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Risk for lunch. Reward for dinner.
Power law outcomes benefit all stakeholders - founders, investors and employees.
Think about the impact of the Paypal Mafia: Elon Musk, Peter Thiel, Reid Hoffman, the founders of Youtube, Yelp, Yammer, 500 startups, and many more. A few massive winners create the bulk of returns. They’ve started a positive flywheel for their entire ecosystem.
These virtuous circles that spring from exceptional outcomes seem concentrated in the US, China and a few other places like Estonia, Holland and Israel, but haven’t permeated the European or other ecosystems yet.
How come? Quite simply, the best ecosystems encourage founders to keep on taking risks as their company grows! Let’s see how it works.
A relationship towards risk.
I remember reading a fascinating study in Science Magazine arguing that our cognitive functions are significantly altered when we are put under financial stress.
Amazing companies are more likely to be built when founders are not walking the tightrope, risking everything they own.
So let me tell you a secret: there is no risk in starting a business.
To launch a business, you need knowledge (to start), capital (to build) and contacts (to sell to).
The Internet made knowledge accessible. Infrastructure (AWS, APIs, Open Source) has brought the cost of building down to practically zero. Google, Amazon and Facebook have put millions of consumers at your fingertips. You can essentially start with nothing and fail without consequences. Of course, the big winners in this tech entrepreneurial era are the infrastructure builders, but they aren't gatekeepers like the previous entrepreneurial generations were.
There are three stages of building a company:
Risk needs to be mitigated at every stage to maximize outcomes. I am referring to financial risk here (the social risk of failure is something different).
Pre-product-market fit, venture capital offsets risk from founders to funds.
Funds let entrepreneurs build the company to find product-market fit without bearing the risk of going into debt for life.
Since this increased pool of potential entrepreneurs should be iterating towards product-market fit in good conditions, founders need to be able to pay themselves a salary in line with the market. At the same time, they should keep team size and burn rate to a minimum, ensuring that they stay aligned with investors on their shared goal: building something people want.
Post-product-market fit, everything changes.
Until product-market fit, a startup is basically worthless. How do you know when you have product-market fit? You know. Clients come knocking at your door, funds start camping outside your office, you stop setting optimistic targets and start forecasting revenues based on real operations. It's a different world.
Your company is actually worth something. Amazing! You now have something to lose.
This is when incentives can fall out of alignment. Investors are highly diversified and want billion dollar exits to move the needle. Entrepreneurs are extremely focused and want billion dollar exits too, but they're also tempted to safeguard what they've already built.
Would a broke Daniel Ek lead Spotify into a high stakes battle with Apple? How do we avoid Booking.com being sold for $100m or Zenly being sold for $200m?
The question is: could those founders have been secured in a way that let them dream of outcomes on even higher orders of magnitude?
Post-product-market fit is the stage at which power law outcomes materialize.
That's when you want founders to keep all their decision-making capability and to make the bold bets to build legendary companies. At this stage, allowing founders to pay themselves (above) market salaries and sell some of their shares via secondary offerings isn't a gift to them, it’s just the right thing to do. And the examples of founders netting millions and then driving the company into the ground isn't a counterargument; it’s just the natural result of probabilities that come in when an ecosystem is playing the smart game.
Downside protection reveals a lack of confidence in large outcomes.
And it becomes a self-fulfilling prophecy.
At The Family we believe that we get the investors we deserve. As ecosystems mature and companies become more exceptional, we've witnessed an inflow of sophisticated capital, including from American VC platforms, software-focused PE funds, and sovereign funds. Money travels more easily than people, goods, and even knowledge.
Yet for entrepreneurs and investors, most ecosystems still lack exit potential:
Local stock markets have little appetite for technology and the hurdles to going public in the US are very high.
Corporations don't understand startups and have been terrible acquirers. They consider software as a stable piece of engineering rather than a living organism. Their negotiations over the selling price are so tough that they create resentment and kill their own purchases. They think the risk is about overpaying, when it’s actually about breaking the power law.
Traditional businesses still pay dividends. In the venture capital model, paying shareholders with dividends is poor capital allocation: capital should be reinvested in growth and shareholders should look to secondary markets for payouts.
Everything starts with education. Different cultures embrace risk in different ways. But we are a generation that grew up on the internet, and we shouldn't be as constrained by our home culture’s aversion to risk.
If you think you are going to lose, you probably will.
Embrace failure, celebrate victories.
Stop saving the zombies, foster novelty.
Forget the downside, optimize for the upside.
And let's reward everyone along the way.
We are firm believers that risk-taking can be taught, just like ambition and high standards.
Feel free to reach out if you want to learn.