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> This is a persistent myth, but if you examine the math it doesn't work out. A VC firm could improve their returns by at most 2x or 3x by extracting really goo

by jules 14y ago

> This is a persistent myth, but if you examine the math it doesn't work out. A VC firm could improve their returns by at most 2x or 3x by extracting really good terms from an inexperienced founder. But that's rounding error compared to the 100x difference between a big success and a small one. Can you explain this? If by some method you can get overall 2x the returns, why does it matter that most of the income is in the big hits? 2x is 2x regardless.

meric 14y ago
You could've put your money in a company that made 200x instead. (VC's don't have unlimited capital.)
InclinedPlane 14y ago
The point pg is making is that it's not an averages game, it's a lottery game. Say there are two different people playing the lottery. Every day they buy a number of tickets. Person A buys tickets in a pool along with someone else. Person B buys tickets on their own. Thus, if Person A wins the lottery they'll have to split their winnings, whereas Person B gets to keep it all. OK, so who ends up being better off? The answer to that is entirely decoupled from their share of the lottery winnings, what matters is entirely whether or not they won the lottery. In terms of VC financing, the RoI from "winning the lottery" by hitching your horse to a small company that grows until a multi-billion dollar enterprise in a few years is going to dwarf any other aspect of investing and returns. Thus it's vastly more important to ensure that you are doing everything possible to maximize "winning the lottery" rather than trying to maximize the share of the prize you'll get. 2x or 3x may seem like a lot, but it's nothing compared to the 100x, 1000x, or 10000x that you'll get from being on the ground floor of the next big thing. For example, Horace Rackham was an early investor in Ford and he received a 1300x RoI, Peter Thiel received a 3000x RoI on his investment in Facebook, while Kleiner and Sequoia capital each turned $12.5 million into $2 billion through their investments in google.
- jules 14y ago
  If strategy A is buying lottery tickets at $5 and strategy B is buying the lottery tickets at $10, A is twice as good off. It doesn't matter that the earnings are dominated by one single winning lottery ticket; strategy A is always twice as good as strategy B. So getting terms that are twice as good for a VC will double their expected earnings. Sure, if you just consider the winning ticket, it doesn't matter whether you are paying $5 or $10 for it. The thing is that you don't know whats the winning ticket, and it does matter whether you are paying $5 or $10 for each.
  - InclinedPlane 14y ago
    You're still not getting it. It doesn't matter how much of the lottery winnings you get, the only thing that matters is winning the lottery or not. 20% of DuckDuckGo is a rounding error compared to 10%, 5%, or even 1% of google.
    - jules 14y ago
      I'm not getting it because the reasoning is not sound. Your reasoning is basically "the numbers are BIG! so a factor of 2x doesn't matter". If you can get your lottery tickets for half price, you can buy twice as many lottery tickets, and double your chances. Equivalently, getting 1% of Google or 5% of Google is a 5x difference, which is huge. That could easily mean the difference between a net profit or net loss for an investor over all his investments. If you really believe that the terms don't matter, then I'm sure lots of YC startups are happy to take money from you at terms that are 5x better than what YC offers.
      - johnrob 14y ago
        Lottery tickets are a good example in this case. By definition, strategy A and B cannot both be winners (there is only one winning ticket). So the only thing that will set either apart is if one of the two strategies has the winning ticket. The price per ticket is only relevant if neither has the winner, in which case you're comparing who had bigger losses. The reason I like the lottery example is that two venture capital firms don't have matching portfolios (if they did, then valuation would matter for relative performance). In reality, when you compare firm A vs firm B it's the performance of the startups that determines the winner (not the amount of equity owned).
james1071 14y ago
Suppose we select the top 100 start-ups according to whatever criteria we use. We can now proceed in one of two ways. a) Make the minimum offer that we know all of the start-ups will accept.We now have a portfolio of 100 investments. b) Make a lower offer that only some of he start-ups will accept. We now have a portfolio of say 90 investments. The question is which portfolio will portfolio will perform better. If there is no difference in average quality of start-up between the portfolios in a) or b), then portfolio b) will do better (because we have obtained better terms). There is no guarantee that this will happen. It could be that he or she has lost the only 10 companies that will be successful. This is the problem that the VC has to face.

by jules 14y ago

meric 14y ago

You could've put your money in a company that made 200x instead. (VC's don't have unlimited capital.)

InclinedPlane 14y ago

The point pg is making is that it's not an averages game, it's a lottery game. Say there are two different people playing the lottery. Every day they buy a number of tickets. Person A buys tickets in a pool along with someone else. Person B buys tickets on their own. Thus, if Person A wins the lottery they'll have to split their winnings, whereas Person B gets to keep it all. OK, so who ends up being better off? The answer to that is entirely decoupled from their share of the lottery winnings, what matters is entirely whether or not they won the lottery. In terms of VC financing, the RoI from "winning the lottery" by hitching your horse to a small company that grows until a multi-billion dollar enterprise in a few years is going to dwarf any other aspect of investing and returns. Thus it's vastly more important to ensure that you are doing everything possible to maximize "winning the lottery" rather than trying to maximize the share of the prize you'll get. 2x or 3x may seem like a lot, but it's nothing compared to the 100x, 1000x, or 10000x that you'll get from being on the ground floor of the next big thing. For example, Horace Rackham was an early investor in Ford and he received a 1300x RoI, Peter Thiel received a 3000x RoI on his investment in Facebook, while Kleiner and Sequoia capital each turned $12.5 million into $2 billion through their investments in google.

jules 14y ago
If strategy A is buying lottery tickets at $5 and strategy B is buying the lottery tickets at $10, A is twice as good off. It doesn't matter that the earnings are dominated by one single winning lottery ticket; strategy A is always twice as good as strategy B. So getting terms that are twice as good for a VC will double their expected earnings. Sure, if you just consider the winning ticket, it doesn't matter whether you are paying $5 or $10 for it. The thing is that you don't know whats the winning ticket, and it does matter whether you are paying $5 or $10 for each.
- InclinedPlane 14y ago
  You're still not getting it. It doesn't matter how much of the lottery winnings you get, the only thing that matters is winning the lottery or not. 20% of DuckDuckGo is a rounding error compared to 10%, 5%, or even 1% of google.
  - jules 14y ago
    I'm not getting it because the reasoning is not sound. Your reasoning is basically "the numbers are BIG! so a factor of 2x doesn't matter". If you can get your lottery tickets for half price, you can buy twice as many lottery tickets, and double your chances. Equivalently, getting 1% of Google or 5% of Google is a 5x difference, which is huge. That could easily mean the difference between a net profit or net loss for an investor over all his investments. If you really believe that the terms don't matter, then I'm sure lots of YC startups are happy to take money from you at terms that are 5x better than what YC offers.
    - johnrob 14y ago
      Lottery tickets are a good example in this case. By definition, strategy A and B cannot both be winners (there is only one winning ticket). So the only thing that will set either apart is if one of the two strategies has the winning ticket. The price per ticket is only relevant if neither has the winner, in which case you're comparing who had bigger losses. The reason I like the lottery example is that two venture capital firms don't have matching portfolios (if they did, then valuation would matter for relative performance). In reality, when you compare firm A vs firm B it's the performance of the startups that determines the winner (not the amount of equity owned).

james1071 14y ago

Suppose we select the top 100 start-ups according to whatever criteria we use. We can now proceed in one of two ways. a) Make the minimum offer that we know all of the start-ups will accept.We now have a portfolio of 100 investments. b) Make a lower offer that only some of he start-ups will accept. We now have a portfolio of say 90 investments. The question is which portfolio will portfolio will perform better. If there is no difference in average quality of start-up between the portfolios in a) or b), then portfolio b) will do better (because we have obtained better terms). There is no guarantee that this will happen. It could be that he or she has lost the only 10 companies that will be successful. This is the problem that the VC has to face.