A Dozen Things I’ve Learned from Andy Rachleff

1. “When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.” “If you address a market that really wants your product, if the dogs are eating the dog food, you can screw up everything in the company and you will succeed. Conversely, if you’re really good at execution but the dogs don’t want to eat the dog food, you have no chance of winning.” A great product in a great market can make an executive look great, regardless of skill. Similarly, when a talented executive tries to achieve success with an offering that is lousy or the market is lousy, the result is inevitably lousy. Warren Buffet has expressed a similar thought: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Andy wants great management and a great market when he invests. One big difference between Andy Rachleff and Warren Buffett is that as a venture capitalist and entrepreneur, Andy builds new moats.  Warren Buffett and Charlie Munger make it clear that they only buy existing moats. Building new moats and buying existing moats are very different objectives, involving very different skills and talents.


2. “A disruptive product addresses a market that previously couldn’t be served — a new-market disruption — or it offers a simpler, cheaper or more convenient alternative to an existing product – a low-end disruption. …Silicon Valley was built on a culture of designing products that are “better, cheaper, faster,” but that does not mean they are disruptive.” Wealthfront, which Andy founded,  is an example of a company providing people with services which could not have been offered before the software-based innovations that are robo-advising. In other words, small accounts served by Wealthfront could not previously have been served by traditional advisors without higher fees, loads and costs.  The lower fees are enabled by technology and new sales channels. One thing I love about Andy making this set of statements about disruption, is that he said publicly that he did not really understand disruption fully until he founded Wealthfront. That sort of intellectual honesty is what makes people succeed in life. Charlie Munger likes to say that if he does not destroy one of his most cherished ideas every year, it is a wasted year.


3. “Instead of starting with the market and then finding the product, the really big winners start with a product and find a market.” Finding a product or service that delivers a 10-2,000X financial return happen much more often when the entrepreneur is harvesting something that is nonlinear, and that comes from a technology rather than something that is just marginally cheaper.  Discovering really big new markets can be especially profitable.  Andy’s friend  Bill Gurley has a masterful essay on total addressable market definition here.  


4. “It’s very difficult to manufacture innovation.” “Great entrepreneurs are far more missionaries than mercenaries. The missionaries are true to their insight, and the money is secondary to it. Mercenaries, whose primary goal is money, fall somewhere on the middle of the entrepreneur bell curve. They seldom have the desire to change the world that is required for a really big outcome, or the patience to see their idea through. I don’t begrudge them their early payouts. They’re just not the best entrepreneurs.” Since only ~15 tape measure home runs a year are what drive venture capital returns, the odds that the same person will get lighting in a bottle at that level multiple times are small. A given person hitting more than one of those home runs is possible, but that ~15 number is a top down constraint on the total number of people who succeed at that level. People who flip the business early or midstream usually don’t last long enough to do this. Experience has shown that it is very likely to be genuine passion and domain knowledge, and not what Andy called “manufacturing innovation,” which produces those ~15 tape measure home runs.

5. “We never meet with companies that aren’t referred or where we don’t know the entrepreneurs.” “It’s sort of a test, if you can’t get an introduction [to the venture capitalist] you are unlikely to succeed in selling the other constituencies.” Being an entrepreneur requires effective selling in the broadest sense of the word. The entrepreneur must sell ideas, prospective employees on jobs, products and services, partners, investors, the media, etc.


6. “[Venture capital is] a very cyclical business. So there was a cycle from 1980-1983 that looked a lot like 1996-1999. Only an order of magnitude smaller on every dimension.”  “I don’t think a bubble is an environment where things are valued highly, I think it’s an environment where crappy companies are valued highly.”  Andy Rachleff, Bill Gurley and many other investors are fans of Howard Marks like I am.  Howard is fond of pointing out that business cycles will always exist and the best approach is to expect their inevitable and unpredictable changes.  All markets are cyclical and always will be.  Venture capital is no exception, and is in fact more cyclical that many other markets.  The timing of business cycles in different industries and sectors is often not synchronized.  As Bill Gurley has pointed out,“venture capital has long been a trailing indicator to the NASDAQ.”


7. “All our advice on Silicon Valley careers is based on a simple idea: that your choice of company trumps everything else. It’s more important than your job title, your pay or your responsibilities.” Feedback is what’s driving returns today in markets, and as Reid Hoffman has said, what company you work for and who you learn from matters more than ever. Networking “early and often” is an excellent approach to business and life especially in a digital world.


8. “Human beings want returns, but they don’t like risk.” Most people talk a good game about risk and uncertainty but will typically back off when it comes time to actually do anything.  Some of these people are your really smart classmates who have never gone anywhere financially in life. People who are comfortable with risk earn a premium as a result of the risk aversion of other people. Ironically, people who are oblivious to risk sometimes also get lucky and earn that same premium (even a blind squirrel finds a nut once in a while).


9. “It doesn’t matter how many losers you have, all that matters is how big your winners are.” “You can only lose 1X your money [as a venture capitalist]. “[As a venture capitalist] you make bets and you have to be willing to be wrong a lot…. It’s one of the few industries I know of where you can be wrong 70% of the time and be brilliant.” If you have been reading this series you recognize that Andy is talking about what I have called “harvesting optionality.”  A tape measure home run hitter can strike out a lot and still be great. It is magnitude of success and not frequency of success that matters most for an investor.


10. “When it comes to investing in venture capital I would follow the old Groucho Marx dictum about ‘never joining a club that would have you as a member.’” The very best venture capital firms and startups don’t need your money. This fact is a byproduct of cumulative advantage and is reflected in the power laws that drive venture capital returns. Andy Rachleff writes: “only about 20 firms – or about 3 percent of the universe of venture capital firms – generate 95 percent of the industry’s returns, and the composition of the top 3 percent doesn’t change very much over time.”


11. “Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. … Now obviously if you’re wrong you don’t make money. What most people don’t realize is if you’re right and consensus you don’t make money. The returns get arbitraged away. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”  All the investors in this series on my blog understand that you cannot outperform a crowd unless you are sometimes contrarian, and right enough times when you decide to be a contrarian. Many people first heard this idea from Howard Marks, but if you trace the idea back even further it leads to Ben Graham  and before him John Maynard Keynes.


12. “Other than my wife, Bruce Dunlevie is the most influential person in my life. His advice was to always put the gun in the other person’s hand. In other words, if you are in negotiations with someone, you tell them to tell you what they think is fair, and then you do it. It’s a much better way to live to give trust first, rather than to make someone prove he is trustworthy.” Bruce Dunlevie is someone I have learned a lot from, especially about being a thoughtful, well-rounded and trustworthy human being. Having a colleague who has these qualities is a fine thing to have in life.  As a bonus, when you develop a network of high quality people who you can trust, you have what Charlie Munger calls a “seamless web of deserved trust” – which enables efficiency and better financial returns. But that should not distract anyone from the fact that being a good person is its own reward.


Notes: PandoDaily – What makes for a great entrepreneur?  

TechCrunch – The Truth About Disruption

This WeekIn Startups – Andy Rachleff, CEO Wealthfront

Stanford Graduate School of Business – Andy Rachleff: How To Meet VCs

Wealthfront blog - Demystifying Venture Capital Economics

SiliconMBA – Deep Thoughts From Andy Rachleff

A Dozen Things I’ve Learned from Peter Thiel


1. “Great companies do three things. First, they create value. Second, they are lasting or permanent in a meaningful way. Finally, they capture at least some of the value they create.”   “More important than being the first mover is the last mover. You have to be durable.”  “The most critical thing for every startup is to be doing one thing uniquely well, better than anybody else in the world.” This set of statements in my view is about what Michael Porter calls “sustainable competitive advantage” (AKA, moats). Yes, you must create new value to be a great company. But unless you capture some of that value as producer surplus in a sustainable way, the only beneficiary is the customer. One of the best explanations of this value capture point is in Charlie Munger’s fantastic Worldly Wisdom essay:  “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.


2. “Maybe we focus so much on going from 1 to n because that’s easier to do. There’s little doubt that going from 0 to 1 is qualitatively different, and almost always harder, than copying something n times. And even trying to achieve vertical, 0 to 1 progress presents the challenge of exceptionalism; any founder or inventor doing something new must wonder: am I sane? Or am I crazy?” Doing something that has never been done before is genuinely hard enough that many people consciously or subconsciously would rather chase the tailpipes of others than genuinely innovate “from 0 to 1.” Failing conventionally, rather than succeeding unconventionally, is unfortunately the path chosen by many people.


3. “We see the power of compounding when companies grow virally. Successful businesses tend to have an exponential arc to them. Maybe they grow at 50% a year and it compounds for a number of years. It could be more or less dramatic than that. But that model—some substantial period of exponential growth—is the core of any successful tech company. And during that exponential period, valuations tend to go up exponentially.” It is nonlinear phenomena which drive the 10-2,000X tape measure home runs a venture capitalist needs to be successful. Straying too far from a nonlinear phenomenon like Moore’s Law can be harmful to a venture capitalist’s financial health. For a some great data on the sort of growth one needs in a venture capital backed startup, I suggest you try this video of a Jules Maltz talk from the recent PreMoney conference.


4. “You’re going to start a business you might as well try to start one where, if it works, it will be really successful, rather than one where you’re competing like crazy with thousands of people who are doing something just like you all the time.” That most people misprice the value the value of optionality is the core driver of the venture capitalist trade. Without mispricing, there is no alpha. And the prime territory for optionality is not where thousands of people are looking.

5. “Consider a 2 x 2 matrix. On one axis you have good, high trust people and then you have low trust people. On the other axis you have low alignment structure with poorly set rules, and then a high alignment structure where the rules are well set.  Good, high trust people with low alignment structure is basically anarchy. The closest to this that succeeded is Google from 2000 to maybe 2007. Talented people could work on all sorts of different projects and generally operate without a whole lot of constraints. Sometimes the opposite combination—low trust people and lots of rules—can work too. This is basically totalitarianism. Foxconn might be a representative example. Lots of people work there. People are sort of slaves. The company even installs suicide nets to catch workers when they jump off the buildings. But it’s a very productive place, and it sort of works.”  The low trust, low alignment model is a dog-eat-dog sort of world argues Thiel. It’s best to avoid this combination. The ideal combination in his view is high-trust people with a structure that provides a high degree of alignment since people are rowing in the same direction, and not by accident. Equity incentives, properly structured, are an important way to think about alignment in startups.

 Peter Thiel's Matrix 

6. “Angel investors may have no clue how to do valuations. Convertible notes allow you to postpone the valuation question for Series A investors to tackle. Other benefits include mathematically eliminating the possibility of having a down round. This can be a problem where angels systemically overvalue companies…. If you must have a down round, it’s probably best that it be a really catastrophic one. That way a lot of the mad people will be completely wiped out and thus won’t show up to cause more problems while you start the hard task of rebuilding. But to repeat, you should never have a down round. If you found a company and every round you raise is an up round, you’ll make at least some money. But if you have a single down round, you probably won’t.”  Valuation is hard. There are (according to one count) 135 micro VCs and thousands of individual angels out there, able to mess up a capitalization table via a poorly chosen valuation.

7. “A robust company culture is one in which people have something in common that distinguishes them quite sharply from rest of the world. If everybody likes ice cream, that probably doesn’t matter….you also need to strike the right balance between athletes (competitive people) and nerds (creators) no matter what.” Peter Thiel is describing some of the core elements of a winning culture: a shared unique mission and the right mix of passionate people.  Great leaders know how to create that mix. Great investors can spot the right mix of people via pattern recognition and good judgment.  As Will Rogers once said:  “Good judgment comes from experience, and a lot of that comes from bad judgment.”


8. “VCs …rely on very discreet networks of people that they’ve become affiliated with. That is, they have access to a unique network of entrepreneurs; the network is the core value proposition…” This statement tracks with my post on Reid Hoffman and I won’t repeat this discussion here other than to say that personal networks of all kinds matter more than ever as the world: (1) becomes more and more digital and (2) moves more and more towards Extremistan .


9. “The founders or one or two key senior people at any multimillion-dollar company should probably spend between 25 percent and 33 percent of their time identifying and attracting talent.” Hiring the right people will first and foremost drive the success of a business. The people who do this well have great pattern recognition skills, which is again a part of good judgment. A top venture capitalist said to me once: “When I see the right team I feel like I have seen the pattern before. The people and chemistry will not be exactly the same as other successful teams, but there is nevertheless a pattern. Not the same and yet still familiar.”


10. “Hubris is an issue at every one of these Silicon Valley companies that are successful.” It can be hard to know a lot about some things or even many things and yet still be modest enough that you know you don’t know everything. Finance writer Morgan Housel absolutely nails it when he writes: “there’s a strong correlation between knowledge and humility.” Charlie Munger has said that he seeks “intellectual humility” and has pointed out that “acknowledging what you don’t know is the dawning of wisdom.”  


11. “As an investor-entrepreneur, I’ve always tried to be contrarian, to go against the crowd, to identify opportunities in places where people are not looking.” I moved this point to near the bottom of my list for this post since it has been consistently on top in other posts in my series on successful venture capitalists. But I include it nevertheless because it is such a vital point to understand. You can’t do better than average by being average. If you can’t be courageously contrarian, you are guaranteed not to beat the market as an investor.  


12. “Actual [venture capital] returns are incredibly skewed. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality you get a power law distribution.” Every top venture capitalist understands this point on power laws in venture capital since it is obvious from the performance of their portfolios. To use a baseball analogy, you can’t play “small ball” in venture capital and succeed financially. Venture capital and value investing are both systems designed around discovery rather than forecasting. A value investor buys mispriced assets at a bargain and waits. A venture capitalist buys mispriced optionality at a bargain and waits. While a value investor waits, they read and think a lot. While the venture capitalist waits, they work hard to help portfolio firms with hiring, sales and distribution etc. – knowing 50% of bets will be a total loss.


PandoDaily – Sarah Lacy’s Fireside Chat with Peter Thiel

Blake Masters Essays – Peter Thiel’s CS183: Startup – Stanford, Spring 2012

A Dozen Things I’ve Learned from Jim Simons

There was so much interest in yesterday’s NYT article on Jim Simons, I thought I would do a special “Dozen Things” on Jim Simons with no commentary.

1. “Models can lower your risk…. It reduces the daily aggravation.” With old-fashioned stock picking: “One day you feel like a hero. The next day you feel like a goat. Either way, most of the time it’s just luck.” “We don’t override the models.”


2. “Certain price patterns are nonrandom and will lead to a predictive effect.”


3.  “Efficient market theory is correct in that there are no gross inefficiencies, but we look at anomalies that may be small in size and brief in time.”


4. “Great people. Great infrastructure. Open environment. Get everyone compensated roughly based on the overall performance… That made a lot of money.”


5. “Luck, is largely responsible for my reputation for genius. I don’t walk into the office in the morning and say, ‘Am I smart today?’ I walk in and wonder, ‘Am I lucky today?’”


6. “We have three criteria. If it’s publicly traded, liquid and amenable to modeling, we trade it.”


7. “We search through historical data looking for anomalous patterns that we would not expect to occur at random. Our scheme is to analyze data and markets to test for statistical significance and consistency over time. Once we find one, we test it for statistical significance and consistency over time. After we determine its validity, we ask, ‘Does this correspond to some aspect of behavior that seems reasonable?’”


8. “Trend-following is not such a good model. It’s simply eroded.” Things change and being able to adjust is what made Mr. Simons so successful. “Statistic predictor signals erode over the next several years; it can be five years or 10 years. You have to keep coming up with new things because the market is against us. If you don’t keep getting better, you’re going to do worse.”


9. “We don’t start with models. We start with data. We don’t have any preconceived notions. We look for things that can be replicated thousands of times. A trouble with convergence trading is that you don’t have a time scale. You say that eventually things will come together. Well, when is eventually?”


10. “Once in a while the phenomena we exploit are particularly present. We like a reasonable amount of volatility. In our business we want some action.” “Tumult is usually good for us. We don’t have credit lines of any significance. We don’t do a lot of leveraged-type financing.”


11. “How we do it isn’t any more mysterious than how a great fundamental investor does it. In some ways it is less mysterious because what we do can be programmed.” 


12. “Academics has its charms, but it doesn’t have enough charms that I regret leaving that field.” “Be guided by beauty. Everything I’ve done has had an aesthetic component to me. Building a company trading bonds, what’s aesthetic? … If you’re the first one to do it right, it’s a terrific feeling and a beautiful thing to do something right, like solving a math problem.”



MIT – Mathematics, common sense and good luck

Institutional Investor – The Secret World of Jim Simons

 Seed Magazine  - Interview with James Simons


A Dozen Things I’ve Learned from Fred Wilson

1. “Venture Capital is a hits business. All of the returns come from the top cohort of investments.” “The distributions of exits each year is distributed on a power law curve.” Venture capitalists working with partners select a portfolio of bets which have significant positive optionality. Over the lifetime of the fund the venture capitalists discover a very small number of blockbuster 10-2,000X hits from the portfolio. After tape measure home runs emerge, it will seem obvious to many people who are not top tier venture capitalists that the startups were destined to be a success. Survivor bias will cause most people who are not involved in the industry to forget that 50% of the bets returned no capital. Venture capitalists will have little survivor bias about this fact as they watch real companies employing real people that they like and care about fail.  An experienced venture capitalist knows that “the whole” of what emerges from the startup creation process is not predictable by looking at the sum of the parts. In fact, it is mostly the connections between the parts of the system that mostly drives change, often in nonlinear ways.

The result of this process are multiple power laws, as I have written before. Why are there power laws in venture capital? You can read the papers on this point and they inevitably indicate in very academic language (plus lots of formulas) that one or more factors are feeding back on themselves. What exactly is feeding back on itself is rarely something on which there is a consensus among the academics. Even if there is consensus, it is likely that there are factors driving change which have not revealed themselves.

In the case of venture capital, my thesis is that networks (defined in the broadest possible sense) with better quality provide access to superior feedback in the form of talent, suppliers, customers, distribution partners and capital. That superior feedback drives things like better product and service offerings, better distribution, and customer awareness. The better a venture capitalist or startup’s network gets, the even better that network gets [repeat in the form of a Matthew effect].

2. “Ideas that most people derided as ridiculous have produced the best outcomes. Don’t do the obvious thing.” As Will Rogers put even more simply: “Always drink upstream from the herd.” Trying to find positive optionality in areas where others are intensely focused is what investors call a crowded trade (i.e., too many people trying to do the same thing). You can’t do better than a mob if you are part of the mob.

People who follow the crowd and expect success remind me of this old joke. “Late one night, a police officer found a drunk man crawling around on his hands and knees under a streetlight. The drunk told the police officer that he was looking for his keys. When the police officer asked if he was sure this is where he dropped his keys, the drunk man replied that he believed he dropped them across the street. “Then why are you looking over here?” the officer asked. Because the light’s better here, explained the drunk man.” A venture capitalist who follows the crowd is like the drunk looking for his keys under the streetlight,when his keys are across the street.

3. “Getting product right means finding product market fit. It does not mean launching the product. It means getting to the point where the market accepts your product and wants more of it.”  “The first step you need to climb is building a product, getting it into the market, and finding product market fit. I think that’s what seed financing should be used for. The second step you need to climb is to hire a small team that can help you operate and grow the business you have now birthed by virtue of finding product market fit. That is what Series A money is for. The third step you need to climb is to scale that team and ramp revenues and take the market. That is what Series B money is for. The fourth step you need to climb is to get to profitability so that your cash flow after all expenses can sustain and grow the business. That is what Series C is for. The fifth step is generating liquidity for you, your team, and your investors. That is what the IPO or the Secondary is for.” There is a rhythm to raising capital which is essential to understand. No two funding processes are exactly the same, but they tend to follow a roughly similar beat. In other words, there are milestones and heuristics which investors and companies tend to use. To paraphrase Mark Twain: startup financing success never repeats itself exactly, but the Kaleidoscopic combinations that constitute the present often seem to be constructed out of the broken fragments of previous attempts. At the two bookends: getting a valuation that is too high can turn into a painful down round or worse, and selling too cheap can mean painful dilution. Like Goldilocks, the entrepreneur must find something that is “just right” when it comes to financing the business.

4. “It is dangerous to ramp up headcount and burn until you are certain that you have the right product and the right people and processes in the organization to support the product. And early revenue traction, often driven by a passionate founder, can be a nasty head fake.” This set of points reminds me of the margin of safety concept from value investing. Making successful predictions about complex systems is a process in which errors are inevitable. Having a margin of safety means that even if you make mistakes you can still win since you have build in a financial safe driving distance. The only unforgivable sin in business is to run out of cash. If you have some cash on hand, you can live to fight again another day if you make a mistake. Firing people is awful and corrosive. Ben Horowitz has a first person account in his book on the downsizing process that everyone interested in business should read. KPCB’s John Doerr once compiled a list of things you can do to avoid running out of cash when things are tough.

5. “Equity capital is expensive. Every time you do a raise, you dilute.”  I like to tell a story about the young company founder who told me he was very proud of his expensive new Herman Miller Aeron chairs in his conference room during the Internet bubble. He bought them with cash that had recently been invested  in his company by some new investors. When I explained to him how much the chairs would eventually cost if the company went public someday via dilution the expression on his face turned from a smile to a frown. Dilution maters. Do the math. People say Warren Buffett can tell you nearly exactly how much income you have forgone if you show him an expensive toy. It is a bit unnerving actually, since he does the math in his head. When someone shows a founder some expensive office space with a beautiful and expansive water view they should immediately think: dilution!

6. “You need more than a lean methodology, you need a lean culture….To me, lean is a state of mind that a founder and his/her team needs to have across all aspects of the business. The specific product and engineering approaches that are at the core of the lean startup movement are paramount for sure. But if you can apply lean to hiring, sales, marketing, customer service, finance, and everything else, you will be rewarded with a fast, nimble company.” Businesses which are more “lean” in the broadest sense of the word are more agile and can adapt far better to change as a result. Adaptability increases optionality.

7. “Putting together the initial team, creating the culture, instilling the mission and values into the team are all like designing and building the initial product.” Most people underestimate how much value a great venture capitalist puts on the people who make up the team and their chemistry. Great people on a fantastic team give a startup optionality, since they can quickly adapt to change.

8. “You simply can’t be tentative in a startup. You have to go for it at every chance you get. And if the leader of the organization is anxious, his or her fear pervades the organization.” Doing a startup, especially in a business with a potential 10x or more return, is in an “all in” process. Both fear and fearlessness are contagious. Chose the latter and not the former. Being the third person to join a startup is something I am glad I have checked off my bucket list. But like anything valuable it came with certain tradeoffs. At the time it seemed like the right choice, but it was in some ways totally irrational given my other options at that time.

9. “Being an entrepreneur is hard. Having supportive and caring investors helps.” “One of the hardest things to do in the venture business is to stick with a struggling investment.” Experienced venture capitalists know that a successful tape measure home run business is often almost dead before it begins its rise to the top of the league tables. Knowing the difference between the walking dead and continuing optionality is part of what makes a great venture capitalist. Judgment is hard to teach, but it usually comes from making bad judgments or watching them get made.

10. “Reputation is the magnet that brings opportunities to you time and time again. I have found that being nice builds your reputation.” Being nice is highly underrated and its importance is on the rise as the importance of networks. Plus, being nice is its own reward. So is being polite. Charlie Munger puts it simply: “Avoid dealing with people of questionable character.” Charlie Munger believes that by dealing only with nice/ethical people overhead drops significantly, since you can operate more efficiently due to a “seamless web of deserved trust.”

11. “Top VCs …get to see the most interesting investment opportunities, but the opportunity cost of saying yes to an investment is that they take themselves out of the running for everything else in that category going forward.” The opportunity cost of investing in company A is that the venture capitalist will chose not to invest in other companies in that category because of a conflict of interest. The greater the probability that a given company will pivot into another category, the more nervous the venture capitalist may be about a potential conflict.

12. “All markets have boom and bust cycles, and I think venture capital market has even more exaggerated boom and bust cycles.” “Anything less than three times your money over a 10-year period [is a mediocre return in venture capital].” ‘The money needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns.” “Venture capital has always been a place where high-risk ventures can get funded. I think it still is the best kind of capital for somebody who’s building a company that has a lot of risk but has a lot of upside as well.” “If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage.” Famous value investor Howard Marks once said: “Rule No. 1:  Most things will prove to be cyclical. – Rule No. 2:  Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” Howard Marks is also aware that there are top down constraints on how much return an industry can generate in a year. Too much money chasing too few opportunities can create investment losses, especially when the financial returns reflect a power law. As I noted in my previous post on Benchmark’s Bill Gurley, the very best time to invest can be in a downturn.


Fred Wilson on The Venture Capital Math Problem

Fred Wilson Interview at Startup School

Technology Review – Fred Wilson on why the Collapse of Venture Capital is Good

Business Insider – Fred Wilson Interview

A Dozen Things I’ve Learned from Reid Hoffman

1. “The top investment is worth the total amount of all the other projects and more. You’re looking for the one high water mark, not the average. People don’t come to you looking for singles.”  Venture capitalists focus on hitting tape measure home runs because that is what overwhelmingly drives investor return.  A portfolio of 30-40 bets on startups per fund, with massive potential upside and small downside, will have its financial return driven by 1-3 huge winners and a distribution of overall financial returns that is a power law.  Andy Rachleff has a great post on venture capital economics in which he notes: “the industry rule of thumb has been to look for deals that have the chance to return 10x your money in five years. … If 20% of a fund is invested in deals that return 10x in five years and everything else results in no value then the fund would have an annual return of approximately 15%.”

One negative outcome of all the attention given to the financial success of a few massive start up successes is that there are many businesses one can start which do not require venture capital, which many people believe are not fundable or worth pursuing.  These non-venture capital-backed businesses can generate attractive financial returns and can, if selected correctly, have a substantially lower probability of failure. This should not surprise anyone, since you simply can’t have the failure rate of venture capital-backed businesses and have the winners return two to five-times invested capital over a similar period. Too many people believe that all startups should raise venture capital and that is a shame, since it is likely that fewer new businesses are created than is optimal for the economy as a result. Bill Gurley has said on this point: “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.” Marc Andreessen has pointed out that there are about 200 “fundable” startups per year by top tier venture firms. A healthy economy must generate far more than 200 new business in a given year to grow and create new employment opportunities.


2. “At a start-up, or early-stage project, the only really massive early-stage projects are where you’re contrarian and right. The projects where everyone agrees often end up having less overall success than the projects where there was some disagreement amongst the board. Where’s the contrarian thinking that, if they turn out to be right, could be really, really big? Consensus indicates it’s probably not a total break-out project. If your thinking isn’t truly contrarian, there’s a dog pile of competitors thinking the same thing, and that will limit your total success.” This series of blog posts has featured a veritable parade of successful investors of all kinds who believe that being contrarian is essential to outperforming a market.  It should surprise no one that these successful investors feel this way, since it is mathematically provable that you can’t beat the crowd if you are the crowd.


3. “A great founding strategy is contrarian and right. That ensures that, at least for an important initial time, no one is coming after you. Eventually people will come after you, if you’re onto something good.” “It’s so important for early stage companies to avoid competition because you can’t isolate it to one front. Competition affects you on the customer front, hiring front, and financing and business development fronts—on all of them. When you’re 1 of n, your job becomes much harder, and it’s hard enough already. Difficult competition with no edge makes for a war of attrition. People may get sucked in to ruthlessly competitive situations by the allure of the pot of gold to be had. It’s like rushing the Cornucopia in the Hunger Games instead of running away into the forest.” Having a barrier to entry against competitors (a moat) is essential. What Reid is saying here is that the creation of the moat can be greatly enabled if the startup is able to avoid competition during its formative period. In other words, it is helpful to have a business operating in a portion of the market that is not “dog-eat-dog” competition from the beginning. In this sense, being a contrarian as an investor has a double benefit: it is where greater market-beating returns can be found and it allows the business to grow in a less competitive environment.


4. “People also underestimate how much of an edge you need. It really should be a compounding competitive edge. If your technology is a little better or you execute a little better, you’re screwed. Marginal improvements are rarely decisive.” The question comes down to…not to think of it just as a question of ‘Oh, I have a better product, and with a better product, my thing will work, as opposed to other things.’ Because unless your product is like 100x better, usually your average consumer…they use what they encounter. If other[s] are much more successful at distribution and they have much better viral spread, they have better index and SEO…it doesn’t matter if your product is 10x better, the folks don’t encounter it.” Going up against an entrenched competitor with loads of cash, experience and sales/marketing/distribution channels is hard enough that you need a significant edge to win. For example, convincing a customer to move to a new product or service is hard if the offering of a new business is only slightly better.


5. “You want to start building a company 1-4 years, maybe 5 years, in advance. So that when the technology converges with the change in the world you see coming, you’re positioned to capitalize. You have to be right about a set of things, including what your competitors are going to do.” The great hockey player Wayne Gretzky is famous for saying “I skate to where the puck is going to be, not where it has been.” This sort of thinking is all about (1) optionality and (2) arbitrage of people’s lack of understanding of exponential phenomenon. Key to finding significant opportunities is realizing that exponential phenomenon are not common. Bill Gates put it this way once: “When things are improving so rapidly, how do you create a model in your head?  Computers are doubling in power, relative to the price, about every 18 months.  Most humans don’t have a situation where something doubles in its power every two years.”


6. “Silicon Valley….should now be called Software Valley.” This is a version of Marc Andreessen’s “software is eating the world” thesis. Software delivered over networks is driving financial returns in the venture capital business because hardware is relatively ubiquitous, can be purchased on demand and in many cases is already in place – most notably in the form of smartphones. Advances in silicon drive the exponential phenomenon, but the companies that surf this wave are largely software driven. Yes, there are important and successful hardware startups, and yes, 3-D printers and GoPro and such, but in most cases if you look deeply at a company that has achieved at least the 10X financial return hurdle that a venture capitalist like Reid Hoffman desires, it is inevitably the software or software enabled cloud-based services that are driving the innovation and new customer value. There are also inevitably a lot of very important software engineers at what some people would call a hardware business.


7. “Having a great product is important but having great product distribution is more important. I meet a lot of entrepreneurs who think the best product is the most important thing and that the best product should always win. What a lot of people fail to realize is that without great distribution, the product dies. How will you get your product in the hands of millions or hundreds of millions of people?” I’ve written on the importance of sales, marketing and distribution previously. Great product distribution is not optional. Customers do not magically appear at a company’s doorway holding stacks of hundred dollar bills ready to buy what a business sells.


8. “In tech, if you’re not continually thinking about catching the next curve, one of the next curves will get you. Yahoo owned the front end of the Internet in 2000. It had the perfect strategy.  But it did not adapt; it failed at social and other trends; that didn’t go so perfectly. Just over a decade later, having missed some very key tech curves, it’s in a very different position.” This is Reid Hoffman’s version of Andy Grove’s “only the paranoid survive” thesis. Because important phenomenon emerge with essentially no warning from complex adaptive systems, you can find yourself in deep trouble for a mistake you made several years before. Looking back at the cause of what is killing a business now may seem obvious, but that is the nature of complex adaptive systems.  What is understandable retroactively is not predictable prospectively.  “Missing a curve” can send a business flying over a precipice.


9. “If you are not embarrassed by the first version of your product, you’ve launched too late.” “Product and market fit requires you to figure out the earliest tells. How do you bring in as much networked intelligence into that process as possible? In Silicon Valley, you bring in early advisors, employees, customers. What you’re trying to figure out is, is the path I’m trying to build the company around accurate? Most people begin with the financing process as a series of hoops to get a certain amount of money in the bank. But the most interesting thing of the financing process is getting network intelligence on the critical question of, “Is this a good plan?” What is the piece of common intelligence about my project? What are the risks in their investment?” “When you have an idea for a startup consult your network. Ask people what they think. Don’t look for flattery. If most people get it right away and call you a genius, you’re probably screwed; it likely means your idea is obvious and won’t work. What you’re looking for is a genuinely thoughtful response.” An idea that is not exposed to feedback from a strong and diverse network of very smart people is not going to get better and attract the sort of people needed to translate that idea into success. Your competitors will be doing this if you don’t. The winners in today’s economy are the businesses that adapt best to change and you can’t adapt without great sources of feedback.


10. “So many entrepreneurs are worried about protecting their precious ideas, but the truly valuable thing is that you’re in motion, you have momentum, you’re gathering all the necessary resources to actually make it happen.” “We’re moving from an information age to a network age. Part of that is, how do you increase the possibility of positive outcome from serendipity? There’s still luck, but you can increase the probability of the right decisions made. When you have a problem connecting challenges and solutions, that generally involves connections in a human network.” An idea without execution is not going to get anyone very far in business. Everyone has ideas for businesses and may think “I thought of that first” when they see a success.  Winning in the market requires doing things, not just generating new ideas.


11. “Entrepreneurs are often given two pieces of contradictory advice: persistence and flexibility. Have a vision and pursue it through years of people telling you you’re out of your mind. Or, be flexible: look at data, iterate, and change based on the signals you’re getting. There isn’t an actual algorithm. You have an investment thesis about why this project is likely to work and have some outside result, and usually that’s expressed in a set of statements and hypotheses, that if you’re right about, adds up like a logical proof and gives you the output you’re looking for. And you can have varying level of confidence in how these pieces are adding up and supporting your theses.” “The challenge is to follow them both, but know which advice is most appropriate for which situation. You must know how to maintain flexible persistence.” There is no substitute for good judgment on questions that involve issues like what Reid calls flexible persistence. And the source of most good judgment is having made bad judgments. Some people learn better from mistakes than others and make mostly new mistakes rather than repeating old ones. If you learn from those people and from your own mistakes and you will have a better life.  Being a learning machine pays big dividends.


12. “It’s not that everyone should start a company, it’s the fact that a career ladder is no longer a strong model for how you do your work and pursue your career. The Good grades -> Good university -> Good career path model has been broken for years, by globalization and technology’s disruption of industry. The model for how to think about your life, career, and work is different. How entrepreneurs think about product market fit, product differentiation, creative risks, all apply to how you, as an individual, live your life.” “The network of people around you is what extends your ability to be effective in terms of expertise and reaching your goals. …really put yourself out there and get the feedback. … don’t be afraid to take a risk.”

“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 or 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.”

“Another huge thing to emphasize is the importance of your network. Get to know smart people. Talk to them. Stay current on what’s happening. People see things that other people don’t. If you try to analyze it all yourself, you miss things. Talk with people about what’s going on. Theoretically, startups should be distributed evenly throughout all countries and all states. They’re not. Silicon Valley is the heart of it all. Why? The network. People are talking to teach other.” As stated above for companies and people, networks of all kinds are of increasing importance. The types of networks which are valuable are very different that the networks people had in mind when they repeated the old adage “it’s not what you know, but who you know that matters.” These old school networks were about webs of what one might call “influence.” By contrast, the intent with networks today should instead be to generate the information and feedback needed to be agile and better informed. As an example: Why do a tiny number of VCs generate 95% the financial return in the venture capital industry? Simply put, they have the best networks defined in the broadest possible sense and the quality of their networks is feeding back on itself to generate even more quality. This is the Matthew Effect at work: better networks get even better as success feeds back on itself.

Notes on Reid Hoffman:

Blake Masters – Peter Thiel’s Startup Class

WSJ - Venture Capitalist Reid Hoffman

Wired  - Reid Hoffman, Network Philosopher

Kissmetrics - Hoffman’s Advice for Entrepreneurs

Financial Times - Reid Hoffman, Mr. LinkedIn

AllThingsD - LinkedIn’s Reid Hoffman’s Five Tips for Startups

BigThink - Interview with Hoffman

FastCompany - How LinkedIn’s Reid Hoffman jumped off a cliff and built an airplane

Babson – Reid Hoffman Commencement Speech

Forbes – Reid Hoffman and Peter Thiel in conversation; the biggest misses

A Dozen Things I’ve Learned from Vinod Khosla

Vinod Khosla started Khosla Ventures in 2004 after a very successful career beginning in 1987 as a venture capitalist at Kleiner Perkins Caufield & Byers. Before becoming a venture capitalist, he was a co-founder of Sun Microsystems. Khosla Ventures announced that it is in the process of raising a new $1 billion fund this past week.

1. “It doesn’t matter what your probability of failure is. If there’s a 90% chance of failure, there’s a 10% chance of changing the world.” “Most technology startups fail. There’s a winner, and there’s 7 out of 10 that lose.” “I don’t mind failing, but if I succeed it better be worth succeeding for.”  “I have seen too many startups where they have reduced risk to a point where they have a higher probability of succeeding, but if they succeed it is inconsequential.”  If you have been reading this series of blog posts you have heard me write repeatedly that there are power law distributions in venture capital and that they are persistent over time. There is (1) a power law within a top tier venture capitalist’s portfolio and (2) power law in terms of the distribution of returns among venture capital firms. Surprisingly few people who see one of more of these power law distribution asks an obvious question: why there is a power law? Vinod Khosla and other great venture capitalists understand that the economy, markets, companies and other aspects of the world are complex adaptive systems, which means they are often nonlinear and have many relationships which have hazy cause and effect. Making relationships even more complex is the fact some future states of the world are unknown and probability is not even computable. Richard Zeckhauser calls this 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:

Relationships that impact venture capital

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 experiment on a trial and error basis in order to discover success from within a portfolio of 30-40 bets that have optionality. Which of these bets will pay off will be apparent only after the fact since success will emerge from the complex adaptive systems. Optionality reflects itself in the power law distributions which are familiar to any venture capitalist. There are top down financial constraints which limit the number of big winners in the venture capital industry to ~15 per year. About 200 active venture capital firms share in those ~15 deals, but in the form of a power law distribution.  Fred Wilson, who I will write about soon, has written a post on the top down constraints which impact the venture capital industry. Andy Rachleff wrote a related post on venture capital economics this week. Andy and Fred don’t agree on everything, but the points they make are directionally similar. The data I have seen in industry venture capital databases puts me in Andy’s camp to the extent they disagree.

2. “We are in the company building business, not in the ‘deal’ or ‘capital’ business.” “I don’t think of myself as being in the investing business. I think private equity investors are very much in the business of doing deals, putting money in, getting money out. To me, that is a very, very different business and all that they are doing is spreadsheets. I think of myself in a completely different business of building companies. I have not made IRR calculations on a spreadsheet ever since 2004. I either believe or I don’t. If I believe, then my goal is to get involved and make things much bigger and help them be successful. It’s a different kind of business.” Great venture capitalists are focused on building companies and relationships rather than doing deals. Building a real company means building new value through genuine innovation. What Vinod is saying is that the result is so far into the fourth quadrant or the domain of ignorance that using spreadsheets is useless for venture capitalists since the inputs can’t be qualified. What a wise venture capitalists knows from experience is that if a team of individuals make 30-40 bets in each fund with potential for 10-2000X upside, it is likely that 1-4 of those bets will pay off, even though 50% of the bets will be a total write off and the rest will return on some capital or generate a modest return. Only those venture capitalist who have the skill and contacts to source the best opportunities and provide the entrepreneur with the right network of contacts and assistance will see these returns. Why the power law? People do not make decisions independently. Founders, employees, venture capitalists, and customers are all attracted to success and that success compounds in the form of a lollapalooza.

3. “If you’re doing what everybody else is doing, you’re not doing anything interesting, and we won’t want to invest.” “Doing things at the edge is what venture is about.” “I don’t even invest in businesses where six other people have the same technology.”  “The idea is how can you turn a technology advantage into a business advantage? It’s much more like playing a chess game than it is investing. It is strategic, it depends how much you can help the company. Therefore, it is much more fun.” You can’t outperform a market (which reflects the consensus view) by adopting a consensus view. By definition outperforming a market means being different. The lineage of this thought goes back to Ben Graham through investors like Howard Marks.

4. “We seek out unfair advantages: proprietary and protected technological advances, business model innovations, unique partnerships and top-notch teams.” This is what Warren Buffet calls a “moat” and Michael Porter calls “sustainable competitive advantage.” Without a moat competition will inevitably drop prices to apoint where there is no economic profit. If you want to understand moats make sure to read some Michael Mauboussin.

5. “We invest more in people than in a specific plan, because plans often change.” “Failing quickly is a good way to plan. Failing often makes failures small and successes large….In small failures you accumulate learnings about what works and what doesn’t. Try many experiments but don’t bet your company on just one, keep trying, keep failing small.” “There are probably three or four things you can control out of ten that matter for the success of your company.” Competitors control another three or four. “The rest is just luck.” Partly for that reason, he is dismissive of business plans. “I’ve never seen one that’s accurate.”  Entrepreneurs who can adapt are far more likely to achieve great success. No plan survives first contact with the competitors and customers in a real market. Investing in great teams generates optionality since great teams can adapt. 

6. “Bad times come for every startup – I haven’t seen a single startup that hasn’t gone through a bad time. Entrepreneurship can be very very depressing. If you really believe in your product, you stick with it.” A real business operating in the real world is never about perfect execution. The great founders and venture capitalists have tremendous will to succeed. Many great successes were at one point millimeters away from failure. And I suspect that many great failures were millimeters away from success. 

7. “Seeking an acquisition from the start is more than just bad advice for an entrepreneur. For the entrepreneur it leads to short term tactical decisions rather than company-building decisions and in my view often reduces the probability of success.” I see this far too often.  If money is all that makes your world go around, venture capital or starting a company is not the business for you. You won’t make the right decisions and you won’t be happy. 

8. “We prefer technology risk to market risk.” There are many different types of risk, one of which is technology risk. If you are a skilled technologist, technology risk is within your circle of competence.  If technology is not within your circle of competence, it is best to avoid technology risk (like Warren Buffett does). Risk comes from not knowing what you are doing. Taking risk in areas in which you know you are competent is wise. It is important to note that risk is not uncertainty. It is in the domain of uncertainty that mis-priced bets are found. The best time to make bets is when uncertainty is high, like buying stocks or  a venture capitalist investing in a startup in 2009.

9. “How would you compete against yourself?” This quotation is straight up Clayton Christiansen: “managers should talk about a possible innovation as something that could threaten their core business — if someone else were to do it first. Research indicates that threats, rather than opportunities, mobilize resources much faster.” Any business should be doing this, since almost certainly their competitors are doing so.

10. “I generally disagree with most of the very high margin opportunities. Why? Because it’s a business strategy tradeoff: the lower the margin you take, the faster you grow.” This is the sort of statement Jeff Bezos makes.Your competitors high margins are your opportunity to grow and absolute dollar free cash flow can be better with lower margins since you can sell more. My blog post on Jeff Bezos discussed this point in detail.

11. “Where most entrepreneurs fail is on the things they don’t know they don’t know.” There are big differences between risk, uncertainty and ignorance. Risk is present when probabilities are known, uncertainty when probabilities are not known and ignorance when future states are not known and probability is not computable. “Things go wrong. There is lots of uncertainty, and there are times when you’re unsure of yourself. I’ve found that the less people know, the more sure they are.”  This is something that has always troubled me.  A great story half told is somehow more convincing usually because muppets suspend disbelief since they want so very much to get rich quick. The best venture capitalist and founders are learning machines, because they realize that there is no end to what you can learn.

12. “The single most important thing an entrepreneur needs to learn is whom to take advice from and on what topic.” “Entrepreneurs could get such great help, but instead they think they need money. It’s this sort of schizophrenic divide between worrying that you’re going out of business and dreaming big that’s needed. Sophisticated entrepreneurs know this. Less sophisticated entrepreneurs don’t even know whom to ask for advice. They’ll ask a marketing and a technology question to the same person. Ask different questions of different people, both those who have been successful and those who haven’t.” The concept of a circle of competence applies not only to your own skills but to the people who you seek advice from. Risk comes from not knowing what you are doing. To reduce risk, find people to advise you who do know what they are doing. It’s that simple.

Vinod Khosla interviews:



CNET – ‘Lessons from the Fail’


A Dozen Things I’ve Learned From Marc Andreessen

Marc Andreessen is able to explain himself so well that I should have less commentary to add to the quotations in this post than usual. But where is the fun in that? My primary task with this blog post has been assembling the quotations and placing them in an order which flows well, since understanding the earlier topics helps the reader understand ideas which come later in the list. Each set of quotations is a mash up from sources like the links identified in the notes at the bottom of this post. My transcription of video interviews may not be perfect and the text is sometimes edited to reflect the brevity required in a blog format.

 1/  “The key characteristic of venture capital is that returns are a power-law distribution. So, the basic math component is that there are about 4,000 startups a year that are founded in the technology industry which would like to raise venture capital and we can invest in about 20.”  “We see about 3,000 inbound referred opportunities per year we narrow that down to a couple hundred that are taken particularly seriously…. There are about  200 of these startups a year that are fundable by top VCs.  … about 15 of those will generate 95% of all the economic returns … even the top VCs write off half their deals.” I have done several posts on the fundamental forces which create power laws in venture capital. If you don’t understand the forces which create power laws in venture capital, you don’t truly understand venture capital. Power laws don’t happen by accident. There are always factors feeding back on themselves when something like investing results are reflected in a power law, and venture capital is no exception.

Why power laws? To understand venture capital as well as many of the phenomena impacting individuals, companies and the global economy right now, you must understand cumulative advantage and its inverse cumulative disadvantage. Robert Merton has described cumulative advantage in this way: “exceptional performance … attracts new resources as well as rewards that facilitate continued high performance [repeat].” Additional ways that people use to describe this phenomenon include the Matthew effectvirtuous circles and the rich get richer. Another important factor known as Path Dependence is used to describe at least three phenomenon: increasing returns, self-reinforcement, and positive feedback. Of course, it also the case in that failure can create negative feedback loops and vicious cycles which can make the poor get poorer.  As was noted above, cumulative advantage and path dependence are operating and are self-reinforcing at every scale (e.g., individuals, startups, established businesses, communities, regions, nations and the global economy).

2/ “We think you can draw a 2×2 matrix for venture capital. …And on one axis you could say, consensus versus non-consensus. And on the other axis you can say, successful or failure. And of course, you make all your money on successful and non-consensus. … it’s very hard to make money on successful and consensus. Because if something is already consensus then money will have already flooded in and the profit opportunity is gone. And so by definition in venture capital, if you are doing it right, you are continuously investing in things that are non-consensus at the time of investment.  And let me translate ‘non-consensus’: in sort of practical terms, it translates to crazy. You are investing in things that look like they are just nuts.”

“The entire art of venture capital in our view is the big breakthrough for ideas. The nature of the big idea is that they are not that predictable.”

“Most of the big breakthrough technologies/companies seem crazy at first: PCs, the internet, Bitcoin, Airbnb, Uber, 140 characters.. It has to be a radical product. It has to be something where, when people look at it, at first they say, ‘I don’t get it, I don’t understand it. I think it’s too weird, I think it’s too unusual.’” This set of quotations reminds me of Howard Marks, who has said:  “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.” The power laws in venture capital virtually guarantee that the poseur venture capitalist who follows the crowd can never make up for all their losers, since they will not get the one or two tape measure home runs required to generate returns that limited partners demand. What is perfectly advisable for the ordinary investor (“be the market”) spells doom for the venture capitalist because venture capital returns reflect the power law noted above. It is only in the non-consensus quadrants that optionality will be mis-priced and bargains found. Buying optionality is not enough to achieve success as a venture capitalist; it must be mis-priced. Paying too much of any asset including optionality is not a solvable problem. The matrix Marc Andreessen describes above, with an example in each quadrant, looks like this:

Screen shot 2014-06-12 at 11.53.33 AM

3/  “You want to have as much ‘prepared mind’ as you possibly can. And learn as much as you can about as many things, as much as you can. You want to enter as close as you can to a zen-like blank slate of perfect humility at the beginning of the meeting saying ‘teach me’…. We try really hard to be educated by the best entrepreneurs.” This set of quotations from Marc Andreessen reminds me of a famous quote from Shunru Suzuki:  “If your mind is empty, it is always ready for anything, it is open to everything. In the beginner’s mind there are many possibilities, but in the expert’s mind there are few.”  If you go into a meeting with a start up thinking you know everything, you will learn nothing.  Similarly, if you think you can predict everything you will fail as a venture capitalist.  Of course, not only must the idea of the investor be non-consensus it must also be right. Most things that seem nuts in fact are nuts. But every once in a while what seems nuts is one of the 15 ideas each year that 95% of financial returns in venture capital.

 4/ “You want to tilt into the really radical ideas… but by their nature you can’t predict what they will be.” “There will be certain points of time when everything collides together and reaches critical mass around a new concept or a new thing that ends up being hugely relevant to a high percentage of people or businesses. But it’s really really hard to predict those. I don’t believe anyone can.”  This set of quotes describes the best way to deal with complex adaptive systems – rather than trying to predict the unpredictable, it is best to purchase a portfolio composed of mis-priced optionality. Warren Buffett describes a portfolio of bets with optionality in this way in his 1993 Chairman’s letter: “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.”  Marc Andreessen describes his firm’s approach as being similar to Benchmark Capital and Arthur Rock (i.e., focus on big breakthrough ideas), which is unlike other venture firms that have a process where they try to create value-chain maps of where markets/the industry is going.

5/ Venture capitalists “spend a lot of time talking about markets and technology…. and we have lots of opinions. …but the decision should be around people…. about 90% of the decision [is people].”… “We are looking for a magic combination of courage and genius .… Courage [“not giving up in the face of adversity”] is the one people can learn.” When you have a team of strong people in a startup, their ability to adapt and innovate gives the company and the investors optionality. Weak teams which can’t adapt to changing environments usually fail. Identifying the right people is all about pattern recognition.

 6/ “An awful lot of successful technology companies ended up being in a slightly different market than they started out in. Microsoft started with programming tools, but came out with an operating system. Oracle started doing contracts for the CIA. AOL started out as an online video gaming network.” Because the future is not predictable with certainty, companies with optionality in the form of strong teams and research & development capability can pivot into other markets. This can present a problems if you are a venture capitalist which has decided to only invest in one company per category.  There is so much pivoting going on in consumer that some venture capitalists have stopped doing Series A rounds in that category.

 7/ “The great saving grace of venture capital is that our money is locked up. The big advantage that we have as a venture capital firm over a hedge fund or a mutual fund is we have a lock up on our money.” “So we invest in these companies with a ten-year outlook.”  “And so enterprise can go in and out of fashion four different times, and we can go and invest in one of these companies, and it’s okay, because we can stay the course.” Another investor who has figured the value of locked up capital from investors is Warren Buffett, who famously closed his partnership and started Berkshire. Unlike a hedge fund, Warren Buffett’s capital is locked up protecting him from people trying to redeem after the panic during a market dip. Bruce Berkowitz:  “That is the secret sauce: permanent capital.  That is essential.  I think that’s the reason Warren Buffett gave up his partnership.  You need it, because when push comes to shove, people run.”  The ability of a venture capital firm to have cash in the bank (or at least the ability to call on cash contractually promised by limited partners) allows it to invest through the downturns, which as my post on Michael Moritz explained, can be a very good time to start a company. Andreessen Horowitz itself is proof of that principle. Marc Andreessen has said: “The spring of 2009…. was not a time when investors wanted to hear about a new venture capital fund. In fact, many of the large investors in venture capital and private equity were in a liquidity crisis in their own businesses, including the big university endowments where they were having real trouble meeting their commitments back to their sponsoring organizations… people have told us it was the harshest, most hostile time to raise new capital funding in 40 years. Of course, we are contrarian or perverse, depending on how you look at it, and we said, Well, then it’s probably going to be a very good time to raise venture capital funding.”

 8/ “The thing all the venture firms have in common is they did not invest in most of the great successful technology companies.” “The mistakes that we make in a field like venture capital generally aren’t investing in something that turns out not to work. … it’s the big hit that you missed. And so every venture capitalist who had the opportunity to invest in Google and didn’t just feels like an idiot. Every venture capitalist who had the opportunity to invest in Facebook and didn’t feels like an idiot. The challenge in the field is all of the great VCs over the last 50 years, the thing that they all have in common, is they all failed to invest in most of the big winners. And so this again is part of the humility in the profession.” Warren Buffett and Charlie Munger call this type of mistake an “error of omission” (i.e., what you don’t do can hurt you more than what you actually do). No one describes this category of mistake better than Charlie Munger: “The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes — we’ve lost billions. And we keep doing it. We’re getting better at it. We never get over it. There are two types of  mistakes:  1) doing nothing, what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.”

 9/ “With tech — and you see this with a lot of these new entrepreneurs — they’re 25, 30, 35 years old, and they’re working to the limit of their physical capability. And from the outside, these companies look like they’re huge successes. On the inside, when you’re running one of these things, it always feels like you’re on the verge of failure; it always feels like it’s so close to slipping away. And people are quitting and competitors are attacking and the press is writing all these nasty articles about you, and you’re kind of on the ragged edge all the time…. “ “The life of any startup can be divided into two parts – before product/market fit (BPMF) and after product/market fit.  When you are BPMF, focus obsessively on getting to product/market fit. Do whatever is required to get to product/market fit. Including changing out people, rewriting your product, moving into a different market, telling customers no when you don’t want to, telling customers yes when you don’t want to, raising that fourth round of highly dilutive venture capital — whatever is required.” Starting a business isn’t easy or for the faint of heart. At the same time there is not business that is easy.  Almost every company is less attractive when viewed from the inside than it appears from the outside. My friend Craig McCaw said to me more than once that a ship as viewed from the dock may look pretty with the captain smiling from the upper deck in a resplendent uniform — but under the decks there is inevitably some ugliness associated with the travails of actually running something.  The goal isn’t to be perfect but rather to be a great success. Working for a startup is something that some people might want to put on a personal bucket list. The reality is that is an amazing life experience, but it is not for everyone. Lots of people talk a good game about wanting to leave a company like Apple for a startup, but when the time comes most don’t actually do it. As an aside, Marc Andreessen does not buy into the conventional notion among many in Silicon Valley that failure is good. Some failures may be inevitable when you venture out as an entrepreneur or when you take a job in a startup and you may learn from that failure, but in his view the failure itself isn’t good.

10/ “There’s a new generation of entrepreneurs in the Valley who have arrived since 2000, after the dotcom bust. They’re completely fearless.”… “Founders today are very technical, very product centric, and they are building great technology and they just don’t have a clue about sales and marketing…it’s almost like they have an aversion to learning about it.” Many entrepreneurs who build great products simply don’t have a good distribution strategy. Even worse is when they insist that they don’t need one, or call no distribution strategy a ‘viral marketing strategy’ … a16z is a sucker for people who have sales and marketing figured out.”  Marc Andreessen believes that a major problem with the 1999-200 bubble was that too many companies were driven by sales and marketing people who forgot or failed to appreciate that the business needed to have the ability to continually innovate. Having said that, these sales, marketing and distribution activities are essential to company success. Finding the right balance between is what great CEOs do well.  Just hoping that an offering will go viral is not going to lead a company to success since something going viral is rarely an accident.  Acquiring customers cost effectively is the essence of business.  Almost always the best way to acquire customers cost effectively is with an organic customer acquisition strategy.  In contrast, formulating a strategy based on buying advertising is unlikely to be successful. My previous post on marketing, distribution and sales goes into detail on this point. 

11/ “You spend most of your time actually dealing with your companies who are struggling and trying to help them. Because it’s the companies that are struggling or failing that actually need the most help. The companies that are succeeding are generally doing just fine without you. The companies that are failing are really the ones that need help and support. And so a lot of what you end up doing at the job is supporting struggling entrepreneurs. It’s kind of continuously humbling. You are a trouble shooter. There’s always something going wrong. Psychologically–we talk about this with our partners–you have to be psychologically prepared for the opposite. It seems like it’s going to be a life of glamor and excitement. It’s more of a life of struggle and misery. And if you are okay with that–because it’s part of the package–then the overall deal is pretty good.” Bill Gurley likes to say that venture capital “is a service business”.  Venture capital isn’t sitting in expensive chairs “picking winners” and speaking at conferences, but rather day in and day out work in the trenches helping entrepreneurs succeed. An effective VC spends time on things like trying to recruit engineers for portfolio companies.  This is not glamorous work for a venture capitalist, but it is essential work.

12/ “Software is eating the world.” “Everybody’s going to have a computer. Everybody’s going to be on the Internet. And that’s a new world. That’s a world that we’ve never lived in before. We have no idea what that world is going to look like. It’s brand new. One of the things that you know is that all of a sudden, if you can conceive of a way to make a product or a service, and if you can conceive of a way to deliver it, through software, you can now actually do that.”

“When you apply software you can do it in a very cost effective way… we now for the first time can basically go field by field, category by category, industry by industry, product by product, and we can say, ‘what would they be like if they were all software.’ ” The ‘software is eating the world’ thesis has always reminded me of what Bill Gates has said about why he refused to build hardware when Paul Allen suggested they should do so in the July 1994 issue of Playboy magazine: “When you have the microprocessor doubling in power every two years, in a sense you can think of computer power as almost free. So you ask, Why be in the business of making something that’s almost free?  What is the scarce resource? What is it that limits being able to get value out of that infinite computing power?  Software.” What is new today, and what Marc is talking about when he says ‘software is eating world’, is that the hardware is already in place waiting for the software at global scale. There is no longer a requirement that a software company manufacture the hardware systems needed to implement that system. Smartphones are increasingly ubiquitous. Computers and storage can be bought on demand as needed. The power of software to enable change drives Marc’s infectious optimism:  “This is sort of where I disagree so much with people who are worried about innovation slowing down, which is that I think the opposite is happening. I think innovation is accelerating. Because the minute you can take something that was not software and make it software, you can change it much faster in the future. It’s much easier to change software than it is to change something with a big, physical, real-world footprint.” Importantly, when this innovation-driven change happens people’s lives get better.  That this improvement in people’s lives is not captured in statistics like GDP, because it is consumer surplus or hard to measure, is a problem with economics – not technology or business.

Notes on Andreessen quotes:  

Youtube: Marc Andreessen on Big Breakthrough Ideas and Courageous Entrepreneurs

EconTalk: Marc Andreessen on Venture Capital and the Digital Future

Stanford’s Entrepreneurship Corner: Marc Andreessen, Serial Entrepreneur

News Genius: Marc Andreessen on Why Software Is Eating The World

PandoDaily: Full interview with a16z’s Marc Andreessen 


Related posts on venture capital and venture capital influencers:

A Dozen Things I’ve Learned from Bill Gurley

A Dozen Things I’ve Learned About Venture Capital

The Matthew Effect and VC Performance

A Dozen Things I’ve Learned from Michael Moritz

A Dozen Things I’ve Learned about Technology Investing

A Dozen Things I’ve Learned from Michael Moritz About Venture Capital

I was introduced to Michael Mortiz only once many years ago during a visit to Sequoia.  I know of him only through stories told by others, his writing and what I have read in the press. His accomplishments are impressive, as is his insight on topics like the venture capital business.

1. “When we help organize one of these companies at the beginning, it never looks like the world’s greatest idea. I think it’s the marketing and PR department that rewrites history and tells you that it was always the world’s greatest idea. What they don’t say is that at the very beginning there was great uncertainty and a great lack of clarity.” “We just love … people who perhaps to others look unbackable. That has always been our leitmotif of doing business.” The best venture capitalists understand that success in the venture capital business is about buying mis-priced optionality. Something “not looking like the world’s greatest idea” is actually helpful since uncertainty is the friend of a wise venture capitalist. In other words, it is uncertainty that causes others to mis-price optionality.  Without some elements which make the startup’s ambition seem audacious/crazy, the potential financial  return is unlikely to be the 20-100X plus tape measure home run needed to make the VC fund a success.  Typically it is one or three  tape measure home runs that generate the necessary financial return for the venture capital fund. For this reason, the distribution of success within a venture firm’s portfolio will follow a power law.

2. “Every single time you write a check you expect, or pay depending on your inclination, for that investment to succeed.”  In order to harvest optionality, the venture capitalist must believe that each swing of the bat may produce a tape measure home run – even though statistically about 50% of startups will fail outright and more will be poor outcomes. Many startups will nearly crash into the ground before they soar to become a success. Of course, others just crash into the ground. But in the beginning you must expect them all to succeed.

3.  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.” In order to outperform any given market, it is mathematically true that you must not essentially *be* that market.  In other words, a venture capitalist can’t outperform other venture capitalist if they act just like them. This may seem like common sense but you would be surprised how much herding happens anyway, since many people would rather fail conventionally than succeed unconventionally.

4. “If you have been around the start of success it is far easier to recognize it again.” Venture capitalist Bruce Dunlevie of Benchmark Capital said to me once: “pattern recognition is an essential skill in venture capital.” While the elements of success in the venture business do not repeat themselves precisely, they often rhyme. In evaluating companies, the successful VC will often see something that reminds them of patterns they have seen before. It might be the style, chemistry or composition of the team or the nature of the business plan. Some things will be fundamentally different but other things may be familiar. While the pattern will be similar, something in what the team is doing will seem to break a rule. Part of the pattern that is being recognized is a rule breaking innovation of some kind which drives new value.

5. “There’s nothing more invigorating than being deeply involved with a small company and … everybody’s betting against us.” Great venture capitalists love the process of creating companies and more importantly creating customer value. Venture capital is a service business. Making others successful is the driving activity in the work.  Finding vicarious joy in the success of others is essential.

6. “The very best companies are the ones where founders build the companies and stay with the companies for a very long time.” The most successful founders have a passion for building a business. This passion is highly correlated with a desire not to flip the business for a quick financial profit.

7. “The venture capital partnership that invests small amounts of money judiciously is almost always going to outperform the venture capital partnership that tries, to use an ugly phrase in the business, ‘to put a lot of money to work.’” The size of a fund at a point works against performance.  Emotional errors kick in when people have more more to spend than they have ideas.  Even worse, they can end up investing too many times which can lead to a lack of focus.  A top 5% venture capital firm may hear thousands of pitches and invest in only 8 to ten new companies each year (depending on the firm). A few outlier venture capital firms may invest in 20 new startups each year at a series A stage, but that is not the norm.

8. “Five-year plans aren’t worth the ink cartridge they’re printed with.”  Great teams are able to respond to a world which changes in ways which cannot be foreseen. This is why venture capitalists spend so much on the people employed by the startup. A strong team of people means the startup itself has optionality. The ability to “steer” as conditions change is more valuable than the ability to create medium- and long-term plans.

9. “It takes a tremendously long time to build a company of value. In many cases, the best venture returns don’t happen in the private phase of the company; they happen in the time that the company is public… “It takes a long time for sales to grow and it takes a long time for true value to be achieved.”  “People would be staggered at the length of time that we hold investments. It’s not uncommon for us to hold investments for 10 years or more. It’s certainly not uncommon for the partners at Sequoia to own stock for 15 or 20 years.”  Most outsiders underestimate the importance of patience in venture capital. Building great companies takes time. A few stories about relative short term payoffs from someone selling out for a big return warp the view of many people about the time required to find success in the venture business.   

10. “A downturn can be a very good time to build a company. The parvenus and the pretenders are gone. The only people who want to start a company in a time like this are the ones with the greatest conviction.” … it gets rid of all the riffraff.  There isn’t as much chaff in the air. There is more time to be thoughtful. You don’t spend your day reacting to all sorts of fruitless entreaties. So to some extent it is easier.  It is easier to hire and find places to locate companies and in some respects also it is easier to get customers. Oddly enough in recessionary times, customers are prepared to take more risk with a young company if they believe that that company offers them a tremendous advantage that will help them become more efficient or lower their costs.” As Howard Marks likes to say, business cycles are inevitable. The best time to be planting seeds is often when others are in a panic and depressed.  Thinking counter-cyclically pays big dividends in business and not just in venture capital.  People see the recent past and then extrapolate it into the future.  Volatility is actually the friend of the investor with control of their emotions

11. “[Venture capital] is a business that’s always had the investment returns concentrated in very few hands.” Path dependence is a huge element in the venture capital business. In short, early luck and skill lead to more success and more skill as a number of factors feed back on themselves in a positive way. This results in two power law distributions: (1) returns within a venture capitalist’s portfolio; and (2) relative returns of venture capital firms in the industry.

12. “I know there are millions of people around the world have worked as hard and diligently as I have and weirdly enough, like [former US President] Jimmy Carter said years and years ago, ‘life’s unfair’. I just happen to have been very fortunate.” “A chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” Luck has way more to do with outcomes in life than most people care to admit. The benefits of luck compound and because successful people attract successful people. Adding to the bounty is that fact that being around other successful and skilled people makes you more skillful. If you happened to be lucky enough to be working as a venture capitalist in 1986 somewhere near Stanford you very likely were the benefit of a massive tailwind that not only make people richers but more skilled.  If you were that lucky and are not humble, you have not been paying attention. Are these people more skilled too? Yes, because being lucky puts you in situations in which you acquire new skills. Luck not only feeds back on itself to create more luck, but also more skill.

P.S., As an aside, what I know about the venture capital business I learned from many people, most notably my friend Bill Gurley of Benchmark Capital. The post I wrote on Bill Gurley is one of the most insightful in this “Dozen Things” series, in my view.  His interviews with GigaOm and PandoDaily are as good an explanation of the venture business as exists anywhere.

If you want to know the source of a quotation above, put the quote in quotation marks in a search engine.

For interviews of Michael Moritz see:

Mercury News



YouTube here and here

A Dozen Things I’ve Learned from Jim Barksdale and “Barksdaleisms”

Since the contributions of business executives with great operations skills are too often underappreciated I decided to do a blog post on a notable example. I intend for this post to be a natural follow up to my recent blog post on sales, marketing and distribution. While there are a significant number of executives who excel at business operations, I decided to pick someone who is less boring than may typically be the case. To achieve this objective I decided to write about Jim Barksdale because his use of colorful southern sayings makes his personality not only more interesting than normal but also unforgettable. Operations may not be the most exciting topic in the world, but it sure as heck is important if you want to be successful. What you want to avoid in the end is being described at your funeral as being “all hat, no cattle.”


1. “You cannot manage that which you cannot measure.” People who are highly skilled at operating a business are a rare and highly valuable asset. Rather obviously perhaps, operating a business is a very different set of skills than founding a business. Some founders are great operators while others are not. When people describe a great operator they will sometimes say that she or he “makes the trains run on time” which is a very good thing since if they don’t run on time very bad things can happen to a business. Operating a business when a business gets to significant scale vastly increases the need for highly developed operational skills. As an example, Craig McCaw said once regarding Jim Barksdale’s skill as an operator: ”He took a great mergers-and-acquisitions company [McCaw Cellular] and made it into a great operating company.”  Jim Barksdale is famous for doing many things as an operator, including putting in place the measurement systems which drove much of the success of Federal Express. Fred Smith said once that information about the packages can be more valuable than the package itself. Great operators also know how to set priorities and one way to do that is to determine what is measurable. Jim Barksdale believes: “If you can’t measure the objective then don’t put it on the list. We got too many things to fix that you can measure to waste time with things you can’t.” Jim Barksdale has also said: “The management of time is just as important as the management of money.” When you have great measurement tools you can react quicker and capitalize on that information faster and more effectively. Michael Cusumano writes that Jim Barksdale “manages by facts” and demands hard analysis- not just “touchy feely impressions.” It can be hard to weigh the facts if you got the scales weighed down with your own opinions, but great operators have a knack for doing that well.  As a final point, great operators love what they do. I know one fantastically successful  operator whose hands literally shake when he is not running a large organization.  This leader lives to lead teams. Not everyone is like this – some people are far happier and better off as an individual contributor.


2. “Now I’m the President around here. So if I say a chicken can pull a tractor trailer, your job is to hitch ‘em up.” “If we have data, let’s look at data. If all we have are opinions, let’s go with mine.” Great leaders are great listeners. What changes their mind on something is facts combined with logic. Opinions are not facts and someone like Jim Barksdale knows the difference.  

3. “The main thing is to keep the main thing, the main thing.” Every business has a profit engine that lies at its core. And that engine is invariably simple if you strip away everything extraneous. Two former Barksdale colleagues write about this “main thing” principle:  


“We loved that expression when we first heard it from Jim Barksdale, then the COO of FedEx. That single sentence captures the greatest challenge that executives and managers face today: keeping their people and their organizations centered on what matters most.  Every organization needs a Main Thing—a single, powerful expression of what it hopes to accomplish. Without it, it’s not possible to align the four elements that produce organizational efficiency and effectiveness: strategy, people, customers, and processes.”   


Relentless focus on “the main thing” is a universal attribute of great operators. As an example of implementing this idea in a nonprofit context, Jim Barksdale has said: “… whatever they say to us about what’s going on here or there, our question is always, ‘But are the children learning to read?’ And we want to just stay focused on that.”


4. “Three rules: if you see a snake, shoot it; don’t play with dead snakes; everything looks like a snake at first.” A Wharton MBA student who heard Jim Barksdale speak elaborates on what he heard Barksdale say“The first rule: If you see a snake, don’t have conference calls about it, don’t leave voice mails about it, don’t have meetings about it, just kill the snake.”  If you perceive a mortal threat to the firm, waste no time, and attack it before it destroys you. The second rule: Don’t play with a dead snake; keep going even if you’ve attacked the wrong threat or solved the wrong problem. The third rule: All opportunities start out looking like a snake.  If a threatening snake turns out not to be a problem, turn from attacking it to using it. 

During a speech at Harvard, Jim Barksdale explained it this way: “getting rid of a snake is sometimes a greater problem than the snake itself. People within a company…. write memos about the snake. And after the snake is officially dead, …sometimes people in an organization continue to insist that the snake is still around. They’re the people who ‘lost the argument’ and were overruled.”    


5. “The infantry is always ahead of headquarters.” People in the field who are near the line of fire know things that people in headquarters don’t know.  Great systems transport that data quickly from the edge to the center of the system that is a company. Great leaders spend lots of time in the field talking with people like call center operators and store managers who understand the customer pain points. When problems arise, great leaders leave their chair at HQ and get out with the infantry to find a solution. John Stanton is another former McCaw Cellular leader who was famous for getting out of his chair and into an airplane to get to the field when a problem came up.  


5. “In a fight between a bear and an alligator, it is the terrain which determines who wins.”   There are some domains in which any business is weaker and some in which they are stronger. Knowing the difference is critically important. As an example, Clayton Christiansen’s “disruptive innovation” thesis is all about finding favorable terrain in which to fight an incumbent.  Strategists have written about this principle for centuries: 


“Sun Tzu devotes a chapter to terrain and the appropriate, associated tactics and strategies. “We may distinguish six kinds of terrain: accessible ground, entangling ground, temporizing ground, narrow passes, precipitous heights, positions at a great distance from the enemy.” Von Clausewitz offers: “There are certain constant factors in any engagement that will affect it to some extent…[one of] these factors [is] the locality or terrain…which can be resolved into a combination of the geographical surroundings and nature of the ground.” Notice the use of the expression “constant factors.” That is the notion of those things that cannot be controlled in a competitive environment; hence, they must be taken as a given by all competitors. Von Clausewitz also devotes a chapter to terrain, which he argues “bears a close and ever-present relation to warfare.”


There are a few related sayings which Jim Barksdale may have used:


“Life is simpler when you plow around the stumps.” 


“You will encounter horse droppings as you go through life. You can walk around them or jump in the middle of them. The choice is yours.”


“If someone tries to hand you fresh horse droppings, whether you grab them is a choice.”


6. “Nothing happens until somebody sells something.” “If a company doesn’t have profits over the long haul, then it’s gonna be a short haul.” & “Quit spitting on the handle and get to hoeing.” In the real world of business, hoeing in no small part means selling. I’m not going to repeat the points made in my very recent post on sales and distribution here, but make no mistake, selling successfully is not only important but hard.


7. “We’re going to jump with every chute we build.” Making sure you “eat your own dog food’” is important. Using your own products is essential because it is a source of feedback but also because it creates the right incentives. Charlie Munger on this:


“Munger cites former Columbia University philosophy professor Charles Frankel who believed that “truly responsible, reliable systems must be designed so that people who make the decisions bear the consequences.”…Frankel “said that systems are responsible in proportion to the degree in which the people making the decisions are living with the results of those decisions…So a system like the Romans had where, if you build a bridge, you stood under the arch when the scaffolding was removed—or if you’re in the parachute corps, you pack your own parachute—those systems tend to work very well.” Conversely, “a CEO who’s there for five years while the company looks good, after which he’s gone on a pension, is not operating in a responsibility system like that of the Roman engineers.”   


Nassim Taleb calls it skin in the game:


“Standard economic theory makes an allowance for the agency problem, but not the compounding of moral hazard in the presence of informational opacity, particularly in what concerns high-impact events in fat tailed domains. But the ancients did; so did many aspects of moral philosophy. We propose a global and morally mandatory heuristic that anyone involved in an action which can possibly generate harm for others, even probabilistically, should be required to be exposed to some damage, regardless of context. While perhaps not sufficient, the heuristic is certainly necessary hence mandatory. It is supposed to counter risk hiding and transfer in the tails. We link the rule to various philosophical approaches to ethics and moral luck.”


9. “Great opportunities are the ones that solve great problems. And a great opportunity for wealth is solving the last link in the chain, that holds the whole system back from working.” If you can find a business that is the last link in the chain, sometimes you can unleash a huge torrent of value that is primed to benefit customers. Lost of the underlying work has been done – the last link solution just unleashes the gusher of value. “Your job is to run as fast as you can towards the cliff. My job is to move the cliff.” One of the jobs of a leader is to make sure that the team is always challenged and moving toward creating additional value. In other words, says Barksdale: “Management spends too much time fixing problems instead of pursuing opportunities.”


10. “They’ve got a bigger bulldog to feed.”  If your competitors have a higher cost of doing business, that can be a huge advantage. Great operators invest only in what adds value. When some young company founder invests in an expensive chair, that money is dilutive of his equity. That may be the most expensive chair ever sold if the company gets a great exit. In the South, people say things about unnecessary spending like: “He squeezes a quarter so tight the eagle screams.” “He’s tighter than a bull’s ass at fly time.


11. “Never mistake a clear view for a short distance.” JimBarksdale has said that this quote is an old “cowboy saying.” The saying originally referred to the fact that a ride to somewhere on a clear day may be further than you think.  Just because something seems obvious does not mean it will happen quickly. People tend to overestimate change in the short term and underestimate it in the long term.


12. “Nobody that I know can predict the next two pings of the pinball.” People who think they can predict the future are as common as ears of corn in a farmer’s field. Yes, they are right some times because: “Even a blind squirrel finds a nut once and a while.” and “Even a broken watch is right – twice a day.” But to focus on those inevitable forecasts driven by luck is a big mistake. It is best to remember that we have zero data about the future, but lots of data about the present. Great operators focus on the present and don’t fool themselves as often about their ability to fully forecast the future.


A Dozen Things I’ve Learned about Great CEOs from “The Outsiders” (Written by William Thorndike)

Many very smart people (e.g., Warren Buffett, Michael Mauboussin) are recommending William Thorndike’s book The Outsiders. Thorndike’s book describes certain attributes/methods of “top performing” CEOs. (page IX)  What does the author mean by a “great” CEO?  In short: “return relative to peers and the market” measured by “compound annual return to shareholders during their tenure.” (page IX)

1. The Outsider CEOs are “positive deviants… deeply iconoclastic” (page 3)-  The way I interpret this “positive deviancy” is that they understand this fundamental truth: it is mathematically impossible to beat the market if you *are* the market. The author makes this point by including this quotation from John Templeton: “It is impossible to produce superior performance unless you do something different.” Being right doesn’t lead to superior performance if the consensus forecast is also right. To beat the market, your views and actions must be non-consensus and you must be right. Thorndike points out that the Outsider CEOs are committed to “thinking for themselves” (page 9) and avoid consultants and advisers like the plague.  They “focus on key assumptions and did not believe in overly detailed spreadsheets” (page 200)

2. The Outsider CEOs are “masters of “capital allocation- the process of deciding how to deploy the firm’s resources” … capital allocation is investment, and as a result all CEOs are both capital allocators and investors.” (page XII)  Warren Buffett has established a simple test for use in capital allocation:

“for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.” (also page 225)

Determining the right “cost of capital” is a process where Thorndike seems to part ways with Warren Buffett.

For Warren Buffett: “Cost of capital is what could be produced by our second best idea and our best idea has to beat it.”  “We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”

In short, Warren Buffett engages in an opportunity cost analysis and ignores what he feels are academic concepts, like “weighted average cost of capital” (WACC).

Warren Buffett starts with a risk free rate that he has decided is the 30 year US Treasury.  He only buys companies that he feels have essentially no risk and yet are trading at a 25% or greater discount to “intrinsic value”, which gives him a “margin of safety.”  Warren Buffett does not dial up a ‘hurdle rate’ to reflect risk and uncertainty.  He instead requires a “margin of safety” to protect himself against his own potential mistakes. Margin of safety is like a safe driving distance on the freeway, it eliminates the need to predict what the other driver ahead of you will do. You react instead of trying to predict.

Thorndike uses a 20% hurdle rate on several occasions in the book.  He arrives at this hurdle rate in a manner very different from Warren Buffett:

“Hurdle rate should be determined in reference to the set of opportunities available to the company and should generally exceed the blended cost of equity and debt (usually in the mid-teens or higher). (page 218-9)

Thorndike is referring to a weighted average cost of capital (WACC) computation which is the product of a complex formula. What does the WACC formula used by an academic look like?

Weighted Average Cost Of Capital (WACC)Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

To say that Warren Buffett and Charlie Munger dislike this formula and the process it represents is an understatement. At the 2014 Berkshire meeting Charlie Munger said: “I’ve never heard an intelligent discussion on cost of capital.” John Huber, who attended the 2014 meeting, described the interaction in this way:

“Both Buffett and Munger agreed that the term “cost of capital” is an abstract concept that is often used by CEO’s and CFO’s to justify investments or acquisitions (i.e. “We think this is “accretive” because the returns exceed our “cost of capital”). Buffett said he has sat in on thousands of these types of discussions where “the CEO has no idea what his cost of capital is” and “I don’t have any idea of what his cost of capital is either.” Buffett and Munger had a much better way to view cost of capital that I thought was much simpler. Buffett went on to say that the “deal test is whether $1 we retain produces more than $1 in market value… not ‘cost of capital’”. Classic Munger: “Cost of capital is stupid.” He went on to say that Warren’s test is the best way to view capital allocation and reinvestment opportunities within a business. “It’s simple: We’re right and they’re wrong”. …Buffett said that they are “always thinking in terms of opportunity costs.” Thinking in this manner, rather than some model that can be manipulated in a spreadsheet, is a much more productive way to analyze investment opportunities within a business.”

Specifically regarding “hurdle rates”, the two partners who run Berkshire have said before:

Buffett- “We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind. We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher?”

Munger- “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”

Buffett and Munger might have significant problems with the way a 20% hurdle rate is presented by Thorndike in the book, despite the fact that Buffett endorses the book with a blurb and recommended it at the Berkshire annual meeting. They might say: Who has an second best investment alternative of 20% right now? If shareholders are distributed cash through share purchases or dividends, can they really earn 20% as a second best alternative?  In his defense, Thorndike is perhaps referring to deals with a lot of risk that must include a substantial risk premium, as explained below.

So given all this discussion regarding the right measure of opportunity cost, what is reasonable right now in 2014?  My suggestion circa May 2014 is to use 10% in most “ordinary” deals.  To explain, investors can earn maybe 6% (real) in public markets right now over very long periods. For an ordinary deal involving an ordinary company which makes a basic consumer good or service that has been around for many years (e.g., one in which Warren Buffett might get involved) I would add in 400 basis points (4%) right now to reflect the fact that other similar private businesses can be bought with that sort of return and call it done.

What about “dialing up” that 10% cost of capital to reflect higher risk, for example in the technology industry?  You can decide to increase the premium over the risk free rate or use a bigger margin of safety, but doing both is tricky since they are achieving the same thing. I say this despite the fact that Warren Buffett says: “You can’t compensate for risk by using a high discount rate.” Risk, uncertainty and ignorance are always present in making an investment, but whether you use a bigger margin of safety or add a bigger premium to the risk free rate seems like a personal choice given that they are two ways to do the same thing. That risk does not go away if you use a higher discount rate is a different issue than what rate is chosen based on opportunity cost. Warren Buffett advocates making no risk bets and having a buffer against mistakes in the form of a margin of safety, but that is not the only way to invest (even though it is a very wise way to invest).

Regarding the right risk premium if one does not take the “no risk plus margin of safety” approach, investing capital in improving a railroad line, is not investing in a new web service, is not providing communications services from a high altitude drone. The risk premium should be different for different investments and that requires judgment, which is one reason why investing is an art and not a science. For railroad improvement investments one might use 10-12% and at the other extreme investments in a communications service provided from high altitude service via high altitude drones might be 20%.

Trying to be very precise about cost of capital using an academic formula for WACC when the right risk premium is a matter of judgment with a large margin for error seems a waste of time and potentially misleading. Common sense is the best policy when it comes to opportunity cost. One of the smartest people I know puts it this way:

“cost of capital is an estimate of opportunity cost. Opportunity cost is the next best thing you can do with your money. In financial markets that are liquid, we generally assume that you can find multiple investments with similar risk and reward profiles. So the idea that is relevant is what I can earn on an alternative investment of similar risk. That is the cost of capital.”

It is worth pointing out that an ordinary investor who does not have the option of buying private companies as a second best alternative if given a divided of buyback proceeds from say Berkshire might have a second best alternative of investing the cash in a low cost portfolio of index funds/ETFS and therefore have a lower opportunity cost.

With public companies, Warren Buffett seems happy with paying 10x pretax earnings for a company that meets his criteria since he probably thinks 15% over the long-term is likely.

Warren Buffett pays more for private companies in part since he gets to manage the cash. On the value of float:

“Charlie Munger has said that the secret to Berkshire’s long- term success has been its ability to ‘generate funds at 3 percent and invest them at 13 percent.’” (page 178)

Questions get more complex when a company is purchased or an investment is made based on optionality. For example, take the case of an evaluation of the merits of buying a company like YouTube when it was bought by Google or Whatsapp when it was bought by Facebook more recently. These decisions can’t be made by looking at a 15 year history of earnings and the technology involved is changing value in nonlinear ways. Buffett and Munger put that sort of decision in the “too hard pile” but a tech CEO has no such choice. Thorndike does not deal with valuing optionality and I won’t either here (though I have wrote posts regarding optionality here and here).

3. “They have the investor’s mind set.” The Outsider CEOs understand that a share of stock is a proportional share of a business and not just a piece of paper. Investing is done best when it is most businesslike, and vice versa. In other words, the better you are as an investor the better you are in business and vice versa. They are conformable with concentration of assets (avoiding standard diversification dogma). They would rather invest in a few things squarely within their circle of competence than speculate about the behavior of large masses of people.

4. They “emphasize cash flow over reported earnings”… “in all cases” the Outsider CEOs “focus on cash flow” and forgo the “holy grail of reported earnings.” (page 9)  Jeff Bezos is a great illustration of this point, who has said:

“Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that.  So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.”  “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

Jeff Bezos is very focused on this “absolute dollar free cash flow metric.” You will see many people talk about Amazon’s focus on “growth” vs. margins, but the right focus is instead absolute dollar fee cash flow. Jeff Bezos spelled out his focus on absolute dollar free cash flow in his 2004 letter to shareholders. He is not about to run his company based on a ratio much beloved by someone outside the company, such as a Wall Street analyst. If you want to see Amazon’s approach to absolute dollar free cash flow generation taken even further, go to China and see Xiaomi and Alibaba up close.

5. They “optimize long term value per share not organizational growth” (page 10) “growth, it turns out, often does not correlate with maximizing shareholder value.” (page 11) Markets inevitably wiggle and simply by waiting out volatility the CEO can generate market outperformance. Morgan Housel writes:

“The reason stocks offer great long-term returns is because they are volatile in the short run. That’s the price you have to pay to earn higher returns than non-volatile assets, like bank CDs. Wharton professor Jeremy Siegel once said, “volatility scares enough people out of the market to generate superior returns for those who stay in.”

6. They resist the “institutional imperative.” (page 6)  The primary work of Warren Buffett and Charlie Munger at Berkshire is: (1) capital allocation; (2) selecting and compensating top managers of businesses and (3) selecting the investments which make up the portfolio.  The most important task in capital allocation for Warren Buffett and Charlie Munger is to take cash/earnings generated by a company like See’s Candies and deploy it to the very best opportunity at Berkshire.

Part of that capital allocation task is to avoid the “institutional imperative”:

“… rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.” Berkshire Hathaway Letter, 1989

7. “small number of … high probability bets” (page 16). The Outsider CEOs realize that opportunities which are substantially in your favor arise rarely so they are patient, prepared to act quickly and yet very aggressive when it is time. When you have the odds substantially in your favor bet big.

8. The Outsider CEOs don’t predict the future - they instead *wait* for the right conditions to exist and are prepared to act quickly and aggressively when that happens. “I like to steer the boat each day rather than plan way ahead into the future.”  (page 53) We have lots of data about the present but zero data about the future.

9. In acquisitions “the benchmark was a double digit after tax return  without leverage” (page 30) “when the companies multiples were low relative to private market comparables, Murphy bought back stock.” (page 30)

The Outsider CEOs only buy companies or their own shares at a substantial discount to intrinsic value (i.e., private market value determined on a DCF basis using “owners earnings”).

The Outsider CEOs buy companies and their own company’s shares when markets are fearful and refrain from doing so when markets are greedy. This is straight up Ben Graham-style “Value Investing”. Warren Buffett, for example, will only buy Berkshire shares when certain conditions are met:

“Buffett told shareholders in his annual letter that in order to trigger repurchases, the stock would have to trade for 120 percent of book value or less. (A company’s book value refers to its assets minus liabilities, and not the size of the contract Michael Lewis could fetch for writing about it.) Berkshire is trading at 138 percent of book, or a price-to-book ratio of 1.38. The multiple hasn’t dipped below 1.2 since 2012.”

10. The Outsider CEOs “lead by example.” (page 20) They walk the talk. It is that simple.

11. “Hire well, manage little” (page 191). Pay in companies controlled by Outside CEOs is often above market to get the very best people who are trustworthy. This enables the Outsider CEO to implement a seamless web of deserved trust. Charlie Munger sets the stage on this point simply:

“A lot of people think if you just had more process and more compliance—checks and double- checks and so forth—you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.”… “Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.”

12.  Outsider CEOs are “master delegators, running highly decentralized organizations and pushing operating decisions down to the lowest most local levels in their organizations.” (page 202) They push down decision-making on everything but capital allocation and choosing and compensating senior executives. They “delegate to the point of anarchy.” (page 24)