More than a decade ago I was privileged to meet Jim Collins who spoke at an Access Fund event. As a lifelong climber, Jim spoke about his provocative article that I re-ready yearly, relating lessons from climbing to business: the concept of “fallure” vs. “failure” — failing after you commit to go all-in vs. giving up right at the cusp of failure, which look the same externally but are drastically different internally; and not letting the probability of failure overshadow the consequence of failure (and vice-versa) — exactly why so many Stanford MBA graduates opt for entrepreneurship.
The same mantra applies to the other side of the table. When a $3B unicorn fails and takes $900M in funding with it, what are the consequences to its investors?
Following my post about venture risk from 2 weeks ago, let’s take a look at the math. Jawbone’s Series A round was led by Khosla Ventures, one of the most renowned venture firms with $2.75B in assets under management and 60 liquidity events (10 IPO & 50 M&A) among the 281 companies that they have invested in. Assuming that Khosla targets 3x returns for their limited partners (higher than the 2.56x average from HBS professor Bill Sahlman’s 2010 study), they need to reach $8.25B in exits.
VC’s typically own 20% of their portfolio companies, meaning that the total value of Khosla’s exiting companies must reach $41.25B to provide their targeted return. If we assume that their investments follow the average distribution as per CB Insight’s venture capital funnel with 28% success, they should reach 78 exits (18 more liquidity events in the future), with an average valuation of $530M for each exiting company.
Net — among their 281 investments, they need 78 Angie’s Lists or 1 Uber. Is it any wonder that they swing for the fences?
And what if they miss? VC’s typically follow the rule of two and twenty, whereby they charge 2% management fees and take 20% carry of profit when their companies exit. In the case of Khosla’s $2.75B assets under management, this equates to $55M/yr in management fees — assuming 20% marketing & overhead costs, this leaves $44M to split among their 16 investment and operating partners: a hefty paycheck that qualifies for the top 0.1%, but not quite FU money. If Khosla reaches their stated exit goal, then their 20% carry equates to an additional $1.1B payday — that’s FU money.
For VC’s, the probability of failure is high but the consequence of failure is low / the probability of success is low but the consequence of success is high, so it’s only rational that they swing big and take a lot of shots on goal. There are 898 VC firms that invested in 7,751 companies in 2016 according to the National Venture Capital Association, meaning that VC firms invested on average in 8.6 companies last year. Compare that to 3600 Private Equity firms that invested in 3,538 companies according to Pitchbook’s annual report, for an average of 1 company per firm.
A different way to train
On his podcast last week, my friend and climber / trainer extraordinaire Kris Hampton, the founder of Power Company Climbing, interviewed Lantien Chu the inspirational swim coach at Lander High School in Wyoming. Coach Chu’s team has won 21 consecutive state titles without ever cutting a swimmer, and some of her students don’t even know how to swim when they join the team. How does she do it? By being in the business not of building swimmers, but building humans.
Her team has won a few state competitions without any winners in individual events — it’s the performance of many second, third, and fourth place finishes that pushes them to victory above competitors that are always seeking 1st place in individual events. It’s great when she has star performers, but there are never enough so it’s not sustainable for her to rely on them. In other words, she has formed her business so that even with a high probability of failure at an individual level, the probability of failure is low at a team level. And in her business, the consequence of success at a team level = success for the individuals.
Coach Chu doesn’t swing for the fences, hits few home runs, and wins lots of championships. I’m all in favor of going after home runs — the Mark McGwire / Sammy Sosa Home Run Chase Season of 1998 was the last time that I was actually interested in baseball — just as I’m an ardent supporter of the VC industry considering its disproportionate impact on job creation and R&D in the American Economy. $69B was invested by VC’s in 2016 as compared to $650B by Private Equity: 1 in 10 equity investments sound like the right number that should be going for the long bomb.
I’m glad that others are out there swinging big. I’ll instead go after championships with my strength at driving in runs. Or to bring the analogy back to climbing, you won’t find me free-soloing a big wall like Alex Honnold. You will find me road tripping with a collaborative community, pushing our own limits on 5.12’s — building ourselves as humans. For those 5,500 entrepreneurs who were venture funded in 2016 that will fail, how many of you want to attempt your next ascent with me?
This article was originally published on Jul 20, 2017.