This weekend’s blog post was intended to be about another topic. I wrote a draft post last weekend but when I read it today I deleted it. I therefore needed a replacement and fast or my streak of one post every weekend for three years was going to end.
Venture capitalist Dave McClure is a controversial and straight talking enough person that I have decided to just present his statements in the raw. They speak for themselves.
I will say that his “spray not pray” approach is probably the most controversial element of his investing style. Core to what he does is dialing up the number of bets he makes from the usual 30-40 per fund. Warren Buffett described a “portfolio of bets with optionality approach” 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.” A key element of this approach is the idea expressed by Michael Mauboussin: “a lesson inherent in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters.”
As further explanation, I have written previously on another post:
Venture capital and value investing share many different elements but each system is based on a different mispricing. This is a critically important point for an investor to understand. If an asset is not mispriced, market outperformance is not mathematically possible. It is also important to understand that investments can be mispriced for different reasons.
In venture capital the mispricing occurs because very few investors or asset owners understand optionality. This allows a VC to buy what are essentially long-dated, deeply-out-of-the-money call options from companies at prices which are a bargain. By purchasing a portfolio of these options, a VC who understands optionality and who has the right deal flow due to “cumulative advantage” can substantially outperform the market. The basic formula is simple for a top 5% VC with the requisite cumulative advantage and deal flow. A VC invests in ~30 companies per fund and the distribution of returns among those companies will reflect a power law. One to three of the companies in the VC’s portfolio will overwhelmingly drive financial returns and ~50% of the companies will be a total or near total loss.
Here’s Dave McClure:
1. “A ‘startup’ is a company that is confused about 1) what its product is, 2) who its customers are, and 3) how to make money. As soon as it figures out all 3 things, it ceases to be a startup and then becomes a real business. Except most times, that doesn’t happen.”
2. “We’re looking for functional products, early customer usage, and, in some cases, a stream of revenue already. We tend to jump in a little earlier than others. Usually we’re not just looking for a good idea but evidence of a successful product that people are actually looking for.” “We hope to understand that there’s a pretty clear match between what the product is doing and what the customer need is.” “Wait until companies have an initial prototype, have shown that they have the potential to be profitable and have the ability to scale. That’s the best time to invest.” “When they get to 10 thousand a month in revenue, that’s usually not accidental. There’s something that’s working so that’s where we like to start investing. If the company continues growing from there, if other investors jump in then we might double down at the seed stage or Series A and write a third check into the Series B round.” “We have three core metrics that we look at to find it: user growth and retention, revenue growth and economics per customer, and other downstream investment decisions. If we see two of those three things, but preferably all three, we’re happy. If we only see one, it’s a relatively easy decision to not invest.” “Your first impressions are not always correct. It often takes six to eighteen months to figure it out. I mean, we often figure out what doesn’t work within six months. But genius emerges more slowly.”
3. “For the most effective pitch, focus 80% on the problem, 20% on the solution.” “Customers don’t care about your solutions. They care about their problems.”
4. “I don’t think many companies need more than $1 million or $2 million in the first couple of years. Normally they’re costs are pretty minimal.” “There are a lot of VCs out there that will write five, ten, or twenty million dollar checks. And I think that’s fine, once [a company] has the unit economics down and once [they’ve] got a growth strategy it’s fine to take a bunch of venture rocket fuel.”
5. “If you have a choice between being a founder or a VC, be a VC. It’s a way better gig.” “If Sequoia’s the Yankees, we’re the Oakland A’s.” “We’re more open to businesses that don’t have to be homeruns.” “We say we like to hit singles and doubles, occasionally we’ll hit a home run.” “People are always interested in the billion dollar company story, but we’re trying to differentiate between not just billion dollar companies. For us, we’re making investments that we think are very successful if they get to the hundred million dollar value. Even when we have exits that are south of a hundred million, they are still meaningful to the founders and are still decent returns for us.” “Unicorns happen very infrequently, those are not very predictable. Centaurs happen more frequently and are a little more predictable and My Little Ponies happen all the time — but we can make money from those three different segments. It’s some way to capture public attention and really draw on the people caught up in the unicorn madness bullshit and get them to pay attention to all the small companies that are meaningful.” “In general, we think that 15-30 per cent of our portfolio will get to an exit and 5-10 per cent will get to meaningfully large exits. We’re optimistic that we’ll get at least 100 wins out of that 1,000 and a few of those have already happened.”
6. “I would say spray not pray. There’s a method to our madness.” “We invest early, way earlier than most people, at an accelerator and seed stage. The earlier you invest, the higher that attrition rate is because it’s compounded. We have a more scientific method of investment.” “We like to think of ourselves as lab scientists at a petri dish rather than gamblers at a roulette table. In the same way those MIT students gamed Vegas, we’re taking that strategy to the world of internet start-ups. It’s about predicting whether or not they’re fail.” “I think they [other VCs] will look like idiots in five to 10 years, or at least 90 percent of them. Ten percent of them will get lucky and look smart. But I think the investment model is incredibly flawed.” “I take incredible issue with the fact that my strategy is considered gambling, or shotgun when I’m the f—ing mathematician.”
7. “The feedback loop on venture capital is very slow. But it may not be apparent if you’re middle of the pack or actually smart until four or five years later.” “If you’re looking backward for the map for the future, you’re going to be looking up your own a**hole.”
8. “Investing in companies and having them not work is the default. We’re not surprised when we make a bad investment. That’s pretty standard. But most investors face what they call FOMO—fear of missing out. Most of us are worried about overlooking or saying no to something that will be big later. It results in us making more stupid decisions sometimes. It’s almost an irrational fear. You’re never going to get every deal. But it hurts even more when you realize you missed one of the best investment opportunities in the last 10 years. It’s usually the companies that I don’t invest in that I end up regretting. I very famously passed on Uber, which turned out to be a multi-million-dollar mistake.”
9. “Find investors who have a clue about the products and services they invest in, who use the products and maybe even write/speak about them.”
10. “Entrepreneurs usually don’t listen to people. Trust them to do their job. Remember, you invested with the understanding the project was likely to fail.”
11. “It might not be a bubble, but sure as hell the rent is too damn high.” “What I’ve been criticizing is companies raising too much money before they’ve demonstrate growth strategies.”
12. “Silicon Valley is a magical place, but it’s comprised of people from somewhere else. It’s more about the attitude–it’s not so much where people are from.”
Definition of a Startup- Quora https://www.quora.com/What-is-the-proper-definition-of-a-startup/answer/Dave-McClure
Johns Hopkins Magazine: http://hub.jhu.edu/magazine/2015/summer/dave-mcclure-500-startups
Mixergy Interview: http://mixergy.com/interviews/dave-mcclure-500-startups/
E27 Interview: http://e27.co/dave-mcclure-talks-investment-strategy-unicorn-hype-20150528/
WSJ Q&A: http://blogs.wsj.com/digits/2012/10/16/qa-with-venture-capitalist-dave-mcclure/
Genius Emerges Slowly http://www.inc.com/francesca-fenzi/dave-mcclure-five-hundred-startups.html
500 Startups co-founder Dave McClure http://www.geekwire.com/2015/500-startups-co-founder-dave-mcclure-90-percent-of-vcs-are-going-to-look-like-idiots-in-10-years/