Secrets of Sand Hill Road

by Scott Kupor

  In a strange way, sometimes familiarity can breed contempt—and conversely, the distance from the problem that comes from having a completely different professional background might actually make one a better founder. Though not venture backed, Southwest Airlines was cofounded in 1967 by Herb Kelleher and of course has gone on to become a very successful business. When interviewed many years later about why, despite being a lawyer by training, he was the natural founder for an airline business, Kelleher quipped: “I knew nothing about airlines, which I think made me eminently qualified to start one, because what we tried to do at Southwest was get away from the traditional way that airlines had done business.”

  This has historically been less typical in the venture world, but, increasingly, as entrepreneurs take on more established industries—particularly those that are regulated—bringing a view of the market that is unconstrained by previous professional experiences may in fact be a plus. We often joke at a16z that there is a tendency to “fight the last battle” in an area in which one has long-standing professional exposure; the scars from previous mistakes run too deep and can make it harder for one to develop creative ways to address the business problem at hand. Perhaps had Kelleher known intimately of all the challenges of entering the airline business, he would have run screaming from the challenge versus deciding to take on the full set of risks.

  Whatever the evidence, the fundamental question VCs are trying to answer is: Why back this founder against this problem set versus waiting to see who else may come along with a better organic understanding of the problem? Can I conceive of a team better equipped to address the market needs that might walk through our doors tomorrow? If the answer is no, then this is the team to back.

  The third big area of team investigation for VCs focuses on the founder’s leadership abilities. In particular, VCs are trying to determine whether this founder will be able to create a compelling story around the company mission in order to attract great engineers, executives, sales and marketing people, etc. In the same vein, the founder has to be able to attract customers to buy the product, partners to help distribute the product, and, eventually, other VCs to fund the business beyond the initial round of financing. Will the founder be able to explain her vision in a way that causes others to want to join her on this mission? And will she walk through walls when the going gets tough—which it inevitably will in nearly all startups—and simply refuse to even consider quitting?

  When Marc and Ben first started Andreessen Horowitz, they described this founder leadership capability as “egomaniacal.” Their theory—notwithstanding the choice of words—was that to make the decision to be a founder (a job fraught with likely failure), an individual needed to be so confident in her abilities to succeed that she would border on being so self-absorbed as to be truly egomaniacal. As you might imagine, the use of that term in our fund-raising deck for our first fund struck a chord with a number of our potential investors, who worried that we would back insufferable founders. We ultimately chose to abandon our word choice, but the principle remains today: you have to be partly delusional to start a company given the prospects of success and the need to keep pushing forward in the wake of the constant stream of doubters.

  After all, nonobvious ideas that could in fact become big businesses are by definition nonobvious. My partner Chris Dixon describes our job as VCs as investing in good ideas that look like bad ideas. If you think about the spectrum of things in which you could invest, there are good ideas that look like good ideas. These are tempting, but likely can’t generate outsize returns because they are simply too obvious and invite too much competition that squeezes out the economic rents. Bad ideas that look like bad ideas are also easily dismissed; as the description implies, they are simply bad and thus likely to be trapdoors through which your investment dollars will vanish. The tempting deals are the bad ideas that look like good ideas, yet they ultimately contain some hidden flaw that reveals their true “badness.” This leaves good VCs to invest in good ideas that look like bad ideas—hidden gems that probably take a slightly delusional or unconventional founder to pursue. For if they were obviously good ideas, they would never produce venture returns.

  Ultimately, what all these inquiries point to is the fundamental principle that most ideas are not proprietary, nor likely to determine success or failure in startup companies. Execution ultimately matters, and execution derives from a team’s members being able to work in concert with one another toward a clearly articulated vision.

  2. Product

  We’ve hinted at many of the product issues already, but the fundamental question to be asked by early-stage VCs is, Will this product solve a fundamental need in the market (whether or not that need is known currently to customers) such that customers will pay real money to purchase it?

  One of the first truisms of product evaluation is that the product is not static. In fact, most VCs assume that the product that is initially conceived of and pitched is not likely the product that will ultimately prevail. Why is that? Simply because until the startup builds a version of the product and gets it into market with early adopter customers, any notion that the company has about the fitness of the product to the market need is purely hypothetical. Only through iterative testing with real customers will the company get the feedback needed to build a truly breakthrough product.

  Thus, much of what an early VC is evaluating at this stage is the founder’s idea maze: How did she get to the current product idea, incorporating which insights and market data to help inform her opinions? Assuming that the product will in fact change many times over the course of discerning product-market fit, it’s the process of the idea maze that is the better predictor of the founder’s success than the actual product idea itself.

  In fact, you’ll often hear VCs say that they like founders who have strong opinions but ones that are weakly held, that is, the ability to incorporate compelling market data and allow it to evolve your product thinking. Have conviction and a well-vetted process, but allow yourself to “pivot” (to invoke one of the great euphemisms in venture capital speak) based on real-world feedback.

  The other vector of product evaluation centers on the breakthrough nature of the product. Large companies have institutional inertia that makes it difficult for them to adopt new products; consumers have habits that also make change difficult. Max Planck, the German scientist who is credited with inventing modern quantum physics, said it most eloquently: Science advances one funeral at a time. Simply put, it’s hard to get people to adopt new technologies.

  So new products won’t succeed if they are marginal improvements against the existing state of the art. They need to be ten times better or ten times cheaper than current best in class to compel companies and consumers to adopt. (Of course, “ten times” here is just a heuristic, but the point is that marginal differences won’t get people off the couch.)

  Ben Horowitz uses the difference between a vitamin and an aspirin to articulate this point. Vitamins are nice to have; they offer some potential health benefits, but you probably don’t interrupt your commute when you are halfway to the office to return home for the vitamin you neglected to take before you left the house. It also takes a very, very long time to know if your vitamins are even working for you. If you have a headache, though, you’ll do just about anything to get an aspirin! They solve your problem and they are fast acting. Similarly, products that often have massive advantages over the status quo are aspirins; VCs want to fund aspirins.

  3. Market Size

  “Market” is the third leg of the stool that VCs use to evaluate early-stage investment opportunities. It turns out that what matters most to VCs is the ultimate size of the market opportunity a founder is going after. If the adage in real estate is “Location, location, location,” the saying in venture capital goes “Market size, market size, market size.” Big markets are good; small markets are bad.

  Why?

  The
big-market rule follows directly from the power-law curve and “at bats per home run” section we covered earlier. If VCs are wrong more often than they are right, and if success (or failure) as a VC is wholly a function of whether you get 10–20 percent of your investments to fall into the home-run category, then size of the winners is all that matters.

  I noted before that a cardinal sin of venture investing is getting the category right but the company wrong. Well, there are a couple of other cardinal sins to supplement that one.

  First, getting the company right but the market wrong, that is, investing in a company that turns out to be a nice, profitable business, with a great team and a great product, but in a market that just isn’t that big. No matter how well the team executes, the business will never get to more than $50–$100 million in revenue, and thus the equity value of the business is capped.

  Second, sins of omission are worse than sins of commission. It’s okay for a VC to invest in a company that ultimately fails—as we’ve discussed, that’s par for the course in this business. What’s not okay is to fail to invest in a company that becomes the next Facebook. Remember, you can’t risk-averse your way to success in this business.

  All of this leads us to the truism that VCs must invest in big-market opportunities. Success against a small market just won’t get a VC the type of returns she needs to generate to stay in business. Thus, VCs often think of market size as the “so what?” question in evaluating a startup’s potential success. It’s all well and good that the team is great and the product is great, but so what, if the market size isn’t sufficient to sustain a large business. Andy Rachleff, a founder of Benchmark Capital, has said that companies can succeed in great markets even with mediocre teams but that great teams will always lose to a bad market.

  Why is market size so challenging to get right? Because often it’s unknowable at the time of investment how big a market actually is. Thus, VCs can fool themselves in multiple ways when evaluating markets.

  Market size estimation is easiest when a new product is positioned as a direct substitute for an existing product.

  Take databases as an example. We know that Oracle is a huge company in the database market, so we can fairly easily posit that a startup going after that market opportunity is playing in a big market—easy enough. But what we don’t know is how the overall database market will play out over time. Will there be other new technologies that might supplant the functions of the database and thus hollow out the market? Or maybe the number of applications that require databases will grow exponentially as cloud computing dominates workflows, and thus the database market will become even bigger than it is today? Those are all good questions, but most VCs would probably be fine assuming that a startup going after the database market, if successful, has a big enough market to build a big company and thus become an investment home run.

  The more challenging aspects of market size estimation come from startups going after markets that do not exist currently or that are smaller markets today because they are constrained by the current state of technology.

  Take Airbnb. When Airbnb first raised money, the use case was predominantly people sleeping on other people’s couches. One could have asked the question of how many starving college students there were who would do such a thing, and have reasonably concluded—similar to the size of the mac and cheese and ramen markets, other products purchased by starving college students—that the market simply wasn’t that big.

  But what if the service expanded to other constituents over time? Maybe then the existing hotel market would be a good proxy for total market size. Okay, but what if the ease of booking reservations and the lower price points that Airbnb offered meant that people who never before traveled decided that they would now do so—what if in fact the market for travelers needing accommodations would expand as a result of the introduction of Airbnb?

  As it turns out, the success of Airbnb to date seems to suggest that the market size has indeed expanded, owing to the existence of a new form of travel accommodations that never previously existed. Fortunes can be won or lost based on a VC’s ability to understand market size and think creatively about the role of technology in developing new markets.

  CHAPTER 4

  What Are LPs and Why Should You Care?

  There is a story that Queen Isabella of Spain was the first true VC. She “backed” an entrepreneur (Christopher Columbus) with capital (money, ships, supplies, crew) to do something that most people at the time thought was insane and certain to fail (a voyage) in exchange for a portion of the to-be-earned profits of the voyage that, while probabilistically unlikely, had an asymmetric payoff compared to her at-risk capital.

  If you attended Harvard Business School, you may have read about a similar early VC-like tale here in the States in the 1800s—the whaling industry. Financing a whaling venture was expensive and fraught with risk but, when successful, highly profitable. In 1840s New Bedford, “agents” (today’s VC equivalent) would raise capital from corporations and wealthy individuals (today’s limited partners) to fund ship captains (entrepreneurs) to launch a whaling venture (startup company) in search of asymmetric returns that were heavily skewed to the top agents, yet often plagued with failure. Thirty percent of voyages lost money . . . .

  Fewer than fifty years later, in 1878, J. P. Morgan would act as “venture capitalist” to Thomas Edison, financing the Edison General Electric Company and becoming its first evangelist/beta tester by having Edison wire Morgan’s New York City home. Rumor has it that not only did Morgan’s house almost burn down from some of the early wiring mishaps, but his neighbors also threatened him as a result of the loud noise emanating from the generators required to sustain the illumination. Banks would continue to play a significant role in the direct financing of many startup businesses until the 1930s passage of the Glass-Steagall Act restricted these activities.

  Today, VC firms exist by the grace of limited partners who invest some of their own funds into specific VC funds. Limited partners do this because, as part of their desire to maintain a diversified portfolio, venture capital is intended to produce what investment managers refer to as alpha—excess returns relative to a specific market index.

  Though each LP may have its own benchmark to measure success, common benchmarks are the S&P 500, Nasdaq, or Russell 3000; many LPs will look to generate excess returns of 500–800 basis points relative to the index. That means that if the S&P 500 were to return 7 percent annualized over a ten-year period, LPs would expect to see at least 12–15 percent returns from their VC portfolio. As an example, the Yale endowment’s venture capital portfolio has generated returns north of 18 percent per year for the past ten years versus an S&P 500 return of about 8 percent in the same time period.

  Types of LPs

  There are many categories of LPs, but most tend to fall into the following buckets:

  University endowments (e.g., Stanford, Yale, Princeton, MIT)—Nearly every university solicits donations from its alumni. Those donated funds need to earn a return on investment. Those returns are used to fund operating expenses and scholarships for the schools and, in some cases, to help fund capital expenditures, such as new buildings.

  Foundations (e.g., Ford Foundation, Hewlett Foundation)—Foundations are bequeathed money by their benefactors and are expected to exist in perpetuity on these funds. Foundations need to earn a return on their funds to make charitable grants. In the US, to maintain their tax-free status, foundations are required to pay out 5 percent of their funds each year in support of their mission. Thus, over the long term, real returns from venture capital and other investments need to exceed this 5 percent payout level to ensure a foundation’s perpetual existence.

  Corporate and state pension funds (e.g., IBM pension, California State Teachers’ Retirement System)—Some corporations (although many fewer these days), most states, and many countries provide pensions for t
heir retirees, funded mostly by contributions from their current employees. Inflation (particularly in health-care costs) and demographics (more retirees than current employees) eat away at the value of these pensions, absent the ability to generate real investment returns.

  Family offices (e.g., U.S. Trust, myCFO)—These are investment managers who are investing on behalf of very-high-net-worth families. Their goals are set by the individual families but often include multigenerational wealth preservation and/or funding large charitable efforts. There are single-family offices (as the name suggests, they are managing the assets of a single family and its heirs) and multifamily offices (essentially, sophisticated money managers who aggregate the assets of multiple families and invest them across various asset classes).

  Sovereign wealth funds (e.g., Temasek, Korea Investment Corporation, Saudi Arabia’s PIF)—These are organizations that manage the economic reserves of a country (often resulting from things that we US citizens know nothing about—government surpluses) to benefit current or future generations of their citizens. In the specific case of many Middle Eastern countries, the sovereign wealth funds are taking profits from today’s oil business and reinvesting in other non-oil assets, to protect against long-term financial reliance on a finite asset.