"risk and return are highly correlated over the long haul" To a point! It's not very different than betting on sports events: you bet on the favourite and you have a low risk/low return. You bet on the underdog and you have a high risk/high return. HOWEVER, you bet on a team that is eliminated from the playoffs and your return is guaranteed to be zero!
The point is: there is a point where the risk is enourmous and the return is guaranteed to be zero.
IS there a similar deviation at the other end? That is, can you get a slam dunk (low risk) on the cheap (high return)? Seems to me that you guys have some unwritten rules, where, in a certain era a first-round deal cannot be priced above $X. So, no matter how good the deal is nobody bids it up. The question is, who gets the deal then? Are those the type of deals that go to Kleiner and Seqoia by default? I don't know the answer...
fredwilson
· 1 year ago
no first round deal is a slam dunk.
there are some late stage deals that at times get priced like early stage deals and that's where you can get a "slam dunk" on the cheap.
it happened a bunch in 2002 and 2003 and maybe it will happen again some day
fred
zachlandes
· 1 year ago
"So my approach to that fact is to keep a lot of "dry powder" and invest in every round at our pro-rata share or less if the price seems truly irrational." meaning if the price seems to be irrationally low in future rounds of financing you invest enough to increase your interest in the company by approx. the same percent of ownership that you purchased in the first round?
fredwilson
· 1 year ago
there's no formula, but if we think the price is irrationally low, we absolutely will look to increase our ownership
Chris
· 1 year ago
Hey Fred, Interesting post.
If you get inspired sometime, I (and I'm sure many others) would love hear your take on b-school and the early part of your career pre/post MBA. Maybe it's a self-indulgent topic but to those of us just starting out, the stories are extremely valuable!
This is great stuff. Can you do a video which we can use as an educational tool for budding entrepreneurs? Not all see the importance of building value and staying with their dream. Great post
Wow, this is a really interesting article. Thanks!
Here's why you should never give control to VCs:
"There are two scenarios that are sub-optimal: 1) Big winner, not enough capital in: your company does really well, really quickly and you only get a fraction of your allocation in. So, you targeted $5m per deal, invested your 30% ($1.5m) and then the company never raised additional capital. If it does really well (say 10x), then you pull down $15m. This, unfortunately, will only pay for 3 complete losers which you may have had ample opportunity (unfortunately) to get your full $5m into"
There is an inherent incentive for the VCs that you don't do well too quickly, or else they can't put enough capital in. So if you give them control, they will impede your progress to a pace that they are comfortable with. What many of them don't realize is how competetive and "winner-takes-all" some markets are. In some cases there is no middle ground: you either have to go full steam ahead or you are toast. The VCs are too preoccupied with their spreadsheets and how to optimize allocation with respect to their own ROI to notice these things... At the end everyone loses.
I had always suspected this, but never seen it written explicitly. Most VCs pay lip service to your comittment to success, but sometimes their actions are different and have completely different motivations. The commenter under the article seems to be in a similar state of "a-ha!" as I am now.
loupaglia
· 1 year ago
I also found the article very interesting (obviously). My sense is, however, when it it comes down to it, want to ensure a successful return on every investment. I can't imagine a time when a VC would want to take a bath on any 'money-in'. ROI is always the measuring stick for the LPs. So good VCs will always put the success of the company first.
That being said, I did find it to be a very interesting two articles that really sheds more transparent light on the actual "motivations" of all interested parties. The challenge for the entrepreneur is when they are executing well early, and both they and their VC does not see an impending threat in the market where moving a bit slower will not hurt, what is the right strategic play versus slowing down simply so the VC and board can get more money in. Great stuff.
Krassen Dimitrov
· 1 year ago
Well, of course, nobody wants to fail on purpose... However, what it comes down is conflicting incentives for VCs.
1. They want as big a fund as they can get. The bigger the fund, the more fees they collect, and that's money-in-the-bank. 2. Now you have a fund that is too big for your dealflow. Obviously, it makes no sense to invest it in crap. 3. That makes it imperative to plow more into your winners. 4. The winners, by rule, become self-sufficient early, so they don't need that much cash.
How do you navigate this?
loupaglia
· 1 year ago
Guess there is only one way to navigate it. What is funny is after all the complicated math, investment scenarios etc, the simple answer is where the art of the VC comes in: Detect your "winners" before anyone else does (i.e. in the seed round) and make as big a bet as possible.
Even if you have a bigger fund, the rule of percentages still hold but it allows you to put a higher nominal value into your detected "winners" early. That is of course if you've have LPs that sign-off on the number of deals you plan on doing in the fund. I would assume the bigger the fund, the higher the number of deals you need to do. But if you do the same number of deals as with a smaller fund, I would assume you could plow more dollars in the seed round for a great stake. (sure there are rules of thumb for the good and bad of doing this as well).
fredwilson
· 1 year ago
that's just not right. i have never met a VC who roots for a company to do poorly so they can put more money in.
nivi
· 1 year ago
I enjoyed the article (as always).
Peter Drucker writes, "Successful innovators are conservative. They have to be. They are not 'risk-focused'; they are 'opportunity-focused.'"
I think there is too much focus on the idea of risk in startups. There is too little attention to the idea of opportunity in startups.
Nobody wants to "take a lot of risk". They want to take a lot of opportunity.
fredwilson
· 1 year ago
true, but the two are related. most opportunity comes with significant risk
LloydFassett
· 1 year ago
I foung this post and response both really interesting. There are only 15 comments in two days. It was a pretty innocuous post to me, but attracted some odd responses of 'VC's hang out with Darth Vader" comments.
I"m not a VC, but I'd think the issue is that anyone is going to put their money where they think the best opportunity is at that time. From the entrepreneurs point of view, you don't know who you are up against. The relative difference of the 'good' and the 'bad' in the pool very well may be a more significant driver I'd think than the absolute measure of 'good' and 'bad'. I'd think if the externalities dirve the outcome, managing risk is really difficult, as in, was there too much external pressure to chase bad deals in 1999? Perhaps, independent thinking is a better compass, though it seems the industry doesn't follow that pattern.
There also is a parallel as an entrepreneur to 'try many alley's' to figure out what is not the dead end as a company vs a portfolio.
At the end of the day it seams like, entrepreneur or VC, those who can be persistent in a sensible objective over a long period of time and a low burn rate...wins.
re: "No investment plays out the way you think it is going to play out". The Black Swan by Nassim Taleb is 400 pages of you don't know what you don't know, and that will frequently turn out to the most significant factor in the out come of things. It's a facinating book that I think could truly inform decision making in business. He mentions VC's too as being too risk averse.
At the end of this day, the only thing I can figure is that the number one element in success is just trying. Right there you eliminate nearly everyone just because they don't pull the trigger.
charlie crystle
· 1 year ago
My limited experience (two funded companies) has been that venture capitalists want to invest in the risk that created a successful product or model, but once the money is in they want to reduce risk, and it stifles innovation. That's too broad a statement, but it feels that way.
Anthony Kuhn
· 1 year ago
Fred: Your views and insights are priceless for those seeking to learn more about risk and the venture capitalist. Not everyone gets to experience the process first-hand and your musings allow a vicarious peek into some of the mechanisms at work when a startup is funded, or not. Thank you for sharing!
Michael
· 1 year ago
"Markets are never rational in the short term. And almost always rational in the long run."
Or as Benjamin Graham would have put it: in the shortrun, markets are a voting machine; in the long run, a weighing machine.
I do not believe that risk and return need be correlated. Return is a function of your information and ability to process it better than the others in the market. Risk is a function of your ability to accurately assess your ability to correctly price return. The two need not be (and are not often) correlated.
All Comments
To a point!
It's not very different than betting on sports events: you bet on the favourite and you have a low risk/low return. You bet on the underdog and you have a high risk/high return. HOWEVER, you bet on a team that is eliminated from the playoffs and your return is guaranteed to be zero!
The point is: there is a point where the risk is enourmous and the return is guaranteed to be zero.
IS there a similar deviation at the other end? That is, can you get a slam dunk (low risk) on the cheap (high return)? Seems to me that you guys have some unwritten rules, where, in a certain era a first-round deal cannot be priced above $X. So, no matter how good the deal is nobody bids it up. The question is, who gets the deal then? Are those the type of deals that go to Kleiner and Seqoia by default? I don't know the answer...
there are some late stage deals that at times get priced like early stage deals and that's where you can get a "slam dunk" on the cheap.
it happened a bunch in 2002 and 2003 and maybe it will happen again some day
fred
meaning if the price seems to be irrationally low in future rounds of financing you invest enough to increase your interest in the company by approx. the same percent of ownership that you purchased in the first round?
Interesting post.
If you get inspired sometime, I (and I'm sure many others) would love hear your take on b-school and the early part of your career pre/post MBA. Maybe it's a self-indulgent topic but to those of us just starting out, the stories are extremely valuable!
http://avc.blogs.com/a_vc/2008/05/i-got-lucky.html
Thank you.
Here's why you should never give control to VCs:
"There are two scenarios that are sub-optimal:
1) Big winner, not enough capital in: your company does really well, really quickly and you only get a fraction of your allocation in. So, you targeted $5m per deal, invested your 30% ($1.5m) and then the company never raised additional capital. If it does really well (say 10x), then you pull down $15m. This, unfortunately, will only pay for 3 complete losers which you may have had ample opportunity (unfortunately) to get your full $5m into"
There is an inherent incentive for the VCs that you don't do well too quickly, or else they can't put enough capital in. So if you give them control, they will impede your progress to a pace that they are comfortable with. What many of them don't realize is how competetive and "winner-takes-all" some markets are. In some cases there is no middle ground: you either have to go full steam ahead or you are toast. The VCs are too preoccupied with their spreadsheets and how to optimize allocation with respect to their own ROI to notice these things... At the end everyone loses.
I had always suspected this, but never seen it written explicitly. Most VCs pay lip service to your comittment to success, but sometimes their actions are different and have completely different motivations. The commenter under the article seems to be in a similar state of "a-ha!" as I am now.
That being said, I did find it to be a very interesting two articles that really sheds more transparent light on the actual "motivations" of all interested parties. The challenge for the entrepreneur is when they are executing well early, and both they and their VC does not see an impending threat in the market where moving a bit slower will not hurt, what is the right strategic play versus slowing down simply so the VC and board can get more money in. Great stuff.
1. They want as big a fund as they can get. The bigger the fund, the more fees they collect, and that's money-in-the-bank.
2. Now you have a fund that is too big for your dealflow. Obviously, it makes no sense to invest it in crap.
3. That makes it imperative to plow more into your winners.
4. The winners, by rule, become self-sufficient early, so they don't need that much cash.
How do you navigate this?
Even if you have a bigger fund, the rule of percentages still hold but it allows you to put a higher nominal value into your detected "winners" early. That is of course if you've have LPs that sign-off on the number of deals you plan on doing in the fund. I would assume the bigger the fund, the higher the number of deals you need to do. But if you do the same number of deals as with a smaller fund, I would assume you could plow more dollars in the seed round for a great stake. (sure there are rules of thumb for the good and bad of doing this as well).
Peter Drucker writes, "Successful innovators are conservative. They have to be. They are not 'risk-focused'; they are 'opportunity-focused.'"
I think there is too much focus on the idea of risk in startups. There is too little attention to the idea of opportunity in startups.
Nobody wants to "take a lot of risk". They want to take a lot of opportunity.
I"m not a VC, but I'd think the issue is that anyone is going to put their money where they think the best opportunity is at that time. From the entrepreneurs point of view, you don't know who you are up against. The relative difference of the 'good' and the 'bad' in the pool very well may be a more significant driver I'd think than the absolute measure of 'good' and 'bad'. I'd think if the externalities dirve the outcome, managing risk is really difficult, as in, was there too much external pressure to chase bad deals in 1999? Perhaps, independent thinking is a better compass, though it seems the industry doesn't follow that pattern.
There also is a parallel as an entrepreneur to 'try many alley's' to figure out what is not the dead end as a company vs a portfolio.
At the end of the day it seams like, entrepreneur or VC, those who can be persistent in a sensible objective over a long period of time and a low burn rate...wins.
re: "No investment plays out the way you think it is going to play out". The Black Swan by Nassim Taleb is 400 pages of you don't know what you don't know, and that will frequently turn out to the most significant factor in the out come of things. It's a facinating book that I think could truly inform decision making in business. He mentions VC's too as being too risk averse.
At the end of this day, the only thing I can figure is that the number one element in success is just trying. Right there you eliminate nearly everyone just because they don't pull the trigger.
Or as Benjamin Graham would have put it: in the shortrun, markets are a voting machine; in the long run, a weighing machine.
I do not believe that risk and return need be correlated. Return is a function of your information and ability to process it better than the others in the market. Risk is a function of your ability to accurately assess your ability to correctly price return. The two need not be (and are not often) correlated.