Power Law Distribution - A Glimpse into a VC Fund

Perhaps the most enlightening lecture about startups I ever attended was class 7 in Peter Thiel’s CS183. In it, Thiel outlined the basics of what a VC firm does, with a particular emphasis on what the graphs must look like in order for a VC firm to come out ahead in any given fund. These words in particular have stuck in my mind for years since I heard him utter them:

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 other words a successful venture capital fund must invest in at least one company that ends up being worth more than every other company invested in, combined. In order to do that, certain numbers are more important than others, like growth.

‘Growth Mentality’ is Aligned with VC interests

Over the last year or so, ‘growth’ has become the single metric that a lot of people in the startup ecosystem have talked about. Paul Graham put out an excellent essay on the topic. From a venture capitalist perspective, growth means that the young company is expanding so rapidly that they have a fighting chance of becoming a monopoly in a given sector and becoming a mythical ‘Unicorn’, that returns an entire fund.

Seen through the lens of someone whose job it is to return their LP’s money, this growth mentality makes sense. Cultivating a ‘growth over everything’ mentality means that there is one bloody, scarred winner, but that winner is fucking massive.

Unfortunately, when seen through the lens of most consumers, the practical implication of this is that VC backed companies sometimes act like mentally deranged humans.

Oh The Humanity

a person with a psychopathic personality whose behavior is antisocial ,often criminal, and who lacks a sense of moral responsibility or social conscience.

Here is the general path that most startups go through in the classical VC model:

  • Solve a pain point in some subset of humans lives in a disruptive enough way that they use your product rather than their previous solution.
  • Slap a ‘product-market’ fit label on it, and gather your first cohort of users.
  • Raise a round of investment money.
  • Ramp up spending to acquire users, often in an unsustainable fashion.
  • Numbers aren’t high enough, tweak the product slightly and floor the acquisition channels again.
  • Repeat until the company burns to the ground or becomes a unicorn.

The successful founders are the ones who manage to keep their wits about them during the ‘tweak the product’ phase. Your first thousand users have specific needs, your next ten thousand have slightly different needs, and the next million have wildly different ones. As a startup founder, you probably have some of the need finding skills that got you growth in the first place, but the tension of maintaining skyrocket growth can lead you to abandon them. 

Growth worship transforms your company goals into a financial numbers game rather than an empathetic game. You no longer think in terms of solving problems for people, but in terms of credit cards on file or sign ups. It’s a subtle, yet powerful distinction.

Yes, those numbers are a proxy of the value consumers place on your product at scale; however if the lifetime value you are capturing is lower than the price you are paying to acquire them, you are fundamentally not in a state of product market fit. The market has dictated that the value of your product is not profitable. Worse yet, what often happens during this phase of rapid experimentation is that your product actually gets worse. Founders tweak the product so that it’s no longer what your first users need, and the new product is usually a hastily thrown together prototype that doesn’t provide enough value for the new users you are targeting. Personally, I get a slimy feeling in my gut whenever I see this happening or implement rapid changes without understanding the targeted users needs. The feeling of inauthenticity is overwhelming, and to me a morally irresponsible way of doing business.

The Startup PR Drumbeat That Makes Me Squirm

I get lots of recruiter emails like this one:

XXX is an early stage startup whose mission is to create a smarter, more connected world on mobile and the Internet, empowering people to do yyy.

There are lots of words about ‘empowerment’ and ‘changing the world’. Frankly, it annoys the shit out of me. The vast majority of startups in the valley are not changing the world in a significantly meaningful way. Chipping away at making the future incrementally better, and radically altering the world we live in are different things. There is a place in the world for both incremental and radical changes, but fusing the two invites the worst kinda of sweeping characterizations like ‘elitist’ and ‘arrogant pricks’ that general culture associates with the techie crowd. Do we really have so little perspective on the world that these kinds of buzz words feel honest?

At least the financial industry has the wherewithal to be upfront about their intentions. The startup crowd has to put on a mask and lie about what we are really doing. Venture capitalists goal is to make money. By taking their money, startup founders also take on that goal. Making money is not immoral in and of itself, but the way startups spew forth their good intentions without recognizing the underlying goal of making money makes the whole industry feel unnecessarily slimy.

Fundamental Differences

Can startups be VC backed, change the world for the better, and not act like a sociopath? Certainly, but in order to do so you have to be cognizant of everyone’s interests.

Venture capitalists, at their core, are fund managers that deal in a high risk investment area. They are responsible for creating a positive return on investment for the large pool of money they are loaned by their limited partners (known as LPs).

On the other hand, founders can have many goals that are not aligned with simply ROI. As a founder, you need to be aware of the incentives of the people you take money from. Venture capital money can be the right answer for some companies. Bootstrapping can be the answer for others. For some it might be a mix of the two.

Most importantly, responsible businesses are continually aware of their customers needs and their internal needs. Hockey stick growth is good for a VC backed startup’s internal needs, but you need to be nuanced enough to realize that there are cycles in a startups lifecycle where you just aren’t going to get that growth. Keep your burn rate responsible, don’t act like a sociopath and stick to your need finding guns.