Being on the VC side of the table, I constantly ask that question to myself - not because I have the super-power or arrogance to claim that I am always able to see the best startup ideas. I just think it’s a question worth asking.
If we look at the past - how many people thought Facebook was a joke in 2004? Come on, some website for college students to “stalk” each other? How you gonna make money out of it? And how many people would be able to say that they knew Google was going to be as big as it is today, given it was “just another search engine” back in 1998 when there were plenty other alternatives already? (there are many interesting examples here too) I guess the answer is not a lot people - certainly only a “lucky” few who had understood the vision and made the investments when others wouldn’t.
Shouldn’t VC’s market expertise, proprietary network and due intelligence help “foresee” the future and predictively pick out those winners? What happened?
As a VC investor, I get pitched a lot. Although I would like to think that I help all the founders I interact with in some way (i.e. make intro, give feedback, etc.), at the end of the day, we still need to make a decision on whether to invest or not. And it’s never been fun to say no – and trust me, I’ve been an entrepreneur myself too, and it’s never been fun to be rejected neither. But, things happen for a reason - investors are sort of positioned to say “no” hundreds or thousands of times just so that they can say “yes” a few times - simple economics.
But still, I think most VCs, when they say no, have probably asked themselves -“What if this is the next Facebook or Google that I am rejecting?” (Its not like it has never happened before). Paul Graham wrote a nice essay on “How to Raise Money.” That details 2 major psychological factors for investors - 1) “fear of missing out on startups that take off” and 2) “fear of investing in startups that fizzle.” Very true. And in most cases, fear #2 is greater than fear #1 unless proven otherwise - well, how to prove then? And in most cases, fear #2 is greater than fear #1. Think about most of your VC pitch meetings, I bet somebody has asked you something about traction, market and business model? Sounds familiar? And what were your answers?
Looping back to the big question - “why do the best startup ideas (usually) have the hardest time to get recognized and funded?” Here is your answer -
On VC side, most of them are driven by fear (never a good thing!) and are looking for “comfort factors” like traction, market and business model;
On the (best) startup side, it’s never easy to feed VC with those “comfort pills,” because either the founders are seeing what most people are not seeing or they are creating their own categories.
In the middle, which is what makes it harder, there are startups (and many many of them) that are simply bad ideas - those are also not able to provide traction, market or business model. Or, good startups can be so early at the curve that it might take decades for the game to start.
Just to make it clearer – I have drawn rough graphs below for illustration:
Y axis is your “traction” and X axis is your “appearing market potential” (not real potential but perceived potential). Roughly speaking, point 1 is the place that people think there is a “huge” market opportunity and, for the “risk reduction” purpose, investors would prefer to invest in something “bigger than huge” (cuz that sounds better, doesn’t it).
So there you have it, the green-shaded part (point 3) is where most startups get funded by VC – usually ones appear to go after billion-dollar market, with or without revenue.
If you were an investor, you would probably like to put money as close to point 5 area as possible, right? Think about it, that’s the area where companies are tackling big problems and are seeing great traction and revenue already. So, why not?!
Well, 2 problems.
The first one is that you would miss out all the great ones – the “good ideas that seem bad” (by Paul Graham) in the point 4 area. These are the companies like Airbnb, Facebook in the early days where they were creating their own categories and have some tractions but not big enough to convince its market potential.
The second problem is about tiers of risk. And that’s what it all comes down about – risk taking. Even if you just invest in the point 5 “startup heaven” areas, you still face a tremendous amount of risk.
To break it down, here is another graph -
There are usually 2 type of risks are generally being recognized – which, in this graph, are what I call “1st tier risk” and “2nd tier risk.” Assuming all kind of startups were born from that blue circle - as each startup grows, most of them would fail before they hit “the promised land.” Those 75% - 90% failure rate comprised the “1st tier risk.” That explaines why most seed and angel investors use the “spray and pray” approach in order to tolerate the “1st tier risk” – it really take a “spray” amount of bets to make the economics work.
Now on the other hand, you can usually avoid the tier 1 risk by dragging behind your investment stage – say focusing on Series A-Z round like most institutional VCs do – but you will be still be facing the “2nd tier risk.” The risk contains several folds – one of which is that “market disappears.”
WTF? You might ask.
Well, it might just turn out that the market you are in is either “too early” (a hype) or “not real” (a fad), or is destroyed by other external reasons such as war, etc. But, these are the risks most VCs are comfortable with and are willing to take. And that’s why you see most VCs spend a lot of time learning about the market and the team (cuz after all, you need to have a great team to execute and innovate to reach the “up-right”).
Interestingly, there is also a “tier 3 risk” that most people don’t formally recognize – that is the risk of missing out “good ideas that seems bad.” As shown in the graph above, these companies might not be able to take off fast and, have probably been struggling to gain some market and survive – therefore, most of the angels would pass because they can’t see the market while most of VCs would wait and choose not to invest until it becomes a “hot deal.”
So there you have it. If you think picking good public stocks is hard, then backing a good startup might be harder. Its very similar to betting on a horse race, except that when investing in public stocks, you know which horses will show up at which track and when the race will start, whereas in the early-stage startup world, you don’t even know if you have bet on a horse (or not!), at an un-heard track-field at a time that you are not even sure when the race would start! (as precisely shown below)
Tricky. Isn’t it.
That’s why when you ask most VC investors how and why they invested in napkin-stage, no-traction, garage-based XYZ co. (insert tech company you admire), often times, they would humbly say - ” I guess I was lucky to find Steve…”
So, luck. Is that what it takes to find and fund the best startups?
Maybe, but that’s not the whole story. It’s ultimately about which kind of investor you are. If you are a hustler, you attract hustler founders; if you are an engineer, you attract engineer founders…
In a successful startup journey, founder and investor have to match, on some level - a level that’s beyond terms like market, traction and business model. Of course, it’s a hard and rare match[a] and that’s why best startups usually have the hardest time to be recognized and funded.
[a] Also, VC usually would like to say - “the best way to get in touch with me is through a warm intro…”? On some level, it’s a match mechanism - to see if the founder belongs to this particular VC’s network/culture.
But it has a problem. Most people only make introductions when they can see and feel the startup idea and vision. So there are these multiple “blocks” or “hurdles” you have to go through if you are a some guy working on something called Twitter back in 2006.
*Thanks to Eric, Nathan, Alan and Shea for the feedback and thoughts.
*Note: I started the post because I wanted to try to answer the question why the best startup ideas (usually) have the hardest time to get funded, but I don’t have the solution for the question. If you do, please reach out and I will be happy to buy you coffee/lunch.