Rob Hayes has been a partner at First Round Capital since 2006. I wrote about First Round previously in the chapter on John Kopelman in my newest book A Dozen Lessons for Entrepreneurs which is a fund raiser for the charity “No Kid Hungry.” Before joining First Round, Hayes was a venture investor at Omidyar Network and prior to that he worked at Palm. Among the investments Hayes has made on behalf of First Round include Uber, Square, Mint.com and Planet Labs.
- “Distribution is absolutely the hardest part of creating an internet company.”
A vast gap can exist between: (1) people in a business who create and build products; and (2) the people who create the sales, distribution and marketing systems. Or not. Let’s be clear: (1) creating a product and finding product market fit (the value hypothesis) and (2) finding repeatable and scalable ways to grow the business (the growth hypothesis) are both very hard. Hayes is saying that distribution is harder (and he is a trained engineer). Maybe the best way to settle some of the conflict on this issue is to say that finding profitable and scalable distribution is “harder,” but creating a product and finding “product market fit” is “rarer.” Regardless of which task is harder (it will vary from business to business) proving that product market fit exists should some first, since otherwise the business can be harmed by or even die from “premature scaling.” There are some very helpful posts for entrepreneurs on distribution written by people like Ben Horowitz and Mark Suster. I have written a post on why direct distribution is becoming more valuable as the need for data to improve the product for customers becomes more valuable. You can find links to these posts in the End Notes.
- “It is a red flag for me if the founders have 20 slides in their deck on their product and are not getting into issues like distribution, team or other parts of the business. There have been very few products that cause people to beat a path to the door of the business on their own [like Google or Facebook]. Successful companies almost always have operators running them who know how to market, sell, manage an income statement and hire.”
Hayes has talked in interviews about the rarity of businesses like Google or Facebook that have product offerings that “sell themselves.” Unfortunately, the existence businesses that do not face normal distribution challenges like Google and Facebook can cause other people to think that they can sell their products in the same way, especially in consumer markets. Thousands of startups and new product launches have failed by assuming that using a “viral” marketing strategy will be enough to create a successful business. A business can have some attributes of these two companies (e.g., a business can work to create factors like virality), but the probability that a founder’s business will have a sales and distribution outcome that is as efficient or profitable as Google or Facebook is close to zero.
A business that can just focus on growth an ignore revenue even after they find product market fit is also uncommon. Mark Suster advises startups to: “ring the freaking cash register.” I expect that he has encountered startups where growth is more important, but that is not the usual case, Ben Horowitz writes:
“When I ask new entrepreneurs what their distribution model will be, I often get answers like: “I don’t want to hire any of those Rolex-wearing, BMW-driving, overly aggressive enterprise sales slimeballs, so we are going to distribute our product like Dropbox did.” In addition to taking stereotyping to a whole new level, this answer demonstrates a deep misunderstanding of how sales channels should be designed. What is a sales channel? It’s a route to market for a product or set of products. It can range from your website to a sophisticated sales force. The sale itself must be supported with the right marketing, process, and optimization strategy. Selecting the right channel is critical for any business — and products often fail because the company chose the wrong route to market.”
I have seen more slide deck presentations and product pitches that completely ignore distribution than I can count. They often look like this:
If a business can’t efficiently and cost effectively distribute its products in a way that delivers positive “unit economics” it is dead (or at best is walking dead).
The best way to learn how to be a successful operator of a business and create successful distribution and other systems is to watch one do their job. All great operators I know are standing on the shoulders of other operators that came before them. A Charlie Munger admonition is applicable: “I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.” That an operator must adapt what they know and do to the specific business does not mean that they should not learn from the best operators that have come before them.
- “You need to do two things as an early stage CEO: (1) hire the best possible people; and (2) make sure you don’t run out of money. There is a lot underneath that, but if you do those things successfully you are likely to have a good run.” “If you’re not spending at least 50% of your time hiring — and that’s the minimum — you’re already on the road to failure.” “Your job is to get great people and get the best out of them. Even if this makes you uncomfortable, you’ll find that really good things happen.” “You can’t be a leader without having people around you who you trust to do the right thing. And that means they’re not always going to do it the same way you would. It’s not your job to micromanage them.” “It’s very common to see company founders after they’re raised they’re money to feel like that’s the big win. They raised their money, so now they’re a company. As you close that first round and the money gets wired to your account, it’s really just beginning for you as a company.” “In the early days, know that it’s only about cash. That’s all the money you have to spend and should be spending.” “Founders should be worried about cash on-hand all the time. Even if employees love you, they won’t stay if you can’t pay them. In the early days, know that it’s only about cash. That’s all the money you have to spend and should be spending. “I hear founders saying all the time, ‘This is where revenue will start flowing in, so we can do X, Y and Z.’ I want to see a cash plan that assumes absolutely zero revenue, because you never know.”
Great hiring is not sufficient to create a successful business, but it is necessary. Discovering product market fit and a repeatable and scalable business model that can generate growth are among the other requirements. Of these inputs, hiring is too often given insufficient attention and energy by founders who must successfully do many things at once. Keith Rabois describes the importance of hiring in this way: “First principle: the team you build is the company you build.”
How much cash a business has on hand determines its “runway” which is the period it has until it is “cash out.” Mark Suster advises:
“VCs want you to raise the “appropriate” amount of capital, which I would define as what is reasonable given your progress to date, your resources and your needs for an 18–24 months.”
Hayes’ partner Josh Kopelman believes:
“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.”
In addition to hiring the other topic discussed in the quote above is our old friend cash flow. Scott Belsky points out that the issue of hiring and retaining good employees and cash on hand are quite related:
“The cash is king (or runway is king, for a fast-growing private company). Without runway, talent takes off. 😉 So, it is no surprise that bold moves to extend runway (think late-stage financings at technically large valuations with some tricky liquidation preferences underneath) are done even if they could hurt the company (and its people) in the long run. This is especially true when these financings are ego-driven rather than strategic. The problem is, the employees at these companies don’t understand the implications.”
There is an interesting tension that I see right how in that seed stage investors are getting nervous about the flood of late stage private money. These steed stage investors are even writing posts arguing essentially: “selling out early can be a great outcome.” They cite cases like the recent FanDuel sale:
“The aggregate value of the consideration to be paid by the Company in the Offer is approximately $465 million. As this consideration is not sufficient to satisfy the aggregate preference payable on the A Preference Shares, no part of the consideration payable in the Offer will be payable on FanDuel’s ordinary shares or options to purchase FanDuel’s ordinary shares.”
In short, seed stage investors are increasingly worried about same issues that employees and founders have faced for years. They are also worried that late stage private money is extending the time that they must wait to get a distribution but that is a topic for another day.
- “Building from nothing to [into a business with scale attractive to a venture capital investor requires a founder that can go from telling you a compelling story about her market at 50,000 feet to asking whether a radio component in the hardware should be moved 3 microns to the right. If you ask me what kind of founders I gravitate to, they’re the ones who can run up and down the stack like this. You often see this quality in the best CEOs.”
People who build a successful business are never one dimensional. They may be very focused on the business, but it takes many skills to be a great CEO or founder. The good news is that CEOs and founders don’t need to have perfect understanding of every skill to be successful. Founders will naturally know some aspects of growing and operating a business better than others. Knowing which approaches to use and when to seek help from others and when to do something that everyone thought was an unbreakable rule is a key part of good judgment. For better or worse, having good judgment often comes from making some bad judgments and learning from those experiences. The process of acquiring wisdom is just that – a process. And that process never ends.
- “Ideally, every founder is excited to get out of bed because they believe they’re doing something big and important in the world. They need to know what this is — to have this kind of North Star to guide them. That’s what’s going to give them the energy they need and the ability to hire all these people and convince all those investors.”
Hayes is yet another investor who values the missionary founder over the mercenary founder. A missionary who can tell stories that attract investors, employees, business partners and customers is particularly desirable. Many people who are great at putting their head down and doing the work are not as good at putting their head up and telling a story. The North Star will help even a missionary get through what Scott Belsky calls “the messy middle” of the inevitably up and down journey to success. In fact, it is the North Star goal that creates a missionary in the first place.
- “There are very few businesses that haven’t changed significantly as they have grown.”
The real world presents founders and investors with uncertainty, risk and ignorance. Give this unavoidable reality, it is wise to learn how to take advantage of optionality. Nassim Taleb frames the opportunity:
“If you ‘have optionality,’ you don’t have much need for what is commonly called intelligence, knowledge, insight, skills, and these complicated things that take place in our brain cells. For you don’t have to be right that often. All you need is the wisdom to not do unintelligent things to hurt yourself (some acts of omission) and recognize favorable outcomes when they occur. (The key is that your assessment doesn’t need to be made beforehand, only after the outcome.)”
It is not always possible, but when positive optionality does appear jumping on that train is a very good idea. Fantastic opportunities don’t present themselves to a human being every day, but when they do it is important to take advantage of them. Being patient and yet aggressive when an attractive opportunity presents itself is a great way to prosper and be happy in life. Low downside and a big upside? You do it. Big downside and a small upside? You don’t do it. Big downside and big upside? You ask yourself whether you are playing with house money that you really don’t need and how passionate you are about what is involved. Small upside and small downside? Meh.
- “I’m a seed investor. My job is to find those people that people have not heard of, met or worked with and make decisions about whether that person can have a real impact.” “I ask: ‘Is there a real problem that this startup is solving. Is it a problem that I either feel myself or a know a lot of people feel deeply. Is there a founder who can execute against the solution to the problem?’” “I think there are two types of founders. Those that find waves to ride and those that create the waves so they can control when and where the ride happens. Elon Musk has done this twice and I can point to many other founders that have created their own destiny when others thought it was not the right time (Travis, Jack, Sergey and Larry, etc.). My question is never ‘is this the right time to build this company’ but ‘is this the right person to build this company given that this person will also have to build the market’.”
Hayes is in part talking about what I wrote about last week in my blog post on Josh Wolfe. An investor should always be seeking an edge of some kind. Whether that edge is informational, analytical or behavioral in nature, the objective is to capture an opportunity that has positive expected value. There are many ways to acquire an edge and some ways to acquire an edge are not right for some people. For example, Josh Wolfe is not Cliff Asness, who I wrote about the week before. They both have different styles as do other successful investors I have profiled on this blog. The more you know about the many different ways that one can capture an edge in investing and operating a business the better your outcomes will be. You may not use every investing or operating style yourself, but you can learn by understanding many styles. You can even learn from styles that are not successful since you can acquire more knowledge on what not to do. It is amazing how much benefit you can generate as an investor or an operator of a business by consistently not being stupid.
- “Marketplaces and platforms extremely difficult to spin up, but once they’re working, they can become massive businesses.”
Marketplaces and platforms bring together two or more interdependent groups who need each other in some way. Uber, eBay, and Airbnb are examples of this phenomenon. Hundreds of big and small businesses fail in trying to create marketplaces and platforms in different categories every year. The payoff from creating a significant marketplace or platform is massive and the financial downside relatively small. As I discussed above that is positive optionality. Founders and venture capital investors are willing to keep experimenting since it is magnitude of correctness and not frequency of correctness that determines financial success. Just one success in creating a platform or marketplace can pay for many dozens of failed attempts. Some people will try again and again to create a large marketplace or platform and never succeed. Successfully creating something like Uber, ebay or Airbnb is not a common event.
- “As a venture capitalist you can look for reason to invest or look for reason not to invest. It is sometimes harder to find reasons to invest.” “There are crazy valuations and not crazy valuations. When you are talking about a 10-15% differential on a term sheet with accompany that has a binary outcome, that can be a big mistake. My ultimate goal is to take money from my investors and return a multiple of that. Until that happens the investment is not a success.”
My friend Bruce Dunlevie likes to ask: “What could go right?” Dunlevie’s friend and colleague Bill Gurley agrees:
“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 must orient yourself toward [the question: what could do right?] You have to kind of think that way all the time. You’re more likely, being overly analytical and talk yourself out of things. You have to twist your brain in the right way.” It’s not a 50/50 thing on the judgment call. If you thought it was a 20 percent chance of success, you should still do it, because the upside is so high.” “You have to be very fortunate to discover 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.”
- “There is a reason why hardware has the word ‘hard’ in it. Producing integrated hardware and software products is one of the hardest tasks in the technology business.” “If you’ve ever worked in product, the first thing you know is that products are never finished. There are all these things you can do to make them better.”
Hayes learned a lot about how “hard” hardware is at Palm. Hardware is not only hard technically and in terms of issues like supply chain management, but hard financially. Life is just better and easier for a business when it has very high gross margins. This chart illustrates this point about gross margins by pointing out how many highly valued businesses have them:
Apple and Amazon are exceptions on the gross margin front, but their businesses make up for lower gross margins based on amazingly high sales volumes. Netflix is similarly trying adopting a volume and scale based strategy. That Apple or Amazon has accomplished X does not mean it easy to do what they have accomplished. I have written a post on what Steve Jobs, Jeff Bezos and Reed Hasting have accomplished that are linked to in the End Notes below.
As an aside, my most interesting story about Palm was being with Craig McCaw when Jeff Hawkins flew to Seattle with a balsa wood prototype to get some input. He was famous for doing this:
“Hawkins produced a balsa wood scale model with a pasted-on screen mock-up, complete with stylus whittled down from a chopstick. In the weeks to come, Hawkins would be seen interacting with his wooden model, pretending to use it as if it were a real device.”
Even with a founder/designer who is a savant about issues like product user interface and form factor, the hardware business in indeed hard. I have written another blog post entitled: “ Peloton: The “SaaS Plus a Box” Business case” and you can also find a link in the End Notes. The recent IPO filing by Sonos reveals some of the challenges of lower gross margins:
- “This is a long-term business. Reputation is made over careers and lost over deals.”
Warren Buffett’s advice on this set of issues is quite similar to the view expressed by Hayes. Buffett famously once said: “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.” The old New York Times test should perhaps now be the Twitter test. The admonition was once phrased in this way: “Never do anything you wouldn’t want to see reported by people you respect on the front page of the New York Times.” A new version might be: “Never do anything you wouldn’t want to see retweeted by people you respect.” Mark Twain’s famous and simple advice on this point is applicable: “Always do right. This will gratify some people and astonish the rest.”
- “It’s really important and imperative for you to be leveraging all the resources that you have, including that investor that has given you money. They want to see you succeed as much as you want to succeed.” “In board meetings Bob Kagle is the kind of person who sits very quietly, listens very intently and when he speaks it is because he has something important to say.”
Many founders are going through their first startup experience and are moving along a steep learning curve. Understanding issues like capital structure, hiring, corporate governance, compensation, sales and marketing is something best done by learning from others. Whenever possible, stand on the shoulder of giants and learn from the mistakes of others. A lucky few founders get a coach like Coach Bill Campbell to help them grow into their roles. Without that resource many founders must assemble a stable of more informal advisers. Venture capitalists can be helpful to founders on some issues as long as it is remembered by the founders that there is a core tension in their relationship on some issues. Chris Dixon puts it this way:
“VCs have a portfolio, and they want to have big wins. They’d rather have a few more lottery tickets.. while for the entrepreneurs, it’s their whole life, and let’s say you raised five million bucks, and you have a fifty million dollar offer, and the entrepreneurs are like, “Look, I make whatever millions of dollars. I’ll be able to start another company.” And the VCs are like, ‘Wait! We invested billions of dollars.’ That is usually where tension comes.”
Getting the balance right as an adviser to a founder, CEO or another manager of a business is tricky and hard. When the adviser you are on the board and have fiduciary obligations to shareholders it is even harder. What I have learned about being a valuable board member is summarized in this blog post. In late 1990s until the Internet and telecom bubbles popped I spent some at Benchmark when I worked with Craig McCaw and it 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. I did not spend as much time with Kagle as I would have liked but I did so indirectly by learning from Bill Gurley, Bruce Dunlevie, Andy Rachleff, Kevin Harvey and Steve Spurlock. If you are not learning when exposed to role models like this, you are not paying attention. If you are not working hard and seizing opportunities to be around people who can teach about important aspects of life, what are you doing instead? When you strive to be a learning machine in as many settings as you can with the smartest, most energetic and interesting people you can, your outcomes in life get better. You are never to old to learn something new.
My blog “SaaS plus a box” post on Peloton: https://25iq.com/2018/03/10/peloton-the-saas-plus-a-box-business-case/ which talks about some of these distribution issues
My blog post on Steve Jobs https://25iq.com/2014/12/28/a-dozen-things-ive-learned-from-steve-jobs-about-business/
My blog post on Jeff Bezos: https://25iq.com/2014/04/26/a-dozen-things-i-have-learned-from-jeff-bezos/
My blog post on Josh Wolfe: https://25iq.com/2018/07/07/lessons-from-josh-wolfe-lux-capital/
Mark Suster: https://bothsidesofthetable.com/the-fallacy-of-channels-startups-beware-681355695a7f and sales generally: https://bothsidesofthetable.com/tagged/sales On runway: https://bothsidesofthetable.com/how-much-should-you-raise-in-your-vc-round-and-what-is-a-vc-looking-at-in-your-model-3b79ff436b63