Venture Investing, From First Principles

wikipolis
wikipolis
Aug 25, 2017 · 11 min read

You don’t change the world without a strategy (ideas) and capital. Nor without a strong point of view regarding each pillar of today’s ecosystem and how it could/should change to be more effective in the pursuit of a future in which we can optimize for time.

How does the ideal fund should look like?

First of all, we must go through a thorough critique of the current paradigm.

Luckily enough you don’t need to take my words on this.

Ubi maior minor cessat. I’ll give you Marc Andreessen’s words.

What he does not say it that the current paradigm is one in which efforts are constantly duplicated and resources squandered and that is more conducive to hierarchies’ perpetuation that to value’s maximization.

Hierarchy Investing

Conceptual low hanging fruits: inefficiencies

The risk-adjusted bit is crucial to explain how the developed world has long stopped growing. An insanely ambitious company like Improbable would not have existed without the founder’s billionaire father.

The current model, despite its fetishism for capital efficiency is grossly inefficient. It’s a model predicated on “industry-level, risk-adjusted ROI and hierarchy-bounded emergence”.

The far superior version I am advocating can be described as “paradigm-level, outcome-optimized, paradigm-bounded emergence”.

Two main inefficiencies

The first is endogenous to the VC model, the second is a more structural approach to r&d, which has an impact on the kind of companies that become venture investable.

  1. VC funds duplicate CAC at each company, impossible to pool resources.
  2. Fear of over-budgeting leads to under-budgeting waste (opportunity cost).

#1. Capital inefficiencies in the VC model

A VC fund is an efficient way to raise capital. Not efficient tout court, of course, but relative to any other option. It also has time tested rules of engament that are, again, relatively efficient.

As a fund, though, you are working for yourself and your LPs. You are funding companies that will have a significant social impacts without the consent of the society they will impact. Since, as a fund, you don’t exist for the customers, you are forced to apply a piecemeal approach to customer acquisition and to duplicate customer acquisition costs because customers don’t buy into an overarching narrative but merely into each single product or service that your portfolio’s companies sell.

Are LPs not concerned that VCs’ portfolio companies have separated customer-acquisition budgets and (most crucially) rely of customers buying into a non agreed upon paradigm? Are they not concerned about the limits of the current model? Probably not. Capital goes where it has more leverage. A Tier1 fund is build upon a porfolio of personal brands and a barrage of PR (both offensive and defensive). The resulting status is then leveraged to collude in Mega rounds meant to kneecap the anointed startup’s competitors, handcuff the founders, raise the acquisition price and bring about self-fulfilling prophecies, even in markets that are not winner that all, or where increasing returns are close to exhaustion. To paraphrase a famous character:”it doesn’t make any difference to me what a man does for a living[…], especially since their interests does not conflict with ours”. Quite the contrary, in fact, they enable them.

#2. Capital inefficiencies in the R&D model

If, as a species, we are to waste resources, we will be much better off wasting them at the basic research level than at the customer acquisition level.

Let’s be clear. Capital efficiency is a relative metric, not an absolute one. And even the relative side is heavily context specific. If the goal is to save fuel you have a set of choices, if the goal is to leave earth’s orbit (wasting as little fuel as possible) you have another set of choices.

Even though over-spending is widely held as the only way of wasting resources, underspending is just as pernicious. It took decades to recognize negative externalities (environmental , social, etc.) as a real costs, hopefully it will be easier to come to a consensus regarding the fact that reaching a goal deemed crucially important (talking fusion energy here, not the nth airport) spending more than anticipated is not a waste. Effectiveness, applied to the right goals, couldn’t care less about efficiency but would also probably not create stellar fiat-denominated risk-adjusted, ROI but this only matters because (and as long as) it’s the only game in town.

Speaking of waste. You know how does waste looks like? Waste is locking researchers into poorly funded projects with the false hope of more resources coming their way. The opportunity costs, in situations like those, are massive. Progress (and its speed) are a function of the researcher’s mindset and the responsiveness of the support infrastructure. Preventing a 1$ waste in “over-budgeting” but wasting 10$ in opportunity costs (due to “under-budgeting”) is a crime, especially given humanity’s pressing needs, the scarcity of time and the abundance of resources (both existing financial resources but also untapped ones).

Waste is using 50% of our waking time to pay for rent and food. We are rightly getting rid of pipetting as inefficient (human errors can lead to serendipitous discoveries, though) but we fail to see the bigger problems because solving them is outside the scope of the ecosystem’s institutions.

Last but not least, there is the opportunity cost of having mismatched talents pursuing sub-optimal objectives because, again, is is well beyong the scope of ecosystem’s institutions to address the problem. The farther apart the talent you are trying to match are, on the cultural spectrum, the harder it is to successfully do it, the more valuable it is. GDP neither measures nor value the human potential wasted because of faulty institutional arrangements.

Resources available for Hierarchy Investing

Let’s see how much money flows, in that VC pipeline.

Debt generates interests. There’s ∼$200Tn worth of it.

Real estate generates income (+ capital gains). There’s $217 Tn worth of it.

Stocks generates income (+ capital gains). There’s ∼$50Tn worth of them.

Some of those yearly gains get allocated in hedge funds ($3Tn and shrinking), some in Private Equity ($4.3Tn, of which $2.9Tn allocated and $1.4Tn in “dry powder”). The two have very different lock up periods. Hedge funds’ lock-up period can be quarters, private equity’s at least five years. Both have started investing in fast growing late stage private companies that decide to stay private longer than in the past.

Just $1.2bn is invested at the seed stage (and only when risk is not deemed excessive)

Hedge fund and Private equity figures represent a stock of capital while VC investment is an annnual flow, but we can compare the amount allocated in US VC (∼$30bln/yr) to the amount (∼$1Tn/yr) paid back in dividends & buybacks.

Even in the leading engine of global innovation capital allocated to VC is not even 3% of the corporate net income distributed to shareholders.

If you include all the money that has flooded fast growing private companies (formerly known as publicly traded companies) the grand total is 128bln/yr, with two orders of magnitude differences (in per capita investments) between countries with similar per capita GDP.

Let’s recap.

Scaling startups is increasingly expansive and, therefore, dilutive.

While starting up is orders of magnitude cheaper than it used to be, Capital is deployed if&when it has a decent chance of winning and it is deployed at the stage in which it has more leverage. Founders get diluted to acquire customers. I think it’s fair to assume that if they had less dilutive means to acquire them (especially in industries that aren’t winner-take-most) some of them will jump at the chance.

Even in the best run portfolios, each startup acquires its own customers and (customers acquisition) costs are horrendously duplicated (at the VC level and at the LPs level).

Why?

Because (even in the best Startup Studios, let alone stock picking VCs&incubators) those startups don’t have a common destination that is clear&desirable enough for an audience big enough to buy into.

What if there was a common destination? Could we not crowdfund that?

Even though equity crowdfunding is no longer reserved to accredited investors, expanding the pool of investors (in a meaningful way) still seems an uphill battle, not just because of widespread lack of capital but also for the equally widespread risk aversion. Even if one were to remove risk, evaluating the value proposition will require filling widespread knowledge gaps by expending a huge amount of the scarcest of commodities: attention.

What if we could have a recurring (Patreon-like) crowdfunding for The Destination?

Most people wouldn’t do that either. You would still need too much money from too few people.

Unless…

Unless?

Unless it wasn’t a digital crowdfunding but an “analogue” one. Unless we were able to tap into a) pre-established consumption patterns and b) pre-established local networks (scalable because they share same entry points and are all affected by the same incentive structure).

Bottom line. The ideal fund would invest in a Paradigm through an evergreen fund with:

  • the best of a startup studio (idea origination),
  • the best of a Tier 1 Incubator (talent matching and partnerships),
  • the best of a financial conglomerate (cost of capital),
  • the best of a sovereign or endowment funds (aligned incentives and long term horizon).
Speaking of talent matching. Peter Thiel, recognize both the widespread bias in favour of organic talent matching and the value in artificial talent matching.

Paradigm Investing

The future is well known for being easier to invent than to predict. Isn’t too bad that nobody has been able to crowdfund their favorite paradigm (yet)?

Well, there’s no reason why things should stay this way.

The crowdfunding need not happen through the intermediation of the Federal budget (more or less) approved by citizens’ representatives, like it happened in the Silicon Valley of the 1950s. Nor it needs to wait for a single person/family to feel confortable with the money he has made. The problem with the former is the principle agent, especially related to the permeability to lobbying; the problem with the latter is the temporal distance between capital stock’s build-up and and capital flow’s deployment. We need a continuous, non-bureaucratic capital flow deployment: money in, money out.

A paradigm boils down to: we are going there, a demand for the destination exist and we can attest that through a) the convertion rate and b) the recurring analogue crowdfunding. A destination is a network effect of products and those that start creating them today will have an advantage over those that will wait for a more widespread adoption (aka a bigger market).

If you can…

a) envision (like in a sci-fi novel) a better paradigm and can

b) work your way back from the paradigm to the network of products/softwares that should underpin it and (there comes the hard part) if you can

c) fund yourself through a recurring crowdfunding embedded into existing behaviors and deliver products that will effectively move the world towards the agreed upon paradigm.

This is the only way to have a shot at socio-political legitimacy (let alone at “once-and-for-all customer-acquisition”).

Provided that you manage to deliver, there should be a self-reinforcing loop of steadily increasing viral coefficient, increasing revenue and lifetime value of customers while decreasing customer acquisition cost and churn.

Is it doable?

Any edifice (intellectual or otherwise) is as strong as its weakest (or, as in this case, untested) part. The untested part, here, is the recurring analogue crowdfunding (REC).

Given that the main incentive, for the consumers, is provided by the “socio-political” goals, let’s explore them a bit more.

The biggest concern, today, is the future of work: what can be automated and what can’t. What kind of work will retain (or increase) its value, what kind will lose it. We know that, for most people, work goes above and beyond its role as financial pre-requisite for life planning.

Globally, manufacturing is a $12 trillion industry (annual spending on ads is little more than $500bn). A spot welding robot costs less than 1/3rd of a human ($8/hr vs. $25/hr) and the gap is only going to widen. (In 1980 it took 25 jobs to generate $1 million in manufacturing output in the U.S. Today it takes five jobs). Since 2000 alone, millions of workers have lost manufacturing jobs paying $25 per hour plus health and retirement benefits. Often the only alternatives were service-sector jobs without benefits, paying $12 an hour.

We know that work provides agency and self-esteem. We also know that there is a wide spectrum of possible equilibria that stand to be determined by interactions (of talent, money and ideas) that are impossible to predict and impossibly complex to fine tune from the outside.

Which is why it is politically crucial to deterministically crowdfund paradigms instead of merely funding startups that passively accept the emergent nature of the future and merely optimize for empire-building within whatever future will emerge. For people who don’t have the option of moving to New Zealand (if & when things go badly wrong) paradigm investing is an insurance policy against socio-economic entropy. We know that evolution works. That’s why competition should happen at the paradigm level, too, not just at the industry level. We should have a market for paradigms and let people chose in which one they want to live.

Just as it takes a skillset to win at the pre-product/market fit level (vs. the post-P/MF) it takes a different skillset to win at the paradigm level that it takes to win at the industry level. If you win at the paradigm level you don’t need to win at the industry level. (similar to what happens between lean applications and fat protocols).

Resources availables for Paradigm Investing

Let’s now take a fresh look at the capital investable in VC. No longer as a percentage of investable capital’s annual flow but as a percentage of annual revenue (Global GDP nominal: ∼$80Tn; PPP: ∼$110Tn). What do you see? Suddenly those $128B no longer represent the ∼3% of the investable capital. They are the 0.16%. You have better believe that net margins are far higher than that. How much higher? Check Aswath Damodaran’s data.

What does that tell you?

Exactly. The power of consumers, even those that live from hand to mouth, to collectively shape the world they want to live in. Their power is much greater than that of the people that rule their lives and they only need to apply a fraction of it.

Of course, most of those industries are impossibly hard to break in. But some are not. Seek inspiration? Look at UK’s ONS for a breakdown of households’ expenditures. Some categories scream as order of magnitude easier than others.

Of course you don’t compete with established companies in established industries by doing what they do. Your battlefield is neither the “what” nor the “how”. Your battlefield is the “why”. Once you nailed the why you need the how to avoid doing what the incumbents are doing.

To the extent that your “why” can motivate consumers to chose products whose profits will be reinvested in R&D you can capture a decent share of those products’ market.

The easiest (and asset lightest) way of doing it would be, of course, through private label products sold to customers who buy into our paradigm. But, as a startup, it could prove tough to be taken seriously by hard-nosed producers, veterans of “shelves warfare” with retailers. Besides, it could be mistaken for a quick scheme to raise money. All thing considered, the best way of doing it would be to demonstrate that we can reinvent the value chain of a single product, from raw materials to distribution. That would allow us to move quickly and with a considerable amount of leverage in establishing relations with both distributors and private label producers.

In Italy alone (60mln people, $2Tn GDP) the market for industrial tomato is $2B but the Ebitda margin is ~10%. A successful reinvention of the value chain can easily double the Ebitda. Even with a negligible market share (1–2%) in a single product, by taking full advantage of the many tax credits available one would become Italy’s single biggest early stage investor. This is how small Italy’s venture capital market is but this is, also, how big the opportunity is. Enough of nickle&diming talents, enough of short-selling them. This is not about Italy, though. Italy is just the beginning. Humanity is sinking while people’s potential is shackled and wasted. Time to unshackle it. Time to let it flourish.

The Recurring Analogue Crowdfunding will finance the development of the tools that will allow, for the first time in human history, to optimize for time rather than for money.

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wikipolis

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wikipolis

Corporate Nationhood (TPP/TTIP/TISA) means (among other things) that Product & OS designers/builders are the new Statesmen

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