NAVAL RAVIKANT IS THE CEO and cofounder of AngelList. Ravikant previously cofounded Epinions (which went public as part of Shopping.com) and Vast.com. Ravikant also worked in the strategic planning group at @Home Network and served as a consultant in the high-tech practice area of the Boston Consulting Group. He was a seed investor in many businesses including Optimizely, Postmates, Stack Overflow, Thumbtack, Twitter, Uber, and Wish. Ravikant earned degrees in computer science and economics from Dartmouth College.
1. “The cost of starting a company has collapsed.”
As the cost of running a startup experiment is coming down, more experiments are being run.
Three years ago, companies could for the first time get all the way through a prototype of a service before they even raised seed money. Two years ago, they could make it through launch before raising money. Now, they can start to get traction with a user base by the time they come looking for seed money.
Entrepreneurs are engaged in “deductive tinkering” as they search for better products and services. Eric Ries describes the process this way: “Learning how to build a sustainable business is the outcome of experiments that follow a three-step process. Build, measure, learn.” Why is experimentation so important in an economy? Because experimentation is the best way to deal with complex, adaptive systems, such as the economy.
An economy is a complex system in that it is networked and therefore adaptive, unlike a simple formalism, such as that used in classical physics, which is unable to accurately predict outcomes. In the case of complex, adaptive systems, such as an economy or a business, the correct approach is to discover solutions via trial and error rather than prediction. Nassim Taleb describes why the experimentation approach works well in business:
It is in complex systems, ones in which we have little visibility of the chains of cause–consequences, that tinkering, bricolage, or similar variations of trial and error have been shown to vastly outperform the teleological—it is nature’s modus operandi. But tinkering needs to be convex; it is imperative…. Critically what is desired is to have the option, not the obligation, to keep the result, which allows us to retain the upper bound and be unaffected by adverse outcomes.
As an example of a convex financial proposition, the most a founder or venture capitalist can lose is 100 percent of what they invest in a startup, yet they can potentially gain many multiples of that investment.
2. “Success rates are definitely coming down, but that is because the cost of running a startup experiment is coming down, so more experiments are being run. In the old days, we would have one company spend $10 million to figure out if it has a market. Today, maybe that same company could do it under $1 to $2 million. The capital, as a whole, may make the same or better returns, but yeah, if the failures don’t cost half of what they used to, you are actually saving money; it is a more efficient market.”
More experiments inevitably mean more failures on an absolute basis. As the rate of business experimentation rises, there will inevitably be an increase in the number of poseurs trying to create new businesses, which will increase failure rates. A lower overall success rate caused by an increase in the number of experiments is a positive tradeoff overall, however, since society benefits from the increased innovation. This net societal benefit occurs even though most experiments fail and some experiments are being conducted on the margin by poseurs who have little or no idea what they are doing. Some failure is essential to the capitalist process since it is experimentation and innovation that fuel success. What the vast reduction in the cost of running business experiments has done is radically increase the pace of the innovation discovery process. Because the creative destruction process is now operating as if it has taken steroids, the rate at which profit is turned into consumer surplus has never been greater, especially in the technology sector. A real economy is messy, with lots of failure. But failure is an essential part of the process of creating innovation and a healthy economy. Failure is literally everywhere and is essential to making capitalism work.
3. “The funding market is so bifurcated because outcomes are so bifurcated.”
Startup outcomes fall on a power-law distribution. So startup financings look the same way. You’re unfundable until you’re oversubscribed.
The nature of the markets has in many cases become more consumerized. People have caught on to how network effects work.
Network effects are increasingly driving both financial success and failure. Google is an example of a company generating strong network effects. Motorola and BlackBberry are examples of businesses that lost network effects. Since venture investors increasingly understand that the network-effects phenomenon is what determines success, they are investing more money in a smaller number of firms, those deemed to have momentum since they were first to achieve product–market fit. As a result, some businesses can easily raise billions of dollars in venture capital whereas other firms cannot raise even small amounts of capital.
4. “The Internet is very efficiently arbitraged. Anything you can think of has been thought of and tried. The only way you’re going to find something is if you stick to it at an irrational level and try a whole bunch of things.”
The number of business experiments being conducted is increasing so quickly that the more obvious opportunity spaces for entrepreneurs are being exhausted with unprecedented efficiency and speed. There are fewer places to hide from the relentless pace of competition if a businessperson’s plan is to do something conventional. This phenomenon places a premium on genuine product breakthroughs, often resulting from original research and development and rapid and frequent experimentation.
5. “You get paid for being right first, and to be first, you can’t wait for consensus.”
In a modern networked economy, the first business to achieve product–market fit often wins. This means that an entrepreneur who is timid because he or she is making a contrarian bet is at a tremendous disadvantage. If another business starts its flywheel first by correctly making the same contrarian bet, catching up can be impossible or prohibitively expensive. Speed and agility have never been so important in business.
6. “The market has to be huge because everyone makes mistakes. You never quite get it right the first time. Companies that don’t do giant pivots are always doing micro-pivots. You need a large enough market that you can pivot in …”
Venture capitalists and entrepreneurs have always favored large addressable markets. But owing to the increasing levels of competition caused by advances in technology, this has never been more true than it is today. Having a huge addressable market increases the convexity of the potential financial outcome since it increases optionality. In other words, there is more room for a business to make adjustments if the addressable market is large. In contrast, small addressable markets provide entrepreneurs with fewer options and are not as convex.
7. “A $1 billion seed fund would destroy the entire market and put prices up 20 percent overnight.”
We don’t think we can allocate that kind of capital without distorting the market.
Even the $400 million we raised will be spread out over six to eight years. Maybe the first year, we’ll deploy $20 or $30 million as we figure out the model, and then scale it out.
The market for venture capital is top-down constrained by the potential for financial exits for businesses created by entrepreneurs. This scalability problem, which Fred Wilson and others have written about, means that in a country like the United States, only about eight hundred startups raised venture capital for the first time in 2016. This constraint is driven by the fact that an economy is limited in its ability to absorb new businesses. The capacity of an economy to provide venture-backed businesses with financial exits does gradually rise over time, however. In theory, the total dollar value of exits could grow bigger faster than in the past, but in practice, the numbers do not suggest that as likely to happen.
8. “It’s just as hard to build a large company as it is a small company, so founders might as well build a large company. It’s roughly the same effort.”
If a founder has the choice between doing one of two things that involve roughly the same amount of work and effort with equal odds of success, but the payoff of one is potentially huge whereas for the other it is relatively small, it is a simple decision to select the one with the bigger payoff. All the decision requires is a basic opportunity-cost analysis. Many important decisions should be made the same way, but unfortunately this is too rarely the case. All investment opportunities should be considered on the basis of expected value. Warren Buffett’s advice is to “take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”
9. “I use Warren Buffett’s criteria for assessing the team: Intelligence, Integrity and Energy. You want someone who is really smart, very hardworking, and trustworthy. A lot of people forget the integrity part, but if you don’t have that, then you have a really hardworking crook, and they will find a way to cheat you.”
Intelligence and energy are easier to measure. Integrity is the most important factor.
Having an honest colleague or partner increases the optionality of an investment since trust gives you more options. Decisions can get made faster and with greater confidence. The work is more fun. Life is better. Research studies show that “high-trust societies achieve higher economic growth due to lower transaction costs. Since trust protects property and contractual rights, it is not necessary to divert resources from production to protection.” These ideas about the value of trust apply at both a company and personal level. One reason the innovation economy is still so concentrated in Silicon Valley is because of the Valley’s highly interconnected trust network. Everyone knows everyone else, and there are lots of easy ways to check out and validate (or invalidate) new entrepreneurs and investors.
10. “Companies only fail for two reasons: The founder gives up, or they run out of money.”
Don’t be proud. Get the cash wherever you can. Cash is everything.
Raise twice as much, and make it last four times as long. Pretend that you don’t have the money in the bank; run lean. Assuming your unit economics are at least breakeven, keep your headcount low, raise money, and stay in it for the long haul. It takes a decade to build a great company. There are no short cuts.
The only unforgivable sin in business is to run out of cash. What does cash give a business? Options. What do options create? Convexity! By now you have probably figured out that convexity is everywhere, if you know how to look. Ravikant says,
There is a whole set of companies that are not financeable by the venture community: service businesses, markets that are heavily played out. If you are fighting a war that has already been won, … you better have some really core differentiation and traction. Other disqualifiers include not enough technical people on the team, … if you are completely out of market, … pre-launch companies tend to not do well, … and teams that have no credibility. The companies that fail to raise funding are the ones that use too many words and too few actions. Your biography is a record of your past actions. Your execution on your current business is a record of your current actions. Talking about what you are going to do in the future is almost pointless. Talking about what you can become is almost pointless. People want evidence. There is a lot of talk out there.
Most startups are unable to raise venture capital, but this is not the end of the world for those businesses. There are many ways to finance a business that do not involve venture capital.
11. “When building a startup, microeconomics is fundamental; macroeconomics is entertainment.”
Getting real traction is hard. Raising millions of dollars is hard. Building a sustainable, long-term company is hard. Your pre-traction company has not achieved product–market fit, and so it has a hard time hiring.
There isn’t a shortage of developers and designers. There’s a surplus of founders.
Understanding microeconomics is essential if you want to be successful in business. The distinction between micro- and macroeconomics was explained by Charlie Munger at the 2016 Berkshire Hathaway shareholder meeting: “Microeconomics is what we do; macro is what we have to put up with.”
12. “It seems like too many people, public and private sector, are making a living slicing the pie rather than baking it.”
Life is far too short to work with poseurs. If you hang out with people who do not actually do anything, there is a significant danger that you will eventually start to adopt doing nothing as your own standard practice. Those that can do, do. Find and work with them. It is that simple. Nothing is better than making a positive difference.