PAUL GRAHAM WAS A cofounder of Y Combinator, the most famous and most successful startup accelerator in the world. Y Combinator provides seed funding, advice, and access to its network of startups in two batches each year. A profile of Graham in Forbes described the accelerator as “a startup-rearing juggernaut that’s part incubator, part drill sergeant and part liaison to the investor class.” Y Combinator invests $120,000 in return for 7 percent of a company’s equity. Graham is also a computer scientist known for, among other things, his work on the Lisp programming languages. Graham has written three books and numerous essays on a wide range of topics, including “Why Nerds Are Unpopular” and “Startup Equals Growth.” He cofounded Viaweb, which was acquired by Yahoo in 1998 and became Yahoo Stores. He has broad interests and at one time studied painting, attending both the Accademia di Belle Arti in Florence and the Rhode Island School of Design.
1. “Y Combinator is a minor league farm club. We send people on up to VCs.”
Graham and his cofounders successfully found a unique place for Y Combinator in the startup ecosystem that has allowed it to thrive. Y Combinator partners with other investors to provide growth capital to its graduates. This symbiotic relationship has produced remarkable success. The New Yorker described what Graham and his cofounders have created in the following way: “Thirteen thousand fledgling software companies applied to Y Combinator this year, and two hundred and forty were accepted, making it more than twice as hard to get into as Stanford University. After graduating thirteen hundred startups, YC now boasts the power—and the peculiarities—of an island nation.”
2. “One of the two most important things to understand about startup investing as a business, is that effectively all the returns are concentrated in a few big winners. I knew this intellectually, but didn’t grasp it until it happened to us. The total value of the companies we’ve funded is around $10 billion, give or take a few. But just two companies, Dropbox and Airbnb, account for about three-quarters of it.”
What investors are looking for when they invest in a startup is the possibility that it could become a giant. It may be a small possibility, but it has to be nonzero. They’re not interested in funding companies that will top out at a certain point.
The most interesting part of this quote is Graham’s admission that even though he understood the power-law phenomenon in venture capital intellectually, he was still surprised when he experienced it. For most of human history, people’s life experiences have been overwhelmingly linear. Humans are accustomed to encountering situations that reflect a simple proportional relationship between cause and effect. People expect that when they do X, Y will happen if Y is what happened in the past. This type of linear thinking is comforting to people since it is familiar. The famous inventor Ray Kurzweil believes, “Our intuition about the future is linear because that is the way the world worked for most of history. Prey animals did not get exponentially faster for example.” Except for a virus or bacterial infection multiplying inside your body, few things in ordinary life are nonlinear.
The rise of modern science combined with modern distribution and other processes developed by businesses has resulted in people increasingly encountering nonlinear change. The economist Paul Romer explains one common reaction: “People are reasonably good at estimating how things add up, but for compounding, which involves repeated multiplication, we fail to appreciate how quickly things grow. As a result, we often lose sight of how important even small changes in the average rate of growth can be.” When something is sufficiently nonlinear, a phenomenon can seem almost magical. Especially when the outcome of a nonlinear change is negative, tendencies like loss aversion can kick in, and people can have a strong tendency to react in highly emotional ways. Even people who are otherwise rational may not think clearly in such situations.
Most entrepreneurs do not raise venture capital. They grow their business from savings, internally generated cash flow, bank loans, or equity capital supplied by investors seeking financial returns that do not reflect the skewed distribution that exists in venture capital. In the United States, the number of new restaurants alone is ten times the number of new startups that seek venture funding each year. There is less failure overall among new nonventure-backed businesses, but fewer of those firms will have the huge financial returns produced by a venture capitalist harvesting convexity.
3. “If you want to start a startup, you’re probably going to have to think of something fairly novel. A startup has to make something it can deliver to a large market, and ideas of that type are so valuable that all the obvious ones are taken. Usually, successful startups happen because the founders are sufficiently different from other people—ideas few others can see seem obvious to them.”
Finding a business opportunity that competitors have not fully discovered and developed and that is capable of generating grand-slam financial returns is unlikely to happen with traditional approaches. By seeking novelty, a startup can sometimes find hidden convexity. In other words, convexity is most likely to be found in places where there is a lot of uncertainty and ignorance. Similarly, financial bets on a startup business that operates in areas with not a lot of uncertainty and ignorance are not as likely to have mispriced convexity. Unique people with unique interests often find value that others do not see.
4. “The very best ideas usually seem like bad ideas at first. Google looked like a bad idea. There were already several other search engines, some of which were operated by public companies. Who needed another? And Facebook? When I first heard about Facebook, it was for college students, who don’t have any money. And what do they do there? Waste time looking at one another’s profiles. That seemed like the stupidest company ever. I’m glad no one gave me an opportunity to turn it down.”
Convexity is everywhere if you know how to find it. Sometimes it is looking you right in the face. The challenge is to see the world in a different way. You won’t always be right, but being right all the time is not required to be a successful venture capitalist or entrepreneur. Since so few investments result in a grand-slam financial outcome, making just one contrarian bet is not a workable approach for a venture capitalist. So venture capitalists create a portfolio of bets. But entrepreneurs are not nearly as diversified. They can make a few bets in their lifetime, but that number is limited. Being an entrepreneur requires more courage.
5. “We thought Airbnb was a bad idea. We funded it because we liked the founders. They were so determined and so imaginative. Focusing on them saved us from our stupidity.”
Great venture capitalists put a large emphasis on a great team since great teams give investors additional optionality. Great teams not only adapt better to change, but they know when to adapt. Great people also attract other great people—who also attract money, partners, distribution, and customers in ways that are mutually reinforcing. The ability to successfully adapt to change is part of what makes a great founder and, in and of itself, adds to the convexity of an investment. In other words, a great team of people gives a business valuable added optionality, which is often essential to success given the need to adapt. Striking the right balance on this set of issues is key since it is important to maintain a founder’s motivation and persistence. Sometimes a founder’s dogged persistence sends a business right off a cliff, whereas at other times it is the key to success.
6. “For a product or service to surprise me, it must be satisfying expectations I didn’t know I had. No focus group is going to discover those. Only a great designer can.”
The greatest founders are savants and artists. They essentially perform alchemy and make something that people could not imagine before they first saw it. Steve Blank puts it this way: “The best entrepreneurs are the ones who are passionate about solving a problem because they’ve had it or seen others have it, love those customers, love solving that problem, or have been domain experts. Those are authentic entrepreneurs.” He believes, “Entrepreneurs, at their heart, are artists. What comes out from the great artists is something completely unexpected. World-class entrepreneurs understand something that is driven by passion.”
7. “I never say, ‘These guys are going to be great.’ All I ever say is, ‘These guys are doing great so far,’ because some percentage of the time, it turns out there’s some explosion around the corner. Not just founder disputes, there are all kinds of explosions. Startups are very, very uncertain.”
Since startups and the markets they target are complex systems, changes can be nonlinear in both a positive and negative way. In the life of a startup, it is “never over until it is over.” Some successful startups will almost fail, and some failures will almost succeed. The world has been fundamentally changed by digital networks and software. Businesses and customers connected by networked digital systems create amplified network effects, which means the velocity of business and the level of competition and innovation are higher than they have ever been. Increasing the ability of a business to adapt to a changing world has never been more important. Virtually every niche in the business world is constantly being explored by challengers. This constant experimentation by entrepreneurs makes profit harder than ever to sustain, especially if its source was traditionally information asymmetry (i.e., the seller knew more about something than the customer). Unless a business has a moat based on something like network effects, there is nowhere to hide from the constant onslaught of competition.
Even if a business is fortunate enough to have a moat based on network effects, the life of a business can still be nasty, brutish, and short. In other words, since network effects are brittle and work in both directions, a moat can be destroyed just as quickly or more quickly than the time it took to create it in the first place.
8. “You need three things to create a successful startup: to start with good people, to make something customers want, and to spend as little money as possible.”
We have discussed the importance of a great team and the need to make dog food that dogs like to eat more than other dog food sold by competitors. The new point illustrated by Graham’s quote here is that acquiring customers while spending as little money as possible is essential. Bill Gates said once, “Take sales, take costs, and try to get this big positive number at the bottom.” Waiting many months or even years for a big-bang product or service launch that is the result of a focus group–driven process may leave a business with insufficient resources to survive a mistake since feedback has come so late in the process. Steve Blank puts it this way:
Why are so many founders so reluctant to invest even five hundred or one thousand hours up front to be sure that, when they’re done, the business they’re building will face genuine, substantial demand or enthusiasm? Without passionate customers, even the most passionate entrepreneur will flounder at best.
9. “The reason startups do better when they turn down acquisition offers is not necessarily that all such offers undervalue startups. More likely the reason is that the kind of founders who have the balls to turn down a big offer also tend to be very successful. That spirit is exactly what you want in a startup.”
Founders who go “all in” because the startup is more about the mission than the money are more likely to generate grand-slam financial outcomes. Some of these missionary founders will fail due to an overreach, but that is a positive for society overall since the successful outcomes are often spectacular. Mercenary founders succeed less often, and even when they do succeed, they do so in less spectacular ways.
10. “The exciting thing about market economies is that stupidity equals opportunity.”
To earn above-market financial returns, assets must be mispriced. Graham is saying that assets are often mispriced when people are “stupid.” This happens when people participating in a market become overly optimistic or pessimistic. The swing between these two states (greed and fear) is a “Mr. Market” phenomenon. By being greedy when others are fearful and fearful when others are greedy, positive things can happen since an investor can buy at a bargain and sell at a premium if they are disciplined and can control their emotions. Warren Buffett believes,
The true investor welcomes volatility. Ben Graham explained why in chapter 8 of The Intelligent Investor. In that classic book on investing, he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.
11. “It’s better to make a few people really happy than to make a lot of people semi-happy.”
Focus matters in a startup, as does finding core product value. When creating a minimum viable product with product–market fit, it is preferable to start with a solution to a real problem that customers really care about instead of a solution to a vague and broadly defined problem that customers are lukewarm about. It is easier to expand from genuine customer delight about a solution than a solution that generates an attitude of “It’s okay.”
12. “It’s hard to do a really good job on anything you don’t think about in the shower.”
What Graham is talking about here is the idea that you are so passionate about your work that you are thinking about it all the time (including in the shower). If you are thinking about your business even in the shower, you are more likely to be focused on making your business better than someone who is less passionate. Steve Blank agrees:
Founders fit the definition of a composer: They see something no one else does. And to help them create it from nothing, they surround themselves with world-class performers. This concept of creating something that few others see—and the reality-distortion field necessary to recruit the team to build it—is at the heart of what startup founders do. It is a very different skill than science, engineering, or management. Entrepreneurial employees are the talented performers who hear the siren song of a founder’s vision. Joining a startup while it is still searching for a business model, they too see the promise of what can be and join the founder to bring the vision to life.