Notes about Benchmark Capital: Andy Rachleff
Demystifying Venture Capital
The other day my co-founder, Dan Carroll, asked me a number of questions about Venture Capital returns because he was stunned by the valuations of some recently announced deals. After I answered the question, Dan and a few colleagues who were within earshot encouraged me to share my perspective on the subject because it is so poorly understood.
Much has been written about the financial performance of the companies backed by venture capitalists, but very little has been written about the economics of the venture capital industry itself. With this post we open the kimono on who funds VCs, what returns they expect and how the best VCs consistently succeed in outperforming those expectations.
Who Funds VCs?
The primary providers of funding to the venture capital industry are managers of large pools of capital. These entities include pension funds, university endowments, charitable foundations, and, to a much lesser extent, insurance companies, wealthy families and corporations. Venture capital funds are raised in the form of a limited partnership that typically has a mandated 10-year lifespan. VCs typically do not invest in new companies beyond the third year of a partnership’s life to insure their latest investments have a chance to reach liquidation before the partnership legally ends. That means they must raise new partnerships every three years if they don’t want to stop investing in new companies. Taking a hiatus from investing in new companies is usually interpreted by the entrepreneurial community as no longer being in business, which makes it hard to restart one’s deal flow later. As a result there is a huge incentive not to let that happen.
Why Do Institutions Fund VCs?
As we explained in our investment methodology white paper and many of our blog posts about diversification, almost every sophisticated large asset pool manager uses modern portfolio theory (the same methodology employed by Wealthfront) to determine its base asset allocation. Because of their size, pensions, endowments and charitable foundations have access to a broader set of asset classes, including hedge funds, private equity (of which VC is a component) and private investments in energy and real estate, than most individuals. Most large asset pool managers would like a 5 – 10% allocation to venture capital because of its past returns and anti-correlation with other asset classes. Unfortunately they can seldom reach their desired allocation because there aren’t enough VC firms that generate returns that justify the risk. That’s because the top 20 firms (out of approximately 1,000 total VC firms) generate approximately 95% of the industry’s returns.
These 20 firms don’t change much over time and are so oversubscribed that they are very hard for new limited partners to access. The premier endowments are considered the most desirable limited partners by venture capitalists because they are the most committed to the asset class. Even these endowments, though, have a hard time getting into funds if they weren’t there in the beginning. Occasionally new firms like Benchmark and Andreessen Horowitz emerge and break into the top tier, but they are the exception rather than the rule.
What Returns Are Expected of VCs?
As we have also explained, with greater risk comes an expectation of greater return. Venture capital has the greatest risk of all the asset classes in which institutions invest, so it must have the highest expected return. I have heard institutions express their required return from venture capital necessary to compensate them for taking the additional risk (i.e. the risk premium) in two ways:
- The S&P 500® return plus 500 basis points (5%) or
- The S&P 500 return times 1.5
These expectations were created when the S&P 500 was expected to return on the order of 12% annually. These days the expectations baked into market options would lead you to believe the investment public expects the S&P 500 to return on the order of 6 – 7% annually. I’m not sure what that means for the current appropriate return expectation, but it’s still probably at least in the mid teens.
How Does a VC Generate These Returns?
According to research by William Sahlman at Harvard Business School, 80% of a typical venture capital fund’s returns are generated by 20% of its investments. The 20% needs to have some very big wins if it’s going to more than cover the large percentage of investments that either go out of business or are sold for a small amount. The only way to have a chance at those big wins is to have a very high hurdle for each prospective investment. Traditionally, the industry rule of thumb has been to look for deals that have the chance to return 10x your money in five years. That works out to an IRR of 58%. Please see the table below to see how returns are affected by time and multiple.
IRR Analysis: Years Invested vs. Return Multiple
Source: J. Skyler Fernandes, OneMatchVentures.com
If 20% of a fund is invested in deals that return 10x in five years and everything else results in no value then the fund would have an annual return of approximately 15%. Few firms are able to generate those returns.
Over the past 10 years, venture capital in general has been a lousy place to invest. According to Cambridge Associates the average annual venture capital return over the past 10 years has only been 8.1% as compared to 5.7% for the S&P 500. That clearly does not compensate the limited partner for taking the increased risk associated with venture capital. However the top quartile (25%) generated an annual rate of return of 22.9%. The top 20 firms have done even better.
You Need To Be Non-Consensus
The only way to generate superior returns in venture capital is to take risk. This reminds me of a framework popularized by my investment idol, Howard Marks of Oaktree Capital. He says the investment business can be described with a two-by-two matrix. On one dimension you can either be right or wrong. On the other you can be consensus or non-consensus. Obviously you don’t make money if you are wrong, but most people don’t realize you don’t make money if you are right and consensus because the opportunity is too obvious and all the returns get arbitraged away. The only way to generate outstanding returns is to be right and non-consensus. That’s hard to do because you only know you’re non-consensus when you make the investment. You don’t know if you’re right.
Being willing to intelligently take this leap of faith is one of the main differences between the venture firms who consistently generate high returns — and everyone else. Unfortunately human nature is not comfortable taking risk; so most venture capital firms want high returns without risk, which doesn’t exist. As a result they often sit on the sideline while other people make the big money from things that most people initially think are crazy. The vast majority of my colleagues in the venture capital business thought we were crazy at Benchmark to have backed eBay. “Beenie babies…really? How can that be a business?” The same was said about Google. “Who needs another search engine. The last six failed.” The leader in a technology market is usually worth more than all the other players in its space combined, so it is not worth backing anyone other than the leader if you want to generate outsized returns.
Needle In a Haystack?
According to some research I did back in the late ‘90s, there are only approximately 15, plus or minus 3, technology companies started nationwide each year that reach at least $100 million in revenue at some point in their independent corporate life. These companies tend to grow to be much larger than $100 million in revenue and usually generate return multiples in excess of 40x. Almost every single one of them would have sounded stupid to you when they started. They don’t today. Investing in just one of these companies each year would lead to a fund with an annual rate of return in excess of 100%.
Speaking of outsized returns, these days the breadth of the Internet has made it possible to generate returns that were never before imagined. Companies like Airbnb, Dropbox, eBay, Google, Facebook, Twitter and Uber return more than 1,000 times the VC’s investment. That leads to amazing fund returns.
Never Join a Club That Would Have You As a Member
Investors who have access to the best firms love venture capital. Those that don’t, hate it, but for some stupid reason continue to set aside an allocation because they think it looks more diversified.
When it comes to investing in venture capital I would follow the old Groucho Marx dictum about ‘never joining a club that would have you as a member.’ Beware private wealth managers who offer you access to venture capital fund of funds. I can assure you, as a past partner of a premier venture capital fund that no firm in the top 20 would allow a brokerage firm fund of funds to invest in their fund.
One of the most challenging things for people outside the technology world to understand about venture capitalists is why they are willing to fund companies that operate at a significant loss. After all, classic security analysis teaches us companies don’t have any value if they can’t produce a profit. The operative word in that statement is can’t. Just because a company operates at a loss today doesn’t mean it can’t be profitable in the future.
As I explained in Part I of this series, big winners drive venture capital fund returns. Prior to the emergence of the Internet, venture capitalists made their big returns behind technological breakthroughs. Almost every successful venture capitalist followed the same playbook originally designed by Tom Perkins, the founder of Kleiner Perkins Caufield & Byers: Find companies that have high technical risk and low market risk. Technical risk was reasonably easy to evaluate if you had a good enough network of experts on which to call. Lack of market, not poor execution, was, and still is, the primary cause of company failure. Therefore you never wanted to take market risk. You looked for companies that attempted to build something that was so technically challenging that you knew people would want to buy it if it were successfully delivered because it offered such a huge price/performance advantage.
Software Changed The Funding Formula
Post 1995 the world changed drastically. Almost every innovation came in the form of software. Unfortunately software startups have the opposite characteristics of what Tom Perkins taught the VC industry to look for. Software companies have relatively low technical risk and high market risk. You know the company could deliver its product. The question was would anyone want to buy it. As I said before, market risk is generally not worth taking, so the intelligent VCs had to change their business model. They outsourced to angel investors the earliest stage funding for what they considered the poor risk/reward consumer-focused companies and instead focused on backing them only when they proved “the dogs wanted to eat the dog food.” The angels thought they won the business away from the VCs, but the poor average returns of the angels would say otherwise. Waiting until a company proved it had product/market fit meant having to pay a much higher price than they did in the past. Fortunately the Internet enabled much bigger markets to be addressed than in the past, so their outsized returns could be maintained.
Let me illustrate with some numbers. Twenty years ago venture capitalists typically initially invested in startups at a $5 million valuation with the hope the company could someday be worth $500 million. That could represent a return of 20 to 30 times their investment based on the likely dilution incurred in future financing rounds (please see The Impact of Dilution for an explanation of dilution). Today VCs are more likely to initially invest at a $50 million valuation with the hope the company could someday be worth $5 billion. Amazingly the number of companies that generate $5 billion of value today is comparable to the number of companies that generated $500 million of value 20 years ago. That means today’s smart VCs are still able to generate the same kind of returns as 20 years ago despite the much higher entry valuation. Please keep in mind not all initial VC rounds are valued at $50 million. My intention was to provide an example that was correct in terms of order of magnitude.
Invest After The Value Hypothesis Has Been Proven
The challenge for the VC is finding a company that exhibits product/market fit — but not so obviously that she has to pay too high a price. Eric Ries’s phenomenal book The Lean Startup, provides an intellectual framework that I believe best explains the VC’s behavior. Eric (and I) believes in order to increase the likelihood of succeeding, a startup should start with a minimally viable product to test what he calls a value hypothesis. The value hypothesis should state the founder’s best guess as to what value will drive customers to adopt her product and indicate which customers the product is most relevant to, as well as what business model should be used to deliver the product. It’s highly unlikely that a founder’s initial hypothesis will prove correct, which is why an entrepreneur has to iterate on her hypothesis through a series of experiments before product/market fit is achieved. As a consumer company, you know you have proved your value hypothesis if your business grows organically at a rapid pace with no marketing spend.
Only once the value hypothesis has been proven should an entrepreneur test her growth hypothesis. The growth hypothesis covers the best way to cost-effectively acquire customers. Unfortunately many founders mistakenly pursue their growth hypothesis before their value hypothesis. I explain the perils of this approach in Why You Should Find Product-Market Fit Before Sniffing Around For Venture Money. Companies that nail their value hypothesis are highly likely to figure out their growth hypothesis, but the inverse is not true (Socialcam is perhaps the most outrageous example).
As you might imagine a company that has figured out its value and growth hypothesis is worth much more, perhaps three to five times more, than the company that has just confirmed its value hypothesis. Therefore the really good VCs try to invest after the value hypothesis has been proved, but before the growth hypothesis works. In other words VCs are willing to take the leap of faith that the company will figure out the growth hypothesis. You might think this is an obvious observation, but as I explained in Part I of this series, the vast majority of VCs are not willing to take that risk.
Once a company proves its value and growth hypothesis, it has likely achieved the leadership role in a new market. This usually spawns a bunch of imitators, but you might be surprised to learn that seldom does an imitator or laggard ever overtake the leader once it has achieved product market fit. That’s true even if the fast follower develops a better product. The only hope for number two in a segment is to change the definition of the market (Nintendo’s Wii is a great example).
Market Leaders Attract Cheap Capital
You might also be surprised to learn that the leader in a market is worth more than all the other players combined (Priceline is a great example). That’s why venture investors try to beat down the doors of a company to have the opportunity to invest once it has achieved market leadership.
Technology market leaders often accept this additional financing even when they don’t need it to execute their business plans. To do so they must believe the increased growth from investing faster in their businesses has to justify the dilution associated with the unneeded financing.
I’m sure you have read about many successful consumer Internet companies that recently raised on the order of $50 million, or more, at a $600-million pre-money valuation soon after they did another round of financing. This is the most common valuation these days (although incredibly high by historical standards) when a startup has achieved clear market leadership in a market that has a chance to be very large.
To justify the dilution associated with such an unneeded financing, the management must believe the incremental percentage growth in revenues from the financing is greater than the dilution taken in the round. For example, let’s say a company currently has a $10-million annualized revenue rate with expected annual revenue of $160 million in four years. Let’s further assume it can raise $50 million at a $600-million pre-money valuation and with that money increase its revenue expectation in four years to $200 million. That would mean it would trade off an extra 7.7% of dilution for a 25% increase in revenues — in almost every case that would lead to a higher value per share for all stockholders.
Cheap Financing Drives Accelerated Growth (And Increased Losses)
The only way the revenue could have been increased by such a sizable amount was to have accelerated the company’s hiring of engineers to produce needed product more quickly (assuming more product leads to faster growth) or to increase paid marketing (assuming it would generate a positive yield).
You often see subscription businesses like SAAS companies accelerate their marketing spend as long as their cost to acquire a customer is less than their average customer lifetime value. This acceleration may lead to significantly increased short-term losses if the annual revenue contribution of an average customer is less than the initial customer acquisition cost; over the long term, however, it is highly worthwhile.
Let’s look an example to illustrate this point. If we assume a company’s average customer generates a profit of $100 per year, 33% of the company’s customers churn each year and it costs the company an average of $150 to acquire a customer, then it is highly worthwhile for that company to spend as much as it can as long as those economics hold. That’s because the customer lifetime value of $300 ($100/33%) is far greater than the customer acquisition cost of $150. However each customer the company adds decreases its profits (or increases its losses) by $50 in the first year ($100 increased annual profit – $150 customer acquisition cost), so it may appear to uninformed outsiders that the company has made a stupid decision. Over the long term the trade will prove worthwhile because the company will continue to generate $100 per customer for three years (the horizon over which the average customer churns).
As frequent observers of this phenomenon, VCs encourage this trade despite the poor short-term optics as long as they believe their portfolio companies’ long-term margins are likely to be attractive. Their point of view is reinforced by the research we shared in Winning VC Strategies To Help You Sell Tech IPO Stock that found technology companies’ performance post-IPO is most dependent on revenue growth, not profitability. Accelerated revenue growth is almost always rewarded with a higher valuation as long as management is able to convince investors that it addresses a huge market and can easily generate profits in the future.
The most exaggerated example of this strategy is Amazon. You have often heard Amazon say it could have much higher margins if it wanted to. This is no joke. Management knows the smarter decision is to invest in growth and they have been handsomely rewarded for it.
Technology Companies Are Valued Differently
There is a huge incentive to grow faster rather than generate profitability. This may sound like heresy but it’s the way the technology business has always worked. Almost every market leader could generate a profit relatively early in their life, but that would leave them open to an aggressive new entrant that wanted to change the rules on them. It’s far better to defer profitability and cement your lead than try to make a profit early.
Unfortunately people from outside the technology business don’t understand how technology companies are valued. As software continues to eat the world, you’ll likely hear many representatives of old line or soon to be disrupted businesses denigrate the disrupters by saying they have an unsustainable business model or will likely go out of business due to their spending rate. They also might point out how small the new entrant is; ignoring the fact that at its current growth rate it will soon become very big. Psychologists have done many studies that have found human beings have a hard time comprehending the impact of compounding. I’ve been to this movie many times and it always ends poorly for the incumbent once an upstart achieves product-market-fit. That’s because momentum seldom dissipates quickly.
All That Matters Is Growth
The other knock the uninformed and threatened use against young companies with momentum is their VCs must be nuts to have invested so much in them because “companies in our space aren’t valued like tech companies and therefore can’t justify the sizable capital invested.” Professional public tech investors care a lot more about the growth of the company in which they invest than they do about the traditional multiples of the industry in which the company participates. Time and time again we’ve seen new software-based entrants that disrupt an old-line industry get valued at what, historically, would have been viewed as crazy valuations. It’s pretty clear the Internet-based winners in cars, clothing, recruiting and travel, among others, command lofty valuations. Motley Fool has dedicated numerous posts to the correlation between growth rate and the price to earnings (P/E) ratio. The higher the growth rate, the higher the P/E, independent of industry. Once again the top VCs understand that this relationship is unlikely to change any time soon.
Economists believe the only way to earn outsized returns is to invest in highly inefficient markets. The lack of common understanding around what constitutes the ideal way to build a startup is one of the greatest examples of inefficiencies I know — which makes it a huge source of the premier venture capitalists’ tremendous returns.
The funding of almost every new and successful technology market can, to the uninitiated, have the appearance of a financial bubble. A tsunami of venture capital flows into hot new markets at what appear to be ridiculous prices. Amazingly, the capital invested in the market winners is almost always justified. A few other companies will drive small returns while the vast majority of new entrants will lose money. This dynamic benefits the premier venture capital firms and consistently hurts second-tier firms.
Most successful new markets begin the same way. A market-sensitive technologist recognizes an inflection point in technology that enables a new kind of product. It’s not uncommon for more than one individual to recognize the potential of the new inflection around the same time, which usually leads to the development of competing companies. This dynamic is so common that VCs often joke that if you meet a company with a compelling new idea, you only have to wait a couple of weeks to see something similar.
It’s Not First to Market That Wins. It’s First to Product / Market Fit.
As I explained in Demystifying Venture Capital Economics, Part 2 the premier VCs now prefer to have angel investors finance startups until they reach product/market fit. They know it’s far better to wait and pay a higher price to finance a company that has proven its value hypothesis because market risk is seldom worth taking. That being said it’s not uncommon for a second-tier venture firm to jump the gun and invest in a company before it finds product/market fit. They are often seduced by the myth that first to market is of critical importance. In fact, first to market seldom matters. Rather, first to product/market fit is almost always the long-term winner. Name a franchise technology company and I can almost assure you it wasn’t first to market.
As the new market develops a very clear hierarchy develops. Geoffrey Moore (the author of Crossing The Chasm) likened this hierarchy to primates in his book The Gorilla Game. Moore calls the market leader the Gorilla because of the dominance it exerts. Chimps start around the same time as the Gorilla, but pursue a different and far less successful product approach to address the same customers. As the attractiveness of the new market becomes clear, Monkeys emerge (even many years later) that attempt to clone the Gorilla’s product, often with a lower price and exaggerated performance claims. In an attempt to survive, most Chimps hop on to the Gorilla bandwagon and become Monkeys. Monkeys seldom achieve more than modest success.
VCs Succeed By Backing the Gorilla
As I explained in When It Comes to Market Leadership, Be the Gorilla it is extremely unusual for a Gorilla to lose its leadership position to a company that attempts to do something similar, even if it is a large incumbent. Only by successfully changing the definition of a market can a new and later entrant ultimately prosper in a big way.
The premier venture capital firms compete vigorously to back the Gorilla because they know the market leader is ultimately worth more than all the Chimps and Monkeys combined. As a result the Gorilla tends to raise far more money at radically higher valuation than the Chimps and Monkeys.
In the past some premier VCs would back a Chimp before it was apparent the Gorilla’s approach would win. These days that is far less common as the strategy of waiting for product/market fit has become more common.
The success of the Gorilla causes many second-tier VC firms to pursue investments in Monkeys based on the significant discount at which they can invest, relative to the valuation of the Gorilla. History has proven that buying on the cheap is a poor venture capital strategy. The big venture capital money is made backing companies that grow into Gorillas, even though you usually have to pay up for the opportunity.
Backing Monkeys Rarely Pays Off
Monkeys seldom get to the scale or profitability necessary to justify a venture capital investment. Unfortunately the second-tier venture firms never seem to learn this lesson and keep making the same mistake of backing the Monkeys.
Corporate investors are last to learn about the downside of investing in Monkeys. Their egos often lead them to believe the combination of their help along with a much lower valuation can overcome the poor historical results of investing in Monkeys. It seldom does. The corporate investors’ overinflated view of the value of their help also makes them the least desirable of all potential funding sources.
The huge flow of money into a new market leads people who are unfamiliar with venture capital to view such inflows as the sign of a bubble. In fact what appears to be an overabundance of capital flowing into a new space is the norm for every new technology market I have observed over the past 30 years. It doesn’t matter if it’s computers (from mainframes to PCs), disc drives (from 14” down to flash), networking equipment (from routers to software-defined networks), software (from material requirements planning to database) or internet services (eCommerce to social networks). At one time there were over 100 personal computer companies funded by the VC industry! Every market appears overfunded, but the ultimate value of the Gorilla consistently swamps the total capital invested in the space.
Hope springs eternal even though the lessons are incredibly obvious. That’s why the poor VCs keep making the same mistake.
Historical Example: Professional Networking
The professional network space is a great recent example that illustrates the rush to fund an emerging market. LinkedIn, Jigsaw, PlanetAll, Plaxo, Ryze, Six Degrees, Spoke, Visible Path, Xing and Zero Degrees started around the same time. BranchOut was founded a number of years later in an attempt to build the equivalent of LinkedIn on top of the Facebook platform.
Although not the first entrant, LinkedIn’s combination of early and distinct traction with top-tier talent attracted premier VCs Sequoia and Greylock. By the time LinkedIn went public it raised more than $200 million at valuations well in excess of all its competitors. Jigsaw, Plaxo and Zero Degrees each raised less than $30 million at much lower prices than LinkedIn and were acquired in relatively small transactions that led to low VC returns. BranchOut raised $50 million, but sold its asset for a pittance to Hearst.
Only three startups, other than LinkedIn in the professional network market, received funding from a top-10 venture firm. Only LinkedIn attracted high-quality later-round funding support. The quality of late-stage investor is often viewed as an important signal for potential recruits when they choose where to work.
The LinkedIn Gorilla is Worth 50x The Chimp
Ultimately only LinkedIn and Xing succeeded. Xing was forced to bootstrap by charging users from the beginning because it was founded in Germany where early-stage capital was quite scarce. This coupled with too much focus on its home country significantly hindered its growth relative to LinkedIn. Today LinkedIn is worth $27 billion vs. $500 million for Xing.
By now I hope you see the pattern. LinkedIn is the Gorilla. Xing is the Chimp and all the other companies were the Monkeys. The value of LinkedIn swamps the value of all the other players in its space combined and is far greater than the aggregate $400 million that was invested in professional networks. Investments in the Monkeys were not justified, especially given their risk.
Don’t Make the Mistake of Funding Chimps & Monkeys
The next time someone tells you there is a bubble going on in a particular market, I encourage you to look a little closer. You’ll very likely find a Gorilla whose lead is increasing, a Chimp or two, and a bunch of Monkeys who claim they’re just as good if not better. Not only will that Gorilla generate huge returns for its investors but its ultimate market value will be far greater than all the money you feared had been invested in a bubble.
Part 4: What Analysts Get Wrong About Innovation
In 2014 our CEO, Adam Nash, caused quite a stir when he said “In the next 10 years, everyone will be using some form of automated investment service.” Frankly, many market analysts thought he was nuts. Twenty-five years in the venture capital business leads me to believe Adam is right. As a matter of fact, I think automated investment services will ultimately attract more than $2 trillion of assets. So what leads to the enormous difference of opinion Adam and I have with market analysts?
In my experience, industry observers consistently make the same mistake. They evaluate innovations based on their magnitude of adoption, rather than their rate of adoption. Put another way, they over-emphasize the current size of the new market, and don’t pay enough attention to how quickly the new market is growing. Very often, that results in them missing the obvious fact that the new market, though currently small, is on a growth path that will have it soon eclipsing the status quo with which it is competing. I saw this analytical failure over and over in my days as a venture capitalist, and I am seeing it again as Chairman of Wealthfront.
Amazon, Facebook or Airbnb are great examples of this phenomenon. The early articles about these companies almost all said they were interesting ideas, but unlikely to beat their much larger competitors (Barnes & Noble, Myspace and hotels respectively). You seldom if ever heard about the rate of adoption of these new entrants vs. their competitors.
Innovations Spread Faster Today
That was a big mistake, because innovations are being adopted at an increasingly rapid rate. For almost 20 years, Mary Meeker, formerly of Morgan Stanley and now a partner at Kleiner Perkins Caufield & Byers, has published a report on the state of the Internet. My favorite chart from her fantastic reports is a graph that compares the rate of adoption of new technologies over time.
As you can see, the slopes of the adoption lines keep increasing as we move through time from left to right. In other words, each new technology that succeeds is adopted at a faster rate than previous new technologies. It took the clothes washer six decades to do what the cell phone was able to do in just one.
We see the same dynamic in the investment space. Consider the graph below (drawn with a log scale), which shows adoption rates for three forms of “passive investing.” You can see that ETFs were adopted at a faster rate than index funds. And automated investment services are being adopted at a faster rate than ETFs. When a new product has a faster rate of adoption than its predecessor, it invariably results in an even larger total market. For some reason market analysts seldom learn this lesson – despite overwhelming evidence.
It’s important to understand that when I use the term automated investment service, I mean fully automated, software-based services like the ones offered by Wealthfront, Schwab, Blackrock and Betterment. As we explained in Not Everyone Wants to Manage Their Own Investments, there is a tremendous difference between an automated investment service and a technology assisted advisor like Vanguard’s Personal Advisor Service. Vanguard offers tremendous value, but it only uses software to open an account and even that isn’t fully automated. Technology assisted advisors are a cost effective alternative for older investors, but not likely to be replicated by others due to Vanguard’s not-for-profit business model.****
Innovations Evolve Faster Than You Think
One of the main reasons market analysts continue to underestimate innovators is they assume innovators will not move beyond their initial products. In fact, innovators not only move beyond their initial products, they move beyond them rapidly. Believe it or not few people foresaw Amazon moving beyond books. Mutual fund market analysts couldn’t imagine an index fund for something other than the S&P 500. Last month Wealthfront surprised analysts when we announced our intention to apply artificial intelligence to our clients’ vast trove of accessible behavioral data to deliver sophisticated financial advice. I say “surprised” because the vast majority of these market analysts thought we would continue to just offer an investment management service. We find this fascinating since we have said from the beginning that our mission is to democratize access to sophisticated financial advice.
Perhaps innovation is being adopted at a more rapid rate because software can be enhanced so much more quickly than previous hardware-based innovations.
The Technology Adoption Life Cycle
The classic argument in favor of using current magnitude to evaluate a new business is the question: If it’s so great then why doesn’t everyone use it now? We hear this all the time at Wealthfront. How compelling could automated investment services be if they represent only $13 billion of managed assets out of a total market of more than $16 trillion? Geoffrey Moore definitively answered this question in his groundbreaking book Crossing the Chasm.
The book’s well-proven premise is every new technology has a similar adoption cycle no matter how great it is. Start-up products initially appeal to “innovators,” people who want to try every new thing, but who are seldom willing to spend very much (if anything) for products that interest them. Then come the “visionaries,” early adopters willing to take a chance on a new product if it solves a burning problem. All they need is a proof of concept to take the leap of faith. After the visionaries come the “pragmatists.” They buy only after friends or colleagues have recommended it – no matter how well a product serves their needs. Typically, the pragmatists or the “early majority” represent by far the largest market segment. The “late majority,” conservatives who buy only after a product has become the standard, follow the early majority. Finally come the “laggards,” who never buy.
The problem is you first have to build a very large base of early adopters to generate the references pragmatists require. You also need to build out the capabilities of your product to address a larger audience. That takes time, and unfortunately there is no way to shortcut this process.
A Niche Market is the Key to the Mass Market
Name a successful tech company. The overwhelming odds are it followed Moore’s advice.
Facebook started with students at Ivy League universities. eBay focused first on collectibles. LinkedIn’s initial target was execs in Silicon Valley. Google’s early ads only appealed to start-ups that couldn’t afford the minimum order size associated with banner ads. Amazon started with books.
Over time each company added functionality and addressed a broader audience – but over time, not from the beginning. Attempting to start with the largest market – the pragmatists – would have been met with failure because this audience doesn’t care how well your product addresses their pain. They only care about references, which take time to build.
The only path to success I know is to start with the early adopters who are desperate for your product and build references among them to address adjacent markets. Adjacent markets typically require additional features. It is those additional features that are required to build the “whole product.” The beauty of software, unlike people-intensive businesses, is it constantly improves over time. For some reason market analysts like to evaluate software-based businesses as though their products will remain in their initial form.
Innovation Will Accelerate
Clearly, history is repeating itself. Automated investment services are being adopted at twice the rate ETFs were at the same point in their life cycle. If the past is any predictor of the future then this is likely the start of something big and it’s going to happen faster than most people appreciate. Maybe this time, analysts won’t be the last ones to figure it out.
When Should New Entrants Partner with Incumbents
At some point in its evolution, every startup faces the question of whether or not it should partner with a large company to accelerate its growth. On the surface, partnering almost always looks like a great idea. Unfortunately, the reality is seldom as rosy.
Partner Motivation: The Chesbrough Framework
In my experience, understanding your potential corporate partner’s motivations will tell you a lot about how likely it will behave post investment. In my product/market fit class at the Stanford Graduate School of Business, I use Hank Chesbrough’s outstanding framework to describe the motivations that drive corporate partnerships (Hank is a professor at the University of California’s Haas School of Business).
Like most compelling frameworks, it is based on a simple two-by-two matrix: On one dimension the “Motivation for the investment” can either be strategic or financial. On the other the dimension, “Organizational fit” with its current business can either be tight or loose.
Chesbrough refers to a strategic motivation with a tight organizational fit as a “driving” investment because it has the opportunity to drive significantly increased revenue in the corporate partner’s own business. A strategic motivation with a loose organizational fit is called “enabling” because it is motivated by a desire to grow the market it currently serves. Intel investing in companies that build products that require a lot of processing power is a classic enabling investment. A financial motivation and a tight organizational fit is called “emergent” because it might be an opportunity in the future, but is not one today. Corporate partners pursue this kind of investment for its option value because they may be interested in a closer relationship in the future. A financial motivation with a loose organizational fit is called a “passive investment” because it is made purely for financial return.
Look for a Driving Investment
In my experience the only kind of corporate relationship worth pursuing is a driving investment. Corporate partners are far more likely to pay attention to their investments if their portfolio companies help drive a significant increase in their own product revenues. That’s because companies are valued based on their future operating cash flows, which are far more likely to be impacted by a multiple increase in their own product revenues than by selling another company’s products.
I am not a fan of enabling investments because as an entrepreneur I want to be my partner’s passion, not option. A corporate partner who invests in your company purely for the opportunity to see how the market plays out has no motivation to help you. As a startup you face enough challenges that you should only want to involve people who are motivated to help in every possible way.
Emergent investments are not terribly relevant because they are quite rare. If a passive investment is what you’re after, then a venture capital firm is likely to provide more help.
The best recent example of a driving investment was Microsoft’s 2007 investment in Facebook. Prior to the partnership, Microsoft faced significant headwinds in its attempt to sell Bing-based advertisements. In return for a $200 million investment, Microsoft earned the exclusive right to sell Facebook ads. The ability to offer a bundle of Facebook and Bing ads enabled Microsoft to significantly grow its Bing business.
Intel’s 2014 investment of $740 million in Cloudera was a classic example of an enabling investment. The success of big data should drive the need for a lot more processing power and therefore more microprocessors. As mentioned earlier Intel was a pioneer when it came to this kind of investment. Unfortunately, over the past 10 years the vast majority of Intel’s investments have been what Chesbrough would classify as passive, which may explain why they haven’t had much of an impact on Intel’s stock price.
Cisco is the company most associated with emerging investments. It has taken minority positions in scores of companies and followed up with acquisitions when the investees proved they had created important new markets.
Corporate Partners: Who is Driving?
The challenge with a driving investment is that its strategic importance usually leads the corporate investor to attempt to exert influence over the investee to get what it believes is appropriate for the market. Unfortunately, the corporate partner’s view of what’s needed seldom jives with the startup’s perspective. This usually leads to an over specified product, which in turn leads to time to market delays.
Eric Ries and Steve Blank revolutionized the way entrepreneurs think about business in large part by stressing the importance of getting a minimum viable product to market to get the feedback necessary to iterate into the most attractive niche. Corporate partners in the driving quadrant typically are not interested in the “lean startup” approach because they usually have very strong opinions about what they need and don’t think it is necessary to experiment to find product/market fit.
Making a profit on its investment is of little value to a corporate partner because publicly traded stocks are valued based on their future operating cash flows. Investment profits are not considering an operating cash flow, so it seldom impacts the value of the corporate investor’s stock. It only has value if the value of the investment exceeds the value of the corporate investor’s main business, which is very rare (think Yahoo and Alibaba). If the value of the investment is meaningless then the only reason to invest is to improve one’s own business (driving) or get an insight into a business that might hurt you (emergent).
Pundits excoriated Microsoft for investing in Facebook at what seemed like a ridiculously high price ($15 billion valuation), but Microsoft believed that the price it paid didn’t matter. As an investment, it turned out Microsoft made billions, but that had very little impact on its stock price. Microsoft and their investors were far more focused on the improved Bing cash flow that resulted from the deal.
The Innovator’s Dilemma Prevents Successful Partnerships
By now you can see there are some significant issues involved in building an effective corporate relationship even when your goals are aligned. Imagine how much worse it might be if you have a business model that is disruptive to your potential corporate partner. By disruptive I mean the Clayton Christensen definition: a product or service that is uneconomic for the incumbent to address.
According to Christensen there are two types of disruptions: new market disruptions and low end disruptions. New market disruptions address consumers who for one reason or another are not able to buy the incumbent’s product. eBay was a classic new market disruption because Sotheby’s was not able to address people who wanted to sell inexpensive items. A low end disruption is something that is simpler, cheaper or more convenient than the incumbent’s product. Dell sold PCs direct to consumers cheaper than its primary competitor Compaq sold to its resellers. Compaq couldn’t cut its price and go direct because it would infuriate its resellers, on whom it was dependent for billions of dollars of revenue. That would have been suicide for a public company.
A true disruptor creates an innovator’s dilemma (the name of Christensen’s book that introduced the concept of disruption) for the incumbent – attempting to compete with the disruptor will destroy earnings and ignoring the disruptor will allow it to grow and destroy you in the future. Thus the dilemma!
It’s awfully hard for a corporate partner to embrace your product if its investment either hurts its margins or acts as a perceived endorsement that might lead its traditional customers to ask for a lower price.
For this reason, almost every successful Internet entrant chose to compete with the incumbents rather than partner with them. The only exception I know of is the real estate market.
Below is a sample of the ever-growing list of traditional markets that have been destroyed by new Internet entrants:
In each of these cases, partnering with an incumbent would have weakened the new entrant’s ability to position the incumbent as the bad guy who was charging way too much. Imagine Amazon partnering with Barnes & Noble!
I raise the Barnes & Noble issue because Amazon did partner with incumbents after it clearly became the leader. It only chose to work with incumbents like Toys “R” Us once it controlled the power dynamic and was able to dictate the terms of how it wanted to do business. And those terms clearly favored Amazon.
To be fair there are always outliers. As I said before real estate is the one market where the new entrants (Zillow and Trulia) worked with, rather than competed against, the real estate agent community. Trulia is a particularly embarrassing example for me because the two founders, Pete Flint and Sami Inkinen, were my students and advisees at Stanford Graduate School of Business. I strongly recommended Pete and Sami compete with real estate agents rather than work with them based on my 20 years of having observed the incumbent/new entrant dynamic. Fortunately for Pete and Sami they ignored my advice.
Disrupters Look for New Channels
Interestingly, Christensen found that disrupters almost always had to create their own distinct channel for their products. That’s because the typically lower price for a disruptive product leads to far lower margins for the reseller. Existing channels resist taking on new products that have lower margins, which forces the disruptor to find a new channel for which even the low margin is better than what it makes on its other products. Selling via the web or mobile rather than through the incumbent distributor is a classic example of Christensen’s observation.
Don’t confuse partnering to access supply with partnering to gain distribution. Supply partnerships have a much higher chance of succeeding because the private company seldom is interested in disrupting its supplier. Hulu partnered with the networks to gain proprietary access to content in an attempt to disrupt cable operators, the classic distributors of such content. The broadcast networks’ investments in Hulu were driving because they created a new channel for their content.
Startups Should Be Cautious Approaching Partnerships
It’s imperative that you consider to whom you might be disruptive when contemplating a corporate partnership. Chesbrough would argue there’s very little incentive for a potentially disrupted incumbent to make an investment other than one that could be characterized as emerging. Again, that provides no incentive for them to help you.
I faced this dilemma up close. My company, Wealthfront, operates an automated investment service. We employ exchange traded funds (ETFs) from Vanguard as part of our managed portfolio, but we would never take an investment from a firm that offers investment advisory services. Having a potential competitor as an investor weakens the messaging we could use to explain how much they take advantage of their clients with high fees. It also creates the potential for a conflict should we ever want to specifically compete against them. For this reason, venture capitalists are usually the preferred source of private funding because their only motivation is to see the value of your equity grow. They don’t care how you do it and who you irritate in the process. In other words, there are no potential conflicts.
Having a corporate investor could increase your revenues in the short term, based on the credibility it might bring or an initial stocking order. But over the long term the potential impact due to conflicts and delays are likely not to be worth it.