Time is a very precious commodity so I do my best to be as succinct and clear as possible everywhere I can. But, occasionally time=time and there’s no way around it so if you want to hear a solid hour of my perspectives about a variety of fintech topics, I had the privilege of being interviewed by Christian Rolon for Wharton’s Fintech Podcast. Have a listen if you happen to have time to kill!
Now to the topic of the day. Just an FYI: My next posts are going to deviate a bit from the normal “self-contained topic” format. Recently I’ve been thinking a fair bit about Venture Capital as an asset class, how investment returns are created, what’s going on with giant funding rounds, etc. so I thought I’d share my perspectives through a short series of Blog posts. By no means have I tried to create a unified theory of Venture Capital, but I have made a few interesting observations and come to a few conclusions that are hopefully worth sharing. With this said, let the ramblings begin!
I personally like starting with first principles whenever I try to understand something at an atomic level, so trying to answer the question “why does Venture Capital exist” was my way of kicking off an internal Socratic process. We all see Venture Capital pouring into private companies at an astounding pace, but not always is it obvious “why” each check is written and what it’s meant to accomplish. It’s too easy to think of Venture Capital as money used to fuel early stage private companies while they prove product/market fit. And while this is true, it never really gets at the “why” or the “what” or the “how” that drives Venture returns.
So in my attempt to answer the basic question about why Venture Capital exists I pulled together the following definition of what Startups are trying to accomplish.
A team is assembled to build a solution to a perceived problem with the goal of distributing and selling it in such a way that economic value accrues to the provider of the solution.
A few concepts are embedded in this simple statement:
- There has to be belief that given the right resources the team can execute on the plan
- There has to be belief that what’s been described can actually be built with the requested resources
- There has to be belief that a significant number of customers can be found who are willing to pay more for the solution than it costs to produce
These beliefs can be used to describe the “why” behind Venture Capital:
Venture Capital exists to provide the financial resources needed for an unproven business to prove out its assumptions around three forms of risk: Operational Risk, Technical/Manufacturing Risk and Market Risk. If right, economic value accrues to the owners of the business which is what the LPs of VC firms want to capture.
To be clear, every business faces these forms of risk (young/established, private/public, etc), but in the case of Venture backable businesses, the distribution of outcomes on the various dimensions of risk has massive variance. Venture returns are created when high variance drivers of a business collapse to the all important “it’s working” state. String together enough things that work and a business emerges from nothing and value is created for everyone involved.
What I find interesting is that various VC firms are more or less comfortable with different forms of risk which matches well with the fact that structurally each sector/business has its own combination of risk factors.
For instance, a pharmaceutical start-up typically doesn’t have to worry about “perceived problems” or “finding customers”. They almost exclusively have to worry about the technical risk that surrounds actually creating a drug that can treat a condition that masses of people suffer from. If it can be built (and get approved), then the market will reward them. Same can be said of the various “moonshot” businesses that are tackling complex issues around clean energy, spaceflight, global internet access and autonomous vehicles.
In the case of most early stage businesses, the operative issues that VCs fixate on are “Team and TAM” because they know that what’s being described in the business plan is inherently “buildable”. When you hear VCs talk about “founder/market fit”, what they’re really saying is that the business’s operational risk has been reduced because the founder understands the market and how to navigate the inevitable landmines that exist in that business’s ecosystem. When you hear VCs talk about “product/market fit”, what they’re really saying is that they want to see evidence that customers are willing to pay for the solution being offered which reduces the business’s market risk.
I think the concept of Operational, Technical/Manufacturing and Marketing risk isn’t novel, but I do think that not all Founders know what type of risk they’re asking VCs to take and many VCs aren’t crisp in their understanding of the risks they’re taking on (and why). But what makes early stage investing so challenging is that a business has to string together a series of “yes we were right” answers before breaking the addiction to outside capital.
Here’s an interesting thought exercise: Would you ever consider purchasing a book one chapter at a time where the cost of each subsequent chapter costs more than the first?
The benefit of this structure is that if you don’t like how the story is evolving you don’t have to finish it or pay for the entire book. You’ve clearly invested time and money into getting part way to what hopefully will be a satisfying ending, but the purity of making a dollar and time decision throughout your reading experience puts pressure on the author to hook you over time and deliver against a growing set of expectations.
This is venture capital in a nutshell. Instead of asking a Founder how much money they’re going to need from the founding of the business to its ultimate Sale or IPO, a Venture Capitalist asks a Founder to break their company’s journey into pieces and then reserves the right to evaluate future investment decisions each step of the way. This isn’t an inherently bad setup, but there is a wrinkle that causes significant problems for many companies that require Venture money.
The issue (using the book analogy to explain): What if you specialized in reading the early chapters of a book and didn’t have the money to buy the middle and later chapters? Your job would be to explain what you liked about the early chapters to a set of potential readers who specialize in reading the middle chapters. You’ll never find out the ending of the book if you can’t excite the “middle chapter readers” with your summary and ultimately have them explain to the “later chapter readers” why they should pay a lot of money to find out the ending to the story.
What this means is that when you start a book you have to believe that there are other readers out there that like the same genre and writing style that you do, otherwise you’re just wasting your time and money reading the early chapters. And the system discourages you from reading something off the beaten path because there’s extreme uncertainty around finding someone downstream who will fall in love with your story. And it explains why Founders need to be extraordinary story tellers and raising capital is a skill that not everyone possesses.
From a practical standpoint, this leaves early stage Venture Capitalists with a few choices.
- We can stay attuned to what the middle and later stage investors are interested in and invest in businesses that cater to their preferences
- We can invest in capital efficient businesses that don’t need middle and later stage investors to believe in the story as it evolves
- We can assemble a more complete stack of capital that allows us to read farther into the book
Problems with #1: There’s almost no way to avoid Type 2 errors (rejecting good businesses) and the uniformity of what the community finds attractive will artificially bid up “in vogue” businesses.
Problems with #2: Forcing capital efficiency severely limits the speed with which businesses can be built and/or completely knocks out businesses with modest/long payback periods
Problems with #3: Not all capital has the same risk appetite or return expectations and it’s really difficult to remain disciplined about whether a book is worth finishing if you have the money to buy the later chapters
I hate ending with “problems”, but hopefully my next post will explain why #1 and #3 are happening in the venture ecosystem today (and why #2 isn’t). I’ll also share a concept that I’ve affectionately dubbed “Act 2 businesses” in an attempt to shed some light on the giant growth rounds that are catalyzing around a handful of very early stage, unproven businesses.