Venture capital is a game.
A person can learn the game by working backwards from its ultimate metric: cash-on-cash returns (Brian Singerman).
This essay highlights 4 (somewhat) non-obvious and counterintuitive rules of the VC game which derive from this ultimate metric.
1. Avoid non-concentrated portfolios
“The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund.” (Peter Thiel)
Venture returns are not normally distributed; they follow a power law: a small number of companies radically outperform all others. Therefore, a VC must only invest in companies which have the potential to return the value of the entire fund (Thiel), i.e. a VC must allocate a not insubstantial percentage of their fund to each of a small number of companies.
There is an important caveat: “no one can know with certainty ex ante which companies will succeed, so even the best VC firms have a ‘portfolio’.” (Thiel). However, this does not mean that the portfolio should be diversified. A VC must “want every dollar” in a concentrated number of companies (Geoff Lewis).
Key takeaway: To maximise cash-on-cash returns, a VC must have their fund concentrated in companies that will radically outperform all others.
2. Avoid consensus
“Superior performance comes from accurate non-consensus forecasts. But because most forecasters aren’t terrible, the actual results fall near the consensus most of the time- and non-consensus forecasts are usually wrong” (Howard Marks).
“Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right.” (Jeff Bezos).
There are two ways a VC can invest in a non-consensus, accurate way.
First, the asymmetrical way, i.e. investing in unpopular companies. These are those companies which most every other VC is either (i) not looking at/for, or (ii) (un)intentionally passing on. These companies may become popular in the future, i.e. retrospectively predictable to other VCs so that those other VCs seek to participate in later rounds.
In short, unpopular companies:
(Probably) have lower valuations; therefore,
Will (probably) provide (more) asymmetrical returns for a VC.
Second, the symmetrical way, i.e. investing in popular companies. This one is counterintuitive, i.e. how can investing in a popular company be non-consensus? The answer is simple: by investing in the popular company in a way which is non-consensus and/or at a time when investing is a non-consensus decision. An example: DST investing $200mm in Facebook for ~2% at a $10bn valuation. The way DST was non-consensus was investing a great sum (i.e. $200mm) at a time when there was major narrative debate about Facebook’s valuation.
In short, popular companies:
(Probably) have (ultra-)competitive rounds; therefore,
(Probably) will have higher valuations; therefore,
Will provide less asymmetrical returns for a VC; therefore,
To ensure great(er) cash-on-cash returns when investing in popular companies, a VC must invest a greater sum.
[To be clear, a VC investing in an early stage popular company can enjoy asymmetrical returns.]
A point which underpins both the asymmetrical and symmetrical ways: just as a company must aim for monopoly (i.e. high % of (niche) market ownership; Thiel), a VC must aim for monopoly (i.e. high % of company ownership) when investing in companies that will radically outperform all others.
Key takeaway: To maximise cash-on-cash returns, a VC must aim to make non-consensus, accurate investing decisions.
3. Avoid highly profitable companies
“Investing in highly profitable businesses is the most unprofitable form of investing.” (Geoff Lewis)
Investing in a highly profitable company is diametrically opposed to maximizing cash-on-cash returns.
Maximizing cash-on-cash returns depends on what Josh Wolfe calls time arbitrage, i.e. exploiting the positive difference in the value of a company between when a VC invests and when a VC gains liquidity.
Put simply, investing in a highly profitable company severely limits the difference between these two points because while high profitability signals decent past performance, it does not (necessarily) signal great future performance.
“[A] great business is defined by its ability to generate cash flows in the future.” (Thiel)
As Thiel emphasises, a VC must value a company as “a discount on the future, not a premium on the past”, i.e. a VC must invest in companies aiming to “maximiz[e] the present value of future cash flows” (Bezos); not those focused on maximizing profitability.
“Why focus on cash flows? Because a share of stock is a share of a company's future cash flows, and, as a result, cash flows more than any other single variable seem to do the best job of explaining a company's stock price over the long term.
If you could know for certain just two things--a company’s future cash flows and its future number of shares outstanding--you would have an excellent idea of the fair value of a share of that company’s stock today. ” (Bezos)
In short: a company which focuses on maximizing profitability is not a company which is maximizing shareholder (inc. VCs who have invested) value over the long-term (see Rule 4 below).
In any event, investing in highly profitable companies is a poor decision by a VC because high profitability gives leverage to the company, i.e. a VC must pay a premium on each % of ownership in the company.
Key takeaway: To maximise cash-on-cash returns, a VC must avoid investing in highly profitable companies.
4. Avoid short-term investments
“The very best investments are investments that really have staying power and duration as companies… for 20+ years.” (Michael Moritz)
"Our favourite holding period is forever." (Warren Buffett)
VC is a highly illiquid asset class, i.e. the average VC fund is 10 years.
As a VC, liquidity is great; but, liquidity at the right time is best (i.e. when cash-on-cash returns will be maximal).
Put another way, a VC must invest in those companies which will endure so that Wolfe’s time arbitrage is exploited to the greatest extent possible. [Again, it is difficult to know ex ante which companies these will be.]
Two important caveats:
The answer to whether or not (and when and how) a company should exit is particular to the individual company; and
The answer to whether or not one holds stock in a particular company beyond public liquidity event is particular to the individual company.
[In short, these questions are not macro questions, they are micro questions ( Singerman).]
Key takeaway: To maximise cash-on-cash returns, a VC (and LPs) must be patient regarding liquidity.
SUMMARY
A VC must:
Avoid non-concentrated portfolios;
Avoid consensus (with other VCs);
Avoid highly profitable companies; and
Avoid short-term investments.