Who sets the pace in your startup?
The main point: It takes time to build a successful business. If you have funding from a venture capital fund, their time horizon might be different than yours. Understanding the potential discrepancy and talking about it openly with your investors can save you from sleepless nights and improve your chances of long term success.
Buffett on successful value creation
Warren Buffett* recently released his annual letter to shareholders. In it he summarizes the way investors get rewarded by productive assets:
“Productive assets such as farms, real estate and, yes, business ownership produce wealth – lots of it. Most owners of such properties will be rewarded. All that’s required is the passage of time, an inner calm, ample diversification and a minimization of transactions and fees.”
Going through the list, your situation as founder (and shareholder of your company) probably looks like this:
Transaction costs: you don’t have any, you’re stuck with illiquid shares in your startup. This is a plus in Buffett’s framework.
Ample diversification: for most founders there is little diversification. Most of your net worth is, or will soon be if you're successful, tied up in one company. There isn’t much you can do.
Inner calm: Assuming you’re experiencing the usual emotional rollercoaster of entrepreneurship, you don’t have much inner calm. Still worth working on this one.
Time: this is where you can make a big difference. Some great businesses get built quickly, others take time.
Considering that you have limited influence on points 1 and 2, and that point 3 is beyond the scope of business, it makes sense to think about time.
How VCs experiences time
Venture capital funds have a business model just like you. They usually have 10-year funds that can be extended for 2 more years. They make money through management fees set at 2% of committed capital and carried interest that captures 20% of realized gains. Growing their assets under management is the way they expand these fees.
Their business is highly competitive and tough. The majority of funds don’t match the performance of a passive public market index like the S&P 500. In order to raise funds they need to show performance, which means two things: realized gains from exits and markups from additional funding rounds in the startups they’ve invested in.
So far, so good.
The challenge comes from their fundraising cycle. It’s normal for fund managers to raise a new fund every 3 or 4 years. That’s the window they have to show performance. That window may or may not work for every startup in their portfolio.
Even if this timeframe works for your particular company, it’s useful to become aware of their pressures, which might explain why you are in such a hurry.
This fundraising dynamic might be changing with the advent of perpetual capital and rolling funds. These structures give investors a more stable capital base and eliminate the fundraising cycle. This allows them to focus more on the quality of their decisiones and less on their timing. A proliferation of these types of structures would probably serve the whole ecosystem well. For now they are in the minority.
More permanent pools of capital like family offices and corporate VCs might also be more flexible about time frames. They don’t have investors to return capital to, which allows them to be more patient.
Why do I need time?
An interesting book published a few years ago studies hundreds of publicly listed companies that generated returns of 100x or more in the past few decades. High-performing VCs generate a total portfolio return of about 3x, with the best of them (Sequoia) in the 10-12x range. So a particular company that generates a return of 100x or 1,000x would be desirable in their portfolios.
The challenge is that it took these companies an average of 26 years to expand their value by 100x. Some took as little as 6 or 7 years, others took more than three decades. This is what Buffett refers to.
In addition to the time required to create value, another challenge is that valuations don’t always reflect that growth in value. For instance Amazon has generated a return of about 2,000x during its 24 years as a public company. Yet its stock price stagnated for nearly one third of that period, it went nowhere for 8 full years.
Amazon is far from alone in this. Iconic companies like Microsoft and Netflix have also gone through similar periods. In fact looking at the list of hundreds of companies that went 100x it’s hard to find one that didn’t experience either large declines in stock price or extended periods of flat valuations.
Public and private market valuations are driven by company-specific fundamentals in the long run. In shorter periods they are also influenced by market cycles. In other words things that you can’t control will, from time to time, impact your company’s valuation.
The relevant question therefore is: if companies like Amazon and Netflix go through long periods of flat valuations, could this happen to your startup?
Graph: Amazon’s stock price from IPO in 1997 to now (February 2021). Note that the right axis is not proportional to the numbers, it’s a much higher mountain, the split adjusted IPO price of $1.50 compares with current price of $3,000.
Can you really set the pace in your startup?
Your role as a founder gives you a unique position to define the pace of growth based on your knowledge of product, team and market. It’s worth thinking deeply about this before raising money. You have significant power to influence this dimension, especially if you’re aware of it and willing to talk about it openly with your investors. Doing this should improve the chances of finding like-minded investors who, despite limitations from their business model, are thinking and acting long term.
If you chose to start a business rather than work for an existing one, the essential bet you made is on yourself. If you made it past a VC funding round, you’ve already beaten the odds twice, first by having the courage to start a business and then by building something that’s impressive enough to get external funding. Betting on yourself was the right move. Now double down on that bet.
* Can a 90-year old be relevant to the world of startups and investing? Perhaps not. But he did turn $10,000 in investor money into $2 billion during his career, a 200,000x return net of all fees. Surely he learned some valuable insights along the way.