could make great sales with wonderful margins. But we are not happy with them if they do that, so we imagine them to be disruptive and invest.
So we are trying to find zebras, grooming a few horses to try to be zebras, and failing a lot of the time. What could we do differently? See the next post on revenue-based financing for a possible answer.