The true nature of venture capital is never fully grasped until you have an investment that arrives at zero.
The road to zero is a lonely place. Runway is dwindling, product market fit is nowhere in sight, investors are passing left and right, team cuts are forced, creating a negative compounding effect of fewer resources with a desperate need for growth.
The confidence-shaking emotional toll that follows can blind even the smartest investors and cause poor future decisioning: in the form of last ditch follow-on investing, misallocation of time, and even, poor treatment of entrepreneurs.
It’s a confounding phenomenon to witness because zeros are fully expected in our business.
Objectively, investing in advanced technology company building is a game fraught with risk. 90% of all startups go to zero and 99% won’t matter for returns. Finding outliers, not avoiding failure is the game. This dynamic is reflected most elegantly in the power law chart in venture.
Yet, objective logic doesn’t matter when the house is burning.
Because most of our LPs are first time venture investors who’ve recognized the opportunity in the built environment, they’re building their own direct portfolios in real time and dealing with first time zeros in their own portfolio.
We often share with them our approach for managing through zeros, which we’ll refer to as the Four Maxims of Zeros:
The power law is a law of mathematics, yet often not fully grasped by new entrants. There are many who believe they can succeed with a private equity style approach, making fewer than ten portfolio investments while hitting modest singles and doubles (3 or 5x’s over a few years), following a normal distribution of outcomes.
Venture is not PE.
Accepting the power law means understanding that a PORTFOLIO must be built and that one cannot attempt to do “one-off” deals and find success.
A portfolio consists of a strategy that accounts for the majority of your investments going to zero and a commitment to investing in a minimum number of companies at specific stages with specific qualities.
Assuming any kind of realistic failure and graduation rates (to the next financing round) in building this strategy, you realize that singles and doubles are irrelevant to your performance. 3x and 5x’s simply do not matter.
To illustrate, it’s entirely possible that in a fund’s 30 company fund, 29 investments go to zero but the 30th turns into a massive monopoly (Google, Facebook, Uber, or Procore, for example) and returns the fund in spades. That fund ends up as a top decile fund in venture and returns a 10x cash on cash with a 97% failure rate.
To reframe zeros, outlier returns come from non-consensus ideas in entirely new categories. 3D printed housing would be an example.
Inherently, investing in non-consensus ideas pursuing new categories means taking on a lot of risk. They are unproven concepts with zero market feedback.
If you agree that this is the optimal approach to finding outliers, then you should also agree that having no zeros in your early portfolio is a negative signal. It’s a signal that you are not taking enough risk. You are investing in “safe” companies within existing categories that do not have outlier potential.
Volatility is vitality in venture.
One of the most difficult aspects of venture is making the conscious decision to spend less of your time with the worst performing companies. Human nature tells us to do the exact opposite.
Yet, most startups simply cannot be saved. You cannot fix bad timing, incorrect founder market fit, or wrong core assumptions about the product/market.
Your time is better spent with your companies showing signs of early product market fit that can leverage more customer introductions, more capital, and more product resources to add fuel to their flywheel.
Being ruthless with time isn’t an excuse to treat entrepreneurs poorly. Reputations are earned during the darkest times of a company and venture is a long game.
What was the cause of death? As an investor, who’s likely going to be placing similar future bets, it’s worth having a thesis on what you missed in within your investment thesis.
Was it market timing?
Poor founder market fit?
Technical execution failure?
A bad idea?
Competitive dynamics that you missed?
If you wrote out your original investment thesis, it’s also a productive exercise to analyze and write down what you missed in your original assessment.
There is often a strong tendency to delude yourself into thinking that failure wasn’t a decisioning error on your part. But that’s not the purpose of this exercise.
If you take away anything from this letter, let it be this: zeros are inevitable, even healthy in venture, but your response to them is not.