KEITH RABOIS HAS BEEN a partner at the venture capital firm Khosla Ventures since March 2013. Rabois was a senior executive at PayPal and subsequently served in influential roles at LinkedIn and as chief operating officer of Square. He joined PayPal when the monthly burn rate was $6 million and LinkedIn, Slide, and Square when they had no revenue. His investments include Airbnb, Counsyl, Eventbrite, Lyft, Mixpanel, Palantir Technologies, Quora, Skybox, Weebly, Wish, Yammer, and YouTube. He is an active and outspoken participant on social media and lectures on industry topics often. He received a BA from Stanford and a JD from Harvard Law School.
1. “The only way to learn how to invest is to invest. You can’t simulate it.”
Getting feedback is fundamental to the learning process. Reading and learning from others are helpful, but at some point the only way to refine your skill is to invest real money. As an example, many people have taken a class in which they make trades that simulate investing in a stock market. Unfortunately for people who do this, a simulation is no substitute for investing, since most mistakes in investing are psychologically based. Without actually testing your emotions and learning from genuine feedback, you really have not put yourself in a place where you can test your ability to control your emotions.
One of the most useful papers I have read on investing is “Investing in the Unknown and Unknowable,” written by the Richard Zeckhauser. In it, Zeckhauser states,
The wisest investors have earned extraordinary returns by investing in the unknown and the unknowable (UU). But they have done so on a reasoned, sensible basis. This essay explains some of the central principles that such investors employ. It starts by discussing “ignorance,” a widespread situation in the real world of investing, where even the possible states of the world are not known. Traditional finance theory does not apply in UU situations…. Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop new technologies.
Who has these complementary skills? Zeckhauser writes,
Venture capitalists can secure extraordinary returns … because early-stage companies need their skills and their connections. In short, the return on these investments comes from the combination of scarce skills and wise selection of companies for investment.
Table 28.1 presents the chart Zeckhauser uses to clarify that risk, uncertainty, and ignorance are very different things.
Table 28.1 Escalating Challenges to Effective Investing
| |
Knowledge of states of the world |
Investment environment |
Skills needed |
| Risk |
Probabilities known |
Distributions of returns known |
Portfolio optimization |
| Uncertainty (U) |
Probabilities unknown |
Distributions of returns conjectured |
Portfolio optimization; decision theory |
| Ignorance (UU) |
States of the world unknown |
Distributions of returns conjectured, often from deductions about others’ behavior; complementary skills often rewarded alongside investment |
Portfolio optimization; decision theory; complementary skills (ideal); strategic inference |
Venture capitalists with complementary skills have developed them over a period of years through experience in real-world investing and involvement in the startup world as founders or early employees. Simulations of bets involving risk do not enable the investor to profit in the uncertainty and ignorance domains. The best way to become a venture investor is to make venture investments. There is no substitute for real-world experience.
2. “Early stage, almost every successful entrepreneur I know doesn’t care as much about the economic terms as much as who they are going to work with.”
If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.
Khosla Ventures believes that the quality of the advice and mentoring given to founders by venture investors is so important that they present the firm as “venture assistance” rather than venture capital. Using Zeckhauser’s taxonomy, it is the complementary skill and not the money that creates the extraordinary investing result. Founders who pay attention have figured out that it is the same venture capitalists consistently generating the grand slams year after year.
An important aspect of any person’s skill set is early luck. People who get lucky early in life end up with more skill through a process called cumulative advantage. What entrepreneurs should take from this is that while money is fungible, the skill of the venture capitalists is not. Money is money (assuming deal terms are equal), but not all venture capitalists are the same. Skill should drive an entrepreneur’s choice of venture capitalist.
In addition to the importance of complementary skills, it is hard to deny that there are signaling benefits from having a top venture firm as an investor. The world is filled with uncertainty, and people look for signals when making decisions. Employees and others are attracted to startups that others are attracted to. Success create more success with a nonlinear impact.
3. “You are looking for outliers as founders.”
Convexity is everywhere if you know where to look, but the best types of positive convexity are found in places where no one else is looking. If a founder is an outlier, it is much more likely that he or she will find something that others are not looking at or can see. An investor will not find mispriced convexity by following the crowd. The critical point here is that when you are a highly skilled venture capitalist, uncertainty and ignorance are your friends. This is where you find the outliers that Rabois is talking about.
4. “The best founders can relay incredibly complex ideas in simple terms, can see things you don’t see, are relentlessly resourceful and are often contrarian.”
Rabois identifies four important qualities of a great founder in this statement. First, they can convey their ideas in ways that are easy for people to understand. Second, they have a unique way of looking at problems. Great founders do not think like other people in at least one important way, and they are fearless about at least one important thing. Third, successful founders almost always have the quality that Jeff Bezos said he looked for in a wife; Bezos said that he wanted someone “who would be resourceful enough to get me out of a Third World prison.” And finally, they understand that to deliver an outsized result from their startups (financially and otherwise), they must be contrarian about something important, and they must be right in their contrarian view. There are also many other attributes in addition to these four that make for a great founder, including the ability to recruit talented people and to hire others who complement their skills.
The ability to find outlier founders (especially in new categories) is an especially valuable skill for a venture capitalist. I believe there is no question that the skills involved in finding the best founders are based on pattern recognition. The more founders a venture capitalist sees in action, the better their ability to “know it when they see it.”
5. “There are fundamental differences between an angel, what I call an amateur investor, and being a professional investor, a venture capitalist.”
Once a person is investing other people’s money, he or she is no longer an angel but rather a professional investor. Great professional seed-stage investors like Ron Conway and Mike Maples Jr. should, in my view, be referred to not as angels but as professional seed-stage investors. Professional investors provide much more than money and are far less likely to distract the founders with requests that do not add value.
6. “We want to be doing what used to be called venture capital, not growth capital.”
Venture capitalists who excel in the early stage of a business provide much more than money to the business. Late-stage financing is often more about finance than receiving significant help from a venture capitalist to build a business. The move of large mutual funds and others into the growth capital business has naturally pushed some venture capitalists to focus on earlier financing rounds where they can add more value.
7. “Many entrepreneurs are raising more money than they need, and it can cause derivative consequences down the road that are not healthy.”
Stories have been written about venture capitalists pushing a startup to raise too much money. Experienced venture capitalists often spend time with entrepreneurs counseling them to raise less money, not more. The experienced investor know that if a business raises too much money, there can be a tendency to use suboptimal approaches to solving the inevitable problems that arise early in the existence of a startup. Trying to solve those problems with money rather than strategy tends to cause dysfunction in one form or another. In other words, solving hard problems with just money does not scale. The better approach is to solve problems with innovation and a sound business culture. For example, it may be possible to use money to retain a talented but divisive software developer who is threatening to quit, but a better approach may be providing coaching or inviting the person to leave the business for another opportunity.
8. “First principle: The team you build is the company you build.”
Rabois said that he first heard this phrase from Vinod Khosla when he joined the board of Square. Some investors believe that everything in a business starts with people. Other people would argue that product is more important, but it is clear that both are foundational elements in building a business. Still other venture capitalists believe that a massive addressable market is most important. One could argue that the process of ranking which element is most important is a bit like asking a parent which of their children is their favorite. Most parents would answer, “I like them all the same.”
9. “There are two categories of good people: there is ammunition and there are barrels. You can add all the ammunition you want, but if you only have five barrels in your company, you can literally only do five things simultaneously. If you add one barrel, you can suddenly do a sixth; if you add another, you can do seven. So finding those barrels that you can shoot through is key.”
I once met with one of the top executives at Boeing with Craig McCaw, and the executive said that of the tens of thousands of engineers in the company, only seven were capable of designing an entire airplane. And he said he could name each of those seven engineers. These engineers are the equivalent of what Rabois calls barrels. Barrels are the unique employees who give other employees direction toward a goal. Finding and hiring barrels is difficult and occurs rarely. Barrels are scarce in the real world—hiring too many barrels is not a phenomenon often encountered.
10. “Silicon Valley … tends to fragment talent across too many companies, so you get a suboptimal number of successful companies.”
Generally speaking you want to hire people who share first principles, which involve strategy, people, and culture.
As you get into the uncharted territory where you don’t actually have any intellectual background, you need perspectives from people who are very different from you. At that point, it’s actually quite valuable to have people who are diverse.
There are only so many great founders with audacious ideas possessing convexity, as well as talented engineers and other team members who can create a great business. This scarcity tends to create strong rivalries in the venture industry since the competition for the best talent is intense.
11. “Matching your priorities against your time is really important.”
The scarcest resource of any venture capitalist is his or her own time. A venture capitalist can sit on only so many company boards or help so many businesses with recruiting. Firms or partners can invest in only so many startups before they dilute themselves and begin to underperform.
12. “Your job as an executive is to edit—not to write. Every time you do something, you should think through and ask yourself, ‘Am I writing or am I editing?’ And you should immediately be able to tell the difference.”
What came to mind when I read this quote is Eric Schmidt’s advice to Marissa Mayer:
“It’s your job as leadership to be defense, not offense. The team decides we’re running in this direction, and it’s your job to clear the path, get things out of the way, get the obstacles out of the way, make it fast to make decisions, and let them run as far and fast as you possibly can.
The executive must decide what is important. Editing should be reserved for matters that are important. More supervision is needed in certain cases, as Rabois points out: “There are people who just know what they don’t know, and there are people who don’t. Until someone shows the propensity to distinguish between those things you can’t let them run amok.”