Circle of Competence and the Venture Capital Investment Triangle

By: Aaron Holiday and Nnamdi Okike

“It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.” – Warren Buffett

Innovations almost always build on previous breakthroughs. At 645 Ventures we draw inspiration from a wide range of innovators who are masters of their craft, ranging from investors and entrepreneurs to social justice leaders, athletes, and musicians. By studying the greats, we are inspired to build on past innovations and apply them in ways they were not originally intended.

A unique aspect of venture capital is that it embraces frequent errors in investment judgment. Errors are typically chalked up to the fact that venture investing encompasses high risk and high reward. However, while embracing failure is good in terms of enabling venture risk-taking, it also makes it more difficult to define exactly where a VC should invest, and which areas are in fact too risky for consistent success.

So we set out to analyze venture capital risk and investment decisions through the lens of one of the greatest investors of all time, Warren Buffett. One might think this an odd choice because Buffett invests in fundamentally different assets than early-stage venture capitalists and often criticizes venture-backed startups and markets. However, we find his framework for analyzing errors very relevant and draw inspiration from his breakthroughs to define a concept that we call the VC Investment Triangle.

Buffett coined a concept he called the investor’s circle of competence. The circle of competence is the set of investment opportunities that an investor is qualified to evaluate, given the investor’s knowledge and experience. Buffett defines an investor’s circle of competence in the following way:

“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”[1]

Buffett describes his process for assessing whether a prospective investment opportunity is in his circle of competence this way:

“I’ve got to decide first, whether I can actually see out five or ten or fifteen years, and have a reasonable probability of gauging the future. And there’s a lot of businesses that I can’t do. So I say, is [this investment] in my circle of competence?”[2]

Buffett also uses the circle of competence to define investing mistakes. He separates investing mistakes into two categories:

1. Mistakes of commission
2. Mistakes of omission

A mistake of commission is making an unwise investment that you should not have made or knew enough to avoid because it was outside your circle of competence. A mistake of commission is like knowingly swinging at a bad pitch in baseball. You knew enough to stay away from it, but you swung anyway.

A mistake of omission is the opposite type of mistake. It is unwisely not making an investment that was within your circle of competence. Buffett defines these mistakes as “the things I knew enough to do, they were within my circle of competence, and I was sucking my thumb.”[3] A mistake of omission happens when a pitcher throws a slow pitch right down the center of your strike zone, right where you like to hit it. Instead of swinging and hitting a home run, you keep your bat on your shoulder and are called out on strikes.

Mistakes of omission in venture capital are more complicated and quite costly. They are often memorialized in VC firms’ “Anti-Portfolios”, which frequently include startups that have become billion dollar companies. In a subsequent post, we delve into these misses, which we argue are caused by VC Blind Spots.

In this post, however, we focus on identifying when to swing for the fences as a VC. We do this by iterating on Warren Buffett’s Circle of Competence to create the Venture Capital Investment Triangle.

Circle of Competence

To define the circle of competence, we begin with Buffett’s original insight. An investment within your circle of competence is one which you understand a product and market well enough to effectively gauge its probability of future success. As an example, if you are a seasoned early-stage software investor, a new early-stage marketing SaaS prospect should be within your circle of competence. A growth-stage biotech deal would not be in your circle of competence, because you know nothing about biotech.

Your historical investment track record should validate that you are able to pick a winner within your circle of competence relatively consistently, and more frequently than investors without your track record and experience.

This traditional conception of the circle of competence is depicted below.

The Circle of Competence [4]

This may seem straightforward. But upon closer analysis, in venture capital, the circle of competence is much more nuanced because most new technology areas have poorly-defined products and markets in their early days. In these investment opportunities, there are usually no experts. So there are serious limitations to “what you know” in these situations, and you may have to rely on “what you think you know” in order to make the right investment decision.

As an example, if you were an investor focusing on software when Salesforce.com was first founded, you would have had no historical context on SaaS businesses or their characteristics. You would not have known whether businesses were willing to store their data in the cloud, whether data would be secure, whether the web would scale to meet enterprise needs, or how the market would value SaaS companies. So it would not have been possible to fall back on your historical knowledge or experience.

So what are VCs to make of the circle of competence in these scenarios? To help us evaluate them, we apply a framework called the Innovation/Market map that is taught at Cornell Tech[5]. The framework helps founders evaluate new startups by placing them on a 2-dimensional graph. The scope of innovation is on the X-axis, and the level of market maturity is on the Y-Axis.

The Innovation/Market Map

We have defined distinct stages of market and technology innovation on this graph. In markets, there are existing markets, known markets, and speculative markets. Existing markets are well-defined, and there is a large number of customers in the market that seek to transact. Existing markets are highly competitive and usually, have a “category king” in place[6]. These category kings usually create moats that prevent new entrants from gaining market share.

Known markets are moderately defined. There is evidence of customer demand, but market participants are more limited, and business models are in flux. Speculative markets are not well-defined at all. Customer demand is often non-existent, and there have been very few successful investments made in these markets.

We define four levels of innovation in this framework: gimmick, incremental, radical, and disruptive. A gimmick in this context is the application of a known technology that is used in a trivial way that won’t lead to a large scale business but may lead to a fad. A good example of this might be the selfie stick, which generated temporary demand but was easy to copy.

Incremental innovation builds on innovation that has come before but does not introduce something fundamentally new, and adoption of this technology is relatively easy. This type of innovation is frequently applied to established markets. An example of this might be PC clones such as Dell and Compaq that arose after the personal computer was first invented, accelerating mass adoption of computers by lowering price and making computers more affordable.

Radical innovation consists of meaningful technical progress, which introduces new customer behaviors. An example of radical innovation would be the digital music player, which transformed how people listened to and shared music. Disruptive innovation consists of highly transformative technology breakthroughs that have the potential to transform customer behavior in a significant way, but where initial adoption may take time. A great example of disruptive innovation is a fully autonomous driverless car network for on-demand transportation run by a decentralized company using smart contracts.

Superimposing the Innovation/Market map developed at Cornell Tech with Warren Buffett’s Circle of Competence, we re-frame how to think about the circle of competence for VCs, a framework that we call the VC Investment Triangle.

645 Ventures’ VC Investment Triangle

There are several key aspects of the framework. First, the most obvious is the lower left area of the graph, where existing markets meet gimmicks and incremental innovation. In traditional areas of finance, this is where one might find an investor’s circle of competence. But venture capital is different. Although companies in the bottom left circle are easy to identify and assess, they are unlikely to generate exponential growth opportunities. Any differentiation that they have is quickly competed away by new entrants, and their innovations are not substantial enough to create large, new markets.

Seasoned VCs can move very quickly and eliminate companies in the bottom left through their depth of understanding of markets and which technology is truly differentiated vs. replicative. Seasoned VCs have a high degree of confidence that these companies will not reach large scale. In the bottom left circle, seasoned VCs avoid mistakes of commission, and where unseasoned VCs may get caught in a trap. Omitting investing in this area is one way in which the best VCs preserve their bullets to invest in companies that can be much higher return multiples. And finding these high-return investments is a prerequisite for being in the top decile of VC firms.[7]

The outsize returns in venture come from companies outside this traditional circle, where innovation shifts from incremental to radical/disruptive, and markets shift from existing to known/speculative. So, to succeed in venture capital, VCs have to actually invert the Buffett framework, and invest outside of the areas that they know with the highest confidence.

This leads to the question, which areas outside of the traditional circle of competence should a VC invest in? We argue that VCs greatest returns are within the right triangle that is depicted on the graph, which we call the VC Investment Triangle. See the diagram below.

Let’s evaluate multiple points on the right triangle, starting with the top left vertex. At the top left vertex of the triangle is an incremental technology being applied to a speculative market. One often sees these types of companies in the consumer sector, where a product has the opportunity to create a new market. For these companies, an investor with a deep understanding of a technology’s applications is more likely to understand how it can be applied to a new market.

Consider an investor with a deep understanding of hardware technologies evaluating personal health tracking devices around the time when Fitbit was founded. At the time, while hardware capable of tracking health characteristics such as sleep patterns, activity levels, and training achievements had been around for some time, it had not yet been put in a form factor and price level to make it accessible to the consumer mass market. However, an investor with an understanding of the capabilities of this incremental technology would have been able to understand its applications to a market that was still speculative.

A second key point in the right triangle is the area at the right-most vertex of the triangle, where the market is known, but the technology is still in the disruptive phase. In these investments, the customer pain point is well-defined and customers are ready to transact, and the question is whether the new technology can solve that pain point.

A good example of this type of market recently is the driverless vehicle market. The technology built to power driverless cars and trucks is certainly disruptive, and may indeed transform the nature of transportation. While the first internal combustion engine vehicles were created in the early 1800’s, and the first mass-produced vehicles were designed by Henry Ford in the early 1990’s, the prospect of vehicles that do not require human operation may introduce entirely new human behaviors. A business in this category is Cruise Automation, acquired by GM for $1 billion in 2016.

The third key point in the triangle is where a radical technology combines with a known market. This is where the best venture opportunities typically arise. This is typically referred to as the Adjacent Possible. Consider a VC with deep experience investing in mobile technologies evaluating new markets for mobile apps in 2011/2012. At that point, mobile technology innovation was in the radical phase. The app store had been introduced, cell phones had dramatically increased capabilities, and there were a broad range of new markets where mobile was being applied. That investor would have been able to effectively understand how mobile technology through GPS and mobile payments could transform the transportation market and enable a new market to be created, that of smartphone-enabled taxi ride-hailing. An investment in Uber or Lyft would, therefore, have been in this investor’s strike zone. One could argue that while the traditional taxi market had existed for a long time, the advent of the smartphone fundamentally changed the realities of that market forever.

A final area within the triangle is the bottom left corner of the triangle, where an incremental technology meets an existing market. This is often where a technology reaches the mass market, where product price points have been driven low enough and the experience is well-accepted enough for the average person to buy a product. A great example of a company in this area historically is Dell Computer. Capitalizing on consumer demand for personal computers, combined with decreasing prices for components, Dell enabled a customer to build their own computer. This innovation spurred adoption of the PC by the average consumer.

A dangerous investment area that is generally outside a VC’s Investment Triangle is where innovation is disruptive and a market is undefined. This is the area to the far top right corner of the graph, outside the right triangle and outside of Buffett’s second circle. This is the area that is most risky, and where you might find companies like Magic Leap and Space X. In this area, while a VC may think they know a potential outcome, that VC is likely just guessing because there is little to go on. These investments will require longer time horizons and significant amounts of capital to sustain themselves until the markets and value propositions catch up. Investing in this area (a.k.a Frontier Technology) is akin to funding research, and for a VC firm to win here, that firm must make several concentrated investments in Frontier Technology to account for the outsized risk of this category. However, winning here will also generate outsized returns. Some of the firms that have done well in Frontier investing include Lux Capital and Founders Fund.

There is a difference between a true hypothesis and a wild guess. A hypothesis is rooted in a well-defined theory about how a market or technology innovation is going to play out.

A final key area to note is the area below the right triangle. In this area, markets are well-established, and customer behavior is ingrained. We argue that this is not a great place for VCs to invest, because even where a disruptive innovation arises, there will likely be diminishing returns, due to aggressive competition. Price competition also occurs here, driving down margins.

In the words of legendary investor Howard Marks, “it’s the investor’s job to intelligently bear risk for profit… and great investors are those who take risks that are less than commensurate with the returns they earn.” [8] VCs who understand their own Investment Triangle are more likely to take the right kinds of risks.

It’s important to note that the Investment Triangle will be different for each firm. The Triangle of a deep tech-focused firm with advanced engineering experience and Ph.D.’s on the team will be moved further out to the right than that of a generalist firm without deep engineering expertise. Consumer behavior that has been adopted in one country may make a market less speculative than in another country, which will impact the perspectives of VCs in each country. The key thing is that a VC firm must diagram the triangle based on its specific knowledge and expertise.

In the second post of this series, we take a deep dive into VC investing mistakes, to understand why they venture outside of their Investment Triangle or pass on investments within their Investment Triangle, and why these mistakes can be costly.

1. Berkshire Hathaway 1996 Shareholder Letter
2. Warren Buffett Describes the Circle of Competence, Jack Welch Management Institute
3. Warren Buffett Speech to the University of Georgia Students Part 1 (Archive 2001)
4. Understanding Your Circle of Competence, Farnam Street
5. The Innovation/Market Map was defined by Greg Pass, former CTO of Twitter and Chief Entrepreneurial Officer at Cornell Tech.
6. Please refer to the book “Play Bigger” for a definition of category kings and their characteristics.
7. Legendary VC Fred Wilson has written, “Every really good venture fund I have been involved in or have witnessed has had one or more investments that paid off so large that one deal single handedly returned the entire fund.” See “Venture Fund Economics: When One Deal Returns the Fund”, AVC
8. Howard Marks, “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor”, Columbia Business School Publishing, at page 71.