I started my friendship with Bill Gurley in the mid-1990s soon after Bill Gates forwarded me a copy of Above the Crowd. I immediately signed up to receive it (by fax!). I then found a way to for us to start talking by phone and the Internet. Gurley was a sell-side analyst living in New York at that time. We kept talking when he moved to Silicon Valley, including the time he spent at Hummer Winblad Venture Partners and then on to Benchmark Capital. As fate would have it, I was sent by Craig McCaw to spend time with Benchmark Capital not soon after Gurley arrived as a partner. It was the late 1990s, the Internet bubble was in full swing and mobile was thought to be “the next big thing” in Silicon Valley. The time I spent co-investing with Benchmark for Eagle River was as much fun as I have ever had in my career. I learned as much from the Benchmark partners during that time as I have from anyone ever. Learning from Gurley, Bruce Dunlevie, Andy Rachleff, Kevin Harvey, Bob Kagle, Steve Spurlock and David Beirne was a dream come true. Unfortunately, the Internet bubble would eventually pop and that would put everyone into firefighting mode for a few years. But I have maintained my friendship with Benchmark over the years and have continued to learn from them. For example, Gurley was the person who pushed me to start using Twitter and from that came my 25IQ blog (my effort to pass along a little of what I have learned before I am dead).
When I wrote my first blog post on Gurley for 25IQ I was limiting myself to 1,000 words per post. I am now up to as much as 4,000 words on some posts since people seem to be actually reading them. So I feel like I owe Gurley and some other people who I wrote about early in this 25IQ series an addendum. As part of my effort to make amends, set out below are a few quotes from a fantastic recent ReCode interview of Gurley by Kara Swisher and my usual commentary. In the notes that are always at the bottom of each post I have assembled a collection of other videos of Gurley, including a particularly insightful interview by Om Malik:
- “I think everybody, to a certain extent, has to play the game on the field. I like to use the example of Hortonworks and Cloudera. So we’re in this company HortonWorks, it’s a Hadoop company. Cloudera raises $950 million from Intel. What do you do? You could sit around and say, ‘We’re going to get to profitability,’ but you’re not going to matter. You might as well lock the door and leave the building. So you’re forced into a game of capital warfare that you may have not been ready to play. And so I don’t know that any one person is responsible. Silicon Valley and venture capital have always been cyclical. And so there’s something about human nature that causes us to be increasingly risk-seeking until someone comes along and really punishes everybody.” “I’ve got an unwritten blog post about unit economics. One of the things that Silicon Valley does when it gets risk-seeking, which it did in ’99 and now, is they invest in businesses with lower and lower gross margins. And that’s riskier. And a lot of times those involve consumer products. And then what they do is they start selling them heavily discounted. And there’s this old saying about selling dollars for 85 cents. But there’s a truism to it. You can create infinite revenue if you sell dollars for 85 cents. And if you give consumers more value than you charge them for, they will love you. And I remind entrepreneurs all the time that Webvan had the highest NPS scores of any company I’ve ever known. It wasn’t that the consumer proposition didn’t work, it was that the economics didn’t work. They weren’t charging enough for the service level.” “When bubbles come along, almost anyone can raise money. And so it creates excessive competition, you get companies that are misbehaving.” Are there any exceptions to the rule that every business needs a moat to generate a sustainable profit? No. However, this is a trick question since it is the existence of a return on investment that is significantly above a firm’s opportunity cost of capital over a number of years that is the test of a moat’s existence in the first place. In other words, the test of whether a moat exists is fundamentally mathematical (i.e., quantitative). But what causes a moat to exist is mostly qualitative since a nest of complex adaptive systems is involved in any business and the economy in which it operates. The successful creation of a new moat is emergent – you know it when you see it. Moats are created through the interaction of a number of phenomena that I have written about many times on 25IQ series and in my book on Charlie Munger. Because moats are emergent it seems rather obvious how they were created after the fact, but the reality is they are hard to predict before the fact (which explains why venture capital firms invest in a portfolio of businesses hoping for one to three grand slam financial home runs per fund).
In order to moderate the risks associated with this phenomenon of startups and other businesses selling dollars for 85 cents Gurley has been playing the role of an industry leader when he says things like he did above. He has been pushing against the wind to try to benefit not only his own portfolio of businesses, but the industry as a whole. People get easily confused about what Gurley is saying because they tend to be almost totally focused on valuation. Valuation is easy to understand. The general public and many mercenary entrepreneurs like to read and dream about wealth. Wealth sells. But the valuation of a business is a very different issue than the issues that can arise due to risk, uncertainty and ignorance in an industry, value chain or business. In short, there is far too much talking and writing about valuation (especially about whether some company is a unicorn) and far too little focus on the set of issues created by risk, uncertainty and ignorance. In other words, the press likes to say Gurley believes valuations are too high, when he is actually saying that risk, uncertainty and ignorance are too high. Valuation ≠ Risk. Valuation can be a source of risk, but it is not the same thing as risk.
Since Gurley is an athlete and a sports fan he uses sports analogies like “play the game on the field.” Another of these analogies is “muscle memory.” He said in the Kara Swisher’s Recode interview:
[Gurley] “People discount risk slowly. Like they forget about pain and they forget about layoffs and they forget about that this is supposed to be hard, you need to profitable. And the younger generation, they’re taught in very short time windows. So most of the entrepreneurs today weren’t around in ’99.
[Kara] So they’ve forgotten.
[Gurley]They have no muscle memory of it whatsoever.”
It is hard to exaggerate what a shock it was when the Internet bubble popped. The business environment moved from a fund raising climate where you could easily raise billions of dollars for a telecom firm or hundreds of millions for a startup in days to one where you could not raise five cents over any period. Any rational founder should have given thought about what they would do if there was no more cash coming in from investors. Prior to the end of the Internet bubble some founders did and some founder didn’t, and that was a life or death decision for their business. Some founders just got lucky since they had recently done a big financing round (what looked like skill was actually luck). People like Mitch Kapor and Josh Kopelman are in 2016 talking about a Watney rule: “We need to act we’re like Mark Watney in the Martian. We can’t assume we will get a shipment of new potatoes to save us.” The Watney Rule is intended as insurance, not as an operating plan while money is available as current costs. Fred Wilson thoughtfully argues that times when liquidity is tight can be cathartic:
“As these expansion stage companies struggle to raise capital, they are forced into a cathartic (and at times painful) process of self-reflection. What is their sales process? Is it efficient? What is their unique value proposition? Is it really unique? What kind of company are they building? Will it be large enough to justify all of this investment? And as a result, these companies are coming out of these hard raises with better businesses, better operating models (lower burn rates!!), and bigger visions to go execute against.”
- “When I was on Wall Street I was just devouring any book I could on investing philosophy — I think I bring a structured approach. And the way I think about it, which will sound trite, but I’m always looking for some kind of competitive advantage, like some type of unfair ability to compete in the marketplace. I don’t get drawn to the kind of enterprise deals that are just, “Who has the better sales force, knock them down,” kind of thing.” “I remember the OpenTable scenario. We’re meeting with Chuck [Templeton], and he’s in, like, three restaurants, and we’re like, “How could this ever work?” And you’re like, “Well, it can work if we tip it into a network effect and then everyone has to buy it.” And that’s what played out. It’s that kind of thing. We were betting on the existence of a network effect. And people talk about network effects all the time, but you come up with ways to try and analyze whether it’s possible or not. Will more diners lead to more restaurants, and will more restaurants lead to more diners? Are there ways to measure and study that? Or to implement the go-to-market strategy such that it exploits it as much as possible?” One particularly challenging element of a technology-based business is the moats of these businesses have network effects at their core. In a value chain dominated by network effects-based moats it is rare that a business can be fully rational about spending on customer acquisition when their competitor is spending on sales and marketing as if they have a printing press set up in a huge warehouse minting non-sequentially numbered $100 bills at zero cost. Since there is no way to predict when the spigots supplying new cash will be less available or even dry up and since network effects are so critical, a technology startup or business must, as Bill Gurley says: “play the game on the field.” The entrepreneur must trade off: (1) the risk of running out of cash against (2) the risk of not acquiring essential network effects before more free spending competitors do so. There is no scientific method for optimally making this tradeoff. However, cash in the bank is something that can give the business a margin of safety. A famous investor once called cash “financial Valium.”
All of this is obviously impacted by the availability and cost of capital. More cash means less people are paying attention to having sound unit economics. Gurley notes: “I was fortunate enough this summer to meet Warren Buffett — Chamath [Palihapitiya] was the one that made that happen. But we only had one question each, and I said, “You know, in our industry we’re seeing that low interest rates are leading to overt competition that’s irrational.” And he says, ‘You bet it is.’ And he’s seeing it in his business as well, and I think it’s played out in natural gas and all these other pockets. Real estate in Silicon Valley, right? All these asset prices, because with interest rates so low you just have people looking for yield, so money sloshes around.” There is clearly a lot of capital looking to find higher returns and that impacts the amount of capital invested in the venture capital industry which ends up in the hands of the businesses. This is having a significant impact on behavior to say the least. As Warren Buffett wrote in his February 28, 2001 Chairman’s letter:
“Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities—that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future—will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
- “When I first arrived at Benchmark, it was like, ‘Nothing can go wrong.’ There was an IPO every week. And then, wham! Man, the door came down hard.”
Joe Wiesenthal asked this question on Twitter recently: What caused the end of the Internet bubble. Here is my answer from a previous post:
“The Internet bubble was literally insane. I’ve never been involved in anything in my life that was more surreal. Fear of missing out (FOMO) caused the bubble to reach unprecedented levels. FOMO is driven by an innate human desire to avoid regret. Daniel Kahneman has counseled financial advisors to “try to prevent people from acting out of regret.” Investors and speculators who are prone to regret are more prone to change their mind at precisely the wrong time. Primarily you want to protect them from regret, you want to protect them from the emotions associated with very big losses.They key takeaway from the Internet bubble, for me, is that when it happens is not predictable. If it is a bubble and it does bust, the day before is like any other day. One key “tell” that can give you a sense that something is up is looking around and seeing lots of companies that are unprofitable paying far too much to acquire customers. What is too much? If the customer over their lifetime is producing a return that is significantly net present value negative the business is paying too much. How much is too much? It depends. If this pattern of acquiring net present value negative customers is persistent and widespread hairs should be standing up on the back of your neck. The bigger the net present value deficit the bigger the risk. Can you predict when a bubble will end? No. “You can’t predict, but you can prepare” says Howard Marks, and I agree. And for the hundredth time: risk is not the same thing as valuation.”
The Internet bubble and its end were nonlinear. There was no single cause of its creation or its demise. They were what Charlie Munger calls “lollapaloozas.” Michael Mauboussin describes the phenomenon: “Increasingly, professionals are forced to confront decisions related to complex systems, which are by their very nature nonlinear…Complex adaptive systems effectively obscure cause and effect. You can’t make predictions in any but the broadest and vaguest terms. … Complexity doesn’t lend itself to tidy mathematics in the way that some traditional, linear financial models do.”
- “It’s called asymmetric returns. If you invest in something that doesn’t work, you lose one times your money. If you miss Google, you lose 10,000 times your money. You have to orient yourself toward — Bruce [Dunlevie] uses the phrase, ‘What could go right?” And you have to kind of think that way all the time.” “The learning is that if you have remarkably asymmetric returns, you have to ask yourself, “How high could up be?” And then that “what could go right?” Because it’s not a 50/50 thing on the judgment call. Like, if you thought it was a 20 percent chance at doing it, you should still do it, because the upside is so high.” “You have to be very fortunate to fall on what people sometimes refer to as positive black swans, these break-out plays. And I think you could spend your whole career and do extremely well and never get behind one of the ones: A Facebook, a Google, that kind of thing. And it’s almost impossible to predict ahead of time what’s going to turn into something like that.” “The moment that John Doerr and Mike Moritz closed the Google investment, which was probably all of a week and half, it was the biggest event in both those firms for over a decade. And something had happened in a week and a half. And for a lot of those companies, and I’ll include the ones we’re in, if you worked there it probably would have come out that way anyway. So the seminal event was that closing event that was very quick.”
Convexity (huge upside and small downside) and power laws drive financial returns in venture capital. Venture capitalists must deal with systems which are, in the words of Nassim Taleb, “more like a cat than a washing machine.” Nassim Taleb provides a quadrant-based model as a guide to decision making. Michael Maubousin provides a summary of what Nassim Taleb has created:
“A two-by-two matrix, where the rows distinguish between activities that have extreme outcomes and those that have more bunched outcomes, and the columns capture simple and complex payoffs. He allows that statistical methods work in the First Quadrant (simple payoffs and bunched outcomes), the Second Quadrant (complex payoffs and bunched outcomes), and the Third Quadrant (simple payoffs and extreme outcomes). But statistical methods fail in the Fourth Quadrant (complex payoffs and extreme outcomes).”
Richard Zeckhauser explains why
“The real world of investing often ratchets the level of non-knowledge into still another dimension, where even the identity and nature of possible future states are not known. This is the world of ignorance. In it, there is no way that one can sensibly assign probabilities to the unknown states of the world. Just as traditional finance theory hits the wall when it encounters uncertainty, modern decision theory hits the wall when addressing the world of ignorance.”
The nature of the venture capital business is that financial returns come from the Fourth Quadrant/the world of ignorance. Standard statistical methods do not work. If you are looking for a career that is more protected from artificial intelligence, the Fourth Quadrant is a place to be. The great venture capitalists person accept this uncertainty and ignorance by seeking to become “antifragile” rather than trying to precisely predict outcomes that are not computable. This is part of the reason why there are venture capital firms. Warren Buffett advises:
“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.”
5. “There aren’t that many [rules]. One of the games you play in venture is to know which rules to break at the right time. And so we constantly challenge ourselves. Like, “Should we maybe be dropping this rule at this moment in time because things are changing?” “In the venture rule book there’s: “Don’t back academics who insist on being CEO.” So [when Google pitched to us] there was a number of things that said, “Don’t do it.” But two of the smartest investors ever [Sequoia and Kleiner] stepped up and did it. They also wanted a price that was seemingly ridiculous, obviously a very good investment. We failed to pursue it. It’s always important to state it that way. Because to say ‘pass’ made it sound like we had a chance. I don’t know if we had a chance. They presented to us and we failed to pursue it. And if we had, we would have had to compete with two of the best.” When venture capitalists make a decision on an investment they must think about a range of issues. One of these issues is valuation. If the investor pays too much for an investment it can become very hard to hit the targeted potential return. Another issue is the ownership level. You need to own at significant stake in a business to justify diverting the time and energy of the venture capitalist and not investing in a business that may be viewed to create a conflict. The venture capital business is about tape measure financial home runs and those returns come from exceptions to what people thought was a rule before or things no one knew. It is worth repeating what Zeckhauser said above: there is no way that one can sensibly assign probabilities to the unknown states of the world. So for the venture capitalist the question is always: what rule it it wise to break in the case of this investment?
6. “Venture’s really hard. And there’s a lot of luck involved. And mistakes that you make — especially missing ideas.” “Most big startup breakouts are where people aren’t paying attention. As opposed to where everybody’s got their guns lined up.” “Between the time we looked at the [Uber] seed and when we did the A, Travis had moved into the CEO position. At the beginning we were just studying him as an angel investor in the thing, and probably by the time the A came around he was the CEO. It was hard. Like I said, we had a theory that it could be like OpenTable. So you know, OpenTable was sold for like $3 billion or something. So I’d be inaccurate if I suggested we had a vision that it could one day cause people to question car ownership. I never had considered that.” The best venture capitalists are open and aware of the role that luck played in their lives and in their portfolio.When you listen to a Gurley interview he always takes time to thank the people who helped him along the way and to point out the good fortune he has experienced in his career. In a Quora AMA, Gurley gave a great answer to this question: What are the top pieces of advice you would give to your younger self? I can’t think of a better way to end this post than Gurley’s answer:
1) Read even more than you did.
2) Thank the people (more) that helped you along the way.
3) When Larry and Sergey ask for $110 pre-money, say “yes, we would be very excited about that.”
Previous 25IQ on Bill Gurley: https://25iq.com/2013/09/09/a-dozen-things-ive-learned-from-bill-gurley-about-investing-and-business/
Above the Crowd: http://abovethecrowd.com/
McCombs Interview: http://www.today.mccombs.utexas.edu/2016/05/high-stakes
Gurley on Coach Campbell: https://www.youtube.com/watch?v=Lfrbn4tH-NY
Fred Wilson: http://avc.com/2016/10/the-hard-raise/