Yesterday evening I had dinner with a good friend of mine who is a world renowned cardiothoracic surgeon. I asked him if he followed a framework when dealing with each patient and he brought up the subject of differential diagnosis. At its core, differential diagnosis is a method used to identify a disease when alternatives are possible while utilizing a process of elimination. A doctor will assess a patient in context (symptoms, patient’s history) and taking into account medical knowledge, go through a decision tree, starting from most likely diagnosis, eliminating each alternative until the right diagnosis is reached.
There are two approaches to differential diagnosis. The specialist and the generalist approach. The specialist approach – used by a surgeon for example – utilizes a sharp shooter technique, selecting from the most likely to the least alternative, one alternative at a time. The specialist approach is narrow and deep. The generalist approach – used by a family doctor for example – utilizes a broad brush technique, also selecting from the most likely to least likely alternative yet considering a group of alternatives together. The generalist approach is broad and shallow (and I do not mean this in a negative way).
Medical doctors have to learn an incredible amount of historical knowledge and then have to practice extensively in live conditions, in hospitals, before becoming experts in their fields. The body of knowledge at their disposal does not change markedly – it is not like we are inventing new diseases, ailments, different ways of breaking a bone on a regular basis. The medical tools, medical drugs at their disposal, and the medical techniques do change. So there is a constant “on the job” training occurring.
The framework I use in venture capital strikes me as eerily similar to differential diagnostics. First, I am a specialist venture investor as I only invest in fintech. It goes without saying that I need to develop a very deep understanding of the financial services world in order to be effective at my job. Without explicitly knowing – it until now – I have developed a sharp shooter approach, akin to the one used by my surgeon friend, that allows me to very quickly assess the merits of a payments startup for example. For each of the five sectors that comprise fintech – lending, capital markets, insurance, asset management and payments – I have a top 10 of “things” I look for for which the presence or the absence are a deal killer. I rarely need to go past thing 3 or 4.
I use the sharp shooter differential diagnostic approach when I first encounter a startup. it is a way for me to eliminate the noise and get to the signs fastl. If I am still interested and impressed past this first stage, I will switch to a generalist differential diagnostic approach where I bunch groups of “things” and attempt to figure out, holistically adds systemically, patterns I like/do not like or that make sense/do not make sense, repeating the process until I eliminate the startup as a potential investment or I confirm my initial positive signal.
Much like my surgeon friend who has to go through thousands of cases per year to hone his skills, I go through approximately 1,000 business models per year. This is the material I need, along with historical knowledge base I built over the years – a mix of theoretical knowledge and many years of practice as both an operator and investor – to keep current. The number of business models does not change at the margin that much, the number of ways a team should be built, how a startup should be scaled, a board should be architected – all the business aspects of building a business – do not vary that much. What changes are the the technologies and how they are applied to specific business models. So I need to constantly learn that aspect to stay ahead.How AI, quantum computing, AR will be applied to fintech are my learning curves.
I continue to apply both differential diagnostics frameworks during the lifetime of an investment, constantly toggling from one to another.
I believe the best VCs are good at differential diagnostics. Not only because they master the framework and have built their own heuristics in their particular domains, but because they also know when to switch from sharp shooter to generalist differential diagnostics. That is a crucial skill. I also believe top VCs are more adept at applying differential diagnostics in context. By that I mean that – taking a fintech example – a US payments company may need a different sharp shooting approach than a EU payments company, while one may need the same generalist approach for both. It all depends on nuances relating to culture, jurisdiction, consumer/user behaviors, market structure. I tend to call these nuances “terroir”. Yes, I like wine. Knowledge of terroir will help you choose the right differential diagnostics approach at the right time, and load the right decision trees.
I also believe specialist VCs have an edge over generalist VCs. To be clear, both need to master the two differential diagnostic techniques. The specialist VC will always have an edge with the sharp shooter technique given the required deep knowledge she needs to operate in only one field. This is especially important considering the changing VC landscape is currently experiencing: the rise of crowdfunding and angel investing on one end of the spectrum and that of corporate VCs, sovereign wealth funds, mutual funds and large PE funds on the other end of the spectrum may force traditional VC funds to specialize in order to retain an edge. Specialized VCs may be the way of the future.
I am also well aware that medical doctors have an edge over venture capital investors when it comes to track records. On the evidence, declining mortality rates and improved longevity beat hands down VC-backed startup survival rates. This means that even with the best differential diagnostics tools and the most astute and timely ways to apply said tools and make a decision, venture investing is an extraordinarily difficult business to succeed in. There is much literature attesting to this fact. VC investing and startups building are ruled by power laws.
I do not pretend to disprove nor fight this fact. What I do is try to refine the odds ever so slightly. For me this means to always have Zebras in mind.
Theodore Woodward, a 1940s professor of medicine coined the aphorism “When you hear hoofbeats, think of horses not zebras.” He meant that if you diagnose something “normal” applying your diagnostic tools, there is a great chance it is indeed a “normal” thing and not something else, something “exotic”.
This works well in the medical field. Not so well in venture capital.
Hence, if there is one thing that keeps me up at night, it is Zebras. Due to the unfathomable emerging properties of large systems, venture investing breeds many more Zebras than horses, even though you may have correctly diagnosed a horse from the beginning. By that I mean that you may start with a horse, but due to unforeseen circumstances, you end up with something else, a Zebra. Very few Zebras end up with positive outcomes. The great majority of Zebras experience neutral to negative outcomes.
Thusly it is imperative to be paranoid about Zebras. I endeavor to excel at differential diagnostics which is a necessary requirement but not a sufficient one. Additionally I try to take risks I can measure in ways that attempt to mitigate negative Zebra effects. I shy away from entrepreneurs and startups that open themselves to fragility. I favor entrepreneurs and startups that strive to capture optionality and build antifragility. This means favoring entrepreneurs and startups that exhibit the right mix of technology, business and talent (the necessary requirements) AND that will thrive during volatile business conditions OR that do not include business variables whose rate of change increases negatively as business conditions fluctuate. Examples of fragility would be a cost of acquisition that increases as the startup increases traction, churn that increases the more clients are acquired, a loan default rate that increases as interest rates increase, a technology build that increases in complexity even as the startup matures. I picked up fragility and antifragility concepts from Nassem Taleb, and encourage anyone involved in investing and startups to read his work. Much more could be written about how one can apply antifragility thinking to startup investing; for another post maybe.
In as much as I apply differential diagnostics techniques to scrutinize the form and substance of a startup, my Zebra heuristics helps me understand the likelihood such form and substance will behave positively in dynamic situations. Not a perfect approach for sure.
The best VCs excel at diagnosing the right horses then shunning the patently negative Zebras. This still leaves the field wide open for a variety of surprises.