Venture Capital Blind Spots:
By Nnamdi Okike and Aaron Holiday
“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological” — Howard Marks
This post is Part II in our series on venture capital investment strategy, following the “Circle of Competence and the Venture Capital Investing Triangle”. In that post, we defined the Venture Capital Investing Triangle, expanding upon the traditional circle of competence and proposing a new model for how VCs can define their sweet spot based on product and market. We received very positive feedback on that post, and hope it will be a valuable framework.
However, some VCs don’t define their focus by product or market. Many pre-seed and seed investors focus primarily on founder characteristics, understanding that some great founders will eventually find product-market fit, even if the product or market changes. This approach can be effective when there is very little information on business performance and when the market opportunity is highly speculative. Other VCs focus primarily on early traction metrics, considering evidence of strong traction as sufficient to validate product and market.
All of these approaches can be applied successfully and combinatorially. While we believe that having a defined product-market strategy increases the probability of long-term success across market cycles, we also realize that there are many ways to successfully generate alpha in early-stage investing.
In this post, we take a different approach to assessing investment decisions. Instead of further defining a model of success, we attempt to explain the key drivers of investment failure. We begin by asking the following questions: What are the most common investment mistakes that VCs make, and why do they make them? And which of these mistakes are most costly?
We explain the two main types mistakes VCs can make, specifically placing bets on investments that fail (Mistakes of Commission) and failing to place bets on investments that win (Mistakes of Omission). While there is a range of reasons why VCs miss deals, we hone in on perhaps the most costly of all mistakes: Missing a huge winner in your strike zone because you overlook, or fail to comprehend, the potential of the opportunity.
We describe these particular mistakes as Blind Spots. At 645 Ventures, we’ve identified the 7 blind spots that most frequently result in VCs missing the largest breakout successes. They are:
- Mis-evaluating the Founding Team
- The Valuation Trap
- Mistakenly Thinking You’re the Target Customer
- Mistakenly Thinking a Market is too Small
- Assuming a Market Has Already Been Won
- Missing a Behavioral Change
Why are Mistakes of Omission So Costly for VCs?
VCs frequently make investing errors. According to an article by Chris Dixon of a16z, using data from fund-of-funds Horsley Bridge, the worst VCs lose money on almost 80% of their investments. Average VCs lose money more than half the time, and even the best VCs lose money on more than 40% of their investments.
As VCs, why do we so frequently commit investing errors? There are many reasons. Sometimes we misevaluate founding teams, failing to identify flaws in the founders’ makeup. Other times we feel a special connection to an idea, blinding us to insurmountable product, market, and competitor challenges. Sometimes we’re wrong about how quickly a market will develop, and the startup runs out of money before the market materializes. FOMO also plays a role. If everyone is investing in a sector, why shouldn’t you jump in too?
We could dive much deeper into mistakes of commission, but we will not do so here. That is because mistakes of commission are not the most costly VC investing mistakes. Mistakes of omission are much more costly.
This might seem a counter-intuitive. Why should we care more about the great deals that we didn’t do, rather than bad deals that we did? Why is missing a huge winner the most costly investing mistake?
We care so much more about the big misses because venture capital returns are governed by a Power Law Distribution, where a small number of companies generate the vast majority of industry returns. Horsley-Bridge’s VC return data indicates that only 6% of deals generated 60% of U.S. fund returns between 1985 and 2014 . In the most extreme form of the power law distribution, the largest technology exit of the year is often larger than every other exit in that year combined. Put simply, it doesn’t matter if you lose money on 9 out of 10 deals, or even 49 of 50, so long as the one remaining investment is in Uber or Airbnb.
So venture investing is all about investing in massive winners, not optimizing for failure rate. This reality makes mistakes of omission much more important in evaluating whether a VC firm will be successful. What do these mistakes look like, and why do they occur?
VC Investing Blind Spots: The Seven Deadly Sins
As smart as we VCs think we are, sometimes there are obvious facts looking us in the face that we choose to overlook or ignore, which can blind us to billion-dollar opportunities. These oversights are often due to cognitive biases. To illuminate them, we assembled a list of the seven most important blind spots that cause VCs to miss billion-dollar outcomes. We use examples from the “anti-portfolios” of top VC firms, including the Bessemer Venture Partners anti-portfolio, perhaps the best known list of VC misses.
- Mis-evaluating the Founding Team
VCs often pride themselves on being able to size up founding teams exceptionally well. But the truth is that VCs often misread or mis-evaluate founding teams. This can be attributed to pattern matching, which leads VCs to overlook founders who come from non-conventional professional backgrounds, did not attend elite schools or are building companies in categories that are not familiar to the VC.
Misreading founders also occurs because VCs may subconsciously be looking for founders who share similarities with themselves (homophily), and may not be able to effectively assess founders who have exceptional but different qualities. Also, VCs rely so heavily on deals that arrive through their networks, this ensures homogeneity in deal flow for VCs who don’t build diverse networks. This common identity bias is further exacerbated when the group of investment decision makers is homogeneous in background, race, and gender. Because all early stage deals are high risk and face many challenges, it becomes easy for a homogeneous group to rule out a founding team that doesn’t appear to check historical patterns of successful teams. This often means that female and minority founders are overlooked, either because they don’t inhabit the right networks, or because they don’t fit the profile of successful companies that have come before them.
As an example, more than thirty VCs and angels passed on Stitch Fix and founder Katrina Lake during their seed fundraising process, as Lake described in the podcast “How I Built This” . Although Lake attended Stanford University and Harvard Business School, VCs continually passed for reasons ranging from inventory requirements to the perceived addressable market size. The fact that Lake was a female founder, focused on a market targeting women, surely contributed to some of these investors passing. One of the primary reasons firms kept passing on Stitch Fix was because almost the individuals evaluating the business were all men. One male VC leveled with Lake, letting her know that while he was impressed by the company, he just couldn’t get excited about the personalized styling market . Stitch Fix, now public, is valued at over $2 billion and generates over $1 billion of revenue.
One way for VCs to avoid misreading founding teams is to become a prepared mind on the business and industry of a startup, while having an open mind, or beginner’s mind , relating to the founder qualities that are best suited for success. If a VC has a well-defined thesis around a market, and why that market might demand a new technology product or service, then evaluation of founding teams becomes a bit easier. A VC looking for the next great retail startup might start looking for someone who resembles Katrina Lake, a woman combining venture capital experience with a consultant’s analytical skills and a willingness to question established norms in retail, rather than the male engineer who dropped out of MIT.
2. The Valuation Trap
In an interview with the “Twenty Minute VC”, Midas List VC Peter Fenton of Benchmark describes turning down a company solely based on valuation as a mental trap. His rationale is that investments do not fail because of high valuations, in the same way that they do not succeed because of low valuations. It is the quality of the team, product and market that drive a great investment. Those qualities are independent of valuation, and focusing too much on valuation can obscure these qualities.
For the small number of companies that reach billion-dollar exits, passing due to a perceived high valuation at the early stage can be a massive mistake. So why do VCs frequently fall victim to this blind spot?
This blind spot arises due to the fact that it’s very difficult to grasp how large a company can become in its early stages. Fenton cites Accel’s Series A investment in Facebook as a good example. He says that if at the time of Facebook’s A round, if someone had said that the company would be worth hundreds of billions of dollars in the future, they would have been called crazy and “hauled away” . Even Accel, which invested at a very high perceived valuation at the time, had a blind spot about how truly large Facebook would eventually get.
The lesson here is that the size of the potential opportunity, and the VC’s assessment of the probability of a company achieving large scale, need to be evaluated carefully in the early days of the startup. One way to avoid this blind spot is for VCs to begin with the question, “How large could this company become if things go right?”. Where a VC has conviction that the potential outcome could be huge, it may make sense for him/her to relax their valuation and ownership requirements for exceptional companies.
3. VCs Mistakenly Thinking They’re the Target Customer
VCs often miss consumer deals because they believe they mistakenly are the target customer for the business. This creates a huge blind spot because the life of a VC is not like the average person’s, primarily due to differences in income but also lifestyle and geography. This often leads VCs to pass on products and services that don’t appeal to them, but which actually appeal to sizable segments of the population.
The gender and racial homogeneity of VC firms also play a huge role in this blind spot. The fact that such a small percentage of VCs are women, for example, often leads VC firms to frequently misunderstand consumer companies that are target women consumers.
The founders of Rent the Runway ran into this blind spot when pitching VCs in the early days of their company. One of the founders’ greatest fears during their early round pitches was that VCs would go home and ask their wives whether they would use the service . Why? Because the wife of an investor likely isn’t Rent the Runway’s target customer. Put simply, due to her household income, the wife of a wealthy venture capitalist may not frequently need to rent clothes.
This blind spot resulted in VCs passing because their wives weren’t demanding the service. To avoid this blind spot, the co-founders of Rent the Runway would invite the VCs to their pop-up shops, to see the actual target demographic enthusiastically using the service. The purpose of this creative ploy was to remind VC’s that there was a large addressable market that was passionate about Rent the Runway. Today, Rent the Runway has over 6 million customers, is valued at almost $800 million, generates over $100 million of revenues.
This blind spot can be avoided relatively easily by doing customer surveying and analyzing early traction data, which are often better indicators of actual demand for a product or service than the gut feel of a VC.
While we VCs pride ourselves on thinking independently, the reality is that we sometimes engage in groupthink, both within firms as well as between firms. Within VC firms, many firms often use a consensus-based approach to make decisions. This can lead to groupthink, and a tendency to pass on new business concepts that are perceived as irrational or contrarian within a group. A similar pattern occurs between firms when firms share notes on companies and founders.
The result of groupthink at the firm level is a herd mentality characteristic of investor syndicates. Many founders have found themselves not being able to convince any VCs to invest, then having many term sheets thrown at them simultaneously shortly thereafter. The participation of a top firm in a deal, such as Sequoia or Benchmark, is sufficient to attract a multitude of VCs who wish to invest alongside them.
A great example of VC groupthink at work is the fact that VCs missed investing in Salesforce. Marc Benioff, a previously successful salesperson at Oracle, went to raise venture capital in the late 1990s for the company. In Benioff’s words, “I had to go hat in hand, like I was a high tech beggar, down to Silicon Valley to raise some money… [And I went] from venture capitalist to venture capitalist to venture capitalist — and a lot of them are my friends, people I’ve gone to lunch with — and each and every one of them said no.”
In Salesforce’s case, VC groupthink was driven was driven by a combination of VCs being afraid of incumbents in the CRM market, as well as a failure to embrace the potential of software-as-a-service. The result was that investors missed out on one of the best software deals in decades. Groupthink is especially difficult to overcome and requires a willingness to depart from the herd.
5. Mistakenly Believing a Market is too Small
Reflexively thinking a market is too small is a frequent cause of VC blind spots. One of the best-known examples of VCs perceiving a market to be small/nonexistent is Starbucks in its early days. When Starbucks began, it proposed to sell gourmet coffee at a high premium to the price of coffee normally sold in coffee shops. The firm OVP Partners, which passed on Starbucks, tells the story: “A guy walks into your office… and says he wants to open a chain of retail shops selling a commodity product you can get anywhere for 25 cents, but he will charge 2 dollars. Of course, you listen politely, and then fall off your chair laughing when he leaves. Howard Schultz didn’t see this as humorous. And we didn’t make 500 times our money.” OVP believed that there was no market for Starbucks’ premium coffee, which may indeed have been the prevailing wisdom at the time,
Why do VCs often perceive new markets to be small? This happens for two reasons. The first is due to what we call a Sleeper Market. In this case, the potential market is actually large, but it is perceived to be small. This may be because of a new behavioral change, a growing trend that is very discernible until it has reached a large scale. In the case of Starbucks, there was actual demand for a gourmet coffee experience, which Howard Schultz first witnessed in Italy, and which he believed he could bring to the U.S.
The second reason is due to what we call an expansion market or Trojan Horse Market. In this case, the immediate market actually is small, but there are much larger markets than the startup can expand into. Facebook is a great example of this. It began by focusing on elite universities, but then rapidly expanded into the broader university market, then to high schools, then to adults, and today it covers more than 25% of the global population. The market for a social network servicing elite schools was actually a small market, but Facebook’s ability to expand into new markets was virtually unconstrained.
To avoid missing these markets, one strategy is to shift one’s attention away from what the market looks like today, and focus on the potential application of the underlying product innovation to a much broader range of customers, assuming that the underlying economics of the business (e.g., product price and COGS) may be able to change over time.
6. Assuming the Market Has Already Been Won
VCs often make errors because they come to a mistaken conclusion that a market has already been won. This often happens when a market is in reality in its relatively early stages. VCs may prematurely conclude that the market has been won by an early winner, or that the market will become a commodity market where companies will compete on price and margins will erode.
A great example of this is blind spot is the search engine market in the late 1990s. At the time, there was a myriad of search engines. Some, like Lycos and AskJeeves, had done very well. Some had failed. But many VCs mistakenly concluded that the market race was over and that the search engine was becoming a commodity business.
When a friend of Bessemer’s David Cowan suggested an introduction to the founders of Google, located in her garage at the time, Cowan replied, “How can I get out of this house without going anywhere near your garage?”  Like many smart VCs at the time, Cowan and Bessemer had a blind spot around the search market itself, believing it was too competitive and that the product was becoming a commodity at the time. But Google was in fact very different than other search engines, due to its innovative algorithm which focused on link relevancy, combined with a new advertising model that paid advertisers on actual click performance, and a superior user experience.
Avoiding this blind spot requires having an open mind about what future innovation may occur in a market and an understanding that technology cycles may be much longer than we perceive. It also requires a belief that incumbents have real weaknesses, and that a new startup that approaches a market differently may have the ability to enlarge an existing market significantly.
7. Missing a Behavioral Change
A common blind spot arises when a VC does not fully understand the nuances of a market change that has occurred. Because technology markets can evolve, what was once an unattractive market can become an attractive market over time. Previous capital losses and startup failures can obscure new market realities, making it difficult to see that technology improvements and changes in customer preferences may have changed underlying market fundamentals.
A great example of this is the electric car market. For decades, this market was one of repeated failure. Companies large and small attempted to build electric cars that could meet the performance and cost requirements of the mass-market consumer, and most failed miserably. After many decades of invention, in 2011 electric cars had roughly one-tenth of one percent market share in the U.S. 
However, these failures obscured the fact that over the course of decades the performance capability of electric cars was constantly improving. Cars could also travel much longer distances between electric charges, and overall performance was approaching that of gas-powered cars . The production cost of electric cars was also going down, making the unit economics more attractive.
When Bessemer took a look at Tesla Motors in 2006, Byron Deeter met the team and test-drove the car. He put a deposit on the car, but passed on the negative margin company, telling his partners, “It’s a win-win. I get a car and some other VC pays for it.” 
What Bessemer and many other VCs missed was that the electric car market was changing rapidly, and Tesla and Elon Musk were driving that change. Consumers, concerned with the impact of fossil fuel emissions on the environment, were willing to pay a premium for an electric car option. Tesla was also innovating quickly to improve its underlying profit margins and was rethinking the traditional car manufacturing process. Tesla today generates over $14 billion of revenue and has one of the highest gross margins in the car business. 
Although challenging, one of the best ways to avoid this blind spot is to overlook the failures and capital losses that may have doomed previous investments in a category, while closely studying the adoption curve of a new technology. One can also not underestimate the power of an outstanding entrepreneurial team to re-think a new category and shift consumer behavior.
Conclusion: The Harper-Collins dictionary defines a blind spot as “an area in your field of vision that you cannot see properly, but which you should really be able to see.” For VCs, blind spots are a natural result of how we have been trained to look at the world, where cognitive biases overshadow objective analysis. The challenge is to understand the limitations of our gut instincts and to embrace a diverse set of perspectives that help us overcome our individual blind spots.
At 645 Ventures, one of our foundational principles is to have a diverse range of perspectives, which we believe helps us to reduce the impact of individual blind spots. We aspire to learn from the great VC firms who have come before us, knowing that an inevitable mark of success in the VC business is to eventually have an anti-portfolio of our own.
- See “The Babe Ruth Effect in Venture Capital”, Chris Dixon.
- Benedict Evans, “In Praise of Failure”
- See “How I Built This with Guy Raz: Stitch Fix, Katrina Lake”. Katrina discusses their seed fundraise starting at 19:30.
- At 645 Ventures, we frequently remind ourselves of the quote by Shunryu Suzuki, “In the beginner’s mind there are many possibilities, but in the expert’s mind there are few.” We strive to maintain a beginner’s mind.
- See The Twenty Minute VC with Peter Fenton.
- For an entertaining interview with CEO Jenn Hyman relating to Rent the Runway’s fundraising process, see “Working with Venture Capitalists as a Fashion Company,” DraperTV.
- “The Anti-Portfolio”, Bessemer Venture Partners.
- See “Plug-In Electric Vehicles in the United States”, Wikipedia.
- See “With Improved Range and Speed, Electric Cars Move Into the Fast Lane,” NBC News.
- “The Anti-Portfolio”, Bessemer Venture Partners.
- See “How Tesla’s Disintermediated Channel Boosts Gross Profits By More Than 30%,” Seeking Alpha.