We Also Failed to Build a Billion-Dollar Company

If you haven’t seen it, you should read this unusually thoughtful and honest account from a founder who built a company that was successful by most reasonable metrics, but not by venture capital ones.

My experience founding Kongregate with my sister Emily was much more positive, but I felt some of the same things. We became a vehicle for many indie game creators to make a living, which I’m extremely proud of. In our case we also had a sale that was very profitable for the founders and early employees, and also profitable for our investors.

But the weird thing is that if our venture investors had known at the outset that they would have a 3x return on their money in three years, they probably wouldn’t have made the investment. A 50% annual rate of return is not worth their time. It’s not what their LPs are looking for.

A commenter on Hacker News objected:

Any guaranteed return above bank interest rate is appealing for investors. Guaranteed return of 50%/year is an amazing investment opportunity.

You would think so, but no. A VC fund has a finite number of investments to make. Typically a partner gets to say “yes” once or twice a year. They usually take a board seat and spend lots of time helping the company.

Knowing that many of those investments will be worthless, they want to maximize the number of shots they get towards a billion dollar company.

If 1/3 of their companies deliver a 3x return, and the rest become worthless, the fund has failed. They’re all aiming for the one company that will deliver the big returns that offset all the failures (and the high fees they charge LPs.)

This situation — where VCs invest a lot of resources into many opportunities, most of which they expect to fail — makes a VC’s incentives very different from those of investors who come in earlier or later. Our angel investors made more like 6.5x and put in less time — most of them would take that deal all day long. I’m an angel now, and I definitely would. Seed stage investors are different. Y Combinator, for instance, spends much less time with each company, and therefore can take lots of shots.

Growth stage venture firms are different too. They aim to invest a few years before a company goes public, and are fine with a 3x-5x return. They are taking much less risk.

The “go big or go home” VC model creates a fundamental tension between their needs and those of the founders. Founders get one shot at a time. A $50M exit represents life-changing money for them (as long as they didn’t raise too much.) Because VCs need their wins to be outsized, they often pressure founders to take greater risks than are rational for them.

Founders need to keep this in mind, and look for VCs that will truly put the founder first (or they need to keep control of their boards and be willing to exercise that control.)

Joel Spolsky explained this well 15 years ago, so we knew about it going in and chose Greylock, a founder-friendly VC firm. Our partner there, James Slavet, encouraged us to sell when we got an offer that made sense for us. But he also knew that we were not on a trajectory towards a billion dollar outcome.

Joel Spolsky’s Simple Math for VC Returns

Thoughtful VCs will do what’s right for the founder in close situations. This is rational because their reputation matters so much when competing for investments. This has changed for the better since Joel’s post because there’s more capital available and the new generation of venture partners are former founders themselves.

The tension between what is a good exit for founders versus VCs still exists, though. Tim O’Reilly makes some good points about it in this recent long read with the main point that “blitzscaled” companies are forced into decisions that can have negative consequences for society. Tim takes exception with Reid Hoffman’s advocacy of blitzscaling. (It’s worth mentioning that Reid encouraged us to go with Greylock because he knew they would be well-behaved.)

The greater availability of capital has been good for founders, but as Tim points out, it’s been a mixed blessing for society. To be honest, I’m not sure what the answer is.