Venture capital looks back to look forward
What is the hottest spring activity of anyone in the startup investor community this year? It’s not golf, replanting the garden, or vest wearing (close second). Instead, the focus has changed to signaling the end of “good times”. With the the Federal Reserve raising rates (its May 4th move was the largest since 2000) and public equities continuing to deteriorate, the startup ecosystem may be entering a period that no investor with less than 10 years of seasoning has seen in their professional career.
What are investors and founders to do in a time like this? As I’ve asked this question over recent weeks, my first inclination as a history nerd is to look backward. Serendipitously, I recently finished Sebastian Mallaby’s fantastic book on the history of venture, The Power Law, which deserves full reference credit for the quotes and stories to come. I’d highly recommend to anyone interested in learning more about the entrepreneurial ecosystem in the 20th and 21st centuries. Mallaby does a fantastic job deeply dissecting the rise of Silicon Valley in the 1950s and how “liberating” original thinkers from the expectation of being a Company Man or Woman sparked a new wave of innovation. In this same vein, it may take “liberation” from the mental frameworks of the past 10 years to find success in days to come. Let’s explore:
- When VCs aren’t your friend — when life is good in the startup ecosystem as it’s been for the better part of a decade, there aren’t many stories of VCs stepping in to dramatically change management (Uber being a headline grabbing exception) but as market shifts continue and portfolio performance begins to wane for some firms, founders should be aware that investors may exercise a heavier governance hand to preserve returns. One historical example of this is Sequoia founder Don Valentine’s work at Cisco starting in late 1987. Just months after the Dow Jones index collapsed 23% on October 19th, Sequoia invested $2.5m for 33% of Cisco and Valentine set aside another 33% of equity for existing managers and future employees to revamp the executive structure. Shortly thereafter, Valentine fired the two co-founders and took the role of interim chief executive. Per Mallaby, this decision was generally well received by other Cisco employees given the founders polarizing personalities, but at a deeper level Valentine was reinventing the venture model by not just bringing in experienced executives to complement a founder, but instead replacing them altogether. What does this mean for founders in 2022 and beyond? I’d expect a higher level of focus on best-in-class operational execution. In a down market where home run exits are likely to be limited, a transcendent idea that doesn’t have the appropriate strategy for efficient growth (healthy unit economics, GTM, etc.) will be a harder sell to investors. As Valentine once said, “I’m not very good at picking people, but I correct my mistakes very quickly.” Let this be a reminder for founders to remember the gravity of taking on venture capital and the expectations that come with it.
- Are big funds better? — many in the investing community have been conditioned to think that AUM = success and in many ways, this can be true. AUM is sometimes a proxy for LP confidence in venture partners, creates significant brand equity, and positions a fund to “move the needle” for a startup it partners with. Interestingly enough, one of the most renowned venture funds in history, Benchmark, actually took the exact opposite approach in the early days of their story, focusing instead of the benefits of being nimble instead of large. A quote from an early Benchmark prospectus argued, “God is not on the side of the big arsenals, but on the side of those who shoot best”. As great deals continue to get more competitive in this tumultuous market, (micro funds, solo GPs, etc.) emerging mangers may profit from using Benchmark’s early approach of taking thoughtful, concentrated bets and rolling up the sleeves to work with founders. Those same founders will also remember those that jump into the mud with them when times get tough. The alternative that we’ve seen in recent time is competition based more on dollars invested and term sheet valuations that “foie gras” startups with cash. Because this approach can create poor operational hygiene and cash management, it’s unlikely to truly help startups as market priorities shift from growth at any cost to growth at the right cost.
- Portfolio management is paramount — while the venture community loves to tout the 100x returns, another metric that is just as important but doesn’t secure the same airtime as the “100x” is dollars returned to the fund. Liquidity events have tightened in 2022 and companies (especially enterprise SaaS) that went public in 2021 are feeling the most concentrated wrath of the public investors. Because of this, making sure to capitalize when you win is paramount. I understand this isn’t a new concept, but a historical example of misallocation in winners that Mallaby outlined made it clear how important this really is, especially for new managers. Many fans of the industry will likely remember a16z’s investment in Instagram. a16z invested $250k in the burgeoning social media app in 2010, just two years before it was purchased by Facebook for $1bn. a16z netted a 312x return on invested capital, a multiple that will (and should) grab headlines. Digging deeper tells another story. While a16z returned $78m, their fund size at the time was an astonishing $1.5bn, meaning this blockbuster exit only returned ~5% of the fund. A top tier firm like a16z may be able to get away with this given the strength of their track record and deal flow, but an emerging manager in the same scenario may not have that luxury. Without properly allocating to capitalize on power law dynamics, returning a top quartile fund is difficult.
- How close are we to the best outcome? — shifting back towards a more founder focused takeaway, combining two concepts from investors of the past may help inform where and what to build. First, we’ll look at how Tom Perkins assessed companies quickly to identify their “white hot” risks. Aptly named “Perkins Law”, he decreed that “market risk is inversely proportional to technical risk”. Perkins believe that if you’re solving truly technical problems, competition from the market is likely to be minimal (and vise-versa). While definitely true in a vacuum, I think pairing this Law with a maxim from Vinod Khosla creates a mental model that is quite interesting. Khosla believed that “if you think existing technology represents only 90% of the best possible version, pushing performance up to 95% is not going to win customers. But if you think existing technology represents only 20% of potential, then a business might be significantly better than competitors and will attract a flood of users.” In a new age of tighter funding, founders that focus on verticals with significant technicality and existing technology that isn’t near potential create a dual recipe for success. Separately, I attribute the combination of these two principals to why crypto/Web3 has seen record funding in recent quarters. Those who have been in the space for multiple years understand the technical risks inherent to each protocol and believe crypto is likely just scratching the surface of its true potential. This combination represents a potential powder keg of market expansion.
Thanks again to Sebastian Mallaby for the incredible amount of time and effort on The Power Law. By taking lessons from the past (both through studying history and chatting with those who have been there) I’m hoping the startup ecosystem can adapt and continuing changing the world. While the bear should be respected, it needn’t be feared.