VINOD KHOSLA IS AN entrepreneur, investor, and technologist. He graduated with a bachelor’s degree in electrical engineering from the Indian Institute of Technology in New Delhi. After graduating, he moved to the United States and obtained a master’s degree in biomedical engineering from Carnegie Mellon University and a master’s degree in business administration from the Stanford Graduate School of Business. Khosla cofounded Daisy Systems, the first significant computer-aided design system for electrical engineers. In 1982, he cofounded and became CEO of Sun Microsystems, which was funded by John Doerr of Kleiner Perkins Caufield & Byers. In 1986, Khosla joined Kleiner Perkins as a general partner. Among his investments at Kleiner Perkins were Cerent, Excite, Juniper Networks, and Nexgen. In 2004, he formed Khosla Ventures to focus on both for-profit and social-impact investments.
1. “I don’t mind failing, but if I succeed it better be worth succeeding for.”
Most technology startups fail. There’s a winner, and there are seven out of ten that lose.
I have seen too many startups where they have reduced risk to a point where they have a higher probability of succeeding, but if they succeed it is inconsequential.
People are accustomed to encountering situations that reflect a simple proportional relationship between cause and effect. When life is linear, we are usually able to predict the future with some degree of accuracy. When we do X, Y happens. This type of linear change is comforting since people tend not to like risk and uncertainty. We particularly hate anything that would cause us to experience a loss (loss aversion). Whether we like it or not, however, the economy is currently changing in ways that are nonlinear. When nonlinear change happens, the aggregate behavior of systems can be much more complicated than would be predicted by summing the inputs into the system. It is this nonlinear change that allows for sufficiently convex investing opportunities to appear, those with the potential to produce grand-slam financial returns for founders and venture capitalists. Making investment choices particularly complex is the fact some future states of the world are unknown, and probability is not even computable. Richard Zeckhauser calls this situation the domain of ignorance. A matrix depicting one set of meaningful relationships that impact venture capital, based on my interpretation of Nassim Taleb’s ideas of Nassim Taleb is presented in table 19.1.
Table 19.1
| |
Binary Outcomes |
Complex Outcomes |
| Thin-tailed probability distribution |
Coin flip |
Outcome of a horse race—statistics are helpful |
| Fat-tailed probability distribution |
Whether a specific book will become a bestseller—statistics are helpful |
Venture capital—statistics are potentially misleading and even dangerous |
Because success in the venture capital industry is driven by actions that occur in the fourth quadrant, successful venture capitalists understand that their objective is not to predict outcomes with certainty since that is impossible. The task of a venture capitalist is instead to experiment on a trial-and-error basis to discover success from within a portfolio of thirty to forty bets that have convexity. Which bets will pay off will become apparent only after the fact since success emerges only as the years pass.
2. “We are in the company-building business, not in the ‘deal’ or ‘capital’ business.”
I don’t think of myself as being in the investing business. I think private equity investors are very much in the business of doing deals, putting money in, getting money out. To me, that is a very, very different business, and all that they are doing is spreadsheets. I think of myself in an entirely different business of building companies. I have not made IRR [internal rate of return] calculations on a spreadsheet ever since 2004. I either believe, or I don’t. If I believe, then my goal is to get involved and make things much bigger and help them be successful. It’s a different kind of business.
The venture capitalists I admire most like to spend their time and effort building real businesses. They almost always understand finance deeply, but for them, finance is an enabler of what they most love to do. One of the ironies of venture capital is that the best way to be financially successful is to pay less attention to finance and more attention to building a business. The right financial structure does not mean anything if all it does is guarantee you a high percentage of nothing. Great venture capitalists are focused on building businesses and relationships rather than “doing deals.” Building a real business means creating new value through genuine innovation. What Khosla is saying is that the potential outcome is so far into the domains of uncertainty and ignorance that using spreadsheets is useless since the inputs cannot be quantified. Venture capitalists with the skill and contacts to source the best opportunities and provide entrepreneurs with the right networks of contacts and assistance experience superior returns. Founders, venture capitalists, employees, and customers will be attracted to the success, and it is a success that compounds.
3. “If you’re doing what everybody else is doing, you’re not doing anything interesting, and we won’t want to invest.”
Doing things at the edge is what venture is about. I don’t even invest in businesses where six other people have the same technology.
The idea is how you can turn a technology advantage into a business advantage. It’s much more like playing a chess game than it is investing. It is strategic; it depends on how much you can help the company. Therefore, it is much more fun.
You cannot outperform a market (which reflects the consensus view) by adopting a consensus view. By definition, beating a market means having a different viewpoint and being right about that viewpoint. Khosla’s impressive track record illustrates the high value of intelligent contrarian thinking in a profession like venture capital.
4. “We seek out unfair advantages: proprietary and protected technological advances, business-model innovations, unique partnerships and top-notch teams.”
What Khosla is talking about here is what Warren Buffett calls a moat and Michael Porter calls sustainable competitive advantage. Without a moat, competition will inevitably drop prices to a point where there is no economic profit (return on investment will not exceed the opportunity cost of capital).
“Someone, somewhere, is making a product that will make your product obsolete.” This is perhaps Georges Doriot’s most famous quote. What Joseph Schumpeter called creative destruction is a constant process in the business world. Schumpeter said, “The process of industrial mutation—if I may use that biological term—incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” The paradox is that in order for productivity and standards of living to grow, some aspects of the economy must be destroyed. Capitalism requires failure so that new productivity and wealth can be created. Every business is in its own way constantly fighting this phenomenon. Warren Buffett once wrote, “Capitalism is all about somebody coming and trying to take the castle. Now what you need is a castle that has some durable competitive advantage—some castle that has a moat around it.” The moat of any business is always under attack by competitors even if you cannot see it. And because moats are constantly under attack, Charlie Munger points out that it is a rare company whose future will not be worse than its present.
5. “We invest more in people than in a specific plan, because plans often change.”
Quickly failing is a good way to plan. Often failing makes failures small and successes large. In small failures, you accumulate learnings about what works and what doesn’t. Try many experiments, but don’t bet your company on just one: keep trying, keep failing small.
There are probably three or four things you can control out of ten that matter for the success of your company. Competitors control another three or four. The rest is just luck. I’ve never seen [a business plan] that’s accurate.
The business you build is the people you hire. Entrepreneurs who can adapt are far more likely to achieve great success than entrepreneurs who expect to be able to follow a rigid plan. No plan survives first contact with competitors and customers in a real market. Investing in great teams generates optionality since great teams can adapt. The real world is dynamic and unpredictable. People who think they can predict the future with sufficient accuracy to create something like a detailed five-year plan have a lousy understanding of how business works and have not been paying attention to life. A spreadsheet is only as good as your assumptions, and when you put garbage into a spreadsheet, garbage comes out.
6. “Bad times come for every startup—I haven’t seen a single startup that hasn’t gone through a bad time. Entrepreneurship can be very depressing. If you believe in your product, you stick with it.”
A real business operating in the real world is never about perfect execution. While great founders, CEOs, and venture capitalists have a tremendous will to succeed, many successes were at one point millimeters away from failure. Many failures were also millimeters away from success. Scott Belsky describes the stage between the glamorous moments when people just start something in the garage and a glorious event like an IPO or an acquisition as “the messy middle.” It is in the messy middle where the bulk of the work gets done and the entrepreneur proves his or her mettle by solving hard problems, day in and day out. The early Microsoft executive and investor Mike Maples Sr. said once, “There’s something about the struggle, adversity, the trial and error and worrying at night about things that makes the entrepreneur better and stronger.”
7. “Seeking an acquisition from the start is more than just bad advice for an entrepreneur. For the entrepreneur, it leads to short-term tactical decisions rather than company-building decisions and in my view often reduces the probability of success.”
I see this far too often. If money is all that makes your world go around, venture capital or starting a company is probably not the business for you. You are unlikely to make the right decisions, and you are unlikely to be happy. Missionaries are best suited to building a business and succeed more often in doing so than mercenaries. The odds of a huge financial success are not good at the start of a business. Being a founder of a startup that is backable by a major venture capital firm is not a rational act. Instead, being a founder is optimally driven by passion.
8. “We prefer technology risk to market risk.”
There are many different types of risk. One type of risk is market risk, and another is technology risk. Khosla is saying that technology risk is easier to retire than market risk, especially if you are a skilled technologist. Because of his background and training, Khosla brings a unique technical skill to a startup, which impacts his preference for technology risk. There are also financial, regulatory, and people risks that must be retired to create a successful business.
9. “How would you compete against yourself?”
Every business should be thinking about what could threaten them since their competitors are almost certainly doing so. The mental exercise I am suggesting here is essentially a stress test: Ask yourself, “What would we do if we were our competitors?” In a larger company, the process might be accomplished by using a “red-team” approach in which an independent group challenges an organization to improve its effectiveness. The founders of a startup do not have the same resources as a large company but still have the ability to think through their competitive strategy with their team or advisers.
10. “I generally disagree with most of the very high-margin opportunities. Why? Because it’s a business strategy tradeoff: the lower the margin you take, the faster you grow.”
This is the sort of statement Jeff Bezos makes. Your competitor’s high margins are your opportunity to grow. For example, absolute-dollar free cash flow can be better with lower margins since you can sell more products and services and increase inventory turns. No one does this more effectively than Amazon and Costco. In a technology business, there is often only one dominant company, so market share matters in a huge way.
11. “Where most entrepreneurs fail is on the things they don’t know they don’t know.”
Things go wrong. There is lots of uncertainty, and there are times when you’re unsure of yourself. I’ve found that the less people know, the surer they are.
The best venture capitalists and founders are “learning machines” because they realize that there is no end to what one can learn. They also know that they will inevitably encounter unknown unknowns (what Zeckhauser calls ignorance). There are some things you cannot know in advance but which you will see clearly after the fact.
12. “The single most important thing an entrepreneur needs to learn is whom to take advice from and on what topic.”
Entrepreneurs could get such great help, but instead they think they need money. It’s this sort of schizophrenic divide between worrying that you’re going out of business and dreaming big that’s needed. Sophisticated entrepreneurs know this. Less sophisticated entrepreneurs don’t even know whom to ask for advice. They’ll ask a marketing and a technology question to the same person. Ask different questions of different people, both those who have been successful and those who haven’t.
The concept of a “circle of competence” applies not only to your skills but to the people from whom you seek advice. Warren Buffett likes to say that risk comes from not knowing what you are doing. It is wise to find people to advise you who do know what they are doing. You can learn from both success and failure. It’s that simple.