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Q&A: How to Approach a Hot Sector

Amid the hot returns of IPOS like Marketo (MKTO), Textura (TXTR) and Rally Software (RALY), there seems to be no loss of investor appetite for cloud companies.

But can the good times last?

To get some insight, I talked to Craig Hanson, a venture capitalist with Next World Capital, whose recent investments include GoodData, Zuora and Datastax.

Craig is no stranger to the VC world. Prior to starting NWC, he worked at firms like FTV Capital and Vista Ventures, during which time he invested in Rally.

The going could get tougher in finding huge returns, however. “In enterprise IT, valuations and round sizes at all stages have risen significantly compared to historical standards, which increases the pressure on investors and raises the expectations hurdle for companies,” Hanson said.

So how is Hanson dealing with this? Well, he has provided six approaches for the situation at hand — and some of the advice is good for most investors in general:

#1: Don’t rationalize high valuations for a broad set of the space.

Call this the “this time it’s different” path. The logical fallacy is applying the high valuations of the top-tier performers to the next couple tiers of the pyramid, based on the anecdotal evidence of a select few stars who justified their high valuation. Investors in this broad-based path look smart on the upswing, and after that … well, you know the rest of the story.

#2: Selectively justify high valuations for only a small subset of the market.

This path says that a few exceptional companies truly deserve great valuations, very good companies deserve very good valuations, and so forth. The difficulty is that you have to be discerning enough to know the difference. Not surprisingly, doing so requires in-depth sector knowledge and rigorous due diligence. The good news is that this will make the venture capital investor a better, more helpful board member, and might even help CEOs see some new insights.

#3: Don’t accept lower returns for the venture capital round.

Some VCs are consciously or subconsciously accepting this, and justifying it with either the greater safety of the investment or the “franchise value” of being associated with a high-flyer. The problem: Achieving subpar returns is rarely a long-term successful strategy, and the limited partners who invest in VC funds are ultimately not impressed by the logos a VC racked up.

#4: Consider the road less traveled.

While tech sectors can be famous for piling on in hot areas — then collectively moving on just as quickly — there are lots of areas that are undercapitalized. These areas can be different sectors that currently are less hot or that traditionally get overlooked, or geographies outside of the major tech hubs. Exits might not be as high, but neither are the entry points. VCs should remember that the key metric of success is not absolute valuation at the time of exit, but the value creation since the time you got involved. By focusing on customer needs and innovation for users, entrepreneurs and their investors can build amazing businesses.

#5: Consider getting in earlier.

In some ways, investing at an earlier stage (e.g. Series A instead of Series C) does lower the absolute valuation of a company and give VCs a little more room to make a decent return on typical exit valuation ranges. The problem: The risk at earlier stages is almost always higher. Valuations and round sizes have risen at all stages of the company lifecycle, so you’re not necessarily getting a better risk-reward balance by just going earlier.

#6: Be disciplined.

This path can be the hardest — it means being willing to walk away or lose an opportunity if you soberly determine that it looks like a great company, but not a great investment.

In light of all this, Hanson is certainly being selective. Here’s his take:

“At Next World Capital, I believe we’ve pursued a strategy of #2, #4 and #6. Our investing philosophy is to know our focus sectors with great depth and rigorous work, in order to find the single leadership company either disrupting a big existing market or pioneering a new one. We’ve also been disciplined and not invested when we don’t find a great fit or justifiable terms.

Finally, we’ll invest outside the usual areas, geographic or sector. For instance, when we started investing in mid-2010, the consumer space was red hot and very highly valued, but the “un-sexy” enterprise space, where we have a lot of experience and knowledge, was overlooked. As a result, we built a strong initial portfolio of companies in areas like SaaS, cloud and storage; fast-forward three years, and those sectors are now getting a lot of attention.”

Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO StrategiesAll About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.

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