HEIDI: Welcome to The Startup Solution. I’m Heidi Roizen from Threshold Ventures.
One of the most memorable pitch meetings I ever had was with the rock star and actress Courtney Love. It was the height of the dotcom boom, and Courtney was developing a website for her following, particularly for the people she most cared about – disenfranchised young women. She was looking for capital for her next stage of development, so a mutual friend connected her with me.
Courtney was impressive. She had a keen understanding of her audience and what she wanted to do for them. She was particularly focused on ways to build community and provide mental health resources. And she was emphatic about doing all this without charging any fees for usage – and she didn’t want to monetize through advertising, either. Courtney also said that it was very important to her to maintain complete control over every business and content decision. And because the company would be so closely associated with her, she never wanted to sell it.
At that point in the pitch, I interrupted her and asked if she knew what venture capitalists actually do. She said, yeah, her friend had told her that VCs provide money for startups to help them grow. Well, yeah, I said, but we invest that money to help them grow their revenue and profit. We usually get a board seat and have some level of voting power over the company’s decisions. And ultimately, we make our money when the company is sold.
She thought about this for a few seconds and then very politely said, “Well then, why in the hell am I meeting with you?”
After that, we had a great conversation about ways she might achieve her goals – but I didn’t offer – nor would she have wanted – my VC dollars with their attached strings.
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Courtney Love is not the only person who’s pitched me a startup that didn’t fit the venture capital model. It actually happens quite a bit, and when it does, it’s frustrating for the entrepreneur to get turned down – and it's also a huge waste of their time.
So, I'm going to try to save you from that by explaining how the venture capital model works and, therefore, what kinds of businesses are and are not a fit.
Venture firms like mine seek out high-potential businesses with huge TAMs, or total available markets. We look for businesses that can achieve both high growth and a competitive advantage with the money we invest – leveraging that money to generate way more enterprise value than whatever we put in.
But even if we see that potential, that’s still not enough to be a fit for venture capital. The business also needs to be able to achieve liquidity – that is, someday, it needs to be sold to an acquirer, or there needs to be a market for its stock, either through an IPO or in private sales called secondaries. That’s how we VCs generate the returns that we then send to our investors so that we can stay in business.
The interesting thing about the venture capital model is that many of these types of high-potential companies fail – even after they’ve raised money from us. It turns out that the potential for high returns also usually comes with high risk. In fact, you might be surprised to learn that even the best VCs will have a third to half of their deals fail to return the capital they invested.
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So, you might wonder, with that poor a track record, how on earth do venture firms make money?
Well, the VC model works because of something called the power law.
The fundamental idea of the power law is that in any successful VC’s portfolio, there’ll be a bunch of things that don’t end up working – but there will also be a few that do. Because they’re all risky bets with big potential upside, when they don’t work, we VCs usually lose some or all of the money that we put in. But for the few that do work, their returns tend to be so massive that they more than make up for the ones that fail – and that’s what generates our returns.
Venture capital is a hits business – and in order to attract VC money, your startup needs to have the potential to be that hit. That usually means not only are you addressing a large market, but you have a credible and compelling plan to dominate that market.
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So why does being dominant matter? Well, as Alec Baldwin so famously said in Glengarry Glen Ross – “first prize is a Cadillac, second prize is a set of steak knives, and third prize is you’re fired.”
It turns out that venture capital returns follow this same kind of curve – the massive returns come from the companies that dominate their spaces – and there’s not a lot of prize money left for the ones that don't.
There are a number of business models that can attract venture capital, but the ones that have historically delivered the best returns are winner-take-all or winner-take-most business models.
For example, take operating systems platforms like Microsoft Windows or Apple’s IOS. For these sorts of platforms to be successful, whole ecosystems of products and services need to be developed on top of them. This is really expensive to accomplish and often involves collaborating with lots of other companies over a number of years.
However, once you get a critical mass of products and services on your platform, you can attract users to it. And the more users you get, the more developers will want to create even more things for that platform. And since it’s expensive for a developer to support a lot of different platforms, they’ll pick the one or maybe two where they have the best business opportunity and dump the rest. This means that all those others who aren’t in the top few won’t see their ecosystems develop, which means that they won’t attract users, which means that they’ll probably die.
This business model has another advantage for the winner, in that once those users build up a library of applications and services, it becomes hard for them to switch to anything else. That switching cost serves as a lock-in for the user – which means that the platform company is even more likely to keep them as a customer – which creates even more long-term value for the platform company.
Because a winner in the operating systems market becomes so valuable, many entrepreneurs tried to build operating system companies, and hundreds of millions, if not billions of dollars went into backing them. Ever heard of CP/M, Symbian, or AmigaOS? They all tried to dominate the operating systems market, but for various reasons, they didn’t ultimately succeed. On the other hand, Microsoft and Apple are currently two of the top three most valuable companies on the planet.
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There are other winner-take-all or winner-take-most business models, like marketplaces or social networks. And there are some massive winners in those spaces too, like Amazon and Meta, who are also ranked in the top ten most valuable companies in the world today.
Let me give you an example of the power law in action with some real numbers from another winner, eBay.
eBay was one of the best venture investments ever. Venture firm Benchmark Capital’s 6.7-million-dollar investment ended up being worth 4.2 billion dollars, which was more than a 600x multiple on the investment. Even if you net out all the companies that Benchmark lost money on in that same fund, they still returned 92 times the entire fund because of that eBay outcome.
And while eBay is an extreme example, the power law still seems to be working across the broader venture industry. According to public data, a top-quartile venture firm delivers returns of 20 to 30 percent per year. And yet, also according to public data, 50 to 75% of venture-backed startups fail. So clearly, if venture capital firms are generating those kinds of returns while at the same time seeing half or more of their investments fail – well, the only way I can explain that is with the power law.
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Now, not all venture investments are winner-take-all or winner-take-most businesses. Software companies are often attractive as VC investments because they tend to have high gross margins and benefit from the high switching costs for their users. They also usually charge their customers using the SaaS, or software as a service model, which means that the customers are paying regularly for access to that software. That creates a nice, predictable cash flow model that investors love.
And there are other kinds of startups that attract VC money to capitalize on proprietary technology – you know, secret sauce – which can then be used to build effective competitive moats around their businesses since other companies can't use that secret sauce.
So, your model doesn’t have to be winner-take-all in order to have VC potential. But your model does need to do the following. It needs to leverage the capital you raise to create a much, much bigger amount of enterprise value. And it has to grow large enough and thrive long enough for there to be a liquidity event, usually through an IPO or an acquisition. And if that doesn’t describe the potential of your company, you probably aren’t a fit for a venture capital fund like mine.
And you know what, that’s not necessarily a bad thing. It turns out that the VC model is not a good fit for the vast majority of startups – and in fact, more than 99% of US startups build their businesses without VC money.
There are all sorts of business models that allow entrepreneurs to pursue their passions and generate financial rewards – without raising venture capital. Most will remain private companies, and many will never get sold – those entrepreneurs make their money off the cash flow from operations, not from selling their equity. Some types don’t grow their revenues year over year but instead deliver consistent cash flow that supports their founder’s financial goals without growth. Of course, some of these startups go through a rise and fall, and they may not last forever – but at least while they do, they might provide years of income for their founders.
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To bring this point home, let me tell you a tale of two entrepreneurs: one I’ll name and one I won’t.
The one I’ll name is Josh Wardle, the Brooklyn-based programmer behind Wordle, a game I play first thing every morning. He designed it in his spare time for his partner, who loved word games – he wasn’t even doing it to make money. He posted it online in 2021, and it took off. But he didn’t raise venture capital to become a gaming platform, and he didn’t hire any other people. He just kept working on it, and so far as I can tell, he even kept his day job. The success of the game actually kind of stressed him out – he worried about continuing to come up with new ideas and battling future knockoffs. And so, Josh decided to sell Wordle to the New York Times Company in 2022 for a number reported to be in the low seven figures – so that’s at least a million dollars. And he got to keep 100% of that.
The other entrepreneur I want to tell you about is one I know from Stanford. Like Josh Wardle, he came up with a game that started getting some traction. But because he was in Silicon Valley, he pitched VCs that he was going to build a game platform company, using this early game as the basis and then building on it with lots of other games. And he ended up raising five million dollars from a VC who believed in that potential.
He tried to launch a bunch of new games, but none of them ever caught on. Meanwhile, his original game, as many do, peaked and then started to decline. He spent the rest of the money he’d raised trying to pump up the stats with paid user acquisition. But that didn’t work, and with the game in decline and the money gone, there was no way to keep the company going. He was able to find a large game company that wanted to take on his employees and buy out his intellectual property. And they were willing to pay in the low seven figures to do that, the same amount as Josh Wardle got. However, since that was less money than what the VC had invested, the VC’s fund got all the proceeds, and the entrepreneur got nothing.
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Hey, I’m a VC, and believe me, I want to invest money in entrepreneurs and their startups. But it’s not good for me – and it’s not good for them either – if the money goes into a company whose growth and exit potential won’t ultimately justify the investment. I’ll end up with little or no return, and so will the entrepreneur. And that’s not good for anybody.
It’s only a good deal – for both the VCs and the entrepreneurs – if the money invested is used to capture and hopefully dominate a large market. And it’s usually some type of business that wouldn't have been able to do so without the venture capital.
And though these types of companies are rare, there are enough of them to support a venture capital industry that invested almost 150 billion dollars in the US in 2023 alone. And maybe this year you’ll be one of them.
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I’ve tried to cover the basics of the venture model in this episode, but I’ve barely scratched the surface. So, I’ve put a bunch more information in the show notes.
And if you do decide that venture capital is right for you, and you end up getting a term sheet, you’ll then be faced with another set of decisions to make – because you’ll be trading your startup’s equity for those VC dollars, and you’ll probably also be giving some of that equity to the people you recruit to help you.
So, that's the topic of my next episode. I’m going to cover dilution, that is, how to think about the tradeoff between what you give up and what you get when it comes to your startup’s equity.
But for now, that concludes today’s episode of The Startup Solution. I hope you’ve enjoyed this episode – or any of our past episodes – and if you have, I’ve got a favor to ask. It’s The Startup Solutions’ one-year anniversary, and if you’ve gotten anything useful out of this, I'd really appreciate it if you’d leave a rating or a review on your favorite podcast app. I’m Heidi Roizen from Threshold Ventures, and thanks for listening.
I promised a lot of additional reading – so here goes.
First off, understanding the VC power law is fundamental to understanding the VC business model. Here’s a post about it and a whole book about it!
The topic of whether venture capital is the right way to fund your business is critically important. Here’s a post by VC Erik Berg that nicely captures many of the key points to consider.
Here’s a fantastic article by the New York Times about why some entrepreneurs didn’t take VC.
And here’s a post by entrepreneur Anthony Collias about the pros and cons of taking that venture investment given his experience as an entrepreneur.
A bit dramatic but also the gist of it isn’t wrong – The warning label that should come with VC money.
And for those of you who like stats – here are some interesting stats on startup financing from Fundera, a great infographic on where startup financing comes from by Entrepreneur, and venture investing data from Crunchbase and the National Venture Capital Association.
As for startup failure rates, there’s this piece from Harvard Law School.
Here’s the story about the Wordle creator and his sale to the New York Times.
The Benchmark/eBay story is summarized here.
And last but not least, my Alec Baldwin quote comes from this famous scene in Glengarry Glen Ross.