An excellent new book was just released yesterday. It is called Secrets of Sand Hill Road: Venture capital and how to get it.” The author is Scott Kupor, managing partner at Andreessen Horowitz — now called a16z — a top tier venture capital firm.
One of Kupor’s colleagues from a16z, Andrew Chen, read the book before it was released and was able to provide a brief review. He notes:
Of all the topics of the book, one of my favorites has to be the math of startups and venture capital, because it gives us a perspective on the life and death of startups as a whole… Over the past few decades, a small number of startups — 6% — end up driving 60% of the returns… In other words, the startups that end up big end up really big. These startups aren’t just unicorns, they are another order of magnitude more successful than that… It also tells you why, as an entrepreneur, that investors are so focused on network effects, high margins, technology differentiation, a 10X product experience, etc. — these are the foundational drivers that help create super huge outcomes.
Here’s another surprise from the data, which is that the best investors don’t seem to be better at avoiding startups that fail. It’s not about the downside. Instead, the data says that a “good” 2-3x fund and a fantastic >5x fund lose money about the same % of the time.
So how does a venture capitalist make bets on which company to fund? Wired Magazine provided some excellent excerpts from the book itself:
At the early stage of venture investing, raw data is very hard to come by… It turns out that there are qualitative and high-level quantitative heuristics that VCs use to evaluate investment prospects. And they generally fall into three categories: people, product, and market.
People is by far the most qualitative criterion and… likely the most important… Many VCs delve deeply into the backgrounds of the founders for clues about their likely effectiveness in executing this new idea.
…what is the unique skill set, background, or experience that led this founding team to pursue this idea? My partners use the concept of a “product-first company” versus a “company-first company.” In the product-first company, the founder has identified or experienced some particular problem that led them to develop a product to solve that problem… A company-first company is one in which the founder first decides they want to start a company and then brainstorms products that might be interesting around which to build one. [There is also] founder-market fit. As a corollary to the product-first company, founder-market fit speaks to the unique characteristics of this founding team to pursue this opportunity
My previous post gave an example of some steps in how to dive into the background of the founder. In that example, of Ethan Brown, the founder of Beyond Meat.
A few concepts in this book are also explained in another book written five years ago by another VC, Zero to One: Notes on Startups, or How to Build the Future (Currency, 2014), by Peter Thiel and Blake Masters.
Peter Thiel also explains the math of startups: “every single company in a good venture capital portfolio must have the potential to succeed at vast scale.”
For example, over the life of a fund with ten companies in the portfolio, nine of those companies will either fail or net a small return, while only one will reach dominant value and be responsible for the success of the venture capital fund.
Most companies do not have this potential. They get funded anyway, either because the VC believed that it had this potential, or they received financing from other sources that had a different investment model.
This means the pitch must present this out-sized potential, or the company seeks financing from investors that align with the risk-reward profile.
Both of these books are worth reading.
Andrew Chen is also worth following. He has an excellent long form blog specializing on topics in growth marketing. His insights are invaluable to tech startups. When reading his posts, it is important to keep in mind that he concentrates on consumer companies where tech is used to achieve viral scaling. This does not apply to many industrial companies and biotech companies.
As one final caveat to the advice presented in these two books, John Ramey’s blog post, “Improving Startup Accelerators (Or Anything Helping Entrepreneurs),” from June 2015 presents an important and different investment model and mindet that is worth reading. As he notes:
Recognize there is a huge difference between venture scale (“Unicorn” path) companies and other forms of entrepreneurship. Most groups treat everything like it’s either Instagram (high risk, technical leverage, huge reward, Silicon Valley style) or a local Chinese restaurant, with nothing in between. But there are many shades of gray in the middle — for example, I love what Bryce is doing with Indie.vc by investing in companies that might be successful but not acquired for billions of dollars.
Kupor’s and Thiel’s books espouse the venture scale model of investing and speak to the entrepreneurs with companies that such VCs seek. Ramey is a good voice for all the rest. Furthermore, Ramey notes:
Don’t try to copy Silicon Valley. You can’t. Or even worse, don’t copy what you think is happening in SF based on movies and blog posts… SF is one specialized ecosystem that is great at some things and really bad at other things. Make your own thing. For example, I liked how The Family in Paris is embracing it, making their community very “French” because to do otherwise would fail.
The model presented by Kupor’s and Thiel’s books is what is practiced in Silicon Valley. Companies created elsewhere and serving other country markets often do not scale the same way.
For example, in Germany and many other European countries, there are many great startup companies where the founders never intend for their companies to be acquired or to go public. A big component of these countries’ business culture is to retain family ownership in the company and to grow it over generations. These are mittelstand or middle market companies.
These middle market companies have been a source of strength for these economies and have created a bulwark in these economies against the destabilizing social effects of globalization, because they can’t be acquired by a global company which then dictate local job conditions through a foreign head office.
In these countries, an entire set of investors and infrastructure exist to invest in these companies. In Canada, the business influence of the United States has prevented this business culture from flourishing, but I see in the province of Quebec an excellent growing business culture that supports this way of entrepreneurship. It has led to a very successful startup ecosystem there.