1. “Y Combinator is a minor league farm club. We send people on up to VCs.” Paul Graham successfully found a role for Y Combinator in the startup ecosystem which has allowed it to thrive. He is saying that Y Combinator is dependent on other investors to provide growth capital to its graduates and that it will continue to specialize in what it does best. Roelof Botha of Sequoia puts it this way: “Since the distribution of startup investment outcomes follows a power law, you cannot simply expect to make money by simply cutting checks. That is, you cannot simply offer a commodity. You have to be able to help portfolio companies in a differentiated way, such as leveraging your network on their behalf or advising them well.” Y Combinator found its differentiation in the startup ecosystem and financial success followed.
2. “[One of] the two most important things to understand about startup investing, as a business [is] that effectively all the returns are concentrated in a few big winners… I knew [this] intellectually, but didn’t really grasp till it happened to us. The total value of the companies we’ve funded is around 10 billion, give or take a few. But just two companies, Dropbox and Airbnb, account for about three quarters of it.” “What investors are looking for when they invest in a startup is the possibility that it could become a giant. It may be a small possibility, but it has to be non-zero. They’re not interested in funding companies that will top out at a certain point.”
“A startup is a company designed to grow fast. Being newly founded does not in itself make a company a startup. Nor is it necessary for a startup to work on technology, or take venture funding, or have some sort of ‘exit.’ The only essential thing is growth. Everything else we associate with startups follows from growth.… To grow rapidly, you need to make something you can sell to a big market.”
Y Combinator has invested in more than 700 startups to date. “Two-thirds of [the fund’s] valuation is in two companies — Dropbox and Airbnb. [Down from 3/4 cited above] Stripe, a third graduate of Y Combinator, has been valued at $1.5 billion. It has been reported that “three companies accounted for almost 90 percent of the $16.5 billion jump in YC company valuations since last June.”
If (1) two to three startups in an Angel investor’s portfolio must generate 2/3-4/5 of financial returns; (2) the expectation is that the fund will generate financial returns that are at least 5% greater than public equity markets and (3) $120,000 is invested for a 7% stake (Pre-Series A) in each startup on average, the mathematics dictate (1) the market must be big and (2) the startup must designed to grow fast. Since most companies backed by Angel investors produce little return of capital or return on capital, the math dictates that the ones that do financially succeed must be huge successes. There is no other way for a pre-series A $120,000 investment, for 7% of the equity, to generate the necessary financial returns.
One of the points made above by Paul Graham about the definition of a startup is really a point of taxonomy. Most entrepreneurs will not raise venture capital. These entrepreneurs will grow their business from savings, internally generated cash flow, bank loans or equity capital supplied by investors seeking financial returns which do not reflect the skewed distribution that exists in venture capital. The number of new restaurants in the US alone is 10X the number of new startups that seek venture funding each year. There will be less failure overall among new businesses that are not what Paul Graham calls “startups”, but fewer of those firms will have the gigantic financial returns produced by a venture capitalist harvesting optionality. Someone may argue: if these other small businesses are not startups, then what are they? They certainly are businesses. But they are not startups under Paul Graham’s taxonomy.
3. “If you want to start a startup, you’re probably going to have to think of something fairly novel. A startup has to make something it can deliver to a large market, and ideas of that type are so valuable that all the obvious ones are already taken…. Usually, successful startups happen because the founders are sufficiently different from other people – ideas few others can see seem obvious to them.” Finding a business which competition has not fully discovered and developed, one that is capable of huge financial returns, is unlikely to happen with traditional approaches. By seeking novelty, a startup can sometimes find hidden optionality. Optionality is everywhere if you know where to look, but it is most likely to be found in places where there is a lot of uncertainty. Financial bets on a startup business that operates in areas where there is not a lot of uncertainty are unlikely to be mispriced.
4. “The very best ideas usually seem like bad ideas at first. Google seemed like a bad idea. There were already several other search engines, some of which were operated by public companies. Who needed another? And Facebook? When I first heard about Facebook, it was for college students, who don’t have any money. And what do they do there? Waste time looking at one another’s profiles. That seemed like the stupidest company ever. I’m glad no one gave me an opportunity to turn it down.” A venture capitalist cannot outperform the equity market by 5% if he or she follows the crowd. It is simply not mathematically possible to beat the crowd if you are the crowd. Outperformance requires at least one correct contrarian bet. Since only about one in ten bets results in a “tape measure financial home run,” making just one contrarian bet is not a workable approach for a venture capitalist. Buffett describes how venture capitalists deal with uncertainty by making multiple bets: “If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.”
5. “We thought Airbnb was a bad idea. We funded it because we really liked the founders. They seemed so determined and so imaginative. Focusing on them saved us from our own stupidity.” Great venture capitalists put a large emphasis on a great team, since that alone gives the investor additional optionality. Great teams can not only adapt better to change, but know when to adapt. Great people also attract other great people which also attracts money, partners, distribution and customers in a lollapalooza fashion.
6. “For [a product or service] to surprise me, it must be satisfying expectations I didn’t know I had. No focus group is going to discover those. Only a great designer can.” Focus groups can be gamed by a team who thinks that they can predict the future rather than discover it. It is easy for someone to formulate the question presented to the focus group to get the answers they want. In contrast, a startup that launches a minimum viable product with real customers will genuinely find out early whether “the dogs are eating the dog food.” For a startup, that early feedback can literally be the difference between life and death. Waiting many months or even years for a big bang product or service launch that is the result of a focus group-driven process may leave the business with insufficient resources to survive a mistake since feedback comes so late in the process.
7. “I never say, ‘These guys are going to be great.’ All I ever say is, ‘These guys are doing great so far,’ because some percentage of the time, it turns out there’s some explosion around the corner. Not just founder disputes, there’s all kinds of explosions. Startups are very, very uncertain.” Since startups and the markets they target are a nest of complex adaptive systems, changes can be nonlinear in both a positive and negative way. It is “never over until it is over.” Some successful startups will almost fail and some failures will almost succeed.
8. “You need three things to create a successful startup: to start with good people, to make something customers actually want, and to spend as little money as possible.” The importance of a good team has already been discussed, as has the need to make dog food that dogs like to eat more than other dog food. The new point being made here by Paul Graham is that acquiring customers while spending as little money as possible is essential. Customer acquisition cost (CAC) and cost of goods sold (COGS) can be stone cold killers of any startup.
9. “The reason startups do better when they turn down acquisition offers is not necessarily that all such offers undervalue startups. More likely the reason is that the kind of founders who have the balls to turn down a big offer also tend to be very successful. That spirit is exactly what you want in a startup.” Founders who go “all in” because the startup is more about the mission than the money will be more likely to generate tape measure home runs. Some of these missionary founders will fail due to an overreach, but that will be obscured by survivor bias. Mercenary founders succeed less often, and even when they do succeed, they do so in less spectacular ways.
10. “The exciting thing about market economies is that stupidity equals opportunity.” To earn above market financial returns, assets must be mispriced and they are most often mispriced when people are being “stupid.” This happens when people participating in a market become overly optimistic or pessimistic. The swing between these two states (greed and fear) is what another fellow named Graham (Ben) described as a “Mr. Market” phenomenon. By being greedy when others are fearful and fearful when others are greedy, good things can happen since an investor can buy at a bargain and sell at a premium. Warren Buffett writes: “the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. In that classic book on investing he introduced ‘Mr. Market,’ an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.”
11. “It’s better to make a few people really happy than to make a lot of people semi-happy.” “Another corollary to the power law is that it’s OK to be lame in a lot of ways, so long as you’re not lame in some really important ways.” Focus matters in a startup, as does greatness, in at least some aspects of what a company does. No company is perfect and every company has problems below the decks. Sometimes the ticket to success is just being marginally better than the competition and then Matthew effects (the rich get richer) kicks in. Paul Graham once said: “You could even say that the whole world is increasingly taking power law shape.” Even if someone is just a little bit better, that may make a massive difference in financial returns since we increasingly live in in what Nassim Taleb calls Extremistan.
12. “It’s hard to do a really good job on anything you don’t think about in the shower.” Studies indicate that people taking showers often get distracted and when that happens the probability that they will incubate an important idea rises. “Aimless engagement in an activity is a great catalyst for free association.” But people who are distracted don’t think about things that they are not interested in or passionate about. And passion is a key element is start up success. So if you combine a shower with passion, your ideas are likely to be something that you can do really well. I would write more on this, but I need to take a shower.
Notes:
Paul Graham – Black Swan Farming
Blake Masters – Peter Thiel’s CS183 Startup Class Notes
Paul Graham – Startup = Growth
Inc – How Paul Graham Became Successful
The Information – YC’s Paul Graham, The Complete Interview
Categories: Uncategorized