Tech, Startups, Capital, Ideas.

Entrepreneurs often ask us to shed light on what venture capitalists look for in a prospective investment. The truth, as you’ve probably guessed, is it’s subjective, dependent on the philosophy of an individual VC and his firm. That said, I have noticed strong similarities among the winners that are more often than not absent in losers.

At the risk of dispelling our mystique, I’d thought I’d remove a bit of the mystery of VC investing. Something I wish someone had done for me back when I drained my bank account for my first startup.

Keep in mind that I invest primarily in consumer and business Internet companies.

I look for startups led by an entrepreneur with extraordinary market insight and the leadership, stubbornness, and passion to render his instincts into reality – in the form of a product or a service. I don’t mean a technologist in any traditional sense, but someone with true vision – a word that’s often overused.

How do I know when faced with the real thing versus a poseur? These entrepreneurs often start their pitch out by describing a critical change in market or technology that has happened or is about to happen. They see big waves ahead of others and capitalize on them. Or they are building a product for themselves, which is the root of their incredible passion. They simplify: they take things that are complex and simplify them so they can raise money, recruit people, and get users or customers.

Steve Jobs is the textbook example. I doubt that Jobs has ever spent much – if any - time coding or on CAD. And yet, his background and experience led him to be the driver behind many of the PC technologies we now take for granted. He popularized the graphical interface. (Yes, he “borrowed” it from Xerox PARC, but it was Jobs - not Xerox - who understood its potential and ran with it.) The advanced multimedia in the Next machine is standard in today’s PCs and Macs. Jobs’ products are sometimes like concept cars; it can take years before the rest of the industry catches up to him.

That brings me to a second key ingredient in any good deal – early market validation. Yahoo and Google already had very significant user bases when their VC’s invested. Calculated risks like Yahoo! and Google are popular these days with VCs, many of whom - dare I say it - were responsible for their share of “irrational exuberance” during the boom and then lived to regret it.

I like entrepreneurs who do a lot with a little. It’s a bias formed when I was forced to make do with the little that I had in my bank account. Take hi5, an online social network with 80 million registered users. Hi5 scaled to 25 million users on a relative pittance - $250,000. We were the first institutional money in. Another MDV investment, Infusion Software posted incredible revenue growth last year (I can’t disclose their numbers) with only minimal investment and a bit of debt prior to our investment. You can test the market for software with - at most - millions of dollars. It still costs tens of millions of dollars to scale up; otherwise VCs would be cut out of the software business.

Why is early market validation so important? Because it’s a good indicator of an entrepreneur who’s not only not afraid to test out his product in the market but also of one who has insight into efficient user acquisition. The world of software today is often much more about cracking this problem – user or customer acquisition – than about the technology itself.

This leads me to the final key ingredient: efficient customer acquisition and retention. For $100,000 a month, anyone can corral a herd of users to sample a hosted business application or a Web site, but few are able to convert them into loyal customers without spending a prohibitive sum on sales and marketing.

Companies like hi5 have perfected what I call “Zero-Cost User Acquisition.” Business Internet companies like Genius, Infusion, and Ironkey spend more to acquire customers, but they also collect more revenue per user. PBWiki, meanwhile, spends next to nothing on marketing and leverages their incredible brand with consumers into paying customers on the business side. Their consumer wikis get rave reviews, and more importantly, generate leads that they efficiently and for little additional investment convert into paying customers for their business Internet product.

Now the hard question, which is the most important of the three ingredients? Having both the visionary and early market validation is ideal. Of course, there are a number of incredible entrepreneurs worth funding just at the vision stage. The hard part for any VC is realizing when you’re looking at the real thing.

The secret ingredient is luck. Because luck is unpredictable and hard to come by, few entrepreneurs replicate success. But that’s a topic for a future blog entry.