BILL GURLEY HAS SPENT over ten years as a partner at Benchmark. Prior to joining Benchmark, Gurley was a partner with Hummer Winblad Venture Partners. Before entering the venture capital business, Bill spent four years on Wall Street as a top-ranked research analyst. His current investments and board seats include Grubhub, Nextdoor, OpenTable, Uber, Ubiquiti Networks, and Zillow. I became friends with Bill Gurley in the mid-1990s soon after Bill Gates forwarded me a copy of his wonderful blog “Above the Crowd.” I immediately signed up to receive it (by fax!). I then found a way to for us to start talking by phone and the Internet. Gurley thinks deeply and has a well-developed investing philosophy. Bill and his partners like to work shoulder to shoulder with founders on building the business. He is always looking for a business with some kind of competitive advantage. He says about the venture capital business, “There aren’t that many rules. One of the games you play in venture is to know which rules to break at the right time. Therefore, we constantly challenge ourselves. ‘Should we maybe be dropping this rule at this moment in time because things are changing?’ ”
1. “All the great investors I’ve ever studied have felt macroeconomics is one of the silliest wastes of time possible.”
There is a nonlinear relationship between the simplicity of the system you are trying to understand and your ability to make bets that can generate financial returns that outperform a benchmark (alpha). The simplest system that one can work to understand in a way that generates valuable insight is an individual business. Charlie Munger puts it this way: “Be a business analyst, not a market, macroeconomic, or security analyst.” Munger has said that microeconomics “is what we do,” whereas macroeconomics is what we put up with.
2. “Venture Capital has long been a trailing indicator to the Nasdaq. Venture capital is a cyclical business.”
The Howard Marks maxim that “most things are cyclical” definitely includes venture capital. Mr. Market’s bipolar nature in the short term affects the venture capital business like any other business. When Mr. Market is depressed and pessimistic, a hardworking venture capitalist with cash available to invest (dry powder) can find opportunities, which do not exist when Mr. Market is euphoric. Being “long-term greedy” often means investing despite the pessimism of others. Nothing good or bad goes on forever. Yet people often extrapolate as if a phenomenon will go on indefinitely. “If something cannot go on forever it will eventually stop,” Herbert Stein once famously said. The mean reversion assumption is the rational investor’s consistent friend. The best time to fund or start a business is often during a recession.
3. “There’s a lot of luck involved in venture capital.”
Luck is easier to describe than skill. Luck is the driver of outcomes in a game like roulette. With roulette, you know all the potential future states and the probability distribution. Because the house takes a rake in roulette, there are no professional roulette players. Michael Mauboussin writes that luck has three core elements: (1) It operates on an individual or organizational basis; (2) it can be positive or negative; and (3) it is reasonable to expect that a different outcome could have occurred. Sometimes you will hear people say things like, “The harder I work, the luckier I become.” Mauboussin has easily demonstrated such a statement to be a non sequitur with a few well-chosen words: “There is no way to improve your luck, because anything you do to improve a result can reasonably be considered skill.” People who acknowledge the role of luck in life are, as a rule, far more humble and less susceptible to mistakes caused by hubris.
4. “If you can’t sell, venture capital is not a good industry to be in.”
The idea that the venture capital business is about sitting in boardrooms thinking about strategy is false and, at most, is maybe 5 percent of what a venture capitalist does in any event. Venture capital is a service business, and the best venture capitalists hustle on behalf of their companies and to grow their personal networks. The best venture capitalists sell “early and often.”
5. “Venture capital is not even a home-run business. It’s a grand-slam business. If your idea is not something that can generate $100 million in revenue, you may not want to take venture capital.”
The size of a venture capital fund and the need for a market-beating financial return determine how much a partner in a venture capital firm should invest in a given company. For example, a $500 million fund must return at least $1.5 billion from its investments. An additional constraint on the firm is that its venture capitalists can help only so many companies at one time. This means that a business that will not generate at least the $100 million in revenue Gurley is talking about is not something that will be attractive to most venture capitalists. It is simply not a big enough return to impact the investing outcome of the firm in the desired manner. The entrepreneur in this situation is better dealing with financiers like banks, or even bootstrapping the business with internally generated cash and some investment support from friends and family. In the right circumstances, a micro VC may be a source of needed capital if a larger venture capital firm is uninterested owing to the small revenue potential of the business.
6. “Good judgment comes from experience, which comes from bad judgment.”
Warren Buffett has said that there is nothing like walking on land for a day if you are a fish to learn about life on the land. We all make mistakes, and personal mistakes can be the best learning experiences. When you listen to Gurley speak, he always takes time to thank the people who helped him along the way and to point out the good fortune he has experienced in his career. In a Quora “Ask Me Anything” interview, Gurley gave a great answer to this question: “What are the top pieces of advice you would give to your younger self?” Gurley responded,
1. Read even more than you did.
2. Thank the people (more) who helped you along the way.
3. When Larry and Sergey ask for $110 pre-money, say, “Yes, we would be very excited about that.”
7. “We like to say that ‘more startups die of indigestion than starvation.’ ”
Gurley is saying that running out of cash is often caused by a business losing focus and diverting resources unnecessarily, straying from the critical path toward success. Too much money is often the root cause of that inability to focus. Failure is often a symptom of mistakes such as premature scaling and wild goose chases. Sometimes when a business tries to do everything, it ends up doing nothing.
8. “Consumers buy from great companies because the product is so good. They aren’t spending tens of millions on marketing.”
Jeff Bezos might just as easily have said these words. Gurley thinks like Bezos (which is not surprising since Amazon was one of the companies he covered as a young Wall Street analyst). Too often, a lifetime-value financial analysis ends up being a justification for too much spending on nonorganic marketing. One essential task for any business is to acquire customers in a cost-effective way. Gurley says, “Organic users typically have a higher NPV [net present value], a higher conversion rate, a lower churn, and are more satisfied than customers acquired through marketing spend.”
9. “High-price/revenue multiple companies have wide moats or strong barriers to entry.”
If the supply of what your competitors offer is not limited in some way, the price of that offering will drop to your cost of capital. Sometimes you do not figure out your business model until after you have broad adoption, but thinking about how to generate networks effects is wise even before your business model is fully formed. Gurley has also said, “Strong-form network effect companies are far and few between. Fortunately, when they do exist, they are typically leading candidates for the 10×+ price/revenue multiple clubs.” Revenue alone is not enough to sustain a business given the inevitable competitive response. A sustained return on invested capital is a prerequisite for the long-term survival of a business. In other words, “For what shall it profit a business, if it shall discover solutions to the value hypothesis and growth hypothesis, but fail anyway because it does not have a moat?” At worst, a business without a moat is never profitable. At best, a business without a moat is profitable for a while, but over time is gradually overtaken. The test of whether a moat exists is quantitative, even though the factors that create moats are qualitative. If a business has not earned returns on capital that substantially exceed the opportunity cost of capital for three to five years, it does not have a moat. Can great management or better business execution create a moat? Warren Buffett’s famous quip on that point is “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
10. “DCF is an unruly valuation tool for young companies. It is not because it is a bad theoretical framework; it is because we don’t have valid inputs. Garbage in, garbage out.”
What is sometimes called “spreadsheet disease” is a byproduct of people not thinking hard about the assumptions that go into a model. Valuing the convexity of an investment in a business is not easy, and anyone who thinks they can do it with a spreadsheet is an example of hope over experience. Establishing a valuation for a startup business will always be hard. The investor Howard Marks once said to Charlie Munger, “It’s not supposed to be easy to make a profit by investing. Anyone who finds it easy is stupid.”
11. “If a disruptive competitor can offer a product or service similar to yours for ‘free,’ and if they can make enough money to keep the lights on, then you likely have a problem.”
Digital offerings have very strange economics in that multisided markets (platforms) are often involved, and offerings in such a market can have a near-zero marginal cost once they have been created. Freemium is a natural business model in many businesses when the offering is digital and has a zero or low marginal cost. By spending a relatively limited amount of money on the free items, the customer acquisition cost can drop dramatically. Because software has a marginal cost of almost zero (it costs almost no additional money to create more copies), there is a natural tendency for the price of software to drop to zero if there are no barriers to entry. Of course, some free services have real storage or egress costs, but the point remains true. Solving the “chicken-and-egg” problem inherent in any platform business usually involves either a free egg or free chicken on one “side” of the market, which is another reason why the price of any given product may drop to zero. It is easy to wake up in a digital world and have whatever you were once selling now being offered “for free.”
12. “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.”
Being a contrarian for its sake is suicidal. Without being a contrarian on certain occasions, you cannot outperform the market. Being genuinely contrarian means you are going to be uncomfortable sometimes. Howard Marks puts it this way: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them—ideally all three.” It is a bit strange that most people don’t realize this truth since it is common sense: You simply cannot be part of the crowd and at the same time beat the crowd, especially after fees and costs are imposed. The Nobel Laureate William Sharpe famously provided the mathematical proof for this in a paper entitled “The Arithmetic of Active Management.” As restated by John Bogle the conclusion is as follows: “In many areas of the market, there will be a loser for every winner so, on average, investors will get the return of that market less fees.” Of course, the part about the investors collectively getting the return of the market is key. Being a long-term investor in the progress of the economy is a very good thing. As life runs its course, some investors get more of that financial return of the market than others.