1. “The only way to learn how to invest is to invest. You can’t simulate it.”
Getting feedback is fundamental to the learning process. Reading and learning from others is great but at some point the only way to refine your skill is to actually invest real money. Many people have taken a class in which they make trades that simulate investing. Simulation is no substitute for investing, since most mistakes in investing are psychological.
Without actually testing your emotions and learning from genuine feedback you really have not put yourself in a place where you can test your ability to control your emotions. Warren Buffett said once: “Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.” The same thing can be said about Investing.
The way to learn about investing is to invest and to have what Nassim Taleb calls “skin in the game.” One of the most useful papers I have read about investing was written by Richard Zeckhauser, who is a professor at Harvard and a top class bridge player. The paper is entitled “Investing in the Unknown and Unknowable”:
“the wisest investors have earned extraordinary returns by investing in the unknown and the unknowable (UU). But they have done so on a reasoned, sensible basis. This essay explains some of the central principles that such investors employ. It starts by discussing “ignorance,” a widespread situation in the real world of investing, where even the possible states of the world are not known. Traditional finance theory does not apply in UU situations … Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop … new technologies.”
Who has complementary skills? Zeckhauser writes: “Venture capitalists can secure extraordinary returns… because early stage companies need their skills and their connections. In soft, the return on these investments comes from the combination of scarce skills and wise section of companies for investment.”
In a post on Keith Rabois’s partner Vinod Khosla I described what Richard Zeckhauser calls the domain of “ignorance.” A matrix which depicts one set of important relationships that impact venture capital, based on my interpretation of the ideas of Nassim Taleb, is as follows:
Because success in an industry is driven by the fourth quadrant (ignorance) successful venture capitalists understand that their objective is not to predict outcomes with certainty, since that is not possible. The task of a venture capitalist is instead to discover success from within a portfolio of 30-40 bets that have optionality. In the paper, Zeckhauser presents this to make clear that risk, uncertainty, and ignorance are very different things:
Venture capitalists with complementary skills have developed them over a period of years with experience in real world investing. Simulations of bets involving risk do not enable the investor to profit in the uncertainty and ignorance domains. The best way to become a venture investor is to make venture investments. There is no substitute for real world experience.
2. “Early stage, almost every successful entrepreneur I know doesn’t care as much about the economic terms as much as who they are going to work with.”
“If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.”
Khosla Ventures believes that the quality of the advice and mentoring given is so important that they present the firm as “venture assistance” rather than venture capital. Using Professor Zeckhauser’s taxonomy, it is the complementary skill and not the money that creates the extraordinary investing result. Founders who are paying attention have figured out that the same venture capitalists are consistently generating the grand slam home runs year after year.
An important aspect of any person’s skill set is that a lot of skill comes from early luck. People who get lucky early in life end up with more skill through a process known as “cumulative advantage.” What entrepreneurs should be taking away as a message is that money is fungible but the skill of the venture capitalists is not. This series on my blog has tried to drive home the idea that money is money (assuming deal terms are equal) but not all venture capitalists are the same. Skill should drive an entrepreneur’s choice of venture capitalist.
In addition to the importance of complementary skills, it is hard to deny that there are signaling benefits from having a top venture firm as an investor. The world is filled with uncertainty and people look for signals when making decisions. Employees and others are attracted to startups that others are attracted to, which causes cumulative advantage and the power laws that exist in venture capital. Success create more success with a power that is nonlinear. As another example of success leading to success see this HBS paper on performance persistence:
“Entrepreneurs with a track record of success are much more likely to succeed than first-time entrepreneurs and those who have previously failed. In particular, they exhibit persistence in selecting the right industry and time to start new ventures. Entrepreneurs with demonstrated market-timing skill are also more likely to outperform industry peers in their subsequent ventures. This is consistent with the view that if suppliers and customers perceive the entrepreneur to have market-timing skill, and is therefore more likely to succeed, they will be more willing to commit resources to the firm. In this way, success breeds success and strengthens performance persistence.”
3. “You are looking for outliers [as Founders].”
Optionality is everywhere if you know where to look, but the best types of positive optionality can be found in places where others are not looking. If a founder is an outlier it is much more likely that will find something that others are not looking at or can see.
In post after post in this series on my blog I have driven home the point that venture capital is an investment system driven by a very small number of tape measure home runs and that distributions of success reflect power laws. An investor will not find mispriced optionality by following the crowd. The optionality will be found in what Zeckhauser calls UU situations, where exists what he calls the ‘domain of ignorance’. This concept is from another Zeckhauser paper that you might want to read, entitled “Grappling with Ignorance.”
The critical point here is that when you are a highly skilled venture capitalist uncertainty and ignorance are your friends. This is where you find the outliers that Keith Rabois is talking about.
4. “The [best founders] can relay incredibly complex ideas in simple terms, can see things you don’t see, are relentlessly resourceful [and are] often contrarian.”
I have seen many great founders in the course of my career and I can say that they are all different in many ways yet also similar in some ways. This topic is worthy of a separate post. Keith Rabois has identified four important qualities of a great founder in his statement. First, successful founders almost always have the quality that Jeff Bezos said he looked for in a wife: “someone who would be resourceful enough to get him out of a Third World prison.” Second, they understand that to deliver an outsized result from their startup (financially and otherwise) they must be contrarian about something important and they must be right. Third, they can convey their ideas in ways that are easy for people to understand. Fourth, they have a unique way of looking at problems. A significant number of hyper-creative people are somewhat dyslexic. Great founders don’t think like other people in at least one important way, and are fearless about at least one important thing. This blog series has identified a range of other attributes in addition to these four that make for a great founder, like the ability to recruit talented people and a founder’s tendency to hire others who complement their skills.
The ability to find outlier founders (especially in new categories) is an especially valuable skill for a venture capitalist. I don’t think that there is any question that the skills involved in finding the best founders are based on pattern recognition. The more founders a venture capitalist sees in action, the better their ability to “know it when they see it.” Mike Moritz is an example of a venture capitalist who is particularly good at finding great outlier founders.
5. “There are fundamental differences between an angel, what I call an amateur investor and being a professional investor, a venture capitalist.”
Once a person is investing other people’s money they are no longer an angel but rather a professional investor. Great professional seed stage investors like Chris Sacca, Mike Maples Jr. and Ron Conway should not be referred to as Angels, but rather professional seed stage investors. In addition, even though someone like Max Levchin is still investing their own money at significant scale (and so might be called an angel) if you compare what Max does to a dentist in Portland writing a $75,000 seed round check, it’s apples and oranges. The way to resolve the question is to say that someone like Max Levchin who is prolific and has company building skills that go beyond being wealthy and well-connected crosses over to the professional category. The result of this taxonomy may be that a given seed round can have both professional and angel investors. My opinion is that Max Levchin investing in a seed round is not an Angel investment, but rather an investment made by a professional.
6. “We want to be doing what used to be called venture capital, not growth capital.”
Venture capitalists who excel in the early stage of a business provide much more than money to the business. Growth capital for companies who have product market fit and figured out a way to scale the business mostly just need more fuel to execute on what they are already doing. Once the fundamentals of the business are put in place while funded by seeds, A, and B financing rounds, many times all the business needs to scale is more capital. Even investment bankers can provide more capital.😉 Not only is providing venture capital less financially rewarding for people with great company building skills, the work for the venture capitalist is more boring. A late-stage financing is often more about finance than building a business. The move of marge mutual funds and others into the growth capital business naturally pushed venture capitalists to focus on earlier rounds.
7. “Many entrepreneurs are raising more money than they need and it can cause derivative consequences down the road that are not healthy.”
There are many people who have written stories about venture capitalists pushing a startup to raise too much money. Experienced venture capitalists know that they often spend time with entrepreneurs counseling them to raise less money, not more. There are many ways to solve the inevitable problems that arise early in the existence of a startup. Trying to solve those problems with too much money tends to cause dysfunction in one form or another. In other words, solving hard problems with just money does not scale.
8. “First principle: The team you build is the company you build.”
Keith Rabois said that he first heard this phrase from Vinod Khosla when he joined the board of Square. Some investors believe that everything in a business starts with people. No one believes that more than perhaps Starbucks’ Howard Schultz, who I’ve discussed in a previous blog post. Bill Campbell, who I’ve also discussed, would argue perhaps that product is more important but it is clear that there are two foundational things in building a business. Other venture capitalists believe that a massive addressable market is most important. One could argue that this ranking process is a bit like asking a parent which child they like best. Most parents answer: “I like them all the same.”
9. “There are two categories of good people: there is ammunition and there is barrels. You can add all the ammunition you want, but if you only have five barrels in your company you can literally only do five things simultaneously. If you add one barrel you can suddenly do a sixth, if you add another you can do seven. So finding those barrels that you can shoot through is key.”
I met with one of the very top executives at Boeing once with Craig McCaw, and he said that of the tens of thousands of engineers in the company only seven of those engineers were capable of designing an entire airplane. He said he could name those seven engineers. These were the equivalent of what Keith Rabois is calling “barrels.” These barrels are the unique employees who give other employees direction and fire them toward a goal. Finding and hiring barrels is hard, and a rare event. There barrels are scarce in the real world – hiring too many barrels is not a phenomenon often encountered.
10. “Silicon Valley, it tends to fragment talent across too many companies, so you get a suboptimal number of successful companies.”
“Generally speaking you want to hire people that share first principles, which involve strategy, people, and culture.”
“As you get into the uncharted territory where you don’t actually have any intellectual background, you need perspectives from people that are very different from you. At that point, it’s actually quite valuable to have people that are diverse.”
There are only so many great founders with audacious ideas possessing optionality, and talented engineers, and others who can create a great business. This tends to create strong rivalries in the venture industry since the competition for the best talent is intense. Competition is always good for a system and makes it more Antifragile.
11. “Matching your priorities against your time is really important.”
The scarcest resource available to any venture capitalist is their own time. The venture capital business scales poorly when the venture capitalist is actively involved in each portfolio company. A venture capitalist can only sit on so many company boards or help so many businesses with recruiting. A firm or partner can invest in so many startups before they dilute themselves and begin to underperform. Many venture capital firms learned this lesson and have pulled back to raise smaller funds and do less out-of-region investing. Of course, this matching your priorities against your time idea is also true for executives and entrepreneurs, (arguably even more so).
12. “Your job as an executive is to edit – not to write. Every time you do something you should think through and ask yourself: am I writing or am I editing? and you should immediately be able to tell the difference.”
What comes to mind in this quote is Eric Schmidt’s advice to Marissa Mayer, which I blogged about in a previous post. He said to her: “it’s your job as leadership to be defense, not offense. The team decides we’re running in this direction and it’s your job to clear the path, get things out of the way, get the obstacles out of the way, make it fast to make decisions, and let them run as far and fast as you possibly can.” The executive should focus on what is important. Editing should be reserved for matters that are important. More supervision is needed in certain cases as Keith Rabois points out: “There are people who just know what they don’t know and there are people who don’t. Until someone shows the propensity to distinguish between those things you can’t let them run amuck.”