Demystifying Venture Capital Economics, Part 3
The funding of almost every new and successful technology market can, to the uninitiated, have the appearance of a financial bubble. A tsunami of venture capital flows into hot new markets at what appear to be ridiculous prices. Amazingly, the capital invested in the market winners is almost always justified. A few other companies will drive small returns while the vast majority of new entrants will lose money. This dynamic benefits the premier venture capital firms and consistently hurts second-tier firms.
Most successful new markets begin the same way. A market-sensitive technologist recognizes an inflection point in technology that enables a new kind of product. It’s not uncommon for more than one individual to recognize the potential of the new inflection around the same time, which usually leads to the development of competing companies. This dynamic is so common that VCs often joke that if you meet a company with a compelling new idea, you only have to wait a couple of weeks to see something similar.
It’s Not First to Market That Wins. It’s First to Product / Market Fit.
As I explained in Demystifying Venture Capital Economics, Part 2 the premier VCs now prefer to have angel investors finance startups until they reach product/market fit. They know it’s far better to wait and pay a higher price to finance a company that has proven its value hypothesis because market risk is seldom worth taking. That being said it’s not uncommon for a second-tier venture firm to jump the gun and invest in a company before it finds product/market fit. They are often seduced by the myth that first to market is of critical importance. In fact, first to market seldom matters. Rather, first to product/market fit is almost always the long-term winner. Name a franchise technology company and I can almost assure you it wasn’t first to market.
As the new market develops a very clear hierarchy develops. Geoffrey Moore (the author of Crossing The Chasm) likened this hierarchy to primates in his book The Gorilla Game. Moore calls the market leader the Gorilla because of the dominance it exerts. Chimps start around the same time as the Gorilla, but pursue a different and far less successful product approach to address the same customers. As the attractiveness of the new market becomes clear, Monkeys emerge (even many years later) that attempt to clone the Gorilla’s product, often with a lower price and exaggerated performance claims. In an attempt to survive, most Chimps hop on to the Gorilla bandwagon and become Monkeys. Monkeys seldom achieve more than modest success.
VCs Succeed By Backing the Gorilla
As I explained in When It Comes to Market Leadership, Be the Gorilla it is extremely unusual for a Gorilla to lose its leadership position to a company that attempts to do something similar, even if it is a large incumbent. Only by successfully changing the definition of a market can a new and later entrant ultimately prosper in a big way.
The premier venture capital firms compete vigorously to back the Gorilla because they know the market leader is ultimately worth more than all the Chimps and Monkeys combined. As a result the Gorilla tends to raise far more money at radically higher valuation than the Chimps and Monkeys.
In the past some premier VCs would back a Chimp before it was apparent the Gorilla’s approach would win. These days that is far less common as the strategy of waiting for product/market fit has become more common.
The success of the Gorilla causes many second-tier VC firms to pursue investments in Monkeys based on the significant discount at which they can invest, relative to the valuation of the Gorilla. History has proven that buying on the cheap is a poor venture capital strategy. The big venture capital money is made backing companies that grow into Gorillas, even though you usually have to pay up for the opportunity.
Backing Monkeys Rarely Pays Off
Monkeys seldom get to the scale or profitability necessary to justify a venture capital investment. Unfortunately the second-tier venture firms never seem to learn this lesson and keep making the same mistake of backing the Monkeys.
Corporate investors are last to learn about the downside of investing in Monkeys. Their egos often lead them to believe the combination of their help along with a much lower valuation can overcome the poor historical results of investing in Monkeys. It seldom does. The corporate investors’ overinflated view of the value of their help also makes them the least desirable of all potential funding sources.
The huge flow of money into a new market leads people who are unfamiliar with venture capital to view such inflows as the sign of a bubble. In fact what appears to be an overabundance of capital flowing into a new space is the norm for every new technology market I have observed over the past 30 years. It doesn’t matter if it’s computers (from mainframes to PCs), disc drives (from 14” down to flash), networking equipment (from routers to software-defined networks), software (from material requirements planning to database) or internet services (eCommerce to social networks). At one time there were over 100 personal computer companies funded by the VC industry! Every market appears overfunded, but the ultimate value of the Gorilla consistently swamps the total capital invested in the space.
Hope springs eternal even though the lessons are incredibly obvious. That’s why the poor VCs keep making the same mistake.
Historical Example: Professional Networking
The professional network space is a great recent example that illustrates the rush to fund an emerging market. LinkedIn, Jigsaw, PlanetAll, Plaxo, Ryze, Six Degrees, Spoke, Visible Path, Xing and Zero Degrees started around the same time. BranchOut was founded a number of years later in an attempt to build the equivalent of LinkedIn on top of the Facebook platform.
Although not the first entrant, LinkedIn’s combination of early and distinct traction with top-tier talent attracted premier VCs Sequoia and Greylock. By the time LinkedIn went public it raised more than $200 million at valuations well in excess of all its competitors. Jigsaw, Plaxo and Zero Degrees each raised less than $30 million at much lower prices than LinkedIn and were acquired in relatively small transactions that led to low VC returns. BranchOut raised $50 million, but sold its asset for a pittance to Hearst.
Only three startups, other than LinkedIn in the professional network market, received funding from a top-10 venture firm. Only LinkedIn attracted high-quality later-round funding support. The quality of late-stage investor is often viewed as an important signal for potential recruits when they choose where to work.
The LinkedIn Gorilla is Worth 50x The Chimp
Ultimately only LinkedIn and Xing succeeded. Xing was forced to bootstrap by charging users from the beginning because it was founded in Germany where early-stage capital was quite scarce. This coupled with too much focus on its home country significantly hindered its growth relative to LinkedIn. Today LinkedIn is worth $27 billion vs. $500 million for Xing.
By now I hope you see the pattern. LinkedIn is the Gorilla. Xing is the Chimp and all the other companies were the Monkeys. The value of LinkedIn swamps the value of all the other players in its space combined and is far greater than the aggregate $400 million that was invested in professional networks. Investments in the Monkeys were not justified, especially given their risk.
Don’t Make the Mistake of Funding Chimps & Monkeys
The next time someone tells you there is a bubble going on in a particular market, I encourage you to look a little closer. You’ll very likely find a Gorilla whose lead is increasing, a Chimp or two, and a bunch of Monkeys who claim they’re just as good if not better. Not only will that Gorilla generate huge returns for its investors but its ultimate market value will be far greater than all the money you feared had been invested in a bubble.
About the author(s)
Andy Rachleff is Wealthfront's co-founder and Chief Executive Officer. He serves as a member of the board of trustees and chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business. View all posts by Andy Rachleff