In honor of the new baseball season (and the start of spring), here’s a blog of mine that first appeared in Forbes. The basic idea? Instead of celebrating home runs alone, let’s bring the art of getting on base to the evaluation of venture capital…and see if that helps everybody rack up the wins.
What Entrepreneurs Evaluating Venture Capitalists Can Learn From The Way We Evaluate Baseball Players
In Major League Baseball, 2018 was the year of the home run. A record 6,105 home runs to be exact. 2018 was also the year of the strikeout, with 40,105 racked up across the 30 teams. It is, many have written, a new era of the game. There’s even a name for it: Three True Outcomes (home runs, strikeouts, and walks).
This is not at dissimilar from the all-or-nothing, home-run-or-bust approach taken by many venture capital firms. The “swing-for-the-fences” philosophy works for some fund managers and for some entrepreneurs as well. But for the vast majority of entrepreneurs who aren’t playing for an IPO, this approach can leave them stuck in the minors, waiting for a call up that’s never going to come.
The problem, for both baseball and entrepreneurs, is that the “Three True Outcomes” aren’t, truly, the only outcomes that matter. It may be much sexier to brag about hitting home runs, but baseball long ago figured out how to value singles, doubles, and triples too. It’s called Slugging Percentage. And it’s time to create one for venture capital.
Here’s how a Venture Slugging Percentage would work, what it would be good for, how else it might be used, and how I think we can get started bringing baseball logic to the investment process:
In baseball, slugging percentage is a measure of total bases per at bat. In other words: how successful a batter is, on average, for each at bat. It’s really a measure of both power and consistency, and it avoids overweighting the “noise” of a home run for the consistency of a solid approach at the plate. A Venture Slugging Percentage would work much the same way, and would be most useful as a tool to analyze a fund manager’s consistency, in addition to already existing tools for measuring absolute return.
Baseball’s slugging percentage formula is pretty simple: Take the number of hits, multiply by the number of bases for each type of hit, then divide by the number of at-bats. It looks like this: [(Single x 1) + (Double x 2) + (Triple x 3) + (Home Run x 4)] /Number of at-bats.
Venture Slugging Percentage could work the same way and utilize the same formula. We only need to agree on a couple definitions.
First: What we call a home run and however we’re measuring it (whether a multiple or internal rate of return) needs to be consistent. For the sake of argument let’s use a multiple. Let’s also agree that a home run is an exit that equates to a multiple of 5x or more—meaning the investors get a return of at least five times their investment. A triple is a 4x exit, a double is 3x, and a single is 2x. Anything less than that is an out (and grand slams, as in baseball’s slugging percentage, don’t count extra).
Second: We need to define what constitutes an at-bat. This is pretty simple. An at-bat is a portfolio company investment. If you have 10 companies in your portfolio, you have 10 at-bats.
The question is, what would this tell us? Basically, it’s a measure of consistency. It’s a formula that takes luck out of the equation. For example, let’s say there’s a venture fund with 10 investments. Of those, nine fail completely. One of them is Facebook. How good are the fund managers, really, at the VC game? The “Facebook Luck” is going to skew their numbers. By a lot.
A Venture Slugging Percentage (VSP) could enable interested investors to compare the consistency of fund managers, beyond looking at absolute returns. So a fund manager who hits a few singles, a double, and a (non-Facebook) home run in their 10 at-bats is, in reality, a lot more consistent than our first example. As Dave Chen, Chairman of Equilibrium Capital says, “The question of return consistency versus home runs is an age old debate. One big hit can make an entire year. So can a more consistent collection of quieter hits. What you look for is dictated by the approach you decide to take.”
For entrepreneurs, consistency across a portfolio might tell you which investors are best at nurturing their companies to success. Or which investors are only interested in spotting the next Facebook and, therefore, have neither the time, patience, nor latitude to consider something with a target market smaller than “everyone, everywhere, with an internet connection.” And since we know that a good relationship with the right investor greatly influences an entrepreneur's ability to succeed, understanding this entrepreneur-investor fit on the front end is important. “Finding an investor who shares your values and goals can make all the difference for an entrepreneur,” says Rob Lalka, Executive Director of the Albert Lepage Center for Entrepreneurship and Innovation at Tulane University’s A.B. Freeman School of Business. “If everyone’s priorities align from the very start, you can also align incentives and decision-making criteria in the short and long-term, which benefits investors and founders alike.”
Putting the question in baseball terms, imagine yourself as a General Manager faced with this team-construction conundrum: Would you rather have peak season Brady Anderson, or career Joe DiMaggio? In 1996 Brady Anderson, an outfielder for the Baltimore Orioles, had one of baseball’s all-time outlier seasons. He hit 50 home runs, had 110 RBI, and a batting average of .297. His slugging percentage of .637 was more than .200 points higher than his career average.
If Anderson’s 1996 season were a full career, his slugging percentage would have placed him second in the history of Major League Baseball, ahead of Ted Williams, Willie Mays, Mickey Mantle, Stan Musial, and, yes, Joe DiMaggio. I may be a Red Sox fan, but I’ll take Joe DiMaggio over Brady Anderson any day of the week. And that’s what VSP does. It helps us avoid mistaking the highest point for the best career.
Once I started thinking in the venture context, I wondered what else VSP could be used for. I came up with two other areas that align very closely with the world of Impact Investing and the Impact Economy, where I spend the bulk of my time. If you’re not familiar with Impact, think of it as an approach that seeks to generate both financial returns and a measurable benefit to society, within the same activity, business, or investment. It’s a field that’s experiencing tremendous growth and surging demand, and a place where I think a VSP-derived formula could be helpful.
Impact Slugging Percentage (ISP): Here, we’d be looking at specific types of Impact across portfolio companies or divisions (whether clean energy or education, health care or good job creation) and establishing goals across those various types of impact. Now, however, we’d be able to standardize for consistency in meeting those goals. We’re not trying to place an economic value per unit of Impact (there’s some very good work being done on that by my friend, Howard W. Buffett, at Columbia University), but are trying to understand the consistency of achieving, and skill in achieving, stated Impact goals.
Diversity Slugging Percentage (DSP): In this case, you could imagine setting goals for individual companies within an investment portfolio, or individual divisions within a corporation. This could help us understand which companies (or funds) are best at consistently building workplaces and cultures that are truly reflective of the communities they seek to serve. You’d establish goals and determine your single/double/triple/home run thresholds using a similar approach as with VSP. In this case, we could anticipate that achieving a diversity goal would be a single. Exceeding a diversity goal by 25% would be a double. 50%, a triple. 75% or more, a home run. And now we’d have a clear, consistent, and replicable framework for analyzing progress.
Here’s a final, but crucial, question: How do we start doing all of this? There are academic centers at major research universities, including Georgetown’s Beeck Center (headed by Sonal Shah, the first Director of the White House Office of Social Innovation and Civic Participation) already set up to handle the data analysis necessary to create a publicly available VSP/ISP/DSP index. Ideally, several of these centers would team together (baseball is, after all, a team sport), to explore the simplest methods of data collection, analysis, and reporting. This could (and should) also include a check list of questions for entrepreneurs to ask in evaluating a manager’s consistency and approach.
Once the models are run, if the concept of VSP proves valuable, we might see capital analytics firms (like Prequin and Cambridge Associates, among others) incorporate the statistic into their annual reports. Or Impact-specific analytics groups like GIIRS might add ISP to their fund evaluation criteria. The goal is to add a new tool to an existing set, to make the process of investing in entrepreneurs better for everyone.
Baseball and investing are ever-changing games, employing ever-evolving methods of measuring what matters. So, if we can bring some of baseball’s best lessons to the worlds of investment and entrepreneurship, maybe we’d better position ourselves to make the most of our opportunities at the plate. And that, no matter how you define it, would be a home run.