startups
MISSING SUBTEXT

How to Invest in Startups (As a Founder)

Does the "power law" math that VCs espouse really work for founders?

January 30, 2020


You should try to limit yourself to opportunities that could be $10 billion companies if they work (which means they have, at least, a fast-growing market and some sort of pricing power).  The power law is that powerful... the data are clear—the failures don’t matter much, the small successes don’t matter much, and the giant returns are where everything happens. - Sam Altman

Sam Altman recently posted an article called How to Invest in Startups. He has so much experience I’m confident in his advice for people we traditionally see as investors (i.e. VCs).

But what about for founders? People are always reminding me that “founders are the primary investors in their companies” and “founders should evaluate companies just like investors because they are really just the earliest, biggest investors.”

Now that I’m 3 years into my first startup, I can see that this cliche is actually understating it. The financial investment is big, but the emotional, physical and time investments are all probably more significant.

If you’re not already rich, the main thing you have to invest in startups is your time, energy, and expertise. Sam’s post didn’t address the idea of founders as “investors” so I wanted to explore that idea a little bit further.

Should founders “invest” in startups?

The easy answer is that you probably shouldn’t.

The brilliant financial blogger Jim Collins has a great post about why your house is a terrible investment. His thought experiment starts: “we’re always talking about good investments. What if we came up with the worst possible investment we can construct? What might that look like?” Then he compiles 20 common features of houses and why they are terrible investments such as: 

It should be illiquid. We’ll make it something that takes weeks, no – wait – even better, months of time and effort to buy or sell.

And:

It should be expensive. Ideally we’ll make it so expensive that it will represent a disproportionate percentage of a person’s net worth. Nothing like squeezing out diversification to increase risk!

You could write a similar post about why startups are a terrible investment:

  • They are illiquid. It can take years for your startup to accrue any value and even then the market for buyers is small.
  • They are un-diversified. Startups are so all-consuming that startup founders’ eggs end up in one basket!
  • And boy is that basket risky! The startup failure rate depends heavily on how you count, but I think most agree it’s very high.
  • They are an intense drain on the investors (aka founder)’s cash and emotional reserves and can lead to expensive health problems via stress.

And so on…you get the idea.

This is where all the talk about “power laws” loses me as a founder/investor. I get that it makes sense for VCs: they are diversified, they can get some liquidity from the “greater fool” in the next round, they aren’t emotionally invested, etc. But for founders?

Still, if you believe entrepreneurs, its still a great time to start a company. I agree:

  • The cost of running a business is so much lower than it has ever been.
  • There is so much free and cheap advice in the form of blogs and forums and books from on startups.
  • We have more collective wisdom as an industry. We’ve learned and survived the heady times of the Dot Com Boom. There are so many incredibly smart people with decades of success building businesses that you can learn from.

Expectations

How can we make founding a startup a better investment? Knowing what you’re aiming for is a good start.

Financial

What’s a reasonable financial target to beat? For many the best financial investment might be working at a FAANG company. That’s possible for a pretty small subset of the population but a reasonable upper bound.

Plug in your own numbers, but let’s generously assume you get hired by a FAANG company and you make $300,000 a year. Meaning your after tax take home pay is: $185,000.

You are extremely rational and frugal and so you live on a very modest $50k in San Francisco which means that you are diligently putting $135,000 a year into Vanguard’s Total Stock Market Index Fun (VTSAX). Assuming a 7% annualized market return for 10 years you will end up with $1.85M in the bank. Very nice!

(This is a very simplified view. Of course you’ll probably get raises and of course this strategy has plenty of risk. But hopefully it gives a nice baseline. )

How can we maximize our chances of beating $1.85M after 10 years as founders?

Owning 33% of a company that sells for $6.6M would do it (assuming 15% long term capital gains tax for simplicity).

Depending on the industry and growth rate that could be a business generating between $660k and $6.6M in annual revenue. (Fast growing SaaS companies in a valued market could command a 10x premium or more while a slow growing business with worse margins might command less).

Even if you don’t have the opportunity to sell, owning 33% a multi-million dollar business could net you a pretty nice salary!

So a reasonable target is to try to build a $3-6M ARR SaaS business. Once you’re there, there is obviously room for upside, but I think that seems like a good starting point.

Human Capital

Another way to de-risk a startup is to think of it as an investment in human capital. You will learn so much by starting a business you can compress a decade of career growth into a really short period.

I don’t think most entrepreneurs “invest” in their startup because of financial upside. Mostly they do it for the challenge and the satisfaction of building something cool and creating wealth. They do it also to learn and to have some freedom in their schedules and the work that they do.

This is hard to quantify so I’m just going to mention it in passing for now and focus on the financial side. But it should be considered a nebulous plus in the column of entrepreneurship.

Meaningful Exits

Not all businesses are startups. Paul Graham’s essay Startup = Growth explains the distinction between startups and small businesses:

Let's start with a distinction that should be obvious but is often overlooked: not every newly founded company is a startup. Millions of companies are started every year in the US. Only a tiny fraction are startups. Most are service businesses — restaurants, barbershops, plumbers, and so on. These are not startups, except in a few unusual cases. A barbershop isn't designed to grow fast. Whereas a search engine, for example, is.

We can all agree that barbershops are relatively low-risk, low-reward ventures.  You don’t have to answer the question “do people need this?” because there are thousands of barber shops all over the world happily serving their local markets. But they aren’t startups because they’re limited by distribution and low barriers to entry (i.e. low margins) and so can’t grow much.

For a long time I took this to be further evidence of Sam Altman’s claim from How to Invest in Startups

You should try to limit yourself to opportunities that could be $10 billion companies…

I read Peter Thiel’s Zero to One in which he makes a similar case for the importance of picking businesses that can become monopolies. But then I started to wonder: is it really so binary? Can’t I build a technology business that has high margins and wide distribution that isn’t a $10B business? Aren’t companies like Basecamp, Github, Zapier, Wistia, Buffer etc. proof that it’s not Barbershop or Billion-dollar IPO?

Technology businesses are getting cheaper to build. You should be able to build high margin, high revenue per employee, widely distributed products for extremely large markets easier than ever.

Sadly, I know founders who have built $50M+ ARR businesses that are considered “zombies” because they bought into the power law model of startups. They could have build wonderful businesses that were fulfilling and financially rewarding to the founders and employees. Instead they are “failures” because the expectations are $10B or bust.

In Meaningful Exits for Founders Bryce Roberts lays out (Bryce’s fund Indie.vc is an investor) some sobering facts: 

A founder selling at the Series D price of $210M, would make the same amount of money at exit as they would have if they’d sold for $38M after having only raised a seed round
Lifetimes of work and risk lie between a Seed round and a Series D round. And, despite increasing the value of the underlying business 7x, the dollars at exit for the founder remain roughly the same. It is also worth noting that an exit at $210M would not even qualify as a home run for even the smallest fund in Sam’s examples.

Building a profitable, sustainable business with the potential to sell for $38M seems much easier than a $10B business (and doing the former doesn’t preclude the latter - e.g. Atlassian and GitHub). And from the founder I know who have done really well, the best times are the early days post seed when you are in control of your destiny.

How to De-risk a startup for a founder investor.

Is it?

Avoid Winner Take All Markets

Winner take all markets exist. Think Facebook and LinkedIn. These are markets where built in dynamics create natural monopolies. If you win you will be ridiculously rich.

The thing is, these markets are cutthroat. Definitionally, you must win all of the market! You must move fast. These markets are great for VC. They are lottery ticket markets. Lottery tickets are fun, but are they a good investment?

Other markets don’t have this dynamic. You want a large enough market with enough variation in preferences and limited network effects so that many flowers may bloom (e.g. application lifecycle management (Atlassian) or project management (Basecamp).

Avoiding winner take all markets affords you time and prevents the need to overspend and to raise dilutive capital. You can grow organically which will mean that you can get those word of mouth affects Sam is talking about (think GitHub in their early days). This allows you to preserve equity but also to build a really good product instead of joining a gold rush.

Note: this doesn’t mean go after small, niche markets. The bigger the market the better! But just avoid network effects and winner take all. Many IPOs and billion dollar exits started in these kinds of markets.

Avoid Steroids

Raising more cash seems like it would de-risk a startup. But there is a risk if you are using steroids to grow artificially.

Raising too much money gives you the alluring but dangerous ability to over hire and to sell things for $.80 that cost $1 to make. This is very risky!

Startups are so inexpensive to run these days! So many tools are available cheaply. You can do so much with so little and so flexibly using: AWS,  Upwork, Google Apps for Business ($5/user/mo), etc. And there is so much competition that these products get better and better and cheaper and cheaper every year.

The expensive part of starting a company is people!

Hiring people before product market fit slows you down and drastically shortens your runway. The two leading causes of death for startups.

Maybe forcing yourself to become ramen profitable before you hire anyone is a good hack for de-risking your startup. It allows you to avoid the fallacy that hiring more people will help you grow faster (do things that don’t scale, fatal pinch) and put a bad idea on life support.

I think founders loose a lot of time (their most valuable asset) investing in ideas that are not healthy enough to live on their own without massive injections of outside capital. For every Uber and Groupon (which still allowed the founders to cash out) there are many failed companies that sputtered along on bad unit economics for a long time.

Keep Optionality

If founders cannot have diversification, they can at least have optionality. Having multiple options for success increase your chances of success. “Zero to One” is a good title for Thiel’s book because things are so binary. Chasing a $10B company is narrow path. You either do it or you fail.

But what if selling for $10M would be a success? What if running a sustainable business and giving your employees Fridays off in the summer started to feel like success? What if paying yourself a big salary for 10 years felt like success? What if you could spin off cash to invest in other ideas and become your own VC was success? What if you stumbled on a rocketship market and end up IPOing?

Having all of these available as potential options seems like a good way to increase the odds of success.

I’m not criticizing VC here. I think they are probably right about the power law thing. But founders should be aware of this and build it into their own risk-assessment for their startup.

(Also, a lot of VC’s are starting to say this very loudly, to their credit. I don’t think this is their fault. It’s on us as founders who crave the security and safety and status their money offers to think twice before reflexively raising big rounds.)

Have a Long Time Horizon

Most people overestimate what they can do in 1 year and underestimate what they can do in 10 years.” - Bill Gates

We've all probably heard Bill Gates’ famous quip but many of us have failed to internalize it.

If you worked as hard as you can on something for 10 years, there is a very good chance you would be successful. Because there is a lot of value to working on something really hard for a long time and becoming an expert. A 10 year horizon allows you to learn and grow and develop expertise. You can evolve in that amount of time. And so if we have a more modest goal of hitting $5M or more in ARR in 10 years that seems pretty achievable.

Don’t expect to be successful right away. It might take several iterations on your idea.

I don’t think you should patiently work away on a company that is going nowhere and try to just drag that out as long as possible. But I do think you should give yourself the time to let the magic happen. The magic of showing up, listening, paying attention, trying experiments and not giving up.

What test can you use to make sure you’re not being too conservative? Revenue. If you don’t have a lot of cash on hand, you’re always chasing revenue. And chasing revenue is very clarifying. If you raise millions and have too much runway, revenue feels less urgent. Running close to empty should keep you on high alert, a great risk management strategy!

Implications

If I were to sum up an overly-simplified version of VC/startup wisdom that I think many in the community are implicitly operating under it would be this:

  • Raise as much as you can in order to…
  • Hire the most talented (i.e. most expensive people) in order to…
  • Chase winner take-all, monopolistic, $10B+ problems/markets and…
  • Go as fast as possible to win the market and…
  • Figure out revenue and profitability and unit economics later

If you are a highly-diversified VC and playing a power law game, I think this makes sense. But if you are a founder/investor with one bullet in the chamber you would be better to do something more like this:

  • Keep as much equity as you can
  • Hire only when you must (with revenue from customers)
  • Choose massive but patient markets
  • Let revenue be the guide that keeps you honest and tells you what to do
  • Maintain a long time horizon with revenue as your guide

Seems like a fairly different playbook for those of us wanting to invest our time and energy into startups.

Notes: This is not meant to be an anti-VC post. I think VC’s are awesome and can be helpful. But they are a powerful and well funded industry. And I think it’s good for founders to think about a new narrative. I am probably simplifying and ignoring a lot of things. I’d love to hear where I am! Please email team@bluecanvas.io with comments for how we can make this better.

More like this