I am going to let the subject of this post introduce himself:
“I am Josh Kopelman and I am a partner at First Round Capital, a seed-stage venture firm. Before that I was an entrepreneur, founding and exiting three companies (one IPO, two acquisitions). I’m based in Philly – but First Round invests nationally, and our biggest office is in San Francisco. My fund has invested in the first rounds of companies like Square, Warby Parker, Uber, On Deck Capital, Appnexus, Flatiron Health, Birchbox, and Blue Apron. First Round is laser-focused on helping seed stage companies become the next big thing.”
Moving on to the usual dozen quotes:
- “We’re seed stage investors – and like to invest in the ‘first round’ – so we’d rather meet with an entrepreneur earlier than later. (Caveat being that an entrepreneur should have selected an idea they want to pursue – and be willing to pursue it fulltime).” First Round has adopted what has become known as a “platform” approach to seed stage investing which involves providing more resources and operational support to businesses in the portfolio than was traditionally the case. When you are trying to add platform value or otherwise it is easier to work with someone who has not made problematic business decisions already. In another blog post I wrote: “…it is easier to train people about the right approach than to change what has already been established. The cynic might say this is because valuations are lower for the ‘first dollar in’ venture capitalist. The non-cynic would reply that the probability of success goes up when a business gets a great start, since that helps retire risk and uncertainty.” On the other point made by Kopelman it is surprising how often I talk to people who think they can get professional venture capital backing while working only part time on top of a full time day job. The best venture capitalists want the entrepreneur “all in” and pursuing the business opportunity full time. Missionaries are easier to spot since they are obsessed with the business and want to go at it full time. Mercenaries are more inclined to hedge their commitment.
- The typical founder spends their time either: PICKING an idea, STARTING a company (hunting for product market fit), or SCALING a company (growing). Most founders spend <5% of their time on idea selection, yet I believe that ‘the pick’ accounts for >50% of startup success/failure. Observation #1) Many founders rush ‘the pick’. If you’re spending the next 5-10 yrs of your life doing something, pick your idea wisely. Observation #2) In my experience, serial entrepreneurs are more likely to rush the pick due to high self-confidence & easy access to $$.” Kopelman sets out a clear taxonomy with “pick,” “start” and “scale” categories. Each stage has its own challenges. Warren Buffett agrees with Kopelman on the value of picking the right category: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Some businesses have terrible economics and “picking” those areas can be problematic to say the least. It is a good idea to be half-crazy when picking an idea so there is sufficient undiscovered optionality, but being fully crazy is unwise. Some things that seem nuts, are actually nuts. And some are not. “Half nuts,” like Goldilocks final sleeping spot, is typically “just right.” I discussed the product market fit and scaling stages in other posts like the one on Eric Ries.
- “Starting a company is lonely. Every day you wake up and there are more unanswered questions and more decisions to make. Find a community of like-minded people because together, you’re able to answer these questions far more effectively than individually.” “You’ll benefit from having a confidant, to work through doubts with and together determine the 90% of advice from investors and customers you should ignore.” There is nothing quite like having a conversation with someone you trust to help you think things through. That process is a lot like writing down your ideas in that you can discover things you have not thought through and also generate new ideas. Having colleagues around you is particularly valuable since there are no formulas for success. If there were formulas for success everyone would be rich.
- “We see a ton of consumer companies who say, ‘We’ll just make it viral’. It’s hard to achieve virality. If there was a virality button, if there was virality dust, then no one would spend a dollar on advertising. Viral is not easy. It’s hard and it has to be built into your product. The best viral apps are built around viral mechanisms. The same thing applies to community. Building a community isn’t easy. You can’t sprinkle community dust on it.” Selling anything is hard. Actually asking for the order and generating cash from a sale is something best appreciated by doing it. For real. Anyone who has actually done this understand that salespeople earn big salaries for a good reason. Sales is not only a real skill but a scarce skill in terms of people who can do it well. Having a product that sells well with little effort requires that a lot of value be delivered versus preexisting alternatives. Usually an offering that is viral has a process that enables the customer to self-educate. The best way to get people to tell their friends is to have a really great product. The essence of business is the ability to cost effectively acquire customers. The very best businesses acquire customers “organically” without advertising. Great products and word of mouth drives sales at these businesses. By contrast, companies which must sell their wares with huge advertising budgets are losing their edge. Jeff Bezos says it best:
“The balance of power is shifting toward consumers and away from companies. The individual is empowered. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it. If I build a great product or service, my customers will tell each other….In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts.” “Your brand is formed primarily, not by what your company says about itself, but what the company does.”
- “Every business plan is wrong. The moment an entrepreneur hits ‘save’ or ‘print’ the plan is out of date. Things change.” “I’ve always said that I’d much rather bet on an entrepreneur who can adapt to change rather than an entrepreneur who is convinced that they have the ability to predict the future. But adapting to change is hard. How do you maintain flexibility yet still preserve a goal oriented culture?” The quotation “Planning is essential, but plans are not” is attributed to a number of famous people. The quote has many variations in terms of the words used but the central point is always the same. The important take away is: things inevitably change and being able to adapt is essential. Mike Tyson version is: “Everybody has a plan until they get punched in the mouth.” The Jeff Bezos quote is: “Any business plan won’t survive its first encounter with reality. Reality will always be different. It will never be the plan.”
- “You should target 18 to 24 months of runway post Series Seed. The best time to raise follow-on capital is when you don’t need it, and 2 years of runway gives you the best chance to land in that situation.” “It used to be private companies would aspire to go public. We’re at the rare moment in time it’s the opposite. The minor league ball players are getting paid far more than the MVP major league players. Until that works itself out in the market it’s gonna create a really challenging time for these companies valued in the private markets to realize anything in the public markets.” Never ever run out of cash. Ever. You can recover from lots of bad situations but an absence of cash is nearly always fatal for equity holders and at least very painful for debtors. Having a margin of safety with respect to cash is a wise idea for that reason. Raising money before you need it is also wise since at that point you still have leverage in negotiating with investors. No cash, no BATNA. Having cash also gives a business optionality (huge upside, limited downside). In an uncertain world, that optionality is very valuable. Having the option to dial down spending to deal with the inability to generate new cash does not mean a business should not be aggressive. Instead it means the business has an option if things turn sour.A business always need to be careful, but sometimes that is more more true than other times. The ability of a given business to raise new cash can be easy or hard. venture capital is a cyclical business. In February of 2016 First Round put out a memo to its portfolio businesses that said:
“During the meeting, there was a conversation about the rapidly changing funding landscape. And one of the company’s (bullish) later stage investors warned the founder that the company should no longer rely on raising additional follow-on financing, saying, “We need to act like we’re Mark Watney in the Martian. We can’t assume we will get a shipment of new potatoes to save us.”
- “I don’t think a lot of people have been entrepreneurial about venture capital.” “Everyone knows that a VC’s job is to ‘pick’ amazing founders and companies. The best VCs are great pickers. But I think that startup founders have to be even BETTER pickers than VCs. VCs can pick dozens of companies, founders pick one at a time,. The typical VC spends most of their time doing one of three things: SOURCING companies, PICKING companies or HELPING companies. While VC’s probably spend less than 5% of their actual time on the picking, I believe the ‘pick’ creates well over 80% of the return. Good VCs are great pickers. The best VCs are great pickers and excellent mentors.” Venture capital is itself a business and it is only natural that new approaches will be developed as more entrepreneurs like Kopelman get involved. Venture capital was already changing but new blood is acting like an accelerant. There are aspects of the venture business that are unlikely to change (e.g., buying underpriced optionality) and some aspects that are more likely to see changes (how venture capitalists interact with entrepreneurs. We have already seen different approaches to governance, stage focus and entrepreneur support and more experiments and changes are likely. With regard to picking, the nature of picking is that you don’t know the 30 to 40% that will be a total loss. But that does not mean that picking is any less important. The venture capitalist must have 30-40 bets that all have great optionality. One of those bets must return the fund. Two or three more must return it again. As Kopelman says in a quote below, “In order to get a 20% return in 6 years, they need to triple the fund.” That is part of the inescapable math of the venture capital business. Let’s be clear: tripling a $400 million fun in 6 years is not easy.
- “Get to know entrepreneurs and who’s best equipped to ‘fill in cells’, seeking out the market and customer data they need to de-risk their business. Look for the ‘heat seeking missiles’ that aim at a target, but constantly scan the environment and adjust course as they separate signal from noise.” Lots of things need to be figured out and invented as a business is created. And in figuring things out there is no manual for success. There are no formulas. People who seek out answers in order to “fill in cells” as problems arise are the ones who succeed. Kopelman is saying there is a premium on inventiveness and good judgement, both of which have big and valuable optionality. Retiring risk is something a great entrepreneur does every day.
- “Start off with smaller checks than you expect to write and view them as tuition.” The venture business takes time to learn. Any new venture capitalist will make mistakes, especially at first. Those mistakes will have a monetary cost, but Kopelman is saying that it is a necessary way to learn (i.e., it is tuition). There is no way to learn to be a good venture capitalist without making mistakes. Good judgement comes from experience which often comes from bad judgement. If you are not aware of your mistakes you will not learn. This is part of the reason why Charlie Munger says that he celebrates his own stupidities. Munger says: “I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn. I like people admitting they were complete stupid horses’ asses.” He does not mince word when it come to his own mistakes. Munger says this because as Feynman said the easiest person to fool is yourself. Munger puts it this way: “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity. The amazing thing is we did so well while being so stupid.” Munger is harder on no one than he is on himself and that’s very intentional. He will say straight up that he was a fool or a horse’s ass when he has made a mistake. His point is simple: never stop learning since the process is extremely competitive. Outperforming the market average is a zero sum game. Outperformance must happen in a a brutal Darwinian process dominated by the best professional investors. To actually outperform the market average you need to being your “A game” and that means constant learning and adaptation to a changing environment. You will need every possible edge you can get which is why Munger advises that investors acquire “worldly wisdom.”
- “Your business [may not] fit venture return profiles (but still may be big for you!) or [perhaps] they’re just not into the team (which they’ll never tell you!).” “Choose bigger ideas. Ideas that, in the success case, the scale is massive and the impact can be large. Chances are you won’t succeed but, if you do, the prize is worth playing for.” Not every business should raise venture capital. Sometimes it is a far better idea to bootstrap a business. It’s perfectly fine and in fact normal to not have venture capital backing and start a business. Most businesses do not need venture capital. If someone does decide to raise venture capital the idea should have massive potential upside since without that it does not have the requisite optionality (huge upside, limited downside). Not every business has the potential for a 50X or more return. That is not only fin but can give the person starting the business a greater dose of what Nassim Taleb calls “antifragility.”
- “We bust our ass to try to get lucky.” If you can hustle, work and apply skill to alter the probability of success, the change being caused by those actions is not luck. What Kopelman is saying humorously is that hustle, skill and hard work can pay big dividends. Michael Mauboussin writes:”There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”
- “A company’s outcome should drive VC returns. When VC’s required returns drive company’s outcomes, it’s a recipe for trouble.” “Take a $400M venture fund. In order to get a 20% return in 6 years, they need to triple the fund — or return $1.2B. Add in fees/carry and you now have to return $1.5B. Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value. So assume that one VC invested in Skype, Myspace and Youtube in the same fund – they would be just halfway to their goal. Seriously? A decade ago, any one of those deals would have been (and should have been) a fundmaker! As a result of this new math, VC’s end up super-focused on the longbets (or moonshots) and frequently remove optionality for mid-tier exits. It is because of the challenges of ‘VC math’ that First Round Capital chose to raise a relatively small fund — allowing us to continue to make initial investments that average $600K. I understand the importance of aligning one’s time and capital to the upside opportunity, and recognize that there is some minimum threshold of ownership that is required for a VC to commit the time and attention to an opportunity. Does it make sense for an investor to spend the time and join the board of a company they own 2% of ? Probably not. However, the difference between 25% and 20% ownership — or even the difference between 20% and 10% — should not prevent a VC from investing in a promising opportunity.” The interests of the company and the investors are not always fully aligned. The best venture capitalists put the interests of the portfolio business first and they don’t get involved in a business where they can’t do that. This is easy to say but sometimes tricky to do in practice. On this issue and others any entrepreneur’s best source of information on potential venture investors is other entrepreneurs. Entrepreneurs should do due diligence on their potential investors. The first part of the quotations above from Kopelman relate to the level of returns needed to make a venture capital fund a success. You don’t turn $400 million into $1.5 billion in just six years investing in a new hockey rink. The venture capitalist needs to find business opportunities that may generate tape measure financial home runs. The only way to do that is to find highly mis-priced optionality. My post “The Best Venture Capitalists Harvest Optionality” discussed that set of issues: https://25iq.com/2014/04/05/the-best-venture-capitalists-harvest-optionality-dealing-with-risk-uncertainty-and-ignorance/ But a recent Jeff Bezos quote says it best:
“Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs. The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.”
Company Math vs. VC Math http://redeye.firstround.com/2009/10/company-math-vs-vc-math.html
Buy When There’s Blood in the Streets” and Other Lessons from Venture Capitalists Fred Wilson and Josh Kopelman http://beacon.wharton.upenn.edu/entrepreneurship/2013/02/buy-when-theres-blood-in-the-streets-and-other-lessons-from-venture-capitalists-fred-wilson-and-josh-kopelman/
Let’s just add in a little virality http://redeye.firstround.com/2009/11/lets-just-add-in-a-little-virality.html
Your Business Plan is Wrong http://redeye.firstround.com/2006/10/your_business_p.html
The Watney Rule for Startups — and the Return to the ‘Old Normal’ https://medium.com/@firstround/the-watney-rule-for-startups-and-the-return-to-the-old-normal-cba75583365e#.6iqmrx1vb
Product Hunt https://www.producthunt.com/live/josh-kopelman-2
Mauboussin- The Success Equation: http://www.amazon.com/Success-Equation-Untangling-Business-Investing/dp/1422184234