The Transformer Startup
Tremors, groanings, and the fat tail future of early-stage investing
For years, founder decision frameworks have pointed toward an approximate true North: growth. How do you know if some thing is the right thing? “Ask yourself if it creates growth. If so, do it. If not … why bother?”
The needle of that reliable compass has started bouncing lately. “Growth at all costs” has entered the zeitgeist as a pejorative. And as an opposite — but by no means equal, not yet — reaction to the growth hacker nation, a new wave of founders and investors have appeared. Their rallying cry? Sustainable growth through profits:
Even Paul Graham, author of the essay “Startup = Growth” that became an industry manifesto and rationalized VC funding for the sake of growth, is piling on:
Into the Fog
For some founders, this shifting investor focus will feel like business as usual — the shroud of uncertainty is a constant companion; still others, burning through cash in pursuit of a dream, believing the next round is just ahead, likely won’t find a safe place to land.
Fred Wilson — a VC with early investments in unicorns like Twitter, Zynga, and Kickstarter, spent some time looking into this Bermuda Triangle between customer growth, revenue, and profits and wrote:
“It got me thinking that there is something about tech, particularly venture capital-backed tech, that allows us to operate for what seems like forever without a need to generate self sustaining profits.” — Fred Wilson, The Profit Motive
Fred continues: “This can be a fantastic way to generate value when the opportunity is large enough (Google, Amazon, Facebook, Twitter, etc). But it is not a fantastic way to generate value when the opportunity is constrained, either by a smallish market size (TAM) or by a ton of competitors (little to no barriers to entry) or a number of other factors.”
The line along which Fred chose to make this distinction — opportunity size, is insightful, perhaps even the beginning of a rubric that a founder could use to inform a new way of thinking. For now, however, his conclusion is a bit of a cliffhanger: “We don’t seem to value [profits] in the tech/VC/startup world very much. Maybe we should.”
Chris Savage, co-founder and CEO of Wistia, hit on the same notion, from the seat of a founder that’s been on — and off, the VC train:
While Fred mused it’s when the opportunity is constrained, Chris outlines the trappings of VC, but doesn’t mention opportunity constraints. In other words, passing on venture capital isn’t due to modest ambitions.
Rand Fishkin, the founder and former CEO of Moz, a business with more than $45m ARR, has launched a new startup called SparkToro. Rand explains the crux of the challenge he and his co-founders faced in finding the right kind of funding for their latest venture:
We spent a lot of time discussing the frustrating binary (succeed on a massive scale or die trying) of the classic tech startup model, and how we might craft a creative structure that would allow for the potential of a huge outcome without forcing an unhealthy growth rate or a destructively impatient approach.
So what’s the takeaway? “Venture capital isn’t for everyone”? This is true, but it does a disservice to the stories that have come to light recently, and painfully, as founders like Joel Gascoigne reach incredible heights but nonetheless choose to disembark the VC train in favor of an organic growth path by paying back their investors.
This pithy slogan also slips into classism, leading to unhealthy friction. Presumably, Harvard also isn’t for everyone either. Yet Chris, Rand, and Joel are just a few of the world class founders that feel the venture industry isn’t meeting their needs as entrepreneurs. This can’t be about the pedigree of the startups in question.
If VC isn’t for everyone, why not? And what is?
Running in Place
It’s hard to move forward with a takeaway like “VC isn’t for everyone” because it’s a negative statement in the literal sense, creating more questions than answers. If VC isn’t for everyone, why not? And what is?
It’s possible that VC isn’t for everyone because VC hasn’t kept up with the needs of entrepreneurs at large.
In September 2010, Paul Graham praised convertible notes, imagining “what high res fundraising will do to the world of investors.”
Eight years later we’ve gained efficiency through angel syndicates, validated novel fundraising techniques like crowdfunding, and tried new structures like SAFE’s … but the rules of the VC game remain largely intact: founders prepare, practice, and pitch; VC’s pontificate and profit — or don’t, and write it off.
It’s been argued that this modus operandi is only logical, viz. the Babe Ruth effect — 60% of VC returns come from 6% of investments. Investors swing hard because grand slams are rewarded so much more handsomely than doubles and triples. It’s the simple math of venture.
Is this why VC isn’t for everyone? In its current incarnation, yes. But should that be the end of the story? “(insert industry here) is a hits-driven business!” is the refrain of antiquated business models. See: Toys ‘R’ Us, Barnes & Noble, Hollywood, music. There’s no point in allocating shelf or studio space to those long tail of niche toys, books, or artists instead of Malibu Barbie, Oprah’s latest choice, or whoever’s hot this season. I’ll lean on power laws and wager Taylor Swift has returned more cash for her producers than any other artist in their history by a margin that breaks the chart. (Fact check: turns out she is responsible for 34.6% of their revenue).
While most incumbents continue to point to the inescapable math of the distribution, some financial innovators have been openly pondering the long tail. Most recently, Rob Walling referred to TinySeed as “venture capital for the rest of us.” While the terms and structures of his and Einar Vollset’s new fund are still unknown, this sentiment is directionally correct, sufficiently at odds with the traditions of the industry.
So if home-runs-only is an antiquated (pre-Internet) business model, why has it remained the way VC’s do business? 
Moving VC Online
As with many disruptions-in-waiting, the main culprit is the mental and physical shelf space required to make VC work. Shelf space is a useful metaphor because it implies scarcity at the point of sale, and check-writing is, to this day, primarily an offline, manual process. This means venture capital has more in common with manufactured items, like cars, dishwashers, and iPhones, than platforms (ironically the kind of businesses in which VC’s love to invest).
In contrast to platforms, which thrive as economies of supply-side abundance which they serve by aggregating demand, VC firms are bespoke manufacturers — veritable florists, selecting, trimming, and arranging startup flowers into portfolio bouquets. They place a relatively small number of bets each year, spending human time and effort on sourcing and diligence for each bet, and committing to a high level of touch for each investment (board seat, value-add activities).
Prudent, yes, but a lack of speed isn’t inherently virtuous. The slow metabolism of most firms is an impedance for founders needing quick answers.  But this cycle exists and perpetuates because, like many manual operations to this day, the dexterity required to select and pick items is beyond the realm of machines. In other words, the first links in the value chain — cold email to partner’s meeting— have not yet been mechanized. Or if you prefer the Marc Andreessen formulation, “software hasn’t yet eaten it.”
How could software eat VC? The first step is to standardize packaging and protocols. As Rob Pike observed, “Data structures, not algorithms, are central to programming.” Consider again the physical supply chain: global trade in the physical supply chain positively exploded with the adoption of the standard 53' container. Before that, bags and barrels filled the bellies of galleons, and longshoremen hauled them off with hooks and pulleys. Now, 90% of the world’s goods travel in containers with strict widths, lengths, and weight limits, enabling cranes, ports, and thereby nations to exchange value at an efficiency previously unimagined.
What about venture? Bryce Roberts highlighted the four reasons that seed stage investing scaled over the past decade; all of them appeal to familiarization with standard ways of labeling, interacting, structuring, and staging capital. In other words, the cognitive overhead of providing and receiving early stage capital shrank. When founders and investors share expectations of what a deal should look like, conversations go faster. Assuming a deal is to be done, the task-at-hand shrinks to populating key numbers into a standard and widely accepted document.
The other accelerant present in the ecosystem today is the movement towards greater transparency. Founders have discovered many positive reasons for sharing their KPI’s and financials with the world: from HR (employee retention and recruiting) to PR (exposure amidst a sea of startups). However, the byproduct of this transparency at the ecosystem level may be even more interesting. The equal and opposite reaction of startups being transparent about themselves will inevitably be investors — especially those that want to court these kinds of startups — also being more transparent. Do we see evidence of this? Yes. Since 2015, Indie.vc has led the way in publishing their terms, and the thought process behind their terms, publicly. More investors are already following suit, and this trend will continue.
As more gets shared in advance of deals being done, expectations will converge and new standards and structures for forecasting and investing will emerge for convenience, increasing speed. The flywheel is spinning.
As the last-mile delivery of capital becomes more efficient, the market will become increasingly viable for startups and investors previously kept out by a lack of signaling and deal flow — perceived or real. Just as Instagram opened the floodgates to a new supply of pro-am photographers, exponentially faster ways to deliver capital will unlock a fresh supply of angels. It’s estimated that more than 4 million accredited individuals in the U.S. currently do not participate in angel investing, but could. Meanwhile, the SEC’s loosening of restrictions through Reg CF — accreditation is no longer required for the first $1m of startup funding, has not yet been leveraged at scale.
Some of these financiers will come armed with their modern portfolio theories seeking quick alpha through volume, hedging, and speculation. But the durable innovation will come from investors looking for ways to appreciate the underlying value of these startups in order to buy low and sell high over the same long horizons as the founders. In contrast to their moonshot counterparts, startups that openly and consistently demonstrate their value in terms of predictable revenue and/or reliable profits will get the most attention.
Just as the record labels continue to search for the next star, unicorn hunting will remain, supported by FAANG’s bottomless hunger for users and engagement. But within the long tail, savvy investors will forego the risky construction of rockets in exchange for browsing a fresh lineup of sturdy, proven aircraft.
While not exotic, their pilots don’t worry about runway. And many of them are more-than-meets-the-eye. Loaded with optionality, rather than pivoting out of weakness, they’re able to transform from strength to strength.
If they want to.
- This torpid cadence is so wasteful that perverse incentives start to appear. The VC’s inability to take a multitude of shots synchronizes with the founder’s burning desire to not have to go through the process of raising again for as long as possible. Through a mutual understanding, “How much money do you need?” becomes “How much money can you take?”
- Founders in the long, fat tail may imagine that they remain undercapitalized because certain aristocrats don’t want him or her to succeed, or just don’t get it. VC’s do mistakenly pass on unicorns, and egos can get in the way, but as a general case, this is ascribing to malice that which shouldn’t. Investors are motivated to make money. If they had a way to make equally-stellar money pursuing the long tail instead of, or in addition to, the home runs, it follows that they would.