Monday, September 10, 2012

What investors don't realize about startups

It's a big bad world out there in regard to differentiating signal from noise.

In Black Swan Farming Paul Graham writes:
"That's made harder by the fact that the best startup ideas seem at first like bad ideas. I've written about this before: if a good idea were obviously good, someone else would already have done it. So the most successful founders tend to work on ideas that few beside them realize are good. Which is not that far from a description of insanity, till you reach the point where you see results."

Success in any field is about seeing around curves. Wayne Gretzky, asked about his success, famously said that he skates not to where the puck is but where it is going to be.

80% of our success comes from 20% of our efforts, but 99% of our great success comes from 1% of our efforts. Graham again:

"Unfortunately picking winners is harder than that. You have to ignore the elephant in front of you, the likelihood they'll succeed, and focus instead on the separate and almost invisibly intangible question of whether they'll succeed really big...

The first rule I knew intellectually, but didn't really grasp till it happened to us. The total value of the companies we've funded is around 10 billion, give or take a few. But just two companies,Dropbox and Airbnb, account for about three quarters of it.

In startups, the big winners are big to a degree that violates our expectations about variation. I don't know whether these expectations are innate or learned, but whatever the cause, we are just not prepared for the 1000x variation in outcomes that one finds in startup investing."

Think about all of the factors that must have gone into the development of Y Combinator. Personal factors in Paul Graham and others. Company factors during its history. 

But three quarters of its value on two picks. Sounds like a 99% to 1% ratio (or more) to me.
So successful investing is really the art and science of finding and managing that 1%.

In the end, for the most successful investors, nothing else matters.

NEVER FORGET THAT.

Reaching Daylight

How does a running back reach the open field?

One relies upon experience, and instinct. But there is also the playbook and studying film. And then, of course, you have to factor in the important factors of the other 21 people on the football field!

Every day we make little decisions that collectively lead to bigger decisions. These bigger decisions, collectively, define our path in life. It's well known that a 1% difference in arc, over time, relates to a dramatically different destination.

The arc, in its vision and its adjustments is part of that 1%.

Could the elite running back tell you how they reach the open field? If they did, would you be capable to understand?

The Next Zuckerberg

If I was the next Zuckerberg (or Jobs or Page) and my company Media 2.0 was the next Facebook or Apple or Google, how would you find me? 

The question is, would I let you?

Graham:

"History tends to get rewritten by big successes, so that in retrospect it seems obvious they were going to make it big. For that reason one of my most valuable memories is how lame Facebook sounded to me when I first heard about it. A site for college students to waste time? It seemed the perfect bad idea: a site (1) for a niche market (2) with no money (3) to do something that didn't matter.

One could have described Microsoft and Apple in exactly the same terms."

Would you recognize Jobs, Page, Zuckerberg and Gates at the earliest stage? 

The great founders manage their investors rather than vice versa. 

When you see the tiny trail out of a forest of noise when the forest looks black you have vision.

Learn from the Past

If you want to find the next Zuckerberg or Page you need to understand them. Volumes have been written on each and yet if the next one walked up to you you could still well miss it.

You're not in the business of examining companies, you're in the business of having a Ph.D. in the next big thing.

You have to live the next big thing, be so immersed in it that the forces of the universe draw it to you.

Or as Obama would say, get out of the weeds and stop playing small ball.

Graham + 1

Is it a matter of having more shots at the basket? Graham writes:
"We can afford to take at least 10x as much risk as Demo Day investors. And since risk is usually proportionate to reward, if you can afford to take more risk you should. What would it mean to take 10x more risk than Demo Day investors? We'd have to be willing to fund 10x more startups than they would."

Compare that to Warren Buffett. When asked about diversification Buffett replied that he believes in putting all of his eggs in one basket and then zealously guarding that basket.

Buffett famously does little buying. He reads and studies voraciously and, as he says, he's looking for that one or two outsized ideas per year.

Of course he's in a different part of the investment curve, dealing only already with highly established companies. But Buffett is living the 1%. He's a diamond finder. And because diamonds don't fade Buffett is not a day trader.

One Day Left to Live

Psychologists help people clarify their values by asking them what they would do if they had only one day left to live. 

If you get rid of all of the noise, then only the signal remains!

If you want to find the 1% investment return, you have to clear away the 99%. Which means that your life becomes a study of the 1%. If you could invest in only one founder, who would it be? What would that individual look like? How would you recognize him or her? How would you appeal to such a person.

And how would you draw them into your life?

Ecosystem

Graham: 
"I'm not saying that the big winners are all that matters, just that they're all that matters financially for investors. Since we're not doing YC mainly for financial reasons, the big winners aren't all that matters to us. We're delighted to have funded Reddit, for example. Even though we made comparatively little from it, Reddit has had a big effect on the world, and it introduced us to Steve Huffman and Alexis Ohanian, both of whom have become good friends."

You have to have enough data points to be able to discern signal from noise. It's the little things that bind to the little things that bind to more little things that become big. But you have to know where things are pointing, and what they mean. Something can be little but leading to something big, or it can be little remaining small. 

The running back takes a step left and another step left and another step left because this leads to exploding through the line to the right. 

Lining up your ducks in a row. You need the right ducks and you need them lined up correctly. 

It's what investors don't know.








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