“William H. Draper, III started his career in venture capital with Draper Gaither & Anderson, the first venture capital firm west of the Mississippi, working there with his father from its creation in 1958 until he left to cofound Draper & Johnson Investment Co. in 1962. Three years later, Draper & Johnson merged with Sutter Hill Ventures to great success. From 1981-1986, Draper served as President and Chairman of the Export-Import Bank of the US, continuing on to become the Administrator and CEO of the United Nations Development Program, serving until 1995. He is also a co-founder of Draper Richards Kaplan Foundation, a venture philanthropy group focused on early-stage, high impact organizations. He is the author of The Startup Game: Inside the Partnership Between Venture Capitalists and Entrepreneurs.”
- “Venture was far more profitable 40 years ago than it is today.” “When I was there, the returns at Sutter Hill were 42 percent.” “[There was] much less competition.” “In the early days of VC, the returns were so attractive that they got Wall Street’s attention. But then perhaps it was too much attention.” “It’s not as cozy and not as nice and not as profitable as it used to be.” “It’s much better for the entrepreneur now. The entrepreneur has a chance to go to lots and lots of places. If he doesn’t like Draper, he has a chance to go to Valentine or some other firm.” “This has been good for the overall economy, because it has meant more entrepreneurs could get started. If there were many fewer venture capitalists, perhaps a company like Facebook or Skype wouldn’t have been created in the first place, or been able to get funding.” Competition between venture capitalists has made the world a better place for founders and consumers. The nature of capitalism means that value in any business is constantly moving from producer surplus to consumer surplus driven by increasing competition. Venture capital is not an exception to this phenomenon. The bigger the venture capital business gets and the more money is under management, the harder it us to generate significant out-performance over a benchmark financial return. Timing matters and being early in the venture business was great luck for some people like Draper. Michael Moritz of Sequoia once said at a Fortune magazine conference: “a chimpanzee could have been a successful Silicon Valley venture capitalist in 1986.” Both today and in the past, financial success in the venture capital business overall is top down constrained by the number of successful exits as Fred Wilson pointed on is a classic post on the business. Fred wrote: “$100bn in [venture capital exits in a given year] produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor’s capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.” If venture capital industry exits are at the level in the chart below the overall financial returns will necessarily be constrained by the level of financial exits in industry. As I have written before, venture capital industry returns are far from spread evenly like peanut butter between all of the venture capital firms. The better venture capital firms capture the lion’s share of the financial returns in the industry. The venture capital business is certainly not like Lake Wobegon where all firms are above average. If the top down industry constraint is ~$100B a year on average, only so many startups (unicorns or otherwise) can achieve an exit in a given year.
- “We had many fewer failures in [the early years of venture capital] In our day we had really very few losses. At Sutter Hill, we had a lot of doubles and triples and not many strikeouts.” “We didn’t have the billion dollar hit, although there were one or two of those.” I believe that the change in the success rate that Draper describes is a natural outcome of increasing competition in the venture capital business. Since risk capital was relatively scarce in the early years the financial returns in venture capital could be excellent even without finding what Draper calls “the billion dollar hit.” As venture capitalist skill levels and capital under management rose over the years, venture capitalists found themselves needing to find new undiscovered sources of value as the obvious bargains disappeared. This process is similar to what happened to value investing when after a period of years after the end of the Great Depression the obvious “cigar butt” bargains disappeared. Venture capital like value investing was forced to evolve. As an analogy, in value investing the change took the form of people like Phil Fisher and Charlie Munger starting to consider quality in assessing whether a bargain was present. In the venture capital industry, Doriot’s massively successful investment in DEC provided a huge clue about where to find undiscovered and undervalued opportunity. What venture capital industry learned from the financial outcome of DEC was that convex payoffs (nonlinear payoff properties that create massive potential upside and small potential downside) which benefit from uncertainty and disorder could generate very attractive financial returns. A portfolio approach was required in venture capital since only a very small number of outsize winners determine the financial outcome of a given fund. Warren Buffett describes the strategy adopted:
“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. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”
By investing in businesses that can generate convex payoffs venture capitalists have been able to generate the returns we see in venture capital today. Because payoffs from convex propositions are determined by complex systems financial returns in modern venture capital reflect a power law distribution. Draper is saying that this was not the case in in the early years. My thesis is that investments like ARD made in DEC fundamentally changed the venture capital business. Draper has his own theory on why there were less failures in the early years, but I just don’t see it as being sufficient to drive the magnitude of the change. He said: “I think the reason [for fewer failures] is we’d share deals with other venture firms, so that you check your judgment, you get your broader contacts, you get more information, and you have a more cooperative spirit. It was a lot less competitive than it is today. Today, there’s these huge companies, and they want to get it all because they’re very hungry. ‘Feed me, feed me, feed me!; So that’s something that has changed. But “The size and the lack of cooperation among venture capitalists [has changed]. It’s hard for them to get a 10 million dollar deal and divide it up and say to Sutter Hill or Sequoia, why don’t you take half of it? We used to do that all the time.” Of course, Draper was actually there and I was not. So you might want to believe his thesis is right instead of mine.
There is one more important point to make that is relevant to what Draper said above abut a lower failure rate in the early years. In the United States there are only about 3,600 startups a year (~800 per quarter) that obtain first time venture capital from a professional investor. That leaves about 280,000 other startups every quarter that need to either raise some form of capital or bootstrap themselves financially. There is room for many other business financing models including what some call “Indie VC” and other approaches that involve cash flow financing like merchant based finance from a factor. Cash flow based financing is available and has a cost that varies with the approach. But it is not “disruptive” to venture capital.
- “For every hundred entrepreneurs, we say yes to four or five. Saying no is the worst part of the job.” Finding a venture capital investment that has the requisite amount of convexity (huge potential upside and small potential downside) is a bit like looking for a needle in a haystack. A venture capital firm may look at thousands of different investments before deciding to invest in as few as two to five businesses a year. Marc Andreessen points out: “the basic math component is that there are about 4,000 startups a year that are founded in the technology industry which would like to raise venture capital and we can invest in about 20. We see about 3,000 inbound referred opportunities per year we narrow that down to a couple hundred that are taken particularly seriously. There are about 200 of these startups a year that are fundable by top VCs.” No one likes to deliver bad news to a founder, but that is part of the job. The venture capitalist does not do the founder any favors if they string them along when they know the answer is no. A founder should realize that hearing the word “no” from venture capitalists is almost always part of the process.
- “Venture capital was not a word known out here. It was known to me and my father and a lot of people in New York because of J.H. Whitney and the Rockefellers were known to do some venture capital. They backed Minute Maid, and Eastern Airlines, but those were both family operations. I knew it more because of General Doriot who, while he was teaching, was also starting up and running American Research and Development. AR&D was a venture capital company that made the big mistake of having a public issue, and being a public company, having to answer to stock holders. [It was a mistake] because in this business it’s just not earnings that you can predict. It’s very blocky, and you don’t really know what the value is of your assets either. So that combination made it very awkward to be a public company.” I have already written a blog post on Georges Doriot and his struggles in creating AR&D. Limited partners who understand that venture investments are not liquid and take a long period of time to pay off are a great luxury for a venture capitalist. The very best limited partners have been involved in venture capital for decades and aren’t doing things like rushing to find a secondary market to unload their holding in the events the market turns negative. Venture capital has always been a cyclical business. Limited partners who can ride out the down cycle end up with superior financial returns as a reward for their patience. A venture capitalist who has experienced and thoughtful limited partners will be better at his or her job since they will not be distracted as much by the antics of nervous limited partners.
- “I consider all characteristics of success, but it’s the CEO, the entrepreneur, that’s the most important among all the factors.” Great people, attractive markets and significant innovation are all required for a business to become a success. Different founders and venture capitalists put different emphasis on these three elements of success at different stages of the evolution of a business. Robin Richards, who co-founded Draper Richards Kaplan with Draper once said: “You’ll find that other investors tend to ask whether the market makes sense and that people are interchangeable. Bill will take on business risk. He doesn’t want to take on people risk. He wants to make sure he can really work with that person or people. That’s what makes Draper unique. He’s always been about the people.” In this way Draper is more like Pitch Johnson and Eugene Kleiner when it comes to people. He would rather take on market risk or technical risk that people risk. Of course, risk and problems related to people can appear to be low at first and then appear as the business evolves. One interesting thing about the rise of software-based business models is that it is not nearly as common today for technical risk to be the primary concern of investors and founders. As a result, most of the risk that a founder must retire is now market risk, if you get the people issues right.
- “The entrepreneurial mind is an inquisitive mind.” I rarely meet a founder who is not a curious person and successful founders who are not curious are even rarer. I have also found that inquisitive people inevitably like to read. Not only do they like to read, but they read broadly. The best founders typically ask great questions and love to learn. Successful founders also tend to have strong opinions that are weakly held (they believe in what they believe because they have done the research to feel that way but can quickly adapt if new evidence becomes available). Eric Ries talks about why an inquisitive mind is so valuable in a founder: “As an entrepreneur everything you do – every action you take in product development, in marketing, every conversation you have, everything you do – is an experiment. If you can conceptualize your work not as building features, not as launching campaigns, but as running experiments, you can get radically more done with less effort.”
- “Venture capital is not all about money, it’s really mostly about building a company with the entrepreneurs who do the heavy lifting.” Implicit in this statement by Draper is that the best venture capitalists help with “light lifting.” Different venture capitalists and firms have different models for how much support they provide to portfolio companies. Venture capitalist support can range from: (1) extensive support from so-called platform approaches which offer end-to-end support (public relations, marketing, finance, recruiting, sales, distribution etc.) to (2) lighter touch support where the VCs get involved in only a few issues like recruiting or scaling growth in addition of their board duties. For example, Chamath Palihapitiya has a system where: “our growth team can help them implement the right data infrastructure, implement the machine learning, implement the right sort of customer acquisition metrics and reporting.” Other venture capital firms have full time recruiters on staff. A first time technical founder will have different needs than an experienced founder, so that there is a range of available venture capital options for founders to choose from is a good thing. Marc Suster writes that a founder should: “Beware of VC Seagulls, who shit on you and then fly away (or worse yet leave you with Red Herrings). The best VCs act as a sounding board for management.”
- “When an entrepreneur has a first board meeting, we called that the ‘Oh shit meeting.’ That’s when the VC finds out the bad news he didn’t know when he made the investment. How the VC reacts to that defines the relationship – it either becomes more brittle or closer.” Honesty is important in any relationship. Not only is honesty the right policy morally but it is vastly more efficient. Charlie Munger puts it this way: “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich – who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich – in money – not just in reputation.” Being ethical and honest is good business and in addition a necessary part of being a good person. Of course, sometimes problems are discovered that have nothing to do with a lack of honesty. A venture capitalist in a board meeting or otherwise may discover things that the founder(s) do not realize are a significant problem. Helping to resolve those problems is part of being a valuable board member. Since relationships like this tend to be both long in duration and intense, strong relationships can be formed just as they do during other life changing events like college or the military. The venture capitalist-founder relationship is sometimes said to be like a marriage, except it is harder to get a divorce.
- “Very often [Founders] overestimate the size of the market that their product or service will reach and underestimate what it takes in the way of a timeline (and) a team. Sometimes they make the mistake of thinking they can do everything themselves.” “We often tell (entrepreneurs) they have underestimated the timeline – toward becoming profitable or becoming an exit candidate, for example. They’d say, ‘No, we’ve doubled the time we think it will take.’ Then we double that timeline, and very often that’s not enough.” If founders were not optimistic and confident they would not be founders. For example, founders would not be able to withstand the many critics who will inevitably say that are crazy. As a result of this optimism and confidence Draper is saying that founders may get ahead of themselves a bit and the board’s job in part is to make their estimates more realistic without choking off their ambition. This is often tricky. I have written about board members like the late Coach Bill Campbell who understand how to strike the right balance. The best venture capitals are patient. As a result of skills developed via pattern recognition the best venture capitalists can provide excellent guidance of timing and staging.
- “A great firm name isn’t worth much if the actual partner on your board isn’t very good.”A great venture capital firm is valuable to a founder since several partners are sometimes available to lend a hand if needed. What Draper is saying is that the quality of a board partner within that firm has great importance for a given founder. This is particularly true for the lead venture capital firm or firm involved in a startup since it is often that partner or partners who are critical in helping the firm raise the next funding round. Not having a lead investor just to minimize dilution can be penny wise and pound foolish. A lead investor who will signal to others that the business is a sound investment is invaluable.
- 11. “[Some founders have] the misconception that things will take care of themselves and that the competition will stay the way it is. Nothing stays the same. So the inflexibility becomes a problem.” The old saying that the only constant is change is true. If a business ever earns a profit or even seems likely to earn a profit competition will inevitably arrive. The ability to successfully adapt to change is part of what makes a great founder and, in and of itself adds, to the convexity of the investment. In other words a great team of people give a business valuable added optionality that is often essential to success given the need to adapt. Draper is saying that he has at times had to encourage founders to be more flexible to respond to competition. Striking the right balance on this set of issues is key, since the founder’s motivation and persistent nature are important to maintain. Sometimes what looks like dogged founder persistence sends a business right off a high cliff and at other times it is the key to success. Knowing the difference between suicidal moves talented differentiation is part of what separates a great venture capitalist from a bad venture capitalist.
- “Venture Capital started because of Stanford University.” “Without Stanford there would be no Silicon Valley. There’s just lots of structural support in Silicon Valley.” Generating strong economic growth in ant region of the world requires a major research university as an anchor. There is no substitute in a modern economy for this engine of growth. If you look at which areas of the world are economically successful, you inevitably see at least one major research university. If a given city or region does not have a major research university it should try to affiliate with a city that does. Silicon Valley not only has Stanford but Berkley and UC San Francisco. Of course, there are range of other support services that a region must have to generate successful technology businesses. When all of the necessary factors come together any given city may find itself having significant success but it is not likely that it will be another Silicon Valley, but rather it will find its own version of success. I have written about this topic previously: http://www.geekwire.com/2016/12-things-seattle-can-teach-others-jobs-economic-development-building-better-city/
The Startup Game: Inside the Partnership between Venture Capitalists and Entrepreneurs https://www.amazon.com/Startup-Game-Partnership-Capitalists-Entrepreneurs/dp/023010486X?ie=UTF8&tag=bisafetynet-20
HBS Interview http://www.hbs.edu/entrepreneurs/pdf/bill.draper.pdf
Interview transcript: http://bancroft.berkeley.edu/ROHO/projects/vc/transcripts.html