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