Venture Capital and Silicon Valley Entrepreneurship
I am rereading Ben Horowitz’s The Hard Thing About Hard Things. First of all, the book is making a whole different impression in me this second time. What has changed? I am now the founder/CEO of a startup, and am experiencing firsthand the pain an struggle of it.
Apart from everything else that I’ll discuss on upcoming Qulture.Rocks’s blog posts, this quote struck me as golden:
“The primary thing that any technology startup must do is build a product that’s at least 10 times better at doing something than the current prevailing way of doing that thing. Two or three times better will not be good enough to get people to switch to the new thing fast enough or in large enough volume to matter. The second thing that any technology startup must do is to take the market. If it’s possible to do something 10X better, it’s also possible that you won’t be the only company to figure that out. Therefore, you must take the market before somebody else does. Very few products are 10X better than the competition, so unseating the new incumbent is much more difficult than unseating the old one.”
Ben summarizes the essence of Silicon Valley entrepreneurship and Venture Capital. To make sense in the Valley, a company must grow fast enough and big enough (or, a unicorn) in a specific time-frame so as to justify the type of capital one such opportunity demands. It’s not enough to become a unicorn. It has to become a unicorn in, roughly, ten years.
It’s kind of like a circular reference formula: great opportunities of growth and size demand a huge amount of capital to be executed… huge amounts of capital need a great opportunity to get attractive risk-adjusted returns.
But why this neurosis about fast-built unicorns? Here’s why:
Venture Capital funds manage other people’s money, who want their dough back. So funds need to see an exit opportunity for their capital before the fund’s end. Since exit opportunities tend to be the same for all investors, the first institutional ones to jump into an opportunity, at Series A, are the ones that dictate the worst case timing scenario. So 10 years, tops, after Series A, is what startups have to reach an exit.
Venture Capital fund managers make more money the bigger the funds they manage. A one percent annual management fee means much more money if charged over a huge, U$ 1 bn portfolio, than if charged over a U$ 100 mio portfolio. As funds get bigger, deal sizes get bigger, because venture capitalists only have so many hours in a day.
Venture Capital funds have managed their portfolios kind of poorly in the past, so that only one or two deals per fund are responsible for the bulk of their portfolio-level returns. So if only 1-5% of deals really make it, these deals have to be big enough to pay for all other mistakes. Since fund managers don’t know which deals are going to be profitable, all deals have to have this behemoth size potential. It’s not enough to make a solid, predictable profit; It’s better to aim for improbable unicorns and pray.
This is a work in progress…