A Dozen Things I’ve Learned from Rich Barton About Startups, Business and Investing

Rich Barton started Expedia inside of Microsoft in the mid-90’s, then spun it out into EXPE in 1999 and was CEO until 2003.  He is a co-founder of Zillow, Glassdoor and Trover, an investor in a range of startups and a Venture Partner at Benchmark Capital. He is also on the board of directors of Netflix, Avvo, Realself and Nextdoor.
 
1. “Marketplace is an important word. It takes two sides to make a marketplace.”

User-generated content models are magic. And they are magic because the more reviews you have of hotels, for instance, the more it attracts users to the site. And the more users you have, of course, the more reviews you get. This is a very simple, elegant example of a positive feedback system. This flywheel spins faster and faster, and what happens is the competitive moat — the defense, the competitive differentiator or the moat around the castle — gets wider and deeper every day with every review that is done.”

The demand-side economies of scale (network effects) and associated supply-side economies of scale that are associated with certain systems are the magic that Rich Barton is referring to. Success with a user generated content business model feeds back on itself in a positive way to create more and more success (as in a flywheel). For example, if Side A values the platform more if there are more customers on Side B, there are positive network effects which are an attractive way for a technology company to create barriers to entry (sometimes called a “moat”). If the right marketplace-based flywheel is operating, the only real limit to success is the size of the addressable market. Marketplaces like Expedia, Zillow, and Glassdoor have multiple “sides” which interact directly through a “platform” which generates barrier to entry as more user generated content appears in the system.
 
2. “If you really do have a flywheel, it is OK to spend money to get it spinning. It is OK to do un-economic things to hand-crank stuff, so long as once it is spinning you can take your hand away.”  

Getting to critical mass with a marketplace platform is sometimes called overcoming the “chicken and egg” problem.  This problem can be described simply: How do you get one side to be interested in a platform until the other side exists, and vice versa. Part of the challenge is to get enough customers on both sides so there is critical mass.  Critical mass is tricky to obtain, particularly if the two sides need to show up simultaneously. Businesses that are slow to get to critical mass can run out of cash and momentum. How do you get one side on board? Well, one critical task is to acquire market participants in a cost effective way. What you want is low customer acquisition cost (CAC). Rich Barton is saying that investing money to get the flywheel spinning from a standing start is a natural part of the process. But the goal is to be able at some point to ramp down the spending once the positive feedback loop is operating.  One way to acquire customers in a cost effective way is with a great brand and a method of creating low-cost impressions.
 
3. “My tendency has been to focus on big vertical industry categories where there has historically been database information that’s been locked up behind walls by the industry.  I want to empower users to access that info. I like those verticals that involve real people, real decisions and real money because it is easier to monetize. It’s not a stretch to sell ads in the industry because they want to be there when people are making decisions.”

Expedia, Zillow and Glassdoor are prime examples that fit into Rich Barton’s “power to the people” thesis. Simply put, the thesis is: “If we’re doing things for regular folks that make their lives better and save them money and give them transparency, we’re on the side of the angels.”

Rich Barton tells a great story about power to the people in a Wired Magazine article: “[I wanted to give] consumers access to information and databases that they knew existed because they either saw or heard professionals over the phone clacking away on a keyboard accessing that information. I remember I wanted to jump through the phone and look at the screen myself, turn it towards me and just take control. And I knew that I would spend more time and do a better job searching than this person who was doing something on my behalf, and who really didn’t know my preferences but was just trying to approximate them.”

Rich Barton is also saying that certain vertical industries involve a lot of real money transactions and often high customer acquisition costs.  If you can create a user-generated content marketplace in a vertical market in which businesses pay significant amounts of cash for effective advertising, it is an attractive segment. Convincing people to pay for things that they have traditionally received for free is a genuinely hard problem. Startups are hard and challenging enough already that taking on addition very hard challenges that are not central to the creation of the core customer value delivered by the startup is unwise.
 
4. “What I tell people is, if it can be rated it will be rated. If it can be free it will be free, and if it can be known it will be known.”

Information that can be made digital is what economists call “a public good.” These sorts of goods are called non-rival (you having it does not mean others can’t have it) and non-excludable (you can’t prevent others from having it without paying you). Rich Barton is saying that information like this that is digital is increasingly not going to be sitting behind firewalls in a way that is not accessible by the public. The model of giving away information to create a marketplace is so strong that it is unlikely that someone won’t decide to make it free. Similarly, the power of a user-generated content business model is so powerful that everything will also be rated.
 
5. “Find me a provocative topic, and I’ll show you something you don’t have to spend a lot of marketing dollars to launch. People like to be provoked, and if you are provoking with information that is on the side of the angels, on the side of the consumer, the louder the industry reacts. And they just can’t win. It’s the greatest way to market, pick a fight with somebody who can’t win.”

What we see in the market today are businesses which are transforming controversy (e.g., Uber) or valued information (e.g., Zillow; Glassdoor) into free brand impressions, which lead to more usage which translates into more controversy or information (i.e., a positive feedback loop which can result in a moat).
 
6. “Ideas are cheap. Execution is dear.”

“Great leaders need three key attributes to successfully execute — brains, courage and heart [pointing to The Wizard of Oz as inspiration].”

Ideas are necessary but not sufficient for success with a startup. And the idea itself will inevitably evolve as time passes and the environment changes. Execution is a harder problem than generating a good idea. Finding a team to build the product, finding product market fit and scaling the business are the biggest tasks. I sat on the board of a startup once and it eventually was a very profitable category. The explanation is long, but the net result was that they always shipped late because they were always building more into the product than the market wanted, which made them late to market. The result was a 2X which is essentially a failure.
 
7. “It is much more powerful long-term to make up a new word (e.g., Expedia, Zillow, or recently Glassdoor, three words that my teams have created) than it is to use a literal word.  I also like high point scrabble letters in my brands if I can work them in. They are high point, because they are rarely used.  A letter that is rarely used is very memorable.  Z and Q are all worth 10 points in scrabble.  X is 8.  They jump off the page when you read them and they stick in your memory as interesting.”

“When you successfully make up a new word and introduce it into everyday language, you own it.  It becomes a major differentiating asset that cannot be confused with anything else or encroached upon by competitors.  At the very best, you end up defining a whole new category – Kleenex, Levis, Polaroid, Nike, eBay.  The downside to creating your own brand is that it is hard, and most of the time, very expensive and time consuming to hammer a new word into the consumer vocabulary.”

Creating a brand that is eventually a verb is an amazing accomplishment. People who make the effort to try to transform a “made up” word into a powerful brand are thinking big, which is attractive to a venture capitalist since they need tape measure home runs to make the venture capital business model work. That an entrepreneur is thinking they can turn their startup into a verb is a tell that they have the right mindset and DNA of an entrepreneur who should be seeking venture capital. But it is hard. Sometimes it is too hard. For example, Buuteeq eventually changed its name to Booking Suite.
 
8. “If you want to have a growing and vibrant organization you want to have big, new opportunities opening in front of you.”

It is much more interesting to work in an organization that is growing and vibrant.  Rich Barton was fortunate to work at Microsoft in an era when it was growing quickly and the opportunities to advance and learn were unlimited. When Microsoft was growing quickly, people’s responsibilities and opportunities were constantly growing. The environment is far from a zero sum game. During Rich Barton’s tenure at Microsoft there were many battlefield promotions. The situation is the same at Zillow and Glassdoor. This is in contrast to a business that is in decline and the employee count is shrinking. Shrinking opportunities mean employees face a less than a zero sum game which can too often create politics and a divisive culture.
 
9. “You can have a great team of people, but if they’re fishing in the wrong spot, you know, they’re fishing in a little puddle in the backyard, they’re not going to catch any fish. So, a big market, is like a proxy for (Total Addressable Market).”

“Tech startups are not capital-intensive. It takes money to build the first version of the software, but it’s very inexpensive to deliver that to millions of people. They’re high-margin businesses if you can get scale.”

“A big dream and a clear vision, and a little bit of nuttiness is required to take something from an idea stage all the way to creating something that [realizes that dream].”

“Dreams are largely self-fulfilling.” “There is almost as much blood sweat and tears in building something small as there is in building something big.”

“Look, you have an at bat, and it takes just as much energy to swing for the fences as it does to bunt.  OK.  So, why bunt?  Why bunt?  Why not swing for the fences?”

Venture capitalists are very focused on finding audacious entrepreneurs who are trying to create value in very large markets. An entrepreneur simply can’t generate the necessary financial returns at scale if the market is small. If you have a small downside (not capital intensive to try) and if it is a big pond (a massive potential upside) you have optionality. It is rare to find a capable entrepreneur with a sufficiently clear, audacious, (and slightly nutty) mission to make venture capital financing work by delivering the necessary tape measure home run. The number of entrepreneurs with these qualities is one reason why cities like Silicon Valley and Seattle are so successful.

The plan must be audacious to deliver 10X to 1,000X returns. The plan must be a little bit nutty or others (particularly large companies) will be working on something similar. He is also saying that as long as you are devoting years of your life to this effort: why not try to accomplish something truly great? And if the goal is genuinely a “mission”, that provides extra motive beyond just financial returns. If you can do great things for society and do well financially at the same time, the combination is a very powerful thing.
 
10. “It’s key to hire the best and sharpest folks in the beginning so that you can build an organizationally wise company.”

“Surround yourself with superstars. And not just the people you choose to work with.  That’s really important.  But the people you raise money from as well. Surround yourself with superstars, and everything else takes care of itself.  Whenever in my career I’ve compromised because I’ve had a short-term itch I needed to scratch – and I just had to hire somebody – it’s been a mistake. And I’ve regretted it. It’s really hard to get rid of the (poor) performers.  Surround yourself with superstars. They hire superstars.”

Being around smart people who love to get things done makes you smarter and more able to get things done. Rich Barton is making the point that the early hires are particularly important as they are the kernel around which culture, value, and best practices are built. He also believes that fixing a bad hire is way more costly and time consuming than people even imagine. People who are easily threatened hire people who are non-threatening and add less value to the business as a result. In short, bad hires can be toxic. And, of course, smart people love to hire and be around other smart people.
 
11. “Get the highest octane fuel in the tank [when choosing a venture capitalist].”

The founders of a fundable startup have lots of options to raise money. Rather than just raising money the smartest entrepreneurs select the VCs who deliver far more than just money. What the great venture capitalists realize is that they are in a service business. A venture capitalist who does not help with recruiting and other aspects of the business is underperforming. As just one example, the world is increasing driven by the power of networks and the best venture capitalists have access to the best networks.  As an example, Rich and I are big fans of “Bill [Gurley], the rare wicked smart guy who can also communicate his analyses and opinions through compelling analogies and in a ‘hat in hand’ Texan’s drawl.” Bill Gurley and his partners have forgotten more than I know about venture capital. Despite that fact, much what I know about the venture capital business is attributable to them. Benchmark is lucky to be working with Rich Barton and vice versa.
 
12. “The whole idea of building a career these days is much different from say when my dad did. My dad graduated from Duke University with an engineering degree — I don’t know what the year was, it was probably like 1956 or something —and he went to work for a large chemical company, which was like the computer company of his age. Plastics. Like in The Graduate. My dad always said: ‘What you are doing on the Internet, I was in plastics, and that was the thing.’

Anyway, he went to work for that company, and he retired from that company 34 years later. And he worked there the whole time, and that was his era’s idea of work. The company man. The gray suit, and the brief case. And the martini on Friday and the hat and whole thing.  I love and admire my dad, and I love that he was always supportive and sort of tickled by how I built my career and my views on the modern career path. From my perspective, building a career is trying something really interesting, getting some skills, putting tools into your tool kit, going to the next place and putting a few more tools in, until finally you have all of the tools that you can build your own house.”

Rich Barton is making a point here about the importance of accumulating skills in an iterative fashion, and that means in today’s world a path that is not a linear march in a single company. The metaphor of a career ladder has been replaced with a jungle gym. What is most remarkable about Rich is his success rate. Very few entrepreneurs have had so many different successes. Nick Hanauer, a Seattle entrepreneur and venture capitalist points out: “You can name people who are richer than Rich, but you can’t name very many people who have his track record. You will find very few people in this country who have as many times created something from nothing.”
 
Notes:

Geekwire – Barton on Transparency

Wired – The Man Who Escaped Microsoft and Took a Whole Company With Him

 

BizJournals – Zillow, Expedia founder Rich Barton on tech bubbles, startups, transparency

Hopper and Dropper (Barton’s blog) – Scrabble Letters and Brand Names
New York Times – The art of something from nothing

Geekwire – Barton on Startups and Competition

 

Zillow’s Rich Barton on Risk and Success

Geekwire – Closet Revolutionary Rich Barton

 

Geekwire Summit – Gurley and Barton

Geekwire Seattle Startup Week – Barton Interview

A Dozen Things Taught by Warren Buffett in his 50th Anniversary Letter that will Benefit Ordinary Investors

 
 
1. “We are limited, of course, to businesses whose economic prospects we can evaluate. And that’s a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now.”

“My experience in business helps me as an investor and that my investment experience has made me a better businessman. Each pursuit teaches lessons that are applicable to the other. And some truths can only be fully learned through experience.”

Treat an investment security as a proportional ownership of a business!  A security is not just a piece of paper. Not all businesses can be reasonably valued. That’s OK. Put them in the “too hard pile” and move on. See my #3 in my Bill Ackman post.

 
 

2. “Periodically, financial markets will become divorced from reality.”

“For those investors who plan to sell within a year or two after their purchase, I can offer no assurances, whatever the entry price. Movements of the general stock market during such abbreviated periods will likely be far more important in determining your results than the concomitant change in the intrinsic value of your Berkshire shares. As Ben Graham said many decades ago: ‘In the short-term the market is a voting machine; in the long-run it acts as a weighing machine.’ Occasionally, the voting decisions of investors – amateurs and professionals alike – border on lunacy.”

Make bi-polar Mr. Market your servant rather than your master! See my Howard Marks post or my Jason Zweig post.

 
 

3. “A business with terrific economics can be a bad investment if it is bought for too high a price. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this.”

Buy at a bargain price which provides a margin of safety! See my Seth Klarman, Bill Ackman or Howard Marks posts.

 
 

4. “As Tom Watson, Sr. of IBM said, ‘I’m no genius, but I’m smart in spots and I stay around those spots.'”

Circle of competence! Risk comes from not knowing what you are doing. See #6 in my Joel Greenblatt post.

 
 

5. “Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: ‘The fault, dear Brutus, is not in our stars, but in ourselves.'”

Most investing mistakes are psychological! Investing is simple, but not easy. Buffett has a great system, but his emotional and psychological temperament is especially suitable for investing. Like Charlie Munger, he is highly rational as human beings go. Everyone, including Buffett, makes mistakes. You can do very well in investing by just avoiding stupid mistakes. See my post on Kahneman or Michael Mauboussin.

 
 

6. “It is entirely predictable that people will occasionally panic, but not at all predictable when this will happen. Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on December 6, 1941 or September 10, 2001.) And if you can’t predict what tomorrow will bring, you must be prepared for whatever it does. Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.”

Buy at a bargain and wait! See my post on avoiding forecasting. See also Seth Klarman and Howard Marks posts on this point. You can determine that buying an investment *now* is a bargain that creates a margin of safety based on a valuation process, but you cannot predict *when* the price will rise.  So you wait.

 
 

7. “Gains won’t come in a smooth or uninterrupted manner; they never have.”

Investing results will always be lumpy! See #10 in my Henry Singleton post.

 
 

8.”Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

“It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.”

Risk is not the same as volatility! See #6 in my Jason Zweig post.

 
 

9. For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky….”

Most investors should buy a diversified portfolio of low fee index funds/ETFs! See my posts on John Bogle and asset allocation.

 
 

10. “Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

Follow the cost matters hypothesis! See #1 and #3 in my John Bogle post.

 
 

11. Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.” “When bills come due, only cash is legal tender. Don’t leave home without it.”

The only unforgivable sin in business is to run out of cash! See #7 in my post on Don Valentine. The need for some cash as dry powder applies to everyone, the only question is how much cash to have on hand.

 
 

12. “We will never play financial Russian roulette with the funds you’ve entrusted to us, even if the metaphorical gun has 100 chambers and only one bullet. In our view, it is madness to risk losing what you need in pursuing what you simply desire.”

Black Swans can appear any time! People will try to get you to buy things by hiding this risk. See my post on Nassim Taleb.

A Dozen Things I’ve Learned from Don Valentine about Venture Capital and Business

“Don Valentine participated in the beginnings of two significant milestones: the birth of the silicon chip and the development of the venture capital industry. From humble beginnings, Valentine became a legendary salesman at Fairchild Semiconductor and National Semiconductor, before founding Sequoia Capital in 1972.” He “was one of the original investors in Apple Computer, Atari, LSI Logic, Cisco Systems, Oracle, and Electronic Arts.”

1. “[Venture capital] is all about figuring out which questions are the right questions to ask, and since we don’t have a clue what the right answer is, we’re very interested in the process by which the entrepreneur get to the conclusion that he offers. Our business is a business of highly intuitive decision making and that fact that it’s done in a scientific area doesn’t make it scientifically practical to make decisions that way…”

“We recognize by Socratic questioning opportunities that are better than others and why.”

“The art of storytelling is incredibly important.  Learning to tell a story is critically important because that’s how the money works. The money flows as a function of the story.”

Michael Mauboussin points out in one of his wonderful slide decks: “The best in all probabilistic fields: 1) focus on process versus outcome and 2) always try to have the odds in their favor.” If you read the many posts in this series on my blog you will see that all great investors focus on having a sound process. A great venture capitalist like Don Valentine learned early in his career the importance of having a sound investing process.

When you are in a business driven by optionality, like the venture capital business, investing a lot of resources in creating spreadsheets is a waste of time since the assumptions in it are guesses. The best way to quantify the opportunity is actually with a story. Chris Sacca puts it this way: “Good stories always beat good spreadsheets….Before drawing a single slide of your pitch deck, tell the story out loud to anyone who will listen. Again and again. Now you have your deck.”  My father’s twin brother recently passed away and at his funeral one of his sons talked about how his dad liked to tell Ah Mo: Indian Legends from the Northwest stories collected by my great grandfather. My uncle knew well that the best way to get good at telling stories is to actually tell stories. He was also a great teller of jokes.

Telling stories is like public speaking: the more you do it, the better you get.  If you must to refer to notes in telling your story, it will be vastly less effective. Speak from the heart in telling your story and you can say a tenth as much but have twice or more as much impact. Sometimes I meet an entrepreneur who reminds me of an Maya Angelou quote in I Know Why the Caged Bird Sings: “There is no greater agony than bearing an untold story inside you.”  This entrepreneur has an idea, but they can’t express it well enough to get funded and attract the necessary team. In a case like that they need a co-founder who can tell the story. Or they need to focus on learning to be a storyteller. Some may consider Dale Carnegie and Toastmasters to be corny, but they work for many people who have not yet learned to tell a story.

 

2. “I’ve always been mystified by the critically important disc drive industry, without which the PC is a useless device. You have to be brilliant in electronics, you have to be brilliant in magnetics and you have to be brilliant in mechanics to get all that memory capacity in a very little place and do it for next to nothing. That market has never been rewarded financially for its brilliance.”

The reason for this “mystery” described by Don Valentine is best explained by Charlie Munger:  “there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” At its heart, what Charlie Munger is taking about here is the importance of a moat.  If a business does not create some barrier to entry, supply will be increased by competitors to a point where profit drops to the opportunity cost of capital.

Don Valentine is pointing out that many things which require sheer brilliance to create technically produce only consumer surplus and no producer surplus (profit). The level of profit of businesses in a given part of the economy can be vastly lower than their importance to society. For example, airlines and many manufacturers generate a lot more value to society than their profitability suggests.

 

3. “We have always focused on the market — the size of the market, the dynamics of the market, the nature of the competition — because our objective always was to build big companies. If you don’t attack a big market, it’s highly unlikely you’re ever going to build a big company.”

“Great markets make great companies.” “We’re never interested in creating markets – it’s too expensive. We’re interested in exploiting markets early.” 

“I like opportunities that are addressing markets so big that even the management team can’t get in its way.” 

Do startups sometimes create new big markets? Sure, but Don Valentine is saying is it too expensive for his taste. The other point he is making is similar to a point made by Warren Buffett: “When an industry with a reputation for difficult economics meets a manager with a reputation for excellence, it is usually the industry that keeps its reputation intact.” Don Valentine is saying that even a subpar management team can win in a market that is really big that is exploited early. And, of course, a first rate management team in that same situation will do even better.

 

4. “The key to making great investments is to assume that the past is wrong, and to do something that’s not part of the past, to do something entirely differently. I asked what was the most outrageous thing you’ve ever done, knowing in my heart of hearts that I’d pick the one who’d done something most outrageous.”

“What is important is to have the ability and willingness to be different. Great companies are built with different products by different people.”

To make a dent in the universe, it will be necessary to be contrarian on something very important and be right about that contrarian view in a big way. This is true both in investing and in building a business. No one speaks more clearly on this point than Howard Marks. I’ve blogged about that here. No one has taught me more about this than Craig McCaw, who is about a different a thinker as I have ever met. Don Valentine’s partner Michael Mortiz said once: “While there is danger in the venture business in getting too far away from the crowd, it can often pay to be unconventional. Don Valentine, the founder of Sequoia Capital, told me to trust my instincts, which lets you avoid getting dragged into conventional thinking and trying to please others.”

 

5. “The trouble with the first time entrepreneur is that he doesn’t know what he doesn’t know. After a failure, he does know what he doesn’t know and can beat the hell out of people who still have to learn.”

A famous Confucius quote is: “True wisdom is knowing what you don’t know.” But the important corollary to that quote is that there are some things that you can’t know, because some future states of the world are not known.  A similarly famous Don Rumsfeld quote is: “As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.” Risk comes from not knowing what you are doing and big problems can come from not knowing what you don’t know.

I have done a few posts on the work of Zeckhauser and Taleb that you can read on this point (e.g., #1 here).

 

6. “The biggest consistent irritant were co-investors more intent on talking over management, rather than listening to them, in the board room.”

“The world of technology thrives best when individuals are left alone to be different, creative, and disobedient.”

Board members who thrive on helping others succeed are the right sort of board members to have.  Board members who love to listen to themselves talk are a disaster. They are the equivalent of the people in the gym who love to stare at themselves when they work out. You might say that there is an inverse relationship between the need of a person to take selfie’s and their suitability to be a board member.

 

7. “There are two things in business that matter, and you can learn this in two minutes- you don’t have to go to business school for two years: high gross margins and cash flow. The other financial metrics you can forget… with high gross margins you can grow the company as fast as the market will allow.”

“All companies that go out of business do so for the same reason – they run out of money.”

Cash is like oxygen or water. Without it you are dead. A lot of things will be forgiven in business, but running out of cash is not one of them. Particularly in a subscription business you can have a huge mismatch between profit and cash flow. Expense can be stacked up in month one and cash coming in only over a long time. “The only unforgivable sin in business is to run out of cash” said Harold Geneen. The markets seem flush with cash right now. But that availability of new cash can disappear in a heartbeat.

 

8. “These binders cost money. Spend it on something more useful.”

Don Valentine is a believer in cost control and sending messages by walking the talk.  Give him something like a report in an expensive binder he is going to say something like “this is not a good way to create value.” Famously frugal managers like Tom Murphy are not opposed to spending money as long as it creates value. One thing that people underestimate the importance of is the need to acquire customers in a cost effective way. Acquiring customers cheaply is such a beautiful way to make generating a profit easier. Conversely, paying too much to acquire a customer is not a solvable problem. The cost of acquiring a customer and the cost of serving a customer can be stone cold killers of a business.

 

9. “We don’t spend a lot of time wondering about where people went to school, how smart they are and all the rest of that. We’re interested in their idea about the market they’re after, the magnitude of the problem they’re solving, and what can happen if the combination of Sequoia and the individuals are correct.”

One of the most attractive things about the venture capital world is that someone without credential x or y can still become a success. That is not to say that credentials are not relevant or helpful, especially early in a person’s career, but history has shown that at least they are not required. One of the very best credentials, of course, is previously scoring a very big financial return, most importantly for the person considering your proposal.

 

10. “One of my jobs as a board member has been to counsel management to avoid distraction and to execute with constructive paranoia.”

It is easy for a startup to lose focus. There are lots of “shiny new pennies” which people like journalists like to talk about that can cause distraction. Paying attention to what is actually going on in a business and avoiding distractions is essential.  The importance of being paranoid is famously attributed to Andy Grove of Intel, who said once: “The ability to recognize that the winds have shifted and to take appropriate action before you wreck your boat in crucial to the future of an enterprise.” Don Valentine is saying that vigilance is important and that the right sort of paranoia is constructive paranoia.

My father-in-law loved to joke that “just because you are paranoid doesn’t mean they are out to get you.” Andy Grove once wrote: “Business success contains the seeds of its own destruction. The more successful you are, the more people want a chunk of your business and then another chunk and then another until there is nothing.” The bigger and more profitable you get, the bigger the X on your back serving as a target for competitors.

 

11. “Think about a company like Eastman Kodak – it was the leader in its market, and now it’s gone. How can a $100 billion company go out of business? The answer is, easily and quickly.”

When optionality driven by network effects pays off, the amount of that payoff in a digital world can be nonlinear. And when network effects disappear, the amount of loss and the speed it disappears is also nonlinear.  In other words, network effects are a double-edged sword – success can disappear just as fast as it was created. Actually, the loss of network benefits is more spectacular since it is something huge transforming into nothing.  When network effects create benefits the early success is unseen and more surprising since the phenomenon involves “emergence.” Something suddenly appearing in a way that is far greater than the sum of its parts can be surprising indeed.

 

12. “I just follow Moore’s Law and make a few guesses about its consequences.”

“The nature of silicon and software and storage go hand in hand. In the case of software, you just have to be more clever about the nature of the application. So all these things kind of tick along, feeding off each other.”

Don Valentine’s partner at Sequoia Michael Mortiz once said:  “A chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” It’s been very good to be associated with Moore’s law over the years. Underestimating Moore’s law’s power is easy to do since its impact is nonlinear. Humans are not well equipped to understand nonlinear phenomenon well since most things in life are linear.

 

Notes:

UC Berkeley Digital Assets – Interviews with Donald Valentine

Computer History Museum – Donald Valentine

 

Sequoia Profile – Founder Don Valentine

SiliconGenesis – Stanford Interview

 

GSB Stanford – What Problem Are You Solving?

GigaOm – Lessons From Silicon Valley VC Legend

 

Forbes Profile – Don Valentine, Venture Capitalist

TechCrunch – VC Titans Perkins and Valentine Articulate What Makes a Good VC

Stanford Talk (video)

 

A Dozen Things I’ve Learned From Arthur Rock about Business & Venture Capital

“Arthur Rock was one of America’s first venture capitalists. He played a key role in launching Fairchild Semiconductor, Teledyne, Intel, Apple, and many other high-tech companies. Following an early career on Wall Street in investment banking, Arthur started his first venture capital partnership with Tommy Davis. Between 1961 and 1968, Davis & Rock invested $3 million and returned $100 million to their investors.”

 

1. “What attracted me first, I got this letter from Gene Kleiner when I was in New York,  actually written by his wife, suggesting that seven of the scientists at Shockley were not happy there and could I find them a job together…”

“The problem at Fairchild Semiconductor had to do with incentives. The whole idea of giving people incentives was something foreign to most companies.” “…employees like to feel they own part of the company, no matter how little.”

Seven scientists who were very unhappy with the management style of William Shockley left Shockley Semiconductor with Bob Noyce to become the famous “traitorous eight.” The capital these scientists needed after leaving Shockley was supplied by Arthur Rock’s investment firm Hayden Stone.  Each of the eight scientists received 10 percent of the equity and Hayden Stone received 20%. The incentive created by that 10% ownership interest was important in motivating these people to create one of history’s greatest businesses (Fairchild Semiconductor).

Therese Poletti once wrote about this group: “It is estimated by some that more than 400 companies can trace their roots to those “Fairchild Eight” … the most famous being Robert Noyce and Gordon Moore, who left to co-found Intel in 1968. Other famous “Fairchildren” include Jerry Sanders, a sales star at Fairchild, who left with a group of engineers to co-found Advanced Micro Devices in 1969. ‘This was the first company to spin off engineers starting something new,’ said Moore. “By luck, we caught up with some financing and got to start our own company.” But it wasn’t easy, the group approached 35 companies with the help of a young Harvard MBA named Arthur Rock.”

Fred Wilson and Andy Rachleff, among others, have both written thoughtfully on the important topic of employee equity.

 

2. “I get my kicks out of building companies…” “[Early venture capitalists] were all company builders. And people entering the business in the late 1990’s were promoters. They’re always promoting their companies and promoting their deals.”  

“You know, a lot of people are just interested in building a company so they can make money and get out. That doesn’t interest me at all.  Usually it’s not a successful way anyway…”  

The venture capitalists I admire most like to spend their time and effort building real businesses. They almost always understand finance deeply, but for them, finance is an enabler of what they most love to do. One of the ironies of venture capital is that the best way to be financially successful is to pay less attention to finance and more attention to building a business. The right financial structure doesn’t mean anything if all it does is guarantee you a high percentage of nothing.

 

3. “We spent a lot of time with our companies... [sometimes] if you divide up the number of companies they’re invested in by the number of partners, you find that the partners haven’t got ten minutes for any one company.”

Time is the scarcest resource that any venture capitalist has to offer any business in their portfolio.  A founder or business is not going to get much time from the venture capitalist if that venture capitalist is investing in too many businesses. This is part of the reason why the venture capital business does not scale well.  You can’t automate the work that a great venture capitalist does in helping grow a business. 

 

 

4. “I was more interested in people, in figuring out whether the people are good people without knowing exactly what it is they are going to do technically.”

Many people in this series on my blog have pointed out that the success of a business is fundamentally tied to its people. The company you build is the people you hire. Arthur Rock himself is not a technologist, but he is an excellent judge of people. Finding the right people is fundamental to the success of a startup. Great people create optionality for the business since they are more able to adapt to an uncertain future.

 

5. “Good ideas and good products are a dime a dozen. Good execution and good management—in a word,  good people—are rare.” “The lesson from Intel? The necessity of having great management.”

Almost everyone has good ideas once in a while. There is a light year of difference between “I thought of that” and “I built that.”  Arthur Rock’s comment on the importance of management also reminds me of the posts I did on “Coach” Bill CampbellJim Barksdale, and Sheryl Sandberg. Strong technical skills are not enough to create a successful business, and strong management skills aren’t enough either. The rarity of “good management and good people” is another reason why venture capital does not scale well as an industry.

 

6. “I am especially interested in what kind of financial people they intend to recruit. So many entrepreneurial companies make mistakes in the accounting end of the business. Many start shipping products before confirming that the orders are good, or that the customers will take the product, or that the accounts are collectible. Such endeavors are more concerned about making a short-term sales quota than about maximizing the long-term revenue stream.”

Accounting revenue is an opinion and real cash flow is a fact. A startup focused on fake metrics will eventually pay the price. The first and second rules of finance are: pay attention to cash and pay attention to cash. When the business has found product/market fit and the task at hand is more focused on scaling the business, if the focus of the sales team is to create faux success by using misleading metrics that is potentially a huge problem. The easiest person to fool is yourself.

 

7. “I look for people who [are] honest. They have fire in their belly. They’re intellectually honest meaning that they see things as they are, not the way they want them to be and, and have priorities and know where they’re going and know how they’re going to get there.”

Confirmation bias and other dysfunctional heuristics drive people to see what they want to see. This gets in the way of the intellectual honesty Arthur Rock seeks. Psychological denial is a powerful and often dysfunctional force in the world of failure. In this interview Arthur Rock is also pointing out that he is trying to sort out whether someone “is a good person.” Whether someone is a good person is a highly underrated success indicator. Not only is it the right thing to do and the most pleasant thing to do, it is the most profitable thing to do. People who deal with each other via what Charlie Munger calls a “seamless web of deserved trust” because they are good people, get more things done quickly and efficiently.

 

8. “When they have their five-year plan and they come down to net profits, that’s okay. But then when they tell you how much your earnings per share is going to be and what the dilution is going to be and then how much, at what price earnings ratio the stock is going to sell at and then they tell you, well, you know if you invest it today you would make twenty times or a hundred times or something on your money, at that point I don’t want to talk to them anymore. Very nice to have met you. Goodbye. Good luck.”

This is such a great statement since the “tell’ Arthur Rock describes reveals so much.  First, people who think they can predict the future with sufficient accuracy to create a detailed five-year plan have a lousy understanding of how business works and have not been paying attention to life. A spreadsheet is only as good as your assumptions and when you put garbage into a spreadsheet garbage comes out. Second and even more importantly, entrepreneurs like Arthur Rock described are not sufficiently focused on solving real customer problems – a precondition for creating a valuable business.

 

9. “One thing that probably has not changed is the need to be a good listener.”

In deciding which venture capitalist to select, Chris Sacca has suggested the founder ask: “Who’s gonna listen?” Mark Suster has similarly said: There are a lot of people with big mouths and small ears. They do a lot of talking; they only stop to listen to figure out the next time they can talk.”

This list of people recommending listening is long. Larry King: “I remind myself every morning: Nothing I say this day will teach me anything. So if I’m going to learn, I must do it by listening.”

It is not just important that you listen to your venture capitalist or your founder – any successful business must listen to its customers, suppliers and employees. Arthur Rock also pointed out in this same interview that whether someone is a good listener is best judged over time, since in the first meeting they may be on their best behavior. 

 

10. “Fred Terman was head of the engineering school at Stanford, and he encouraged his students, especially the doctoral and postdoctoral students, to form companies and continue to teach at Stanford.”

“It is entirely possible that there would be no silicon in Silicon Valley if Fairchild Semiconductor had not been established.”

The positive feedback loop that Stanford has created is powerful.  The formula is simple: allow professors and students to be entrepreneurial and give them access to great facilities and other resources. Teach them to be empathetic, ethical and thoughtful. These professors and students will build valuable businesses and will eventually be philanthropic toward the university, which creates a source of funds that can be re-invested in students, professors and infrastructure and other resources in a way that grows over time [repeat indefinitely]. That William Shockley was born south of San Francisco area was a lucky break for the San Francisco area just as Bill Gates being born in Seattle as a lucky break for the Seattle area. If you look at which areas of the world are economically successful, you inevitably see major research universities. If the research university has archaic rules about conflicts of interest the universities suffer, and so does the surrounding area’s economic environment.

 

11. “Over the past 30 years, I estimate that I’ve looked at an average of one business plan per day, or about 300 a year, in addition to the large numbers of phone calls and business plans that simply are not appropriate. Of the 300 likely plans, I may invest in only one or two a year; and even among those carefully chosen few, I’d say that a good half fail to perform up to expectations.”

This fundamental aspect of venture capital investing – the power law distribution of financial returns – has not changed and will not change. The combination of (1) the optionality discovery process inherent in venture capital and (2) the top down constraint an economy puts on income for any given business/all business collectively, means that the power law is here to stay. To find the one unicorn that drives financial returns in the venture capital industry requires that the venture capitalist look at a lot of prospects before finding an opportunity that may be mispriced. And even after carefully examining hundreds of opportunities, half of all venture opportunities will fail outright and most of the rest will mostly be “meh” results.

 

12. “Success breeds success.”

This is a simple statement of one of the most powerful forces operating in the world today. The more technical term to describe the phenomenon is “cumulative advantage.” Columbia University’s Duncan Watts puts it this way:

The reason is that when people tend to like what other people like, differences in popularity are subject to what is called “cumulative advantage,” or the “rich get richer” effect. This means that if one object happens to be slightly more popular than another at just the right point, it will tend to become more popular still. As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors — a phenomenon that is similar in some ways to the famous “butterfly effect” from chaos theory.”

& this way: 

“…hindsight isn’t 20/20; it’s reductive and unreliable. In a section on the Mona Lisa, for example (see excerpt), he discusses how the painting languished in relative obscurity for centuries, only becoming world famous after it was stolen from the Louvre in the early 1900s—but since the idea of its greatness owing to a fluke is so inherently unsatisfying, people ascribe post-facto “common sense” explanations. (It’s the smile! It’s the fantastical background! It’s the genius of Leonardo da Vinci!) “Common sense is the mythology—the religion—of the social world,” Watts says. “It’s the simple answer that maps directly onto our experience, the explanation we need to make things make sense. So we hear thunder and say, ‘The gods are fighting.’ That’s something we understand; people get angry and throw things. Common sense is socially adaptive. If we constantly had to grapple with the complexity of the world, we wouldn’t be able to get out of bed in the morning.”… if an answer and its opposite can seem equally obvious through the right mental gymnastics, there’s something wrong with the idea of “obviousness” in the first place. “We make this mistake so often, and it really hurts us,” Watts says. “We can’t understand the social world just by telling a bunch of cute stories. You need theories, experiments, data. It’s tricky and counterintuitive, and everything is more complicated than you think it is. Your intuition is always misleading you into thinking you understand things that you don’t.” 

Descriptions of this so-called “Matthew effect” (the rich get richer) are old enough that the source of its name is the bible. What is new is that digital systems are accelerants of the Matthew effect. The rich are getting even richer since cumulative advantage scales even better when the phenomenon is digital.  As Nassim Taleb has pointed out, more and more of the world is Extremistan. Taleb gives the example of the recording device as a contributor to Extremistan results:

“Our ability to reproduce and repeat performances allows me to listen to hours of background music of the pianist Vladimir Horowitz (now extremely dead) performing Rachmaninoff’s Preludes, instead of to the local Russian émigré musician (still living), who is now reduced to giving piano lessons to generally untalented children for close to minimum wage. Horowitz, though dead, is putting the poor man out of business. I would rather listen to Horowitz for $10.99 a CD than pay $9.99 for one by some unknown (but very talented) graduate of the Julliard School. If you ask me why I select Horowitz, I will answer that it is because of the order, rhythm or passion, when in fact there are probably a legion of people I have never heard about, and will never hear about – those who did not make it to the stage, but who might play just as well.”

 

Notes:

 

HBS – Done Deals

Computer History – Arthur Rock

 

Harvard Business Review – Strategy vs Tactics

HBS – Harvard Entrepreneurs: Arthur Rock

 

Digital Assets – Oral History

Mike Markula Interviews Arthur Rock (video)

A Dozen Things I’ve Learned from Sheryl Sandberg about Management, Careers & Business

1. “I sat down with Eric Schmidt, who had just become the CEO [of Google], and I showed him the spread sheet and I said, this job meets none of my criteria. He put his hand on my spreadsheet and he looked at me and said, ‘Don’t be an idiot.’ Excellent career advice. And then he said, ‘get on a rocket ship. When companies are growing quickly and they are having a lot of impact, careers take care of themselves.’ ”

This quote above extends on the importance of getting involved in situations that create positive optionality. For example, when companies grow there is a need to do new things – workers become managers, people who do X are trained to do Y and Z, and everyone learns new skills. There tends to be more opportunity and less politics in a growing company since it is more than a zero sum game. Companies that are shrinking tend to be the reverse.

A less than zero sum game at your place of work is problematic when it comes to your career. Startups can be particularly attractive sources of optionality. In the early days of a growing company (when there are just a few people working at the company) there was no shortage of opportunity. Startups tend to make for more battlefield promotions and people are more often allowed to learn new things and grow as employees.  

 

2. “The reason I don’t have a plan is because if I have a plan I’m limited to today’s options.”

Positive optionality is very valuable. If you are not open to opportunity as it arises, you can’t harvest optionality. My friend Craig McCaw likes to say flexibility is heaven. If he can delay a decision somehow, he will do it because he knows a better option might arise in the meantime. Sheryl Sandberg is a protégé of Larry Summers who is close to Robert Rubin. So to understand Sheryl it is useful to understand Rubin. In a New York Times article Summers describes Rubin’s approach: “Rubin ends half the meetings with – ‘So we don’t have to make a decision on this today, do we?’ Summers says. New information will evolve.”

“What so many people have a tendency to do is to lock into a scenario,” Summers says. “What Rubin will say, at times to the frustration of others, is that some questions don’t have answers – which is to say that just because a problem is terrible, we don’t have to act. It may not be the right time.” In a Fortune magazine article Carol Loomis wrote about Rubin: “Part of Rubin’s approach to decisions at the Treasury was to put them off as long as possible. Some people might call that procrastination; Rubin called it getting that one last fact or well-judged opinion, from whoever at the table might offer it, that might make a decision the right one. Geithner says the young members of the Treasury staff would on occasion rush into Rubin’s office, imploring him for a decision about something consequential. Rubin’s first question would often be,How much time do we have before we have to decide? Summers calls this Rubin’s habit of “preserving his optionality.”

 

3. “There is no straight path from your seat today to where you are going. Don’t try to draw that line.”  

Life is not linear. Opportunity usually arrives in life in strange and unexpected ways.  Opportunity also tends to arrive in a lumpy fashion. This nonlinearity and lumpiness means that it is wise to be both patient and ready to be very aggressive when opportunity presents itself. One odd thing that I like to do (there are many) is read obituaries. When you read a good obituary it often reinforces how nonlinear life can be. The line “life is one damn thing after another” is variously attributed to Edna St Vincent Millay and to Elbert Hubbard, but whoever said it was speaking to a fundamental truth. You can see the nonlinear path life takes in many obituaries.

 

4. “The traditional metaphor for careers is a ladder, but I no longer think that metaphor holds. It doesn’t make sense in a less hierarchical world. … Build your skills, not your resume. Evaluate what you can do, not the title they’re going to give you. Do real work. Take a sales quota, a line role, an ops job, don’t plan too much, and don’t expect a direct climb. If I had mapped out my career when I was sitting where you are, I would have missed my career.”

Sheryl Sandberg is saying that the traditional career path is history. And that you must sometimes move horizontally into positions where you acquire new skills to advance in life.

Reid Hoffman has a similar view: “The notion of a career has changed. Whereas we used to have a career ladder, now we have a career jungle gym. Success in a career is no longer a simple ascension on a path of steps. You need to climb sideways and sometimes down; sometimes you need to swing and jump from one set of bars to the next. And, to extend the metaphor, sometimes you need to spring from the jungle gym and establish your own turf somewhere else on the playground. And, if we really want the playground metaphor to accurately describe the modern world, neither the playground nor the jungle gym are fixed. They are constantly changing—new structures emerge, old structures are in constant change and sometimes collapse, and the playground constantly moves the structure around.”

 

5. “All of us, and especially leaders, need to speak and hear the truth. The workplace is an especially difficult place for anyone to tell the truth, because no matter how flat we want our organizations to be, all organizations have some form of hierarchy. What that means is that one person’s performance is assessed by someone else’s perception. This is not a setup for honesty.”  

Genuine listening is hard. People in senior management tend to get surrounded by people who tell them what they want to hear. In his famous speech The Psychology of Human Misjudgment Charlie Munger pointed out: Now you’ve got Persian messenger syndrome. The Persians really did kill the messenger who brought the bad news. You think that is dead? I mean you should’ve seen Bill Paley in his last 20 years. [Paley was the former owner, chairman and CEO of CBS]. He didn’t hear one damn thing he didn’t want to hear. People knew that it was bad for the messenger to bring Bill Paley things he didn’t want to hear. Well that means that the leader gets in a cocoon of unreality, and this is a great big enterprise, and boy, did he make some dumb decisions in the last 20 years.”

 

6. “Leadership is about making others better as a result of your presence and making sure that impact lasts in your absence.”

Here I think Sandberg shares the view that Marissa Mayer and others have, which is that at a top level in management the job is less about making many decisions but rather making a few very important decisions – then doing what it takes to enable other people to get things done that matter. An effective leader needs to articulate a set of priorities that enables the team to make decisions in the absence of a leader, which is necessary most of the time. Effective leaders find ways to amplify their impact whether they are present or not.

 

7. “Your life’s course will not be determined by doing the things that you are certain you can do. Those are the easy things. It will be determined by whether you try the things that are hard.” 

“Ask yourself: What would I do if I weren’t afraid? And then go do it.”

This again is thinking about your life as if you were a venture capitalist. As I pointed out in my post on Chris Dixon, it is in the areas where people are not looking that you can find mispriced opportunities. The “price” you pay in a career when trying to capitalize on an opportunity is not just money, but time and energy.  If you aren’t failing sometimes you are not learning. Try not to repeat the same mistakes and instead make new mistakes. Good judgment is often acquired by a progress that often involves bad judgment.

 

8. “The most important thing I can tell you is to open yourselves to honesty. So often the truth is sacrificed to conflict avoidance. You know your closest friends’ strengths and weaknesses, and what cliff they might drive off. Ask them for honest feedback.”

No one has perspective on themselves. We all need people who can tell us when we are off course. Charlie Munger puts it this way: “This first really hit me between the eyes when a friend of our family had a super-athlete, super-student son who flew off a carrier in the north Atlantic and never came back, and his mother, who was a very sane woman, just never believed that he was dead. And, of course, if you turn on the television, you’ll find the mothers of the most obvious criminals that man could ever diagnose, and they all think their sons are innocent. That’s simple psychological denial. The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems.”

 

9. “Google is fundamentally about algorithms and machine learning. And that that has been very important and continues to be very important. They’re doing a great job. [At Facebook] we start from a totally different place. We start from an individual. Who are you? You know, what do you want to do? What do you want to share?….There’s one thing that I think is most important that’s to Facebook, which is that we are focused on doing one thing incredibly well. We only really want to do one thing.”  

Focus matters. For a company to be a master of one thing can be very valuable, whereas an attempt to be a jack of all trades can be problematic. One thing that is tremendously clarifying for a business is a single principle around which a company can optimize decisions (that one thing). This allows people, even in a large business, to know how to optimize daily decisions. At Google, people know that the “one thing” is selling more targeted advertising. Everything is optimized to achieve that objective.

 

10.  “No one can have it all.”

“Life and business inevitably involves tradeoffs. Family, work, personal life all potentially create conflicts. Some people have a great ability to balance things in life, but no one can have everything. Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.”

Tradeoffs are inevitable in business and in one’s personal life. There is work, personal life and family. Getting the mix right between these three things is neither simple or easy. Often the tradeoffs are caused by limitations created by laws of physics. Business must also make tradeoffs. I have always found this quote from Michael Porter to be useful: “Strategy is about making choices, trade-offs; it’s about deliberately choosing to be different.”

 

11. “Done is better than perfect.”

The people who succeed in life are people who get things done. Not just getting anything done, but the things that matter. They don’t necessarily clear their screens or desks every day, they clear their screens or desks of the things that matter most. Here’s an example of done being better than perfect: Every weekend I write 5,000 words or so. The post aren’t perfect, but I get them done. The perfect blog post is the one that has never been written. The perfect life is the life that has never been lived. Mark Zuckerberg wrote in the letter that accompanied Facebook’s S-1 filing with the SEC:

“Hackers try to build the best services over the long term by quickly releasing and learning from smaller iterations rather than trying to get everything right all at once. To support this, we have built a testing framework that at any given time can try out thousands of versions of Facebook. We have the words “Done is better than perfect” painted on our walls to remind ourselves to always keep shipping.”

Facebook has created a system where everything they ship is an experiment that is rigorously tested and improved through nearly constant iteration. Hundreds or even thousands of experiments are conducted at a software company like Facebook every day.  Most things fail, but the experimentation process discovers improvements via what Nassim Taleb Calls via negativa.

 

12. “Work hard, stick with what you like, and don’t let go.” 

Being relentless and working hard often pays big dividends, financially and otherwise. Staying relentless in pursuit of your goals and working hard is far easier and more likely to be successful if you are doing what you like. Sheryl Sandberg’s statement is not always true, since life is often unfair, but not working hard, doing what you hate and letting go, almost certainly won’t get you anywhere. What Sheryl Sandberg is saying here is quite simple. Someone might even complain that it is too simple or even obvious. Business is often made too complex and at its core is simple. Being a great manager like Jim Barksdale or Tom Murphy requires the daily equivalent of blocking and tackling in football.  Building a business brick-by-brick is what great managers do.

 

 

Notes:

New Yorker – A Woman’s Place

HBS Speech – Sheryl Sandberg: Get On A Rocketship Whenever You Get The Chance

 

Harvard Magazine – Harvard College Class Day 2014

McKinsey Interview – Facebook’s Sandberg: No one can have it all

 

Amazon – Lean In

Harvard Commencement – Sheryl Sandberg Graduation Wisdom (video)

 

NY Times – Keeping the Boom From Busting

Fortune – Robert Rubin on the job he never wanted

A Dozen Things I’ve Learned from Keith Rabois about Venture Capital and Business

1. “The only way to learn how to invest is to invest. You can’t simulate it.”

Getting feedback is fundamental to the learning process. Reading and learning from others is great but at some point the only way to refine your skill is to actually invest real money. Many people have taken a class in which they make trades that simulate investing. Simulation is no substitute for investing, since most mistakes in investing are psychological.

Without actually testing your emotions and learning from genuine feedback you really have not put yourself in a place where you can test your ability to control your emotions. Warren Buffett said once:  “Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.” The same thing can be said about Investing.

The way to learn about investing is to invest and to have what Nassim Taleb calls “skin in the game.” One of the most useful papers I have read about investing was written by Richard Zeckhauser, who is a professor at Harvard and a top class bridge player.  The paper is entitled “Investing in the Unknown and Unknowable”:

“the wisest investors have earned extraordinary returns by investing in the unknown and the unknowable (UU). But they have done so on a reasoned, sensible basis. This essay explains some of the central principles that such investors employ. It starts by discussing “ignorance,” a widespread situation in the real world of investing, where even the possible states of the world are not known. Traditional finance theory does not apply in UU situations … Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop … new technologies.”

Who has complementary skills? Zeckhauser writes: “Venture capitalists can secure extraordinary returns… because early stage companies need their skills and their connections. In soft, the return on these investments comes from the combination of scarce skills and wise section of companies for investment.”

In a post on Keith Rabois’s partner Vinod Khosla I described what Richard Zeckhauser calls the domain of “ignorance.”  A matrix which depicts one set of important relationships that impact venture capital, based on my interpretation of the ideas of Nassim Taleb, is as follows:

Binary outcomes, complex outcomes, probability distributions

Because success in an industry is driven by the fourth quadrant (ignorance) successful venture capitalists understand that their objective is not to predict outcomes with certainty, since that is not possible. The task of a venture capitalist is instead to discover success from within a portfolio of 30-40 bets that have optionality. In the paper, Zeckhauser presents this to make clear that risk, uncertainty, and ignorance are very different things:

Escalating Challenges to Effective Investing

Venture capitalists with complementary skills have developed them over a period of years with experience in real world investing. Simulations of bets involving risk do not enable the investor to profit in the uncertainty and ignorance domains. The best way to become a venture investor is to make venture investments. There is no substitute for real world experience.

 

2. “Early stage, almost every successful entrepreneur I know doesn’t care as much about the economic terms as much as who they are going to work with.”

“If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.”

Khosla Ventures believes that the quality of the advice and mentoring given is so important that they present the firm as “venture assistance” rather than venture capital. Using Professor Zeckhauser’s taxonomy, it is the complementary skill and not the money that creates the extraordinary investing result.  Founders who are paying attention have figured out that the same venture capitalists are consistently generating the grand slam home runs year after year.

An important aspect of any person’s skill set is that a lot of skill comes from early luck. People who get lucky early in life end up with more skill through a process known as “cumulative advantage.” What entrepreneurs should be taking away as a message is that money is fungible but the skill of the venture capitalists is not. This series on my blog has tried to drive home the idea that money is money (assuming deal terms are equal) but not all venture capitalists are the same. Skill should drive an entrepreneur’s choice of venture capitalist.

In addition to the importance of complementary skills, it is hard to deny that there are signaling benefits from having a top venture firm as an investor. The world is filled with uncertainty and people look for signals when making decisions. Employees and others are attracted to startups that others are attracted to, which causes cumulative advantage and the power laws that exist in venture capital. Success create more success with a power that is nonlinear. As another example of success leading to success see this HBS paper on performance persistence:

“Entrepreneurs with a track record of success are much more likely to succeed than first-time entrepreneurs and those who have previously failed. In particular, they exhibit persistence in selecting the right industry and time to start new ventures. Entrepreneurs with demonstrated market-timing skill are also more likely to outperform industry peers in their subsequent ventures. This is consistent with the view that if suppliers and customers perceive the entrepreneur to have market-timing skill, and is therefore more likely to succeed, they will be more willing to commit resources to the firm. In this way, success breeds success and strengthens performance persistence.” 

 

3.  “You are looking for outliers [as Founders].”

Optionality is everywhere if you know where to look, but the best types of positive optionality can be found in places where others are not looking. If a founder is an outlier it is much more likely that will find something that others are not looking at or can see.

In post after post in this series on my blog I have driven home the point that venture capital is an investment system driven by a very small number of tape measure home runs and that distributions of success reflect power laws. An investor will not find mispriced optionality by following the crowd. The optionality will be found in what Zeckhauser calls UU situations, where exists what he calls the ‘domain of ignorance’. This concept is from another Zeckhauser paper that you might want to read, entitled “Grappling with Ignorance.”

The critical point here is that when you are a highly skilled venture capitalist uncertainty and ignorance are your friends. This is where you find the outliers that Keith Rabois is talking about.

 

4. “The [best founders] can relay incredibly complex ideas in simple terms, can see things you don’t see, are relentlessly resourceful [and are] often contrarian.”

I have seen many great founders in the course of my career and I can say that they are all different in many ways yet also similar in some ways. This topic is worthy of a separate post. Keith Rabois has identified four important qualities of a great founder in his statement. First, successful founders almost always have the quality that Jeff Bezos said he looked for in a wife: “someone who would be resourceful enough to get him out of a Third World prison.” Second, they understand that to deliver an outsized result from their startup (financially and otherwise) they must be contrarian about something important and they must be right.  Third, they can convey their ideas in ways that are easy for people to understand. Fourth, they have a unique way of looking at problems. A significant number of hyper-creative people are somewhat dyslexic. Great founders don’t think like other people in at least one important way, and are fearless about at least one important thing. This blog series has identified a range of other attributes in addition to these four that make for a great founder, like the ability to recruit talented people and a founder’s tendency to hire others who complement their skills.

The ability to find outlier founders (especially in new categories) is an especially valuable skill for a venture capitalist. I don’t think that there is any question that the skills involved in finding the best founders are based on pattern recognition. The more founders a venture capitalist sees in action, the better their ability to “know it when they see it.”  Mike Moritz is an example of a venture capitalist who is particularly good at finding great outlier founders.

 

5. “There are fundamental differences between an angel, what I call an amateur investor and being a professional investor, a venture capitalist.”

Once a person is investing other people’s money they are no longer an angel but rather a professional investor.  Great professional seed stage investors like Chris Sacca, Mike Maples Jr. and Ron Conway should not be referred to as Angels, but rather professional seed stage investors. In addition, even though someone like Max Levchin is still investing their own money at significant scale (and so might be called an angel) if you compare what Max does to a dentist in Portland writing a $75,000 seed round check, it’s apples and oranges. The way to resolve the question is to say that someone like Max Levchin who is prolific and has company building skills that go beyond being wealthy and well-connected crosses over to the professional category. The result of this taxonomy may be that a given seed round can have both professional and angel investors. My opinion is that Max Levchin investing in a seed round is not an Angel investment, but rather an investment made by a professional.

 

6. “We want to be doing what used to be called venture capital, not growth capital.”

Venture capitalists who excel in the early stage of a business provide much more than money to the business. Growth capital for companies who have product market fit and figured out a way to scale the business mostly just need more fuel to execute on what they are already doing. Once the fundamentals of the business are put in place while funded by seeds, A, and B financing rounds, many times all the business needs to scale is more capital. Even investment bankers can provide more capital. ;-) Not only is providing venture capital less financially rewarding for people with great company building skills, the work for the venture capitalist is more boring. A late-stage financing is often more about finance than building a business.  The move of marge mutual funds and others into the growth capital business naturally pushed venture capitalists to focus on earlier rounds.

 

7.  “Many entrepreneurs are raising more money than they need and it can cause derivative consequences down the road that are not healthy.”

There are many people who have written stories about venture capitalists pushing a startup to raise too much money. Experienced venture capitalists know that they often spend time with entrepreneurs counseling them to raise less money, not more. There are many ways to solve the inevitable problems that arise early in the existence of a startup. Trying to solve those problems with too much money tends to cause dysfunction in one form or another. In other words, solving hard problems with just money does not scale.

 

8. “First principle: The team you build is the company you build.”

Keith Rabois said that he first heard this phrase from Vinod Khosla when he joined the board of Square. Some investors believe that everything in a business starts with people. No one believes that more than perhaps Starbucks’ Howard Schultz, who I’ve discussed in a previous blog post.  Bill Campbell, who I’ve also discussed, would argue perhaps that product is more important but it is clear that there are two foundational things in building a business. Other venture capitalists believe that a massive addressable market is most important. One could argue that this ranking process is a bit like asking a parent which child they like best. Most parents answer: “I like them all the same.”

 

9. “There are two categories of good people: there is ammunition and there is barrels. You can add all the ammunition you want, but if you only have five barrels in your company you can literally only do five things simultaneously. If you add one barrel you can suddenly do a sixth, if you add another you can do seven. So finding those barrels that you can shoot through is key.”

I met with one of the very top executives at Boeing once with Craig McCaw, and he said that of the tens of thousands of engineers in the company only seven of those engineers were capable of designing an entire airplane. He said he could name those seven engineers. These were the equivalent of what Keith Rabois is calling “barrels.” These barrels are the unique employees who give other employees direction and fire them toward a goal. Finding and hiring barrels is hard, and a rare event. There barrels are scarce in the real world – hiring too many barrels is not a phenomenon often encountered.

 

10. “Silicon Valley, it tends to fragment talent across too many companies, so you get a suboptimal number of successful companies.”

“Generally speaking you want to hire people that share first principles, which involve strategy, people, and culture.”

“As you get into the uncharted territory where you don’t actually have any intellectual background, you need perspectives from people that are very different from you. At that point, it’s actually quite valuable to have people that are diverse.”

There are only so many great founders with audacious ideas possessing optionality, and talented engineers, and others who can create a great business. This tends to create strong rivalries in the venture industry since the competition for the best talent is intense. Competition is always good for a system and makes it more Antifragile.

 

11.  “Matching your priorities against your time is really important.”

The scarcest resource available to any venture capitalist is their own time. The venture capital business scales poorly when the venture capitalist is actively involved in each portfolio company. A venture capitalist can only sit on so many company boards or help so many businesses with recruiting. A firm or partner can invest in so many startups before they dilute themselves and begin to underperform. Many venture capital firms learned this lesson and have pulled back to raise smaller funds and do less out-of-region investing. Of course, this matching your priorities against your time idea is also true for executives and entrepreneurs, (arguably even more so).

 

12. “Your job as an executive is to edit – not to write. Every time you do something you should think through and ask yourself: am I writing or am I editing? and you should immediately be able to tell the difference.”

What comes to mind in this quote is Eric Schmidt’s advice to Marissa Mayer, which I blogged about in a previous post. He said to her: “it’s your job as leadership to be defense, not offense. The team decides we’re running in this direction and it’s your job to clear the path, get things out of the way, get the obstacles out of the way, make it fast to make decisions, and let them run as far and fast as you possibly can.” The executive should focus on what is important. Editing should be reserved for matters that are important. More supervision is needed in certain cases as Keith Rabois points out: “There are people who just know what they don’t know and there are people who don’t. Until someone shows the propensity to distinguish between those things you can’t let them run amuck.”

 

Notes:  

First Round Review – How to hire and why transparency matters

Business Insider – Eight principles for companies in 2014

 

Vimeo – Eric Eldon interview of Keith Rabois (video)

Gigaom – Angel Investor Keith Rabois 

 

Semil Shah – Interview of Keith Rabois

WSJ – Startups spend with abandon, flush with capital

AOL – Kara Swisher interview with Keith Rabois (video)

A Dozen Things I’ve Learned from Joel Greenblatt about Value Investing

Joel Greenblatt is a very successful value investor and the founder of Gotham Capital, which offers four diversified long/short equity mutual funds. He has written several books on value investing identified in the notes below.

 

1. “One of the greatest stock market writers and thinkers, Benjamin Graham, put it this way.  Imagine that you are partners in the ownership of a business with a crazy guy named Mr. Market. Mr. Market is subject to wild mood swings. Each day he offers to buy your share of the business or sell you his share of the business at a particular price. Mr. Market always leaves the decision completely to you, and every day you have three choices. You can sell your shares to Mr. Market at his stated price, you can buy Mr. Market’s shares at that same price, or you can do nothing.

Sometimes Mr. Market is in such a good mood that he names a price that is much higher than the true worth of the business. On those days, it would probably make sense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that he names a very low price for the business.  On those days, you might want to take advantage of Mr. Market’s crazy offer to sell you shares at such a low price and to buy Mr. Market’s share of the business. If the price named by Mr. Market is neither very high nor extraordinarily low relative to the value of the business, you might very logically choose to do nothing.”

Joel Greenblatt is a genuine Graham value investor.  Benjamin Graham’s value investing system has only three essential bedrock principles. The first bedrock principle is:  Mr. Market is your servant and not your master. The value investor does not try to predict the timing of stock market prices since that would make Mr. Market your master. The value investor buys at a bargain and waits for the bipolar Mr. Market to inevitably deliver a valuable financial gift to them. This difference transforms Mr. Market into the investor’s servant.

For a value investor, value is determined using methods that produce a fuzzy but very important benchmark, which is called “intrinsic value.” It is perfectly acceptable that the result of an intrinsic valuation is fuzzy and that approaches can vary bit from investor to investor.  It is also acceptable that the intrinsic value of some businesses can’t be reliably determined since they can be put in a “too hard” pile to free up time for other things. There are many thousands of other businesses to invest in that are not in the too hard pile. Admitting that the intrinsic value of some businesses can’t be reliably determined is also very hard for some people to accept.

Joel Greenblatt makes a key point here: “Prices fluctuate more than values—so therein lies opportunity. Why do the prices fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen. I just want to take advantage of it. We could sit there and figure it all out, but I like to keep it simple.  It happens; it continues to happen; the opportunities are there. 

I just want to take advantage of prices away from value.. If you do good valuation work and you are right, Mr. Market will pay you back.  In the short term, one to two years, the market is inefficient.  But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis. You don’t have to look at the next quarter, the next six months, if you do good valuation work—.. Mr. Market will pay you.”

Here again is this idea that predicting that prices will fluctuate, and that eventually they will rise to intrinsic value or above, is not to predict when that will happen. Gotham’s philosophy is: “We believe that although stock prices often react to emotion over the short term, they generally trade toward fair value over the long term. Therefore, if we are good at identifying mispriced businesses (a share of stock represents a percentage ownership stake in a business), the market will agree with us…eventually.”

The Mr. Market metaphor is hard for many people to grasp. For this reason some people are never really comfortable with the value investing system. This is not a tragedy, since value investing is not the only way to invest successfully. There are other successful investing systems. For example, there is factor-based investing, which calls itself value investing, but isn’t Graham value investing. There is also activist investing, which can be combined with value investing. There are other investing systems like merger arbitrage. Benjamin Graham style value investing is not for everyone, but anyone who is an investor can benefit from at least understanding the system.

 

2. “Buying good businesses at bargain prices is the secret to making lots of money.” 

“Graham figured that always using the margin of safety principle when deciding whether to purchase shares of a business from a crazy partner like Mr. Market was the secret to making safe and reliable investment profits.”

“Look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.”

“We use EBIT–earnings before interest and taxes–and we compare that to enterprise value, which is the market value of a company’s stock plus the long-term debt that a company has. That adjusts for companies that have different ratios of leverage, different tax rates, all those things. But the concept is still the same. We want to get more earnings for the price we’re paying. That was sort of the principles that Benjamin Graham taught, meaning that cheap is good. If you buy cheap, you leave yourself a large margin of safety. Warren Buffett had a twist on that and said, ‘Gee, it’s nice to buy cheap things but I also like to buy good businesses.’

So if I could buy good businesses at a cheap price, it’s better than just cheap… We rank all companies based on their return on capital and we also rank all companies based on how cheaply we can buy them relative to their earnings. The more earnings, the better. Then we combine those rankings. And the companies that have the best combination of that ranking go to the top. So we’re not looking for the cheapest company. We’re not looking for the highest return-on-capital company. We’re looking for the companies that have the best combinations of those two attributes.”

The second bedrock principle of Benjamin Graham’s value investing system is that assets should only be purchased when the price of the asset creates enough of a bargain that it providers the buyers with a “margin of safety.” What Joel Greenblatt means when he says “look down” is that you should think about Warren Buffett’s first and second rules on investing: don’t lose money and don’t lose money. The right amount of margin of safety will vary based on the investor involved, but it should be large enough to cover any mistakes. One common margin of safety is 25%. The margin of safety for a company for which intrinsic value can actually be calculated (i.e. not in the “too hard” pile) should be so big that a really smart person can do the valuation in their head.

In the quotes above Joel Greenblatt describes how it is possible for value investing to evolve over time, as long as the three bedrock principles stay the same. Charlie Munger convinced Warren Buffett that quality (a good business) when combined with a bargain price was even better than just a business bought at a bargain price. Value investors like Greenblatt spend a lot of time thinking about Return on Equity and Return on Capital. These are the concepts that allow them to differentiate the earnings power of one company versus another.  Determining value by only a database screen that sorts based on book value and price tells you nothing about the quality of the earnings power of a business.

 

3. “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

“Most people don’t (and shouldn’t) invest by buying stocks and holding them for only one month. Besides the huge amount of time, transaction costs, and tax expenses involved, this is essentially a trading strategy, not really a practical long-term investment strategy.”

The third bedrock principle of Ben Graham value investing system is that a security is an ownership interest in an actual business rather than a piece of paper to be traded based on person’s view about the views of other people, about the views of other people [repeat]. To value a stock, a value investor must understand the underlying business. This process involves understanding the fundamentals of the business and doing some relatively simple math related to the performance of the business.

“A number of years ago I was trying to explain to my son what I did for a living.  He is 11 years old.   I spoke about selling gum. Jason, a boy in my son’s class, sold gum each day at school.  He would buy a pack of gum for 25 cents and he would sell sticks of gum for 25 cents each.  He sells 4 packs a day, 5 days a week, 36 weeks or about $4,000 a year. What if Jason offered to sell you half the business today?  What would you pay?

My son replied, ‘Well, he may only sell three packs a day so he would make $3000 a year.’ Would you pay $1,500 now? ‘Why would I do that if I have to wait several years for the $1,500?’ Would you pay a $1?  ‘Yes, of course!  But not $1,500.  I would pay $450 now to collect $1,500 over the next few years, which would be fair.’

Now, you understand what I do for a living, I told my son.”

Joel Greenblatt is not thinking in all of this: “I think others will pay me more than $X for this business”, because that is trying to predict the psychology of potential buyers. Warren Buffett once described the stock market as a “drunken psycho.” The financier Bernard Baruch similarly said once that “the main purpose of the stock market was to make fools of as many people as possible.” Emotions and psychological errors are the enemy of the value investor.  Graham Value investors stay focused on the value of the business and only look at the stock market when they may want to have it be their servant.

 

4. “Periods of underperformance [make Graham Value Investing] difficult – and, for some professionals, impractical to implement.” 

“Over the long term, despite significant drops from time to time, stocks (especially an intelligently selected stock portfolio) will be one of your best investment options. The trick is to GET to the long term. Think in terms of 5 years, 10 years and longer. Do your planning and asset allocation ahead of time. Choose a portion of your assets to invest in the stock market – and stick with it! Yes, the bad times will come, but over the truly long term, the good times will win out – and I hope the lessons from 2008 will help get you there to enjoy them.”

The Ben Graham value investing system is designed to underperform during a bull market and outperform doing falling and flat markets. This is very hard for many people to handle so they are not candidates to be successful value investors. Seth Klarman, who is one of the very best value investors, writes: “Short–term underperformance doesn’t trouble us; indeed, because it is the price that must sometimes be paid for longer-term outperformance.” Few investors have the fortitude to endure this period of underperformance referred to by Joel Greenblatt.  Investment managers with a Graham value investing style work hard to attract the right sort of shareholders who won’t panic and ask to redeem their interest in a fund at the worst possible time. Value investors who manage funds typically spend a lot of time trying to educate their limited partners about how value investing works.

Warren Buffett has created the better solution in that the structure of Berkshire does not allow redemptions by limited partners. Berkshire investors can sell their shares to someone else but they cannot ask for their ownership interest to be redeemed for cash. Bruce Berkowitz said once about Berkshire Hathaway: “That is the secret sauce: permanent capital.  That is essential.  I think that’s the reason Buffett gave up his partnership.  You need it, because when push comes to shove, people run … That’s why we keep a lot of cash around…. Cash is the equivalent of financial Valium. It keeps you cool, calm and collected.”

 

5. “Companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.”

Benjamin Graham style value investors who have evolved their value investing system to include an optional quality dimension understand that a moat is necessary to maintain high returns on capital. To understand moats I suggest that you read this essay (the 2013 updated version especially) and even if you have read it already I suggest you read it again. The concept of a moat is the same concept that individuals like Michael Porter talk about when they refer to a barrier to entry or sustainable competitive advantage. If you do not have a moat, the supply of what you sell inevitably increases to a point where the price of your product drops to a point where there is no long term industry profit above the cost of capital of the business. Increased supply from competitors is a killer of value for a producer of goods and services. A moat is something that puts limits on that supply and therefore makes a business more valuable. Moats, like people, come in all shapes and sizes. Some moats are strong and some moats are weak.  Some moats protect things that are very profitable and some don’t.

 

6. “You have to know what you know—Your Circle of Competence.”

People get into trouble as investors when they do not know what they are doing. This idea is not rocket science and yet people ignore it all the time. This is true whether the situation involves any combination of risk, uncertainty or ignorance. There are a number of behavioral biases that contribution to this problem including overconfidence bias, over optimism bias, hindsight bias and the illusion of control.   The right approach for an investor is to find areas in which you are competent. Charlie Munger puts it this way: “Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent, and you have to allocate it smartly.”

The idea behind the Circle of Competence filter is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing. What could be simpler?  And yet humans often don’t do this.  For example, the otherwise smart doctor or dentist is easy prey for the promoter selling cattle limited partnerships or securities in a company that makes technology for the petroleum industry. Really smart people fall prey to this problem. As another example, if you lived through the first Internet bubble like I did you saw literally insane behavior from people who were highly intelligent.

 

7. “Remember, it’s the quality of your ideas not the quantity that will result in the big money.”

Value investors understand that investment outcomes are determined by magnitude of success rather than frequency of success. This is the so-called Babe Ruth effect. This is one of the greatest essays on this investing principle ever written. Fail to read it at your peril. Michael Mauboussin writes: “being right frequently is not necessarily consistent with an investment portfolio that outperforms its benchmark…The percentage of stocks that go up in a portfolio does not determine its performance, it is the dollar change in the portfolio. A few stocks going up or down dramatically will often have a much greater impact on portfolio performance than the batting average.” Venture capital returns are especially driven by the Babe Ruth effect.

 

8. There is no sense diluting your best ideas or favorite situations by continuing to work your way down a list of attractive opportunities.”

The best investors who “know what they are doing” understand that investing decisions should be made based on an opportunity-cost analysis. And some investors, as a result, decide to concentrate their investments rather than diversify. Charlie Munger has his own take on this same idea: “Everything is based on opportunity costs. Academia has done a terrible disservice: they teach in one sentence in first-year economics about opportunity costs, but that’s it. In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire. We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to.”

Seth Klarman makes a point here that is similar to the one he made above: “Concentrating your portfolio in the most compelling opportunities and avoiding over diversification for its own sake may sometimes lead to short-term underperformance, but eventually it pays off in outperformance.” Having said this, Greenblatt has moved to a more diversified approach. Gotham’s web site explains: “Our stock positions, which generally include over 300 names on both the long and short sides, are not equally weighted. Generally, the cheaper a company appears to us, the larger allocation it receives on the long side. On the short side, the more expensive a company appears relative to our assessment of value, the larger short allocation it receives. We manage our risks by requiring substantial portfolio diversification, setting maximum limits for sector concentration and maintaining overall gross and net exposures within carefully defined ranges.”

Greenblatt explains his views on diversification in a recent interview with Consuelo Mack. My take on his view (starts at about minute 14:30): what comes with a concentrated portfolio, is outside investors in the fund who lose patience and leave the fund when there is a period of underperformance. If you are investing your own money and have the patience, concentration can work better. He now more focused on being “right on average” for outside investors instead of concentrated investing in about eight stocks.

 

9. “Even finding one good opportunity a month is far more than you should need or want.”

Fundamental to value investing is the idea that mispriced securities and other assets which fall within your circle of competence are rarely available to purchase at a price which reflects a margin of safety. For this reason, value investors are patient and yet aggressive, ready to act quickly whenever the opportunity is presented. Most of the time the value investor does nothing but read, think, and research businesses and industries. Actual buying and selling of securities and other assets happens rarely. Warren Buffett has a few thoughts on this point which are  set out below:

  • “You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”
  • “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”
  • “I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”
  • “The stock market is a no-called-strike game. You don’t have to swing at everything–you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!’”
  • “One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as`marketability’ and `liquidity,” sing the praises of companies with high share turnover… but investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pick pocket of enterprise.”

 

10. “If you are going to be a very concentrated investor, you should not use leverage. You can’t leverage because you need to live through the downturns and that is incredibly important.”

Being a successful value investor requires that you have staying power. When you use financial leverage your mistakes are as just as magnified as your successes, and those mistakes can be big enough to make you a non-investor since you may have no longer have funds to invest. Don’t just take it from me. Please listen to these three investors. First, Charlie Munger: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Second, James Montier: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility, that impairs your ability to stay in an investment which can result in a permanent loss of capital.” Third, Howard Marks: “Leverage magnifies outcomes, but doesn’t add value.”

 

11. “The odds of anyone calling you on the phone with good investment advice are about the same as winning the Lotto without buying a ticket.”

To be a successful value investor of any kind requires actual work. And since work is necessarily involved, many people will try to avoid it, since that is human nature. Relying on people who call you on the phone with investment advice to avoid work, doesn’t, ahem, work. One way to avoid some of the work is to rely on others, but finding reliable and skilled people to rely on requires work too. Taking the time and devoting the time necessary to get sound financial advice will pay big dividends. This topic reminds me of a man I know who once pleaded with his doctor: “You have to help me stop talking to myself.” The doctor asked: “Why is that?” The man responded: “I’m a salesman and I keep selling myself things I don’t want.”

 

12. “Almost everyone should have a significant portion of their assets in stocks. But here it comes – few people should put ALL their money in stocks. Whether you choose to place 90% of your assets or 40% of your assets in stocks should be based largely on how much pain you can take on the downside.”

Joel Greenblatt is talking about the “asset allocation” set of issues, which present a number of choices that both active and index investors must face.  Stock prices can drop by a lot, and that and that can cause people to panic. Charlie Munger points out: “You can argue that if you’re not willing to react with equanimity to a market price decline of fifty percent two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result that you’re going to get.”

The best way to acquire good judgment so that you don’t panic is to read widely so you are prepared for this sort of result. Unfortunately, many people only learn these lessons by panicking and then missing a subsequent stock market rally while they sit in an emotional foxhole too terrified to participate in stock or bond markets. Unfortunately, many people learn about this so-called behavior gap by actually touching a hot stove. Some people learn the lesson and others never recover fully.

 

Greenblatt’s books:

The Little Book That Still Beats the Market

You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits

The Big Secret for the Small Investor: A New Route to Long-Term Investment Success

 

Notes:

Market Folly – Joel Greenblatt on risk investment

Forbes – The Little Book That Beats the Market (Intelligent Investing)

 

Wealthtrack – Greenblatt’s Strategy Change

CBS – Greenblatt Class #1 Notes

The Little Book That Beats The Market: Review, Quotes, & Lessons Learned

A Dozen Things I’ve Learned from Chris Dixon About Venture Capital and Startups

1. “If everyone loves your idea, I might be worried that it’s not forward thinking enough.” 

Anyone thinking about starting a business should be searching for mispriced opportunities.  While markets are mostly efficient in eliminating opportunities for extraordinary profit, there are always areas of an economy in which there are significant uncertainty. These areas are excellent places for a startup to look for opportunities.

The best entrepreneurs have learned that large businesses are investing huge amounts of capital in areas in which extensive information is already available, and that it’s most advantageous to create new businesses where information is not available. In other words, the best opportunities for startups tend to be in areas that are overlooked and less well-known by others. What Chris Dixon is saying is that if everyone loves your idea, this may be a “tell” that there will not be opportunities for extraordinary profit. The venture investor Peter Thiel has said: “The best startups are good ideas that look like bad ideas. Good ideas that look like good ideas are already being worked on by big companies.”

Dixon also says in this insightful post that “you shouldn’t keep your startup idea secret.” He identifies a range of positive benefits that flow from sharing the idea and getting feedback, while pointing out “there are at best a handful of people in the world who might actually drop everything and copy your idea.”

While most businesses do not require a result that generates extraordinary profit to be a success, this is not the case for a startup that seeks to raise venture capital. Venture capitalists invest in a portfolio of startups, knowing that only one to three in every fund could likely be a massive success. Chris Dixon’s partner Marc Andreessen describes the approach of a venture capitalist more technically as ‘buying a portfolio of long-dated, deeply-out-of-the-money call options’. Entrepreneurs are in the business of creating those options and selling some of them to investors to fund the business.

Like a startup or any other investor, a venture capitalist is seeking a mispriced opportunity.  All intelligent investors seek mispriced assets and if you want to explore this topic you can do no better than reading Howard Marks.  Why do large businesses and others leave this opportunity in areas with significant uncertainty available for startups? Howard Marks traces the source to bias and closed mindedness, capital rigidity, psychological success, and herd behavior. Markets are not fully efficient. Private, emerging and obscure markets are especially inefficient.

 

2. “How do you develop a good idea that looks like a bad idea? You need to know a secret — in the Peter Thiel sense: something you believe that most other people don’t believe. How do you develop a secret? (a) know the tools better than anyone else; (b) know the problems better than anyone else; and/or (c) draw from unique life experience.”

“Founders have to choose a market long before they have any idea whether they will reach product/market fit. In my opinion, the best predictor of success is whether there is what David Lee calls ‘founder/market fit.’ Founder/market fit means the founders have a deep understanding of the market they are entering, and are people who ‘personify their product, business, and ultimately their company’.”  

Chris Dixon is saying that the people most likely to know the “a secret” about a business opportunity are people who have deep domain expertise. In other words, it is not nearly as likely that someone without deep domain expertise will be successful without understanding the technology, the best methods to create the product, the best ways to bring products to market or the needs of the customer. Another way to think about this point is in terms of a moat or sustainable competitive advantage. Founders and employees of the startup are themselves contributors to the moat of a company, both directly and indirectly.

People who work for the startup who have deep domain knowledge are a likely source of what is called “optionality” which I have explained in a previous blog post. When a team of people in a startup have what Dixon called “secrets” as a result of deep domain expertise, their ability to adapt and innovate gives the startup and the investors optionality. Teams that do not have this optionality usually can’t adapt to changing environments, and fail more often.

The other skill that people with deep understanding have is the ability to see a phenomenon that is emerging within a complex adaptive system. When something bigger than the sum of its parts is emerging in an economy, some people with deep domain expertise are going to see the potential (the secret) before other people.

 

3. “[The] business of seed investing, and frankly, early-stage entrepreneurship, is so much about getting good information. And almost all of that information, unfortunately, is not published.”

The fact that information about a business is hard to get is actually a great thing for a startup, since it can help create the mispriced opportunity they seek. Uncertainty in the early stages of a startup is the friend of the entrepreneur. As the team pushes forward to reduce technology risk, find product/market fit and discover methods to scale the business, uncertainty is retired and value is created. The job of a great venture capitalist is in no small part to provide entrepreneurs with an entry into networks that allows them to quickly and cost-effectively find this private information. The same principle applies to the venture capitalists themselves. Great venture capitalists are always trying to find good sources of information, particularly information that is not published.

 

4. “Ideas …matter, just not in the narrow sense in which startup ideas are popularly defined. Good startup ideas are well developed, multi-year plans that contemplate many possible paths according to how the world changes.”

“Characteristics of the best ideas: (a) powerful people dismiss them as toys; (b) they unbundle functions done by others; (c) they often start off as hobbies and/or (d) they often challenge social norms.” 

“The best ideas come through direct experience. …When you differentiate your direct experience from conventional wisdom, that’s where the best startup ideas come from.”

My deepest exposure to what Chris Dixon is talking about immediately above (direct experience) came during the time I worked for Craig McCaw, who without question is a savant when it comes to ideas that can be developed into great businesses.  In the very early days, the “cell phone” only offered enough value to be a commercial success to a very small number of users. In the beginning, the device was so big it required a suitcase or a car installation to be useful. I remember real estate agents and construction sites as the biggest users. On the infrastructure side, a city like Seattle could be served by radios on only three very tall towers.

Eventually mobile phones appeared, but they were very expensive, analog, heavy and large. During that time period, McKinsey famously predicted that no one would ever use a mobile phone if a land line phone was available. McKinsey placed little or no value on what Craig McCaw called the ability of people to be “nomadic.” The mobile phone had each of the attributes Chris Dixon noted above. Some people thought of the mobile phone as a toy. Since my first mobile phone cost more than $4,000 dollars I actually felt awkward using it in some social settings. Talking into a mobile phone in some pubic settings would cause people to frown at you.

To continue my example, Craig McCaw was also an enthusiastic personal user of what we then called “cellular” phones. Craig McCaw loved working out of the ‘mobile office’ – meaning cars, planes, boats and ships. Which meant he was a natural enthusiast for the product. When the time came to sell his cable TV business in order to double down on the mobile phone business, the choice was made easy by his love of the mobile phone.

 

5. “There is a widespread myth that the most important part of building a great company is coming up with a great idea.” “What you should really be focused on when pitching your early stage startup is pitching yourself and your team. Of course a great way to show you can build stuff is to build a prototype of the product you are raising money for. This is why so many VCs tell entrepreneurs to ‘come back when you have a demo.’ They aren’t wondering whether your product can be built – they are wondering whether you can build it.”

Great ideas matter, as the previous quotations noted. But the ability of a team to execute is a more important consideration than a clever idea. Most everyone has said more than once “I thought of that idea first” when they see a new business being formed. The best idea in the world without a team to make it happen, won’t amount to a hill of beans. Chris Dixon is saying that the best evidence that a team can actually execute, is actually executing on something like a demo. The best evidence that you can do something like create software, is actually creating software. As the old proverb points out, the proof of the pudding is in the eating.

 

6. “What the smartest people do on the weekend is what everyone else will do during the week in ten years.” “Hobbies are what the smartest people spend their time on when they aren’t constrained by near-term financial goals.”  Chris Dixon is not referring to smart people who play ping pong in their garage or pay fantasy baseball in their dorm rooms on weekends. He is referencing the smartest people that are building things like the first PCs, drones, or a better search engine.  The Homebrew Computer Club, an early hobbyist group which had it first meeting on March 5, 1975, is just one example. The critical element here is an advanced technology that is useful to very smart hobbyists but does not yet have obvious financial returns associated with its use. Inevitably, technologies driven by phenomena like Moore’s law drive costs to lower levels and performance to high enough levels so that what was once a hobby becomes a thriving business.

As an aside, it is easier to understand Moore’s law now. But I will say that although I am probably in the top few percent in the US who understand its power, I underestimate that power every single year.

 

7. “This era of technology, it seems to be the core theme is about moving beyond bits to atoms. Meaning technology that affects real word, and transportation and housing and healthcare and all these other things, as opposed to just moving bits around. And those areas tend to be more heavily regulated and, this issue is only beginning to be significant and will probably the defining issue of the next decade in technology.” 

I include this quotation since it is an example of something that I value, which is an ability of a person to make a genuine non-consensus prediction about the future rather than predicting the present. Too many venture capitalists are camp followers. They are moving into a trend when others have long since moved on to other opportunities. To outperform, a venture capitalist must think like Howard Marks described here: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Deviating from a consensus view for its own sake is suicidal, but doing it occasionally and being very right is what makes a great venture capitalist like Dixon.

 

8. “Anyone who has pitched VCs knows they are obsessed with market size.” “If you can’t make the case that you’re addressing a possible billion dollar market, you’ll have difficulty getting VCs to invest. (Smaller, venture-style investors like angels and seed funds also prioritize market size but are usually more flexible – they’ll often invest when the market is “only” ~$100M).  This is perfectly rational since VC returns tend to be driven by a few big hits in big markets.” 

“If you are arguing market size with a VC using a spreadsheet, you’ve already lost the debate.” For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this.” “Startups that fill white spaces [areas where there is latent demand without supply] aren’t usually world-changing companies, but they often have solid exits. They force incumbents to see a demand they had missed, and those incumbents often respond with an acquisition.”

It is not possible to make silk purse out of a pig’s ear.  For a startup to generate the necessary financial return for a VC, the potential market being addressed must be massive. The entrepreneur who pulls out a spreadsheet and tries to make the case that the market is large enough based on fake quantitative assumptions does little but destroy his or her credibility. Venture capitalists hate to see hockey stick shaped distribution curves based on unrealistic assumptions that don’t map to reality. Chris Dixon is saying that what they do want to see for markets that can’t be defined with much certainty is a strongly argued narrative which explains that the market has or will attain the required size. Yes, they want to see as many related facts as possible that support the narrative. No, they don’t want to hear wild guesses presented as facts.

 

9. “There are two kinds of investors: Ron Conways who try to create value by finding good people and helping them create something great, and others, who want a piece of someone else’s things. The builders and the extractors. Avoid the extractors.” 

“Founders too often view raising capital as a transaction, when it is actually a very deep relationship. They think of money as money, when there is actually smart money, dumb money, high-integrity money, and low-integrity money.”

Particularly in the United States, money is not the scarce resource in venture capital.  The scarce resource is fundable startups. The outcome for any startup will increasingly be determined by access to networks of people and resources.  If a startup has a choice between (1) just money and (2) money plus access to these networks, is it wise to choose the latter.  Because startups most compete in an Extremistan environment (i.e., winner-take-all or winner-take-most-all) even the smallest advantage can end up topping the balance of success and cumulative advantage to one company.  Perhaps some founders are cheered up by a venture capitalist who is mostly a cheerleader, but the smart entrepreneurs want someone who can directly help with tasks like recruiting and problems like pricing and distribution.

 

10. “VCs have a portfolio, and they want to have big wins. They’d rather have a few more lottery tickets.. while for the entrepreneurs, it’s their whole life, and let’s say you raised five million bucks, and you have a fifty million dollar offer, and the entrepreneurs are like, “Look, I make whatever millions of dollars. I’ll be able to start another company.” And the VCs are like, ‘Wait! We invested billions of dollars.’ That is usually where tension comes.”

Chris Dixon has been both a founder and a VC.  He has empathy for both venture capitalists and founders on this set of issues. He is most certainly correct that this type of situation creates tension. The wave of discussion about this topic is proof of that. The question is: what is the best way to resolve the tension in ways that are mutually beneficial?  First, a brief note about what is at stake. The economist Harry Markowitz called diversification the only free lunch investing. Warren Buffett discussed the issues involved as follows:

“Of course, some investment strategies require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry.  That investor should both own a large number of equities and space out his purchases.  By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.  Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.  I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential.  In the words of the prophet Mae West:  ‘Too much of a good thing can be wonderful.’ ”

The wisest outcome on founder and employee liquidity issues will depend on the facts and circumstances of each case. There is no connect-the-dots-formula that is right in all cases. Fred Wilson has written a very thoughtful post on this issue. He points out that even from the view of the VC there is an incentive to create some liquidity:providing some founder liquidity, at the appropriate time, will incentivize the founders to have a longer term focus and that will result in exits at much larger valuations because, contrary to popular belief, founders drive the timing of exit way more than VCs do.”

In addition to what Fred Wilson notes, it is one thing to concentrate your investments if you have a net worth measured in millions and quite another if you have little financial cushion if the business fails. The important point that Chis Dixon raises is that there is an issue here, and it can create tension if not dealt with intelligently. Founders are smarter and better informed than ever before and they want a venture capitalist who is empathetic and thoughtful.

 

11. “If you aren’t getting rejected on a daily basis, your goals are not ambitious enough. The most valuable lesson I had starting out in my career was when I was trying to break in the tech world and I applied to jobs at big companies and at startups, at VC firms. I got rejected everywhere. I had sort of an unusual background. I was a philosophy major, a self-taught programmer. It turned out to be the most valuable experience of my career because I eventually developed such thick skin that I just didn’t care anymore about getting rejected. And, in fact, I kind of turned it around and started embracing it. I eventually — that sort of emboldened me. Through those sort of bolder tactics, eventually landed a job that got my first startup funded. So every day to this day I try to make sure I get rejected.”

The ability to handle rejection in a sales process is something that has always fascinated me.  Why can some people knock on door after door and suffer rejection and after rejection and still maintain a positive attitude long enough to generate the eventual sale? For some people a single rejection turns them into a nervous wreck, while others power through to close a sale. It seem to me to be explained by a combination of innate personality and a learned skill.

In any event, starting a business and even building a successful career involves way more selling than people who have never done it before imagine. Entrepreneurs are constantly selling themselves, their business and its products to potential employees, suppliers, distributors, investors and customers. If you can’t sell, starting a business is probably unwise.

 

12. “Before I started my first company, an experienced entrepreneur I know said, ‘Get ready to feel sick to your stomach for the next five years.’ And I was, ‘Eh, whatever.’ Then later, I was, ‘Shoot, I should listen to the guy.'” 

“You’ve either started a company or you haven’t. ‘Started’ doesn’t mean joining as an early employee, or investing or advising or helping out. It means starting with no money, no help, no one who believes in you (except perhaps your closest friends and family), and building an organization from a borrowed cubicle with credit card debt and nowhere to sleep except the office. It almost invariably means being dismissed by arrogant investors who show up a half hour late, totally unprepared and then instead of saying ‘no’ give you non-committal rejections like ‘we invest in later stage companies.’ It means looking prospective employees in the eyes and convincing them to leave safe jobs, quit everything and throw their lot in with you. It means having pundits in the press and blogs who’ve never built anything criticize you and armchair quarterback your every mistake. It means lying awake at night worrying about running out of cash and having a constant knot in your stomach during the day fearing you’ll disappoint the few people who believed in you and validate your smug doubters.”

I was the third employee of a company founded by Craig McCaw, and although I wasn’t a founder it was nevertheless a life changing experience.  It was a particularly notable day since I received two job offers the very same day. One job was a very safe position with an established company. The other was with the startup. What tipped the decision was that I wanted to have the life experience of being part of a startup. I wanted the experience more than the immediate monetary rewards that the other position offered.

From a post by Chris Dixon on climbing the wrong hill in your career“People tend to systematically overvalue near-term over long-term rewards.  This effect seems to be even stronger in more ambitious people.  Their ambition seems to make it hard for them to forgo the nearby upward step.”

There were lots of times I thought that I had made a mistake in not taking the safer and better-paying job. I experienced all the things Chris Dixon talks about in that post, including attacks from armchair critics. I worried often about other employees and how my family would cope with failure if that happened. The tale of this startup is actually one of the great untold stores in business history. It resulted in a 4X return for early investors which was not terrible, but not great either. That’s a story for another time.

 

 

Notes:

Chris Dixon – Why you shouldn’t keep you startup idea secret 

Github – Startup School 2013

 

Chris Dixon – The idea maze

Chris Dixon – What the smartest people do on the weekend

 

Chris Dixon – Founder Market Fit 

Chris Dixon – Size markets using narratives, not numbers

 

This Week in Startups – Chris Dixon, General Partner at a16z (video)

Chris Dixon – Size markets using narratives, not numbers

 

9 inspirational startup quotes from Chris Dixon

Chris Dixon – Pitch yourself, not your idea

 

Gigaom – Why the VC Model is Broken

Chris Dixon – Climbing the Wrong Hill

Chris Dixon – If you are not getting rejected

A Dozen Things I’ve Learned from Tom Murphy About Capital Allocation and Management

Some people, particularly those that are in the early stages of their career, may ask: who was Tom Murphy?  He is the sort of person that industry hall of fames write about in this way: He began his broadcasting career as the first employee of a bankrupt television station in Albany, New York. Acquisition by acquisition, he built the company.” “Tom, who became President of Cap Cities, gradually built the company into a telecommunications empire. In 1985 he engineered the purchase of ABC with the backing of his long-time friend Warren Buffett, and the company became Cap Cities/ABC. He describes it as ‘the minnow that ate the whale’. Ten years later, Tom sold Cap Cities/ABC to Disney for approximately $19 billion.”

In 1985, Fortune wrote: “Under Murphy and Burke, Capital Cities has turned in an exceptional performance in its principal businesses: broadcasting, which produced 51% of the company’s 1984 operating profits, and publishing (48%). Without much show of effort, Capital Cities’ per-share earnings growth since 1974 has averaged 22% annually, compounded. Return on shareholders’ equity, a key measure of performance, averaged a splendid 19.2% during the period.”

Warren Buffett is one of Tom Murphy’s biggest admirers. For Warren Buffett to say this is high praise indeed: “Tom Murphy and Dan Burke were probably the greatest two-person combination in management that the world has ever seen, or maybe ever will see.” Similarly, Warren Buffett once told Lawrence Cunningham, the author of the book Berkshire Beyond Buffett:  “Most of what I learned about management, I learned from Murph. I kick myself, because I should have applied it much earlier.” He has also said it as directly as possible: “I think (Murphy) is the top manager in the U.S.”

When you study what Warren Buffet has said and written about managing a business, in many cases you are learning indirectly from Tom Murphy. That is a good thing since Tom Murphy did not say or write very much in comparison to Buffett. Like many great operators and managers Tom Murphy mostly let his business results speak for themselves, and did not spend any significant time seeking to be noticed by the public.

1. “There’s no substitute for being a good business, and there are not many of them.” “There are not many great businesses that come along in a lifetime.” Warren Buffett and Tom Murphy see eye-to-eye on this point, with the Berkshire chairman famously saying: “When a management team with a reputation for brilliance joins a business with poor fundamental economics, it is the reputation of the business that remains intact.” Without a moat, any business will inevitably see the price of their company’s products reduced to a point equal to the opportunity cost of capital – even if the business has managers who have great operational skills. Yes, you definitely want great managers and occasionally you might find one as talented as Tom Murphy or Ajit Jain. But that does not mean you should invest in a business without a moat if you think it has great management.

The forces of competition are relentless, and the ability to copy the operational effectiveness of a competitor is a constant problem for businesses that do not have a moat. Tom Murphy is making the point above that businesses which have a moat are rarer than most people imagine. In other words, a good moat is truly hard to find. And contrary to what Peter Thiel would have you believe, moats come in all sizes with varying strengths and weaknesses.

The width and depth of a given moat shifts constantly. There is no binary phase transition between moat and no moat. I do find it a bit ironic given the Buffett/Berkshire connection that Tom Murphy once said: “I loved the business I was in, and I loved going to work every morning. If it had been the railroad business, it would not have been as much fun.”

2. “The goal is not to have the longest train, but to arrive at the station first using the least fuel.” This quote is a great setup to contrast the management style of Tom Murphy with William Paley, who ran the competing CBS television network.  Tom Murphy was not a fan of a business getting bigger for its own sake or diversifying into unrelated businesses to achieve “synergy” or diversification. Unlike William Paley, Tom Murphy did not buy businesses like a baseball team or a toy company. When Tom Murphy bought a business it was to generate additional benefits for the core media business.

As we discussed, Tom Murphy thought that a business with a moat is very hard to find and for this reason alone he preferred to put capital to work in the business where he had the greatest advantage. When Tom Murphy allocated capital he preferred a focused approach rather than diversification, since he was investing in a business he knew very well and that had very attractive characteristics.

3. “We just kept opportunistically buying assets, intelligently leveraging the company, improving operations and then we’d … take a bite of something else.” One of the great skills that any investor or businessperson can have is a talent for capital allocation. And Tom Murphy, like Warren Buffett, was a master at capital allocation.  When Tom Murphy bought a business he used debt or cash generated by the business rather that diluting equity by issuing stock. In this way, he acted a lot like John Malone or Craig McCaw as they rolled up business after business so as to benefit from demand and supply-side economies of scale.

William Thorndike, the author of the popular business book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, believes that the best CEOs have an “investor’s mind set.” When they consider a business decision like an acquisition or the purchase of capital equipment, “they viewed it as investment and when it had attractive returns they did a lot of it.”

4. “The business of business is a lot of little decisions every day mixed up with a few big decisions.” A great business is built brick-by-brick on a daily basis. The job of a CEO is to make a few really important decisions that set strategic direction, and then find ways to enable the rest of the company to achieve their goals. Dan Burke, Murphy’s long-time business partner, said in an interview that the process is simpler than people imagine. You gather the facts and then you make decisions based on good judgment. Of course, having good judgment is easier said than done. It is certainly easier if your business itself is sound.

On Warren Buffett’s company, Tom Murphy wrote in the forward to Berkshire Beyond Buffett: “From afar, it may look like Berkshire’s wide-ranging businesses are very different from one another. In fact … while they span industries, they are united by certain key values, like managerial autonomy, entrepreneurship, frugality and integrity.” Dan Burke was fond of a quotation attributed to a Chinese philosopher: ”A leader is best when people barely know he exists, not so good when people obey and acclaim him — worse when they despise him. But of a good leader who talks little when his work is done and his aim is fulfilled, they will say: We did it ourselves.”

5. ”Decentralization is the cornerstone of our management philosophy.” “[Warren Buffett and I] are both proponents of a decentralized management philosophy: of hiring key people carefully; of pushing decisions down the organization; and of setting overall principles and resisting temptation to be involved with details. In other words, don’t hire a dog and try to do the barking.” 

“Decentralization, though, is not a magic bullet….  In the wrong environment, chaos and anarchy sit side-by-side with decentralization.” Warren Buffett has said his strength is his weakness: delegation to the point of anarchy. What Tom Murphy taught him was that if you (1) hire the very best people and (2) don’t delegate the critical job of capital allocation, you can create what Buffett’s partner Charlie Munger calls a ‘seamless web of deserved trust’. It is tremendously cost efficient to have a culture that is based on trust, since you don’t have the cost or the inefficiency associated with layers of management that try to act as a substitute. When Tom Murphy bought the ABC Television network, the Capital Cites headquarters consisted of only 36 people. Of course, this seamless web of deserved trust system does not work if you do not hire great people, allocate capital wisely, and delegate authority. Fortune magazine pointed out: “The great exception to the local-autonomy principle is a rigorous annual budgeting process that Burke personally oversees.”

6. “We expect a great deal from our managers.” The flip side to Tom Murphy’s aggressive delegation of authority was that he held his managers accountable for performance.  If you have delegation without accountability it is an absolute recipe for disaster. For example, accountability for sales targets was not something that was casually considered at Capital Cities.  As another example, in the television broadcast industry feedback is quick. Someone once quoted Murphy as saying: “Every day you wake up and get a report card on how you’re doing.”

In the Berkshire context, Jim Weber, the CEO of Brooks Running, has pointed out that Buffett and Munger “fall in love with a business that has great management in place, so that they don’t have to run it [but] I’ve never felt more responsible and accountable.” Murphy’s #2 Dan Burke put the process at Capital Cities this way:  ”We sit everybody down in the dark once a year and show them what they said they were going to do for the year and what they actually did. Then we look at what they say they’re going to do next year. It’s sort of compelling to know that a year from now you’re going to be back in that same slot.”

7. “Cost control was the baseline of our company culture.” “We worked to make cost-consciousness a part of our company’s DNA. Budgets, which are set yearly and reviewed quarterly, originate with the operating units that are responsible for them.”  Tom Murphy was famously frugal. One story often told is about Tom Murphy only painting the two sides of a building Capital Cities owned that faced the road. But when it came to buying assets that produced excellent financial returns, Tom Murphy did not hesitate to spend money. If he was cheap, it was on expenditures that he felt did not produce an adequate financial return.

A producer for ABC said once that if your programs went over budget “you would be invited to seek employment elsewhere.” In The Outsiders William Thorndike wrote: “Murphy, however, was a cab man and from very early on showed up to all ABC meetings in cabs. Before long, this practice rippled through the ABC executive ranks, and the broader Capital Cities ethos slowly began to permeate the ABC culture. When asked whether this was a case of leading by example, Murphy responded, Is there any other way?”  Focus on cost control meant that Murphy’s stations had the highest margins in the business, north of 50% compared to an average of 30%.”

8. “Gauge performance over the long haul.” Tom Murphy was famously patient when it came to acquisitions and he adopted the same view when it came to the performance of his managers. Like Warren Buffett, he was willing to accept results that could be lumpy if that higher volatility improved long-term overall performance. The process was rigorous: “Murphy’s method of deal sourcing … involved staying out of the public eye, and spending years developing relationships with potential prospects. He never financed with equity, either generating cash internally, or using debt which was nearly always paid off within three years. All his major deals were through direct contact with sellers; they were never hostile, and never through an auction. He had strict return requirements: a double-digit after-tax return over 10 years, without leverage.”

9. “There’s no substitute for people with brains who are willing to work hard.” “One wrong hiring decision at a senior level can really hurt hiring decisions down the line.” “If you hire mediocre people, they will hire mediocre people.”

“In terms of culture, we told our employees that we hire the smartest people we can find and that we have no more of them around than necessary.” For Murphy, no partner was more important than Dan Burke who “shaped the culture of the company, with an emphasis on accountability, directness, irreverence and community service.” [Dan Burke had] a “wicked sense of humor that made every day more fun.” Tom Murphy and Dan Burke preferred to hire someone with brains rather than experience. Tom Murphy once said that his company “doesn’t like to have more personnel than it needs. Too many people with too little to do leads to office politicking and other behavior that’s destructive for an organization.”

10. “One of the most uncommon things in life is common sense. It’s very hard to notice whether people have common sense.” Judgment and common sense are among the hardest things to teach. I think everyone can get better at making decisions, but some people have more common sense than others it seems.  In many respects, making better decisions and having more common sense is a trained response. In my view, the first rule on this point is to read as much about Charlie Munger’s views on the psychology of human misjudgment and worldly wisdom as you possibly can. The second rule is to not forget the first rule.

11. “As an entrepreneur you don’t want to run out of cash. You don’t want to borrow any more money than you absolutely need.” This point is so obvious, and yet some people forget it and seal their doom. Running out of cash is an unforgivable sin in business.  If you have enough cash, you can even go through bankruptcy and survive as a business. Holding the right amount of cash is an art, especially if you are being financed with debt. I plan to write a post on Michael Milken at some point which will deal with this set of issues.

12. “Don’t spend your time on things you can’t control. Instead, spend your time thinking about what you can.” Carl Richards has a wonderful graphic that makes this same point on a napkin-like sketch.

Things that matter, Things you can control

Notes:

Amazon – Berkshire Beyond Buffett

Amazon - The Outsiders

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Tom Murphy, Harvard Business School notes

Tom Murphy Interview (video)

Smart Company – Warren Buffett: How a rowboat beat an ocean liner 

Fortune – Capital Cities Capital Coup

A Dozen Things I’ve Learned from Doug Leone About Startups & Venture Capital

Doug Leone is the Managing Partner of Sequoia Capital, where he has been a partner since 1993. Prior to joining Sequoia in 1988 he worked at Sun, HP and Prime in sales and sales management positions.

1. “We want to be partners with entrepreneurs from day one… We know after many, many years that your DNA is set in the first 60 to 90 days.”  

Doug Leone would prefer to be the “first outside dollar” in a new business. He believes it is easier to train people about the right approach than to change what has already been established. The cynic might say he is saying this because valuations are lower for the “first dollar in” venture capitalist. The non-cynic would reply that the probability of success goes up when a business gets a great start, since investing early helps retire risk and uncertainty.

Doug Leone makes a reference to genetics in the quote. What is the DNA of a business?  In my view it is culture and values, plus a range of best practices. Best practices can’t be reduced to a formula since every business is different, but there are ways to learn from others. Many posts on this blog have been about best practices and company culture. I learned most of what I know about optimal company culture and best practices mostly during one magical period in my life when I would sit in on meetings as Craig McCaw met various captains of industry as they came to visit him. A parade of executives like Charlie Ergen, Alan Mulally and Jeff Hawkins passed through my life during that period, and what I learned in those meetings was magical. I tried to be a sponge for knowledge and best practices, and to make the best parts of their DNA part of my DNA.

It is important to break at least a few rules in creating a startup, since you can’t outperform a market by simply copying others. BUT, not taking the time to learn from others about best practices is a huge mistake. A group called the Startup Genome team created this “avoid-to-achieve-success” list, which is instructive rather than complete:

  • Spending too much on customer acquisition before product/market fit and a repeatable scalable business model
  • Overcompensating missing product/market fit with marketing and press
  • Building a product without problem/solution fit
  • Investing into scalability of the product before product/market fit
  • Adding “nice to have” features
  • Raising too little money to get thru the valley of death
  • Raising too much money. It isn’t necessarily bad, but usually makes entrepreneurs undisciplined and gives them the freedom to prematurely scale other dimensions. I.e. over-hiring and over-building. Raising too much is also more risky for investors than if they give startups how much they actually needed, and waited to see how they progressed.
  • Focusing too much on profit maximization too early
  • Over-planning, executing without regular feedback loop
  • Not adapting business model to a changing market
  • Failing to focus on the business model and finding out that you can’t get costs lower than revenue at scale.

2. “[In venture] big is completely the enemy of great. You want very small, tight teams, same thing with running an engineering department.”

Doug Leone believes that small teams of people making decisions make better decisions (too many cooks spoils the broth). The Startup Genome team also makes a few points on small team failures:

  • Hiring too many people too early
  • Hiring specialists before they are critical: CFO’s, Customer Service Reps, Database specialists, etc.
  • Hiring managers (VPs, product managers, etc.) instead of doers
  • Having more than 1 level of hierarchy

3. “We’re happy to help recruit the first 3, 4, 5 engineers but we firmly do believe that recruiting is a core competency that companies should learn.”

A repeated theme of successful VCs in this series of blog posts has been that the composition and chemistry of the team will determine the success of the business. Since great people attract other great people in a nonlinear way, getting a strong early start with recruiting is essential. Doug Leone is also saying that if the company can’t recruit its own people after getting an assist from the venture capitalist, they are in trouble. If great people aren’t being attracted to the startup something is wrong.

Because hiring the right people is so important Sequoia has in house recruiters to help companies. If a startup if not able to attract great employees that is a “tell” for an investor that something is wrong with the business or its culture. By contrast, a startup that punches above its weight in attracting great employees is a sign that the business is on the right track. If you think to yourself: “How did they hire someone of her or his caliber” that’s a good indicator that the startup will be successful.

4. “There are three types of start-ups: 1) Ones that are so young that it’s difficult to tell if the dogs are going to eat the dog food. 2) Ones where there’s clear evidence of market pull.  3) Ones that are unfortunately stuck in a push market or have a very difficult product to sell. The trick is to say away from #3.  You only go to #1 if you are a domain expert and you have an informed opinion on a product/market, but this is a rare trait. The real trick is to end-up in #2.”

When he said this, Doug Leone was giving advice to salespeople about joining a startup. In the best case for the salesperson, product/market fit has been found and there is at least some sales traction. In other words, dogs are eating the startup’s dog food and want more. Doug Leone is pointing out that if the business has not yet established product/market fit (ie., it’s still difficult to tell if the dogs are going to eat the dog food) it is best for the salesperson to leave the opportunity to others who have special skills and aptitudes. A different breed of employee is required when it is unclear whether the dogs will eat the dog food (type 1).

5. “Little companies have really two advantages: stealth and speed. You [Arrington] come from the world of speed and no stealth. The best thing for little companies do is to stay away from the cocktail circuit.”

As my blog post on LinkedIn’s Reid Hoffman pointed out, startups need feedback when developing a product or service. Having said that, a startup need not spend a lot of time promoting the offerings until the time is right. There is a big difference between developing a product and finding product/market fit, and promoting a product in ways that do not relate to product/market fit.  Attending parties is not what creates great companies. Typically you are not interacting with customers at a party. Having said that, as I wrote in my post on Nassim Taleb: “Living in a city, going to parties, taking classes, acquiring entrepreneurial skills, having cash in your bank account, avoiding debt are all examples of activities which increase optionality.” A balance is required in all things, and the level and intensity of party attendance and socializing is a part of that.

6. “Don’t confuse the cost to start a company [with] the cost of building a company.”  Creating a product or service and finding product market fit are only small steps toward success. Unless the business finds sales, marketing and distribution approaches that scale, a startup will not find success. There is a huge gap between finding product market fit and scaling a company. Bill Gurley of Benchmark Capital points out: “If you want to get to 50 to 100 employees (unless you’ve discovered the next Google AdWords) you’re going to need outside funding, but that doesn’t mean VC investment is the path for everyone.”

There are many attractive business opportunities that do not require and should not raise venture capital. Ben Horowitz of a16z writes: “Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks, and has raised hundreds of millions of dollars to build their business. But building the initial Facebook product cost well under $1M and did not entail hiring a head of manufacturing or building a factory.”

7. “Hire the guy who has something to prove.” “We want people who come from humble backgrounds and have a need to win.”

Especially since he came from humble beginnings economically, Doug Leone is a big fan of hiring people who are hungry for success. His partner Michael Mortiz explains: “Every time we invest in a little company, it’s a battle against the odds. We’re always outgunned by companies that are far larger than us, who have threatened us and the founders with extinction.”

The best VCs prefer missionaries to mercenaries, and people who have something to prove tend to be missionaries. I certainly have met people who were driven by the fact that they started with literally nothing before building a business. I’ve have found in my own life that many people who come from comfortable financial backgrounds are also driven to find success. Bill Gates and Craig McCaw are just two examples. Of course, some people from affluent backgrounds are also growing organic vegetables in a commune (not that there is anything wrong with that if it makes them happy).

8. “Be incredibly, ruthlessly selfish with your equity.”

Entrepreneurs who are not careful about dilution often learn a hard lesson about selling equity too cheaply.  The founders will need shares to compensate key people and to keep themselves motivated to stay “all in.” Bill Gurley has said that he’s “seen companies take one or two angel rounds and wind up giving away half their company.” There is a relevant old saying in the venture capital business: “There are three phenomena that can wreck even the best of investments: Dilution, Dilution, Dilution.”

A16z points out that there are many tradeoffs involved: “The easiest way to think about valuation is the tradeoff it provides relative to dilution: As valuation goes up, dilution goes down. This is obviously a good thing for founders and other existing investors. However, for some startups there’s an added wrinkle; they may face an additional tradeoff, of valuation versus “structure.” Which reminds us of the old adage that ‘You set the price, I’ll set the terms.’

Lots of people like Sam Altman  and Wealthfront have also written thoughtful, informative posts on this topic.

9. “What differentiated knowledge does the angel bring? . . . Don’t just do an angel round with people whose money is thrown your way.”

Given a choice between Angels who add both money & other contributions, or Angels with only money to contribute, choose the former. Especially circa 2015, raising money is not a problem if you have a great team and an offering under development with significant optionality. Founders increasingly realize that they need more than money from an investor. For this reason you see more and more venture capitalists blogging and using social media to convey to founders that they have more to contribute to a business than money. When is raising money from Angels a good idea? Ben Horowitz writes: “If you are a small team building a product with the hope of “seeing if it takes” (with the implication being that you’ll try something else if it doesn’t), then you don’t need a board or a lot of money and an angel round is likely the best option.”

10. “There are [venture] firms that have never generated a positive return or have not even returned capital in 10 years that are raising money successfully. And that surprises the heck out of me. People talk about the top quartile — it’s not about the top quartile, it’s barely about the top decile, or even a smaller subset than that.”

Pension funds and universities have ~ 8% return assumptions, and hope for some sort of justification that they will deliver magical returns via the venture capital asset class. In other words, they invest in the way that Doug Leone describes, since it enables the investment committee of the pension or endowment to defer the pain of reducing the return assumption – and that makes the underfunding problem the job of someone else in the future. No one associated with an endowment or pension likes to cut spending or raise contributions, so they pretend that certain returns are possible. This results in more money coming into the VC asset class than would otherwise be the case.

What this also causes is for money to chase performance in the venture capital asset class, and for this to be true: “Venture Capital has long been a trailing indicator to the NASDAQ. Venture capital is a cyclical business.” (quote from Bill Gurley)

11. “Just keep in mind that we are in a venture capital business. It’s called venture capital because nothing is certain. But if you look at our portfolio, it doesn’t include Twitter. It doesn’t include Pinterest. We have made many, many errors over the last 40, 50 years. But I’ll also tell you we’ve got many, many right.”

Venture capital is a business in which you are guaranteed to make mistakes, since it is all about buying mispriced optionality. It is magnitude of success and not frequency of success that matters in the end. The greatest venture capitalists, just like Babe Ruth, strike out a lot, but hit massive “tape measure home runs”. It is worth emphasizing that Doug Leone talked about “uncertainty” rather than risk. Uncertainty is actually the investor’s friend since it is the primary cause of mispriced assets. I discuss the difference between risk and uncertainty in my post on Vinod Khosla of Khosla Ventures. Without mispriced assets (i.e., the mistakes of other people), you can’t outperform the market, and it is when there is uncertainty that assets most often get attractively mispriced.

12. “If you’re in Cleveland, we cannot help you.”

Doug Leone said this in 2011. Unfortunately, physical location matters even with the Internet as a powerful tool to distribute expertise. My late friend Keith Grinstein used to say that “you can’t milk a cow over the phone.” Physical location still matters, which is why there are cities that benefit from agglomeration effects. Smart cities embrace this fact and create their own positive feedback loops.

If the venture capital firm is too far away from the startup, it is hard for the venture capitalist to provide much more than money. Without more than money, Doug Leone does not feel the company has the same probability of success. Since Doug Leone has helped established Sequoia branches overseas, he must believe that the Sequoia VCs in overseas city X can help startups in city X. Doug Leone obviously feels other cities can have agglomeration effects while investing in, or Sequoia would not have such big investments in China and India.

Don Valentine (the Founder of Sequoia), who I will write about soon, said once about his firm: “In 30 years we haven’t convinced ourselves to set up a presence in Boston. It’s a very difficult business to be good at consistently over a long period of time, and it requires a lot of thoughtful and integrated decision-making… We make enough mistakes on investments we make here (in Silicon Valley), that we’re not comfortable we can (be successful) 3,000 miles away, never mind 8,000 miles away.” If a city is a just a couple of hours away from a venture capitalist, I would argue that the rule doesn’t apply. Lots of venture capitalists from San Francisco have been successful investing in Seattle and vice versa, especially if they have strong venture partners in the other city. A firm like Benchmark Capital benefits immensely from having a partner like Rich Barton in Seattle.

Notes:

PEHub – Sequoia’s Doug Leone to Mike Arrington: Why You Want to Be a VC is Beyond Me

Forbes – Douglas Leone, Sequoia Capital’s secrets to success and PR for venture firms

Medalia – So you want to sell a startup? QA with Leone

WSJ – Sequoia Capital’s Leone: In Venture, Big Is the Enemy of Great

Kedrosky – Infectious Greed

Adweek – Are Startups Thinking Too Small?

Upstart – Sequoia’s Doug Leone

Techcrunch – Disruptive Tendencies