On Attractive Early Stage Investments

Startup investments are weird and very unlike picking stocks. Startups in a successful VC’s portfolio tends to follow an incredibly skewed distribution called a Power law distribution. The following is a power law graph.

24 Power Law

Mark the X-Axis with the startup name and Y-Axis as returns from the startup, what you will get is a typical graph you get from successful VC funds. Some startups hit outsize returns relative to everyone else combined.

Here’s what Peter Thiel says about his Founders Fund portfolio,

“If you look at Founders Fund’s 2005 fund, the best investment ended up being worth about as much as all the rest combined. And the investment in the second best company was about as valuable as number three through the rest. This same dynamic generally held true throughout the fund. This is the power law distribution in practice. To a first approximation, a VC portfolio will only make money if your best company investment ends up being worth more than your whole fund. In practice, it’s quite hard to be profitable as a VC if you don’t get to those numbers. “

As Thiel says, in the best funds, one startup investment tends to return the value of the entire fund. Kind of hard to believe isn’t it?

Here’s a graph of the 100 US backed exits from 2009 to 2014.

25 Power Law Exits

Source: CB Insights

If that is the case, how do you approach VC investments? Peter Thiel tells how not to – don’t try to be safe:

“If you invest in 100 companies to try and cover your bases through volume, there’s probably sloppy thinking somewhere. There just aren’t that many businesses that you can have the requisite high degree of conviction about. A better model is to invest in maybe 7 or 8 promising companies from which you think you can get a 10x return. It’s true that in theory, the math works out the same if try investing in 100 different companies that you think will bring 100x returns. But in practice that starts looking less like investing and more like buying lottery tickets.

Chris Dixon of Andreessen Horowitz calls for a Babe Ruth kind of hitting it very big without fear of missing.

“How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.”  –Babe Ruth

He presents an analysis of VC funds since 1985. Great funds have home runs of huge magnitude (of course).

26 Fund Home Runs

And great funds tend to have more money losing investments compared to good funds (surprising) as seen below.

27 Fund Losing Money

That most VCs don’t do well is a given. The Kauffman foundation published a report on VCs where for all the press coverage that a lot of VCs get, one simple statistic stands out:

The average VC fund fails to return investor capital after fees… A majority of funds failed to exceed returns available from public markets

Often times you need to invest in a startup early to get the kind of huge returns that will return your fund. For example consider the returns from the Box IPO of the different VC funds that invested in it:

28 Box Returns

The different returns invested at different timelines speak for themselves!

The invested startups must exit at a high valuation and the VC must be early in the startup. So how many VC funds have invested in billion dollar startups and have invested early? (Data from CB Insights 2004-2013)

29 At least one exit

Out of 479 active VCs (at the time) – only 68 or 14% ever invested in a billion dollar company. And only 5% invested in at least one billion dollar startup early. So it is very likely that the rest of the funds would likely have really poor or negative returns.

So what attributes of disruptive early stage startups to look for if you try to get home runs? In my opinion, the attractiveness of an investment goes up with each of the following:

1. Huge Potential Market or rather huge non-consuming market. The startup caters to potential customers who are not served by current incumbents. Startups cater to non-consumers by lowering one or more of the five barriers they face: wealth, time, access, skill or motivation.

2. The job-to-be-done of the customer is very important. Or to put it bluntly, it is a problem that the customer absolutely needs to a solution for.

3. The Founder(s) and as an extension his team. Are they competent and learn quickly (two separate attributes)? Does the team figure out quickly what works or does not work? If selling to companies rather than consumers, does the founder know the space very well? Is the founder competitive and attracts fast learners?

Does the founder have a history of experimenting with different things? Successful founders of very successful startups have often been very high on experimentation – breaking and fixing things. Also some side projects have been turned into very big companies – Twitter, Slack and Twitch.tv being some blowout successes that have emerged from the ashes of a previous startup.

4. Strong defensibility of the product. Does the product have IP? Does the team have unique domain competence? Are there network effects? Highly defensible characteristics like these prevents competition (at least in the short term) from other talented startups. Also businesses with highly defensible characteristics makes for a great exit later on.

This one characteristic might be very crucial. So much so that, the very successful venture capital firm USV had their earlier investing thesis where defensibility through network effects was a major point.

Large networks of engaged users, differentiated through user experience, and defensible through network effects.

5. A new business model that challenges some fundamental assumptions of how things are currently being done. New Technology enablers typically cause what I call fundamental distortions. These distortions enable startups to challenge assumptions. The more entrenched, basic and long held the assumptions, the more lucrative the investment.

6. The market is addressable or the team has a strong plan for addressability. Very successful startups find creative ways of addressing the market or building their initial mass. They don’t throw money around easily to acquire customers.

7. Startups compete in an area with Non-Tech Incumbents or with Incumbents not motivated to go after a market (often because it is too small initially).

8. Non-market forces don’t matter or are favorable. This is something that prevents sectors like education from producing multi-billion dollar startups.

9. The Timing. Why now? Why not earlier? Are there any technology, demographic, economic or culture trends contributing to the idea’s success?

10. High acquisition possibilities. Especially true in this age where the world is awash with capital. Startups with proprietary tech or new data sources or highly competent teams are going to be attractive acquisitions for the giants seeking to remain competitive.

The above characteristics in my opinion provides the best odds of an early stage startup becoming a home run investment.

Are there any other characteristics that you look for? Which are the top 3 characteristics from above that enable home run investments? Let me know in the comments.

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