1. “We don’t fund inventions. We like inventions.” “We don’t fund products. We only fund software companies.” Two important points are being made here by Ann Winblad. The first is that she decided early in her career as a venture capitalist to only invest in software companies. She was ahead of her time in understanding the value of software and the value of specialization. Mark Suster writes: “The VC structure is changing and there appears to be a bifurcation into small & large VCs with an impact on ‘traditionally sized’ VCs.” In a world that is more and more falling into what Nassim Taleb calls Extremistan, it should not be surprising that there are Matthew Effects (the rich get richer) in venture capital.
As Andy Rachleff writes: “these days the breadth of the Internet has made it possible to generate returns that were never before imagined. Companies like Airbnb, Dropbox, eBay, Google, Facebook, Twitter and Uber return more than 1,000 times a VC’s investment. That leads to amazing fund returns.” The big venture capital firms with existing track records are getting bigger and more successful and “the middle” of the industry is feeling the pain of this shift. In today’s venture capital industry, differentiation and specialization is the best way forward for many VC firms. a16z’s Scott Kupor has argued that more specialized venture capital firms will play a bigger role going forward as the number of “traditionally sized” firms shrinks.
The second point Ann Winblad makes in the quotations above is regarding the difference between an invention and a profitable business. Many people mistakenly think that an idea or invention is what makes for a successful startup. What makes a successful startup is a lollapalooza of positive feedback loops that build from the kernel that is an invention or innovation. Success happening in many dimensions feeds back on itself, creating this self-reinforcing network of positive feedback loops. Talent, customer traction, partners, press, money, all attract more of each other and with the right conditions can scale in nonlinear ways to become one of the ~15 businesses a year that drive VC industry returns. The venture capitalist’s job is to be an important hub in the social network that makes this lollapalooza, which is what makes a successful “unicorn” business happen.
2. “We look closely at the products and technology to see if what you’re going to deliver to market can at least for the foreseeable future deliver a sustainable competitive advantage.” If a company does not have a sustainable competitive advantage (a “moat”) competition will inevitably cause the return on investment for that business to drop to opportunity cost, and there will be no economic profit for the producer. In other words, if what you do can easily be copied or imitated, or if substitute goods and services exist, the business will never see a profit that exceeds its cost of capital. This is such a simple idea. But frequently it is poorly understood. Having a great product or service is not enough to achieve significant profitability. Sometimes the only people who benefit financially from a good or service that a company provides in a market are the customers.
3. “We invest in markets. If the opportunity is not large, then the business, independent of the people or the technology, will fail. Because of this issue of intense competition and capital efficiency, opportunities always get smaller as soon as you fund the company.” Even if a business has sustainable competitive advantage (moat) and significant market share, if the relevant market is small the venture capitalist will never earn the financial returns that it takes to make their business model work (at least S&P 500 return plus 5%). Each VC can only have so many startups in his or her portfolio, given that time is their scarcest asset, and that means putting significant funds (e.g., $10 million) to work in each startup. Only large opportunities justify that sort of investment.
4. “Warren Buffet’s quote: ‘The market bats last’ means ‘Have you figured out: are there customers out there?'” “Do the dogs have their head in the dish? Are the customers buying?” The customer development process during which a startup finds a “minimum viable product” is an essential step a business must take before moving on to scaling the business. If the “dogs don’t eat the startup’s dog food” the only alternative (that is not shutting down the startup) is to pivot back to begin the customer discovery process again.
5. “If you start a company, in order to get your engineering team staffed, to hire your other executives, you’ve got to get people to leave other jobs. So we look at your ability to attract excellence.” The ability to attract great employees is critically important since it is a key element of the lollapalooza which creates the positive feedback loops that drive business success. And the early hires are the most important hires, which is why venture capitalists often personally get involved in hiring – particularly at the earliest stages of the business.
6. “The role of venture capitalists is to be great opportunists. So, the visionaries are the entrepreneurs. I gave up my visionary hat when I moved to California and became a venture capitalist in the late 80s.” What drives venture capital finance returns is optionality. Optionality is all about discovery rather than precise prediction. Great venture capitalists know how to successfully buy long-dated, deeply-out-of-the-money call options on the prospects of a startup. Half of these call options will be worth nothing at all in the future, and only two or three will determine the venture capitalist’s financial success.
7. “Start-up building is hard. There is no manual for it.” “You’re always going to be short of people, you’re always going to be short of money…. So you have to find leverage points, versus working your way up through tiny little rungs and seeing if you get there. Think like a big dog and find leverage to get there.” Finding innovative ways to scale different aspects of a startup is a mission-critical activity. In other words, innovations are needed not only in the product or service but in the ways (1) the company is created, (2) the product or service is developed and brought to market.
8. “What does separate some entrepreneurs from other entrepreneurs is they’re not handwringers. They don’t worry about the unknown. They don’t really worry about the risk points ahead. As you get older and you get more experience, you train yourself to think ahead about the risk points versus just to take the next hill. But non-risk-takers and non-entrepreneurs would really have big headaches about this. They would need some level of comfort and safety. That’s something that we look for in entrepreneurs—that they have the courage to do the job. That they’ll have the ability to judge the business situation. They’ll have the ability to lead people. They’ll have the ability to interact with the marketplace and to really build confidence into strategy.” Uncertainty is fundamentally the friend of the rational investor. Founders instinctively know that uncertainty is what creates the greatest opportunities, since it causes others to fail to see the opportunity (i.e., misprice optionality). In contrast, risk, defined as not knowing what you are doing, is not the investor’s friend.
9. “All we are is good pattern matchers, but we do look for a few indicators. One: do they seem like they need control over everything, that’s not scalable. Two: are they going to have a trusting relationship with all of their stakeholders, their employees, their partners, their customers, as well as their investors. Can we all grow together? And three: do they have the intellectual and physical stamina to go the distance in building a company? It is very hard to build a company from scratch.” “The majority of companies fail by self-inflicted wounds by the leadership team.” Great founders and teams need a mix of skills, and for this reason a diverse team is a stronger team. As the comic strip character Pogo famously once said: “We have met the enemy and he is us.” Having people on a team who are diverse lowers that risk.
10. “Whenever we pass on an idea, we wonder…. We consider it errors of omission. They are to me as stupid as sins of selection.” Often the biggest mistakes in life are what you don’t do. The companies a venture capitalist does not invest in and the people they don’t recruit can be the biggest mistakes of all. As an analogy, Warren Buffet has said that the biggest mistake he made was not investing in Wal-Mart and that this mistake of omission probably cost Berkshire $10 billion.
11. “Being goal oriented and focused is a glass half full. You have to look at the positive and optimistic side,” “Women in particular should hold this glass in front of them all the time,” she said and to focus on the positives by thinking about what is going right — not just what isn’t. “Otherwise, you’ll never march forward.” “We went out to raise our first fund, we had 132 meetings before we got our first commitment…. Most people would have given up. But John and I were pretty competitive. The more ‘nos” we got, the more motivated we were. John neglected to tell me when we went out to raise the first fund that no new venture fund had been created for several years. I always pick bad economic times to start things.” These quotes remind me of a story about a boy and some horse manure. Worried that their young son was too optimistic, his parents sent him to see a psychiatrist. The psychiatrist had seen this same condition in patients before. He took the child to a special room containing nothing but a huge pile of horse manure. The young boy immediately began digging into the pile of manure with his hands. The little boy gleefully cried out for everyone to hear “With all this manure, there must be a pony in here somewhere” which confirmed the diagnosis.
The best venture capitalists I know are optimists. Great venture capitalists power through bad news like that young boy pushed through manure in that pile. They are also tireless when doing things like helping recruit the right employees for their portfolio companies, connecting with potential limited partners and receiving rejection after rejection. Ann Winblad’s experience is also another story of people finding success in doing things at what otherwise seems to be the worst possible time.
12. “Mary [Gates] was an amazing person. She clearly was a great mother because she has three great children [including Bill Gates] ; a great wife; she had a great and loving husband. Mary herself was active in the schools, on the board of the University of Washington, on multiple other boards. Whenever you would meet Mary, you got a handwritten thank-you note. And she always looked put together, she never looked tired, she always was present in the moment. I said to her, thirty years ago, ‘Mary, how do you find time for all this?’ At this point in time, I am a relatively young venture capitalist, I’m not on that many boards, I haven’t yet joined my university board, I haven’t joined a nonprofit board yet. She said, ‘You know Ann, it’s amazing how much time you really have, and how much time you waste, and how much time you can find for others, how much time you can find to sit down quietly and thank others, how much time you can find for kindness, let alone how much time you can find for contributing your own intellectual capital as well as your financial capital. As you get older you’ll find that you actually get even better at that.”’ And that was a real inspiration to me, to say, hey, it’s not about how fast you pedal, it’s about how clearly you focus.” Other than my own family, Mary Gates and her husband Bill have had more to do with who I am as a person than any two people anywhere. She was a dynamo and far ahead of her time. Mary was whip smart and was liked by everyone she met. She was on many boards before it was common for women to do so. She helped many people. For example, she was the person who convinced me to work in the mobile industry in the 1980s. She knew about the opportunity because she was on the board of one of the very first “cellular” companies. Her friendship with my mom went back to the time they were in college together. They both had breast cancer at the exact same time. Mary Gates wrote a beautiful hand written note to my mom about their fight with cancer. My mom is still alive, but tragically Mary Gates did not win her battle. People like Ann Winblad still carry on this tradition of being role models for women everywhere.