There are two things that everyone in Venture Capital agrees on:
- Most start-ups fail
- Returns are exponential so of the few start-ups that succeed only the biggest winners matter.
Silicon Valley billionaire Peter Thiel wrote in his book that VCs should
‘Only invest in companies that have the potential to return the value of the entire fund.’
Y Combinator’s Paul Graham has said one of the
‘most important things to understand about startup investing, as a business, are (1) that effectively all the returns are concentrated in a few big winners… The first rule I knew intellectually, but didn’t really grasp till it happened to us. The total value of the companies we’ve funded is around 10 billion, give or take a few. But just two companies, Dropbox and Airbnb, account for about three quarters of it.
Ben Horowitz of Venture Capital firm Andreessen Horowitz gave a presentation where one of the slides was
The result of this has been investors, or at least the smart ones
- Make lots of small investments
- Use the investment criteria of if this works could it become a $10 billion company?
But of course the number and type of businesses which can be launched on a few hundred thousand dollars but with the potential of becoming multi-billion dollar companies are very small and limited. Thus it’s hardly surprising that VCs have a strong bias towards software based platforms because these are the only start-ups that fit their criteria.
My assertion in this essay is that VCs have learnt the wrong lesson and in particular capital-intensive start-ups, where angel rounds may be in the tens of millions, could be very profitable.
Whether I’m right or the VCs are right all depends upon why start-ups fail. This is actually an incredibly complex question where risks include founder/team risk, product risk, market risk, financial risk and execution risk. It is therefore not surprising that capital-intensive technology companies are deemed such terrible investments because in addition to all these risks you throw in significant technology risk plus much higher stakes (because they require more capital).
What I would argue here though is that this is looking at the problem of VC investing from the wrong perspective and in particular it forgets the most important risk of all: competition risk. Companies, when they are small, understandably focus on a niche of the market but the problem is this gives the false impression of differentiation. What is hidden is that for these companies to succeed (which in terms of VC returns means being a multi-billion dollar company) there is going to be an incredible amount of convergence to similar problems. As every VC knows these markets are inherently winner takes all but every year hundreds of start-ups are funded where the long-run convergence is to the same billion dollar company/market.
Using the above example where you have seven different start-ups this means that the long-run chance of success is already just 14% (=1/7) and that is assuming that at least one of the companies will succeed. If we take as given that no top VC is significantly better at choosing the long-term winner than another (which evidence suggests is the case) this means that there is a huge incentive to invest in companies that have no competition.
Elon Musk’s story is remarkable because he invested in two industries which are both very capital-intensive and widely deemed to be very risky. Clearly Musk is a remarkable person but perhaps his story also speaks to a deeper truth which is that these capital-intensive industries for all the additional technology risk may actually have a better risk-reward profile than software companies because you can avoid competition risk.