Why ‘The Next Snapchat’ Might Raise Funding Quicker Than ‘The Next Google’
The Fear of IRR is the Bane of Disruptive Innovation’s Existence
For the purpose of this post, I use the phrase ‘The Next Snapchat’ to refer to products that reach $1 billion+ private/public market valuations while only instituting infinitesimally small incremental change in the lives of a mostly 1st world consumer audience. Products in this category are typically applications built on existing platforms and mostly help people solve ‘problems’ that are non-existent to the vast majority of people outside of the 1st world e.g. sending a ‘Yo’ to a friend with a push of a button as opposed to 3 button pushes via text or sending transient photos or videos of one’s person and/or surroundings to a group of friends.
These are the ‘I could have built that in one weekend if only I thought of it first, but I didn’t’ type of ideas that can go from $0 to $1 billion in less that 3 years on little or no revenue and mostly on virality based metrics.
I use the phrase ‘The Next Google’ to refer to technologies that come with significant investment risk but that aim to serve as the backbone of a fundamental paradigm shift that positively impacts masses across all financial strata in both developed and developing nations. This category includes transformation technology whose founders might be out of academia or might just be crazy people who genuinely believe that they can succeed at creating a technology or process that could fundamentally change the way the world works and push the entire human race a couple of steps forward.
The technical feasibility of such products is usually not necessarily fully proven and such products don’t right off the bat have the short term virality potential that their counter parts in ‘The Next Snapchat’ category have. It usually takes lot of investments of money and time to get them to a point where they achieve their full disruptive potential.
To understand why a lot of venture capitalists today will more naturally throw their cash at products in the former category, it helps to understand the high level structure of VC funds, what IRR is and how it comes into play in measuring a VC fund’s success or failure.
What is IRR & Why Does it Matter?
Not unlike the entrepreneurs that they fund, VCs have to raise money. They raise money from Limited Partners (LPs) which typically include Institutional Investors (Pension Funds, Endowments, Foundations, Pensions, Insurance, Funds of Funds) and Families (High Net Worth Individuals & Family Offices).
The LPs above invest in a number of other asset classes and Venture Capital is a small sub-asset of the Private Equity class. As LP investor, Chris Douvos puts it (culled from ‘The Business of Venture Capital’):
If public markets are like an ocean — multi-trillions of dollars at work — and private equity is a bath tub … say $300 billion a year … venture capital is like a small sink …
Consequently, venture funds need to compete for a relatively limited pool of LP dollars, and LPs on the other hand measure the performance of Venture Capital funds using the IRR (Internal Rate of Return), in order to gauge which firms to continue to invest their limited venture capital asset allocation into.
The IRR is a function of time and varies inversely with elapsed time i.e. a 2x return 3 years after investment will translate to a 26% IRR while a similar return 10 years after investment will translates to a 7% IRR. So quicker exits generally look much better for a VCs fund.
When LPs rank the top decile fund, they do so based on the net IRR for the most part. And seeing as the IRR varies inversely with elapsed time, an acquisition of the ‘The Next Snapchat’ by Google for $10 billion 3 years after an initial investment is much better for a VC firm trying to raise subsequent funds than an similar investment in a hard science/engineering company that could easily spend a decade and tons of subsequent cash investments trying to wade through completely novel technological waters and possibly trying to institute tremendous change in global consumer behavior in a new or existing category.
So while some VCs claim to or might genuinely want to invest in world changing technologies, the fear of taking humongous bets in a number of companies that fit the profile of the next ‘The Next Google’ which could ultimately negatively impact their IRR and threaten the future of their firms mostly outweighs the zeal to actually fund the future. This is why most settle for companies with growth and adoption metrics similar to companies like Snapchat that have gone from $0 to $1 billion+ in only a matter of 2–3 years.
All hope is not lost for longer term plays solving extremely hard problems. Some firms still actively block out short term noise and remain focused purely on finding companies that can institute radical change in the long term. Peter Theil’s Founder’s Fund for instance states in its manifesto that that they seek to invest in “smart people solving difficult problems, often difficult scientific or engineering problems…” and their relatively small portfolio which includes companies like Oculus, SpaceX, Palantir & Knewton seems to support this manifesto.
Founders Fund is not the only VC firm that funds disruptive innovation, some other firms like A16z and Khosla ventures have a good number of hard science/engineering investments in potential ‘Next Googles’ in their portfolios. The hope is that more VC firms overcome the short term fear of IRR and take bigger and longer bets in more disruptive companies and that the LPs that fund them will be much more open to exploring such long term bets.
If VCs don’t fund disruptive innovation, there are not too many other option out there for young transformational companies. After all, the investor Arthur Rock, often credited as one of the fathers of modern venture capital, was most likely thinking mostly about long term potential for instituting disruptive change when he painstakingly worked to help raise funding for the eight scientists out of the Shockley Laboratory Division known as the traitorous eight whom no one in more traditional funding channels agreed to fund back in the 50's. After tons of rejections, Arthur Rock would eventually convince Sherman Fairchild to back the group, and this set into motion a series of events that led to the birth of both Silicon Valley and modern venture capital.
It is very possible that Silicon Valley as we know it today would not exist if no one took the long term bet on the traitorous eight and the technically challenging problems they were trying to solve.
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