Sonali de Rycker is a general partner at the venture capital firm Accel. De Rycker focuses on investments in consumer, software and financial services businesses. She was born in Mumbai and is a graduate of Bryn Mawr and Harvard Business School. De Rycker began her professional career as an analyst at Goldman and went on to join Atlas Ventures in 2000.
1. “We advise breaking down the [process of building a business] into milestones. Don’t just look at it as a ten year goal. Break it down into two year to 18 month milestones and then work backwards.”
A business must have the potential to become a multi-billion dollar business to be attractive to a venture capital investor. The magnitude of what must be accomplished to achieve that objective can be daunting, especially for a startup that has not proven that it has discovered product market fit and zero revenue. To illustrate how challenging that goal can be, it is useful to review the math: Assume the goal is to create a business with a market capitalization of $10 billion. To justify this valuation the business must generate $1 billion in cash flow every year in perpetuity, assuming a 10% discount rate. If that cash flow is delayed more cash must be generated later to make up for it. How many businesses today generate $1 billion or even half of that in cash a year? As a point of reference, Boeing’s operating cash flow is expected to be $15 billion this year. If generating 1/15th of Boeing’s cash flow is required to support a valuation of $10 billion, that’s a tall order. Of course, many businesses are valued are more than $10 billion even though they have not achieved anything approaching this amount of cash flow. As will be discussed below, the market must believe that this growth will eventually happen in the future or that a “strategic buyer” will purchase the asset at an attractive price.
De Rycker is suggested that breaking a huge goal down into smaller segments marked by milestones can be helpful to the team running a business in dealing with an objective that may seem daunting. As an analogy, once upon a time, a long time ago I ran a marathon in 3 hours and 20 minutes. That requires a pace of less than 8 minutes per mile for 26.2 miles. My method for doing that was to run the race a mile at a time. Each mile completed was a milestones in my journey. My best time is nowhere close to the world record which is close enough to 2 hours that people are hard at work trying break it. Think about the math of breaking that 2 hour marathon barrier:
“One marathon is equal to 422 lots of 100m, and to break the world record you would need to run each of them in a time of 17 seconds. It might not sound too hard, running a 17-second 100m race, you could probably go out and do it right now if you are physically active, but that would be one. Try doing 421 more at the same pace, in a row, with no breaks…”
Sometimes a milestone is defined for the company by external forces and sometimes it is created by the management team. Jim Barksdale, who has been the CEO of several important companies, said once: “Your job is to run as fast as you can towards the cliff. My job [as CEO] is to move the cliff.” That cliff can take the form of things like running out of cash or not having the right people to take the business to the next stage. “Moving the cliff” (e.g., a new round of funding) can be a milestone as can hiring a great CFO.
The founders and any other members of the team in the early stages of a startup will inevitably be required to do things to grow the business that do not scale. The process must include customer feedback, experimentation and product iteration among other things. As an example, Mixpanel founder Suhail Doshi recently described his own journey in a Tweetstorm: (edited version):
+Getting my first 100 customers always felt like a puzzle. The next 1000 seemed unreachable. Besides, how can you get feedback to make the product better w/o users? After many years, we ended up w/ 6,000+ paying customers.
+ This 1st lesson comes hard learned for most engineers: get up — away from your monitor—and talk to your users! I know it’s safer & comfortable to just email people but it’s also easier to ignore you. Your first 100 customers are usually acquired as a result of YOU selling.
+Get early customers on chat. A few reasons: (1) a great way to get them to follow through on using the product because you can hold their hand & (2) invaluable way to get feedback & troubleshoot their issues to fix later in the product. I did this w/ the first 200+ customers.
+Acquiring your first users/customers requires creativity, resourcefulness, and, often, a lot of manual hard work in the early days. There’s no silver bullet. Roll up your sleeves & make it happen.
The journalist David Carr once said: “Keep typing until it turns into writing.” Similarly, in building a business, the goal is to keep experimenting with product offerings until they turn into product market fit. The rise of modern analytics and data science means the process will be more efficient than ever before. The founders can’t precisely predict what the consumers will want to buy. But they can run experiments that drive them down the path to path toward possible product market fit. Guessing has been replaced by real world testing. The good news is that this process that may lead to product market fit can be accomplished faster and less expensively than ever before. The bad news is that competitors can do that too.
2. Getting to a milestones around value creation will allow you to fundraise.” “Money is like oxygen. If you run out at the wrong time, no matter how big the vision is, you won’t get there.”
Hitting the milestones on time is critically important for a startup since doing so enables the business to refuel to reach the next stage. To grow fast in many businesses will require regular infusions of capital. If the business can be grown using cash that is internally generated, the founders should sing the Hallelujah Chorus! My own practice when the business is cash flow positive is to repeat the word four times: Hallelujah, Hallelujah, Hallelujah, Hallelujah! I like free cash flow very much.
Unfortunately, external capital will be needed to create rapid growth in most cases. What potential financiers will want to see when they fund that growth is a business that is retiring risk step-by-step. Financial risk, people risk, technical risk, market risk and product risk all must be retired step-by-step. Hitting or better yet exceeding milestones are what demonstrates to investors that these risks are being retired. When risks get retired the valuation of the business goes up and investors are happy. When risks are not retired, the valuation of the company will stay flat or drop and investors are unhappy. A falling or flat valuation is itself a risk since it can set off a negative feedback loop.
Investors are looking for a business that has a history of exceeding milestones or the potential to do so. They also want a management team that has the ability to tell a great story about its business. Unfortunately, some stories are fake and some milestones are vanity metrics. For example, when telling a story some people may try to assert that accounting earnings are the same as cash. This can be a fatal assumption. It is possible to have earnings and at the same time have no cash. It is also possible to have no earnings and a lot of cash. It depends. John Malone made the key point about cash in this way: “The first thing you do is make sure you have enough juice to survive…” As the business executive Harold Geneen once famously said: “The only unforgivable sin in business is to run out of cash.”
3. “We encourage entrepreneurs to take measured risk.”
As I noted above, there are many types of risk. As just one example, how do founders and employees best “measure financial risk” and make wise decisions about that risk? They should adopt an “expected value” approach. The formula is simple:
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.
Michael Mauboussin adds clarity to that simple point by explaining: ‘Expected value is a function of the weighted probability of potential outcomes. Most experiments that have significant potentially positive outcomes fail. What matters is not how many times you fail, but the magnitude of success if you succeed. My friend Bruce Dunlevie likes to ask: “What can go right?” If the outcome is potentially massive in a positive way, you can take on a significant risk of failure, as long as the investment of collective investments is financially attractive in an expected value basis.
4. “There is huge pent-up demand on the buying side for growth stories.”
The amount of capital that is currently engaged in a desperate search for higher yields is unprecedented. Pension funds and endowments in particular have a burning desire to generate enough financial return to support their existing and planned spending or at least have a story that indicates that they may do so. One of the few ways these investors can see to grow their financial return or to tell a story about high future rates of return is to find a business that is quickly growing and hope that this growth will translate into a return that is higher than what can delivered by a benchmark like investing in a market index. Of course, the nature of the growth is matters in a nontrivial way. Revenue is not cash flow. Earnings are not cash flow. History has shown that a desperate search for yield can produce high valuations until it doesn’t.
Howard Marks describes his view on where the markets are now in this way:
“The need of investors to wring out good returns in this ‘low-return world’ is causing them to engage in what I call pro-risk behavior. They’re paying high prices for assets and accepting risky and poorly structured propositions .In such a climate, it’s hard for ‘prudent’ investors to insist on traditional levels of safety. Investors who don’t want to sign on for risk (that is, who ‘refuse to dance’) can be constrained to the sidelines…. It appears many investment decisions are being made today on the basis of relative return, the unacceptability of the returns on cash and treasuries, the belief that the overpriced market may have further to go, and FOMO. That is, they’re not being based on absolute returns or the fairness of price relative to intrinsic value.”
5. “The next big thing could look very different from the last big thing.” “The hallmark of being a great venture capitalist is not having a fixed view. The minute you have a fixed view you are dead.”
Generating above market financial outcomes is not possible if you do exactly what the market does. That is true by definition since if you are the market you can’t beat the market. De Ryker is saying that investment convexity that makes the venture capital investment model work is discoverable if you know how to find it, but it is unlikely to be found where people have been exploring a lot previously. So-called “convex” venture capital style payoffs are most likely to be found where few or no other entrepreneurs are looking. Convexity is best discovered by experimentation, which the venture capital industry has systemized. Most of these experiments fail, but magnitude of success is what matters, not frequency.
6. “A [seasoned venture capitalist] investor has seen every version of the story. Tuning your gut via pattern recognition [is part of the job].” “Venture capital is a humbling experience…at least it should be because you are always wrong. Even when you think something is going to be good, you do not know how good it is going to be.”
Humans are can be very skilled at pattern recognition. Or not. It depends. And some people are better at it than others. The key skill as you go through life is to keep adjusting (De Rycker calls it “tuning”) your decision making skills and approaches (e.g., your instincts and judgment). If you are not growing more humble as you go through life you are not paying attention. Everyone makes mistakes.
7. “Almost every single company we’ve done well with has involved us chasing and hounding. Before I did this job, I thought you’d just sit at your desk and wait for people to come to you. But we’ve called companies 50 times before we even got to a second meeting.”
Venture capital is a business which delivers a premium to people to hustle. De Rycker is saying that Accel, one of the best brands there is in venture capital, believes that they still must hustle to generate the best opportunities. If a well know brand like Accel needs to hustle then Wylie E. Coyote at Acme Venture Partners needs to hustle even more.
8. “Who is the person we are backing who will make it all happen? To invest, I need to have unwavering belief that the founder is the person we think she or he is. Almost everything else is secondary.” “Is this person going to break down doors, figure stuff out in a sustainable way and create a great culture?” “People exhibit entrepreneurship, hustle and empathy because of who they are, not what they have done.”
This blog has featured many venture capital investors who have said they want to invest in “missionaries” rather than “mercenaries.” De Rycker is saying that hustle, empathy, drive to prove something, being a great culture builder, being inventive, being genuine and entrepreneurship are just a few of the attributes she is looking for. This is what most people would expect. Most interestingly, she is also saying that a resume style pedigree is not the key determinant in her decision. Who the the entrepreneur is as a person is vastly more important than credentials.
9. “Culture is not sufficient, but it is necessary. It is not about command and control.”
It is not possible to have enough rules so that every employee will know what to do in every situation. It is organizational and community culture that best helps people fill in the gaps that inevitably exist between what the rules describe and reality. The better and stronger the culture of the organization, the more the business can operate via a seamless web of deserved trust. A strong culture cuts down administrative and bureaucratic overhead, speeds decisions and makes employees feel valued. These factors can create positive feedback loops which drive the business forward. Culture increasingly is a critical recruiting tool. In short, people want to work in environments that have an attractive culture:
“while pay can help get new talent in the door, [Glassdoor’s] research shows it’s not likely to keep them there without real investments in workplace culture: making a commitment to positive culture and values, improving the quality of senior management, and creating career pathways that elevate workers through a career arc in the organization.”
10. “Venture capital is all about outliers. Our model it hits driven and our kind of capital forces you to be big.” “The truth is that there aren’t that many multi-billion dollar companies.”
Venture capital is a cyclical business. Capital flows into and out of the venture capital business as it does in other markets. Because Mr. Market is bi-polar, sometimes too much capital flows into venture capital and sometimes too little. Rebecca Lynn has said on the current state of this ebb and flow of capital into venture capital: “The venture industry is overfunded. And it is not evenly distributed.” Josh Wolfe has similarly said: “I worry that the amount of capital that’s out there is not only raising valuations, but the speed at which people are putting it out and the expectation that they’re going to be able to raise a subsequent fund.” This overfunding creates a range of challenges and opportunities.
As I have written about a number of times recently, the venture industry is just not that big when compared to the size of capital markets as a whole. Why isn’t the venture capital business bigger? As De Rycker says, size of the venture business is limited because there are only so many new “multi-billion dollar companies” that can be formed at any given time. In other words, there are fundamental top-down constraints on spending by businesses and consumers which limit how many financial outcomes for investors can be as big as Google or Facebook over a given period. In other words, the amount venture capitalists can earn on their investments and distribute to limited partners is limited by the economy itself. For an example of how much the economy is able to enable in exists in a given year it is useful to look at figures compiled by PitchBook:
In 2017 with $67 billion exited across 1,265 deals, according to the 2017 PitchBook Liquidity Report. Although this is the third consecutive year exit counts have declined, the maturing venture environment across North America and Europe coupled with generous valuations, allowed for the proliferation of larger exits. In 2017, exits over $100 million comprised just over a third of total exit counts, while these transactions made up 88.7% of total exit value. While larger deals have always had an outsized effect on VC exit value, the relationship continues to be more pronounced.
The returns of venture capital firms within this top down constraint reflect a power law. In other words, the share of a top 5% venture capital firm will look much different than the share of a venture capital firm in the bottom 5%. When limited partners start moving toward the exists in the venture category it will be the marginal returns on the marginal firms that drives them to pull back. The probability that limited partners will stop investing in a top quartile venture firms is about zero, but whether they will continue to invest in the bottom quartile is a different story. The old joke that is relevant top this point is that there are no venture capital firms in the lowest quartile!
How important are the outliers in generating financial returns on venture capital?
11. “Venture capital is a boutique business. It is hard to institutionalize.”
Venture capital is a hard business to scale because the startups and the business of venture capital itself are complex adaptive systems interacting with other complex adaptive systems. It is not like roulette where the future sates and the probability distribution are known. One way that people have tried to institutionalize venture capital is to create accelerators. Y Combinator and other accelerators have created a model that many people have emulated. Getting willing founders ready for their first significant early stage financing is a problem that accelerators have tackled with great enthusiasm and resources. There are hundreds of accelerators operating around the world right now. Going through an accelerator is not the right approach for everyone, but the alternative is there if a founder wants to use them. Organizations like the Kauffman Foundation and commercial businesses like PitchBook and CB Insights are tracking the outcomes of accelerated startups versus firms which decide not to do so.
12. “The easiest part of venture capital is to invest.”
In my blog post on boards of directors last weekend I quoted De Rycker describing the ways in which board members can influence the outcome of an investment. How much the investors can help versus hurt a startup can be a contentious issue. Vinod Khosla wrote recently:
The companies need help from board members with hiring key executives and with introductions to unreachable candidates. The need help with critical decisions, and with handling internal conflicts. And they need board members who will push them to be as great as they can be without voting against them on their board or crossing the line of making board “decisions”. Boards in my view should rarely make decisions. They deserve brutal honesty rather than hypocritical politeness, even when it is inconvenient to give or get. They need to be pushed to think hard and critically about complex problems that board members can see with the benefit of experience, but they need to be left alone and empowered to make their own final decisions.
What I believe Khosla is talking about is what I wrote about on this blog last week: Don’t hire a dog and then try to do the barking for it. If you do not have the right dog, then hire a new dog that can do the barking. The entrepreneur and the management team know the business better than the investor. This is why boards in their effort to provide assistance and create value should focus on asking the founders and management the right questions and not try to direct the day-to-day management of the business.
End Notes:
De Rycker
http://www.dailymotion.com/video/x342kxo
https://www.youtube.com/watch?v=NesXptPMLGI
https://medium.com/startup-grind/sonali-de-rycker-general-partner-accel-c5128d7c5c67
http://www.wired.co.uk/article/investor-stories-accel-partners
PitchBook:
Vinod Khosla:
Howard Marks
https://www.oaktreecapital.com/docs/default-source/memos/latest-thinking.pdf?sfvrsn=2
Marathons:
http://mathematics-in-europe.eu/?p=1240
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