## Peter Thiel’s CS183 @ Stanford: Startup—Venture Capital and You

December 9, 2012 Leave a comment

I. Venture Capital and You

Many people who start businesses never deal with venture capitalists. Founders who do interact with VCs don’t necessarily do that early on. First you get your founders together and get working. Then maybe you get friends, family, or angels to invest. If you do end up needing to raise a larger amount of capital, you need to know how VC works. Understanding how VCs think about money—or, in some cases, how they don’t think about it and thus lose it—is important.

VC started in late 1940s. Before that, wealthy individuals and families were investing in new ventures quite frequently. But the idea of pooling funds that professionals would invest in early stage companies was a product of the ‘40s. The Sand Hill road, Silicon Valley version came in the late 1960s, with Sequoia, Kleiner Perkins, and Mayfield leading the field.

Venture basically works like this: you pool a bunch of money that you get from people called limited partners. Then you take money from that pool and invest it in portfolio companies that you think are promising. Hopefully those companies become more valuable over time and everybody makes money. So VCs have the dual role of encouraging LPs to give them money and then finding (hopefully) successful companies to back.

Most of the profits go back to LPs as returns on their investment. VCs, of course, take a cut. The typical model is called 2-and-20, which means that the VC firm charges an annual management fee of 2% of the fund and then gets 20% of the gains beyond the original investment. The 2% management fee is theoretically just enough to allow the VC firm to continue to operate. In practice, it can end up being a lot more than that; a $200m fund would earn $4m in management fees under a 2-and-20 structure. But it’s certainly true that the real payout that VCs look for come with the 20% cut of the gains, which is called the carry.

VC funds last for several years, because it usually takes years for the companies you invest in to grow in value. Many of the investments in a given fund either don’t make money or go to zero. But the idea is that the companies that do well get you all your money back and then some; you end up with more money in the fund at the end than LPs put in to begin with.

There are many dimensions to being a good VC. You have to be skilled at coming up with reasonable valuations, identifying great entrepreneurs, etc. But there’s one dimension that is particularly important, yet surprisingly poorly understood. It is far and away the most important structural element of venture capital: exponential power. This may seem odd because it’s just basic math. But just as 3^{rd}grade arithmetic—knowing not just how many shares you get, but dividing that by the shares outstanding—was crucial to understand equity, 7^{th} grade math—understanding exponents—is necessary to understand VC.

The standard Einstein line on this is that the most powerful force in universe is compound interest. We see the power of compounding when companies grow virally. Successful businesses tend to have an exponential arc to them. Maybe they grow at 50% a year and it compounds for a number of years. It could be more or less dramatic than that. But that model—some substantial period of exponential growth—is the core of any successful tech company. And during that exponential period, valuations tend to go up exponentially.

So consider a prototypical successful venture fund. A number of investments go to zero over a period of time. Those tend to happen earlier rather than later. The investments that succeed do so on some sort of exponential curve. Sum it over the life of a portfolio and you get a J curve. Early investments fail. You have to pay management fees. But then the exponential growth takes place, at least in theory. Since you start out underwater, the big question is when you make it above the water line. A lot of funds never get there.

To answer that big question you have to ask another: what does the distribution of returns in venture fund look like? The naïve response is just to rank companies from best to worst according to their return in multiple of dollars invested. People tend to group investments into three buckets. The bad companies go to zero. The mediocre ones do maybe 1x, so you don’t lose much or gain much. And then the great companies do maybe 3-10x.

But that model misses the key insight that actual returns are *incredibly skewed*. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality you get a power law distribution.

An example will help clarify. If you look at Founders Fund’s 2005 fund, the best investment ended up being worth about as much as all the rest combined. And the investment in the second best company was about as valuable as number three through the rest. This same dynamic generally held true throughout the fund. This is the power law distribution in practice. *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 practice, it’s quite hard to be profitable as a VC if you don’t get to those numbers.

PayPal sold to eBay for $1.5bn. PayPal’s early stage investors had a large enough stake such that their investment was ultimately worth about the size of their fund. The rest of the fund’s portfolio didn’t do so well, so they more or less broke even riding on PayPal. But PayPal’s series B investors, despite doing quite well with the PayPal investment, didn’t break even on their fund. Like many other VC funds in the early 2000’s, theirs lost money.

That investment returns take a power law distribution leads to a few important conclusions. First, you need to remember that, management fees aside, you only get paid if you return all the money invested plus more. You have to at least hit the 100% of fund size mark. So given power law distribution, you have to ask the question: “Is there a reasonable scenario where our stake in this company will be worth more than the whole fund?”

Second is that, given a big power law distribution, you want to be fairly concentrated. If you invest in 100 companies to try and cover your bases through volume, there’s probably sloppy thinking somewhere. There just aren’t that many businesses that you can have the requisite high degree of conviction about. A better model is to invest in maybe 7 or 8 promising companies from which you think you can get a 10x return. It’s true that in theory, the math works out the same if try investing in 100 different companies that you think will bring 100x returns. But in practice that starts looking less like investing and more like buying lottery tickets.

Despite being rooted in middle school math, exponential thinking is hard. We live in a world where we normally don’t experience anything exponentially. Our general life experience is pretty linear. We vastly underestimate exponential things. If you backtest Founders Fund’s portfolios, one heuristic that’s worked shockingly well is that you should always exercise your pro rata participation rights whenever a smart VC was leading a portfolio company’s up round. Conversely, the test showed that you should never increase your investment on a flat or down round.

Why might there be such a pricing inefficiency? One intuition is that people do not believe in a power law distribution. They intuitively don’t believe that returns could be that uneven. So when you have an up round with a big increase in valuation, many or even most VCs tend to believe that the step up is too big and they will thus underprice it. The practical analogue would be to picture yourself working in a startup. You have an office. You haven’t hit the exponential growth phase yet. Then the exponential growth comes. But you might discount that change and underestimate the massive shift that has occurred simply because you’re still in the same office, and many things look the same.

Flat rounds, by contrast, should be avoided because they mean that the VCs involved believe things can’t have gotten that much worse. Flat rounds are driven by people who think they might get, say, a 2x return from an investment. But in reality, often something has gone very badly wrong—hence the flat round’s not being an up round. One shouldn’t be mechanical about this heuristic, or treat it as some immutable investment strategy. But it actually checks out pretty well, so at the very least it compels you to think about power law distribution.

Understanding exponents and power law distributions isn’t just about understanding VC. There are important personal applications too. Many things, such as key life decisions or starting businesses, also result in similar distributions. We tend to think about these things too moderately. There is a perception that some things are sort of better than other things, sometimes. But the reality is probably more extreme than that.

Not always, of course. Sometimes the straighter, perceived curve actually reflects reality quite closely. If you were to think about going to work for the Postal Service, for example, the perceived curve is probably right. What you see is what you get. And there are plenty of things like that. But it’s also true that we are, for some reason or other, basically trained to think like that. So we tend to miscalculate in places where the perceived curve does not, in fact, accurately reflect reality. The tech startup context is one of those places. The skew of distributions for tech startups is really vast.

This means that when you focus on the percentage of equity you get in a company, you need to need to add a modifier: given something like a power law distribution, where your company is on that curve can matter just as much or more than your individual equity stake.

All else equal, having 1% of a company is better than having 0.5%. But the 100^{th}employee at Google did much better than the average venture-backed CEO did in the last decade. The distribution is worth thinking hard about. You could spin this into argument against joining startups. But it needn’t go that far. The power law distribution simply means you have to think hard about a given company is going to fall on the curve.

The pushback to this is that the standard perception is reasonable—or at least is not unreasonable—because the actual distribution curve turns out to be random. The thesis is that you are just a lottery ticket. That is wrong. We will talk about why that is wrong later. For now, it’s enough to point out that the actual curve is a power law distribution. You don’t have to understand every detail and implication of what that means. But it’s important to get some handle on it. Even a tiny bit of understanding of this dimension is incredibly valuable.

Peter Thiel’s CS183: Startup—Notes Essay—Follow the Money