The trick this VC used when talking to entrepreneurs

October 29, 2010 — 3:38 AM UTC by Andy Rachleff, Guest Columnist

2 Comments

Elizabeth’s note: It’s been oft observed on our web pages that the independent advisory business is a young one. For the industry to grow into a real alternative to Wall Street, a larger number of RIAs will need to figure out how to scale their business up. In this column, Andy Rachleff, president and chief executive officer of Wealthfront, brings the perspective of an outsider and a former venture capitalist to the question of how they can do so. After I read it, I was already thinking about how Pareto’s principle applies to RIABiz.

Over my 25 years as a venture capitalist in Silicon Valley I have had the good fortune to observe many start-ups. While some of my former firm’s investments went on to become billion dollar enterprises (eBay, Equinix, Juniper Networks & Red Hat Software, among others), others failed miserably. One common characteristic across all our portfolio companies was: They were seldom able to do more than one thing well.

Registered Investment Advisers (RIAs) are often no different from the tech companies we backed. They’re led by bright and motivated entrepreneurs who want to build great businesses and serve their customers. However, they also sometimes tend to want to do too much. The best way to scale a business is to figure out what you do best and focus solely on it. As for the rest, if it’s not your strength, outsource it. If it’s not important, don’t worry about it.

80/20 rule applies to management



One of my favorite mantras is “Pareto is the patron saint of start-ups.” Vilfredo Pareto was a mathematician who observed the “80/20 rule.” Eighty percent of the wealth is owned by 20% of the population. Eighty percent of the sales are generated by 20% of the sales force. Eighty percent of the returns are generated by 20% of the positions. It’s amazing how it applies to almost every statistic … and that includes management. Managers who determine which 20% of their business will generate 80% of the value almost always win.

As a board member, I often use the following little trick to see how “Pareto-optimized” the CEO is: I ask a lot of questions, not all of which are relevant and most of which can’t be answered immediately. The CEO who responds with all the answers seldom succeeds. Rather the CEO who only answers the important questions is the one I’ll double down on. Finding the 80/20 is really a proxy for judgment.

 So what does this mean for an RIA?

You should determine what you’re best at. If it’s investing then you should spend the vast majority of your time focused on generating outstanding returns. Believe me, the word will get out to new prospective clients if you consistently perform well. Scott Cook, the founder of Intuit and one of the best marketers I know, is a big advocate of the “Net Promoter Score” as the best measure of the likeliness of positive “word of mouth.”

According to Wikipedia, Net Promoter Score is obtained by asking customers a single question on a 0 to 10 rating scale: “How likely is it that you would recommend our company to a friend or colleague?” Based on their responses, customers are categorized into one of three groups: Promoters (9-10 rating), Passives (7-8 rating), and Detractors (0-6 rating). The percentage of Detractors is then subtracted from the percentage of Promoters to obtain a Net Promoter score. A score of 75% or above is considered quite high. It’s no coincidence that companies with high Net Promoter Scores are successful and profitable because they don’t have to spend much money or resources on marketing.

Lesson for RIAs from hedge funds

Then again, not all RIAs are great investors. If you’re great at customer relations, then partner with a firm that is great at investing. While it’s true you might not make as much money in the short term, the partnership of a great relationship firm with a great investment firm will lead to happier clients. If sales are your specialty, perhaps you might be better served offering your clients access to other money managers for investment advice.

Operations is seldom a competitive advantage, so by all means outsource it! Almost every hedge fund I know does. I have often heard RIAs say, “I can’t scale my business because I can’t hire operations people fast enough and that’s not how I want to build my firm.” It’s almost impossible to find an IT start-up that runs its own operations anymore. I don’t know any RIAs who want to be IT experts.

Partner with software providers who offload all the work by offering software as a service (SaaS) so you don’t need to manage any computers or software. Ideally these vendors will provide open interfaces to your data so you can move to another vendor if you’re not happy with their service. It’s your data, not theirs. Don’t stand for closed systems. No one in Silicon Valley would. Why should you?

By determining which area of your business will generate the most revenue, and by pinpointing what area you’re best at and focusing on that area with a steadfast intensity, you will be well on your way toward bringing a new focus to your work that will make your clients, partners and Mr. Pareto proud.

A co-founder of venture capital firm Benchmark Capital, Andy is on the faculty of the Stanford Graduate School of Business, where he has developed new classes to help students succeed as entrepreneurs. Andy serves on the Board of Trustees of the University of Pennsylvania and is a member of their endowment investment committee. A graduate of the University of Pennsylvania, he holds an M.B.A. from Stanford Graduate School of Business.


Mentioned in this article:

Wealthfront
Portfolio Management System
Top Executive: Andy Rachleff



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Jim Cannon said:

October 30, 2010 — 1:00 AM UTC

Excellent post. I could not agree more with the advice to advisors to focus on what you do best and outsource the rest. We see too many advisors and firms attempting to put together the pieces of puzzle necessary to operate an RIA and struggling to establish and continue to operate the infrastructure they need. Without substantial scale and resources to insource technology, operations, investment management, and compliance, operators are faced with on-going challenges.

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Brooke Southall said:

October 30, 2010 — 4:29 PM UTC

In my day to day reporting for RIABiz, I am seeing more and more outsourcing by advisors. I attribute it to both the rising quantity and quality of outsourcing services available and to the growing understanding of RIAs about its importance. Some of this understanding can be attributed to wirehouse brokers who were accustomed to entrusting giant de facto outsourcers — their employers.

I like that Andy used hedge funds as an example in this article.

Brooke


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