If you missed part 1 – the big ideas from Dixon – you can find that here. This is part 2 and it’s all about venture capital.
These notes are from Shane Parrish’s conversation with Chris Dixon on the wonderful The Knowledge Project podcast.
Why should companies stay private?
Parrish asks why companies – like Uber – stay private. There are two reasons Dixon says. First, there’s plenty of money in the private markets. Huge public companies like Fidelity, have access to the private markets and companies like Uber don’t need to go public to raise money. Second, companies can keep a long term vision. The technology sector, Dixon says, perceives markets as too short term oriented.
Seed, series A, series B explained.
Dixon defines the different types of funding.
Seed funding (aka Angel) is investing in 1-2 entrepreneurs with an idea. This round might be for 1-2M$.
Series A is investing in a small team with an initial product. This round might raise 10M$.
Series B is investing in a company with some traction that needs money to grow. This round might be 20M$.
It’s helpful to know the nomenclature, but the big idea here is when Dixon talks about prorata rights. It’s briefly covered in the interview and worth expanding on here. Prorata rights are the option for a company to maintain their same funding level. If you invest 1M$ for 40% in the seed round, having prorata rights means you get a chance to invest enough to keep your 40% position during the Series A round. Here’s the key part of this, you get to but you don’t have to. Prorata rights are optionality.
Don’t take my word for it. Mark Suster wrote, “this (the prorata right) is important for nearly every institutional investor because once you have 25-50 investments being able to “follow” the investments that are working well is critical to making money.” Suster is explaining that VC’s expect some companies to do better than others – and it’s those positions that should be held on to.
Fred Wilson, another VC, wrote much the same thing. “I think this is the single most important term anyone can negotiate for in a venture capital investment….The meta point I have come to understand about early stage investing is that a small portion of your investments produce all of the returns. In those investments, you want to own as much as you can.”
An investor – like Dixon – will only invoke their rights for companies that are doing well. This post includes other examples of optionality. To think well, we need to think about having options.
On a post at his site Dixon writes about the Babe Ruth Effect. “Great funds lose money more often than good funds do. The best VCs funds truly do exemplify the Babe Ruth effect: they swing hard, and either hit big or miss big.”
Dixon says that about half of all a16z investments will fail, some will have moderate success, and some will be huge hits. It reminded me of what Seth Godin wrote, “it’s not always easy to measure what matters.”
VC wants a high slugging percentage. Baseball wants a high on base percentage. Different domains want to measure different things. It’s valuable to figure out what matters most.
The people or the product, the lyrics or the music.
In high school my group of friends used to argue whether the lyrics or music were more important to a song. One friend was a huge Dylan fan so he clearly favored lyrics. Another was a guitar player, he preferred the music.
Startups have a similar paradigm, the person or the product. Dixon makes it’s clear – invest in the person.
“It’s 90% people and 10% product at this state (Series A),” Dixon says. “At this point we know that the idea will change.”
Dixon explains that when Dropbox was founded in 2007, mobile wasn’t a thing. The company was founded to share documents between computers. Things changed. Dixon expects to pivot and looks for opportunities with good people. But sometimes things go bad.
“Some reasonable percentage of time the entrepreneur does everything right and things happen,” Dixon says. Google releases a competing product. The FDA rejects an application. Stuff happens. The hard part is figuring out what was due to luck and what was skill.
Michael Mauboussin provides a good framework to dismantle skill and luck. The more purposefully you can lose, Mauboussin said, the more skill is involved.
Imagine a tennis match. I could easily return each serve out of bounds and lose. Tennis is heavily skill based.
Now imagine investments. I could pick stocks that I thought were bad and maybe win or maybe lose. There’s more luck in stock picking than tennis. Some stocks labelled “sell/bad” outperform those labeled “buy/good.”*
Finally, imagine a slot machine. I could pull on the lever all day, chanting mantras and burning incense and nothing would change the odds. That’s all luck.
To successfully identify an outcome as skill or luck one needs to figure out where on the spectrum they are.
Dixon cleans up the situation with what he calls “Founder-Market fit.” That’s too much jargon for this site. We’ll call it “The Nic Cage effect.”
The Nic Cage effect.
I always wondered how Nicolas Cage didn’t make good movies. He won an Academy Award early in his career! Doesn’t that mean he’s a good actor? No, it means he was a good actor in that roll.
There are great actors for sure – Meryl Streep we’re looking at you – but a lot of it is about matching the person and the roll. I disliked Amy Poehler on Saturday Night Live, but Leslie Knope on Parks and Rec is my favorite character of all time.
That’s what Dixon look for. He says there are three ways founders fit well.
The technical founder. Dixon says that technical expertise (coding) is one way a founder can be good. The business aspects, Dixon says, someone can learn on the job, but not the other way around. Both Jimmy Wales and Mark Cuban are examples of this.
The cultural movement founder. The final type of successful founder is one who’s part of a movement. Dixon says that the Airbnb founders fit this mode. Matt Barrie fit the freelancing movement.
If a founder fits, Dixon has another filter, the maze.
The question is, what do you do in the maze?
Dixon says successful entrepreneurship figure out the maze. In startups there will be moments of confusion, disorientation, and wanting to resign. Really obsessed founders, says Dixon, will have thought about these dead ends and considered options for what to do next. And there are always dead ends.
“I’ve almost never been involved with a company that didn’t have moments of almost failure,” says Dixon.
That Dixon uses the analogy of the maze is interesting. A lot of successful people reframe challenges into puzzles, situations into games. In Surely You’re Joking Mr. Feynman, Richard Feynman said he couldn’t “do” good physics. But when he decided to “play with physics,” “it was like uncorking a bottle.”
Ray Dalio writes about this in Principles:
“I learned that there is an incredible beauty to mistakes, because embedded in each mistake is a puzzle, and a gem that I could get if I solved it, i.e., a principle that I could use to reduce my mistakes in the future.”
Many people use games as a filter to make solving problems fun. If you want more on that try Jane McGonigal’s book; Reality is Broken.
Thanks for reading, I’m @mikedariano on Twitter.
*One year ago (September 2014), ⅓ of financial analysts had “Sell” ratings for Clorox (CLX) and Campbell Soup (CPB). If you wanted to sabotage a portfolio that seems like a good place to start. But you’d only sabotage your success, because those stock soared. Those stucks are up 26% and 18%.