With Thanksgiving fresh in the memory, I feel the urge to give thanks for the ideals of entrepreneurship as my sixth and final “The Art of VC” article in 2006. Living in Silicon Valley it’s very easy to take the unending supply of entrepreneurs for granted, but as a Brit I can appreciate the unique combination of factors – world class universities, the American/Wild West “can do” attitude, a favorable tax system (capital gains versus income tax), a great place to live, a culture that does not punish failure, access to capital, support services for startups, a known path to liquidity – that have given Silicon Valley its pre-eminent place in the world of entrepreneurship (at this point my partner Brad would gently remind me of MIT). Now many have argued, and I am one of them, that these factors are changing and Silicon Valley’s position is thus at risk. However that is not the focus for this article; I shall leave that for another day. Rather I want to celebrate and examine the “riddle that is wrapped inside an enigma” (borrowing another turn of phrase from that literary maestro Churchill) that is entrepreneurship.
Definition
One of my favourite anecdotes about President George W. Bush emerged in the British press in July 2002. President Bush, Britain's Prime Minister Tony Blair, and France's President Jacques Chirac were discussing economics and, in particular, the decline of the French economy. "The problem with the French," Bush afterwards confided in Blair, "is that they don't have a word for entrepreneur."
Leaving aside the veracity of this anecdote, the humour does highlight a subtle point. While the origin of the word is French (from entreprendre meaning to undertake) it has become synonymous with American business formation. America has deified many of its entrepreneurial heroes over the past century - J Pierpont Morgan, Thomas Edison, Henry Ford, Bill Gates, Steve Jobs, Jeff Bezos, Jerry Yang/David Filo, Larry Page/Sergey Brin – all of whom have founded entire industries through their risk taking. The entrepreneur is seen as the central figure in wealth creation and driving the economy. In Britain until recently, the entrepreneur was seen as a curious creature and on the periphery of the economy rather than at the centre. Growing up in Britain I only had two entrepreneur role models. The first was my father who had worked for himself since the age of 26, created two successful companies, put his two sons through private school and onto university and supported our extended family. I saw the hard work he put in, the difficult decisions he faced, the burden of making payroll, the loyalty he earned from his employees and the satisfaction of being his own man. The second model was (now Sir) Richard Branson, founder of the Virgin Group.
There are many varied definitions of entrepreneurship, but I believe there are five fundamental elements. Most definitions would only encompass two or three of these elements, but I strongly believe all five are necessary attributes.
1. Identification of an opportunity.
This is the distinction between an inventor and an entrepreneur. An inventor focused on the product; an entrepreneur focuses on the problem, the market and how to make customers lives better. Alexander Graham Bell was an inventor; Richard Branson in launching Virgin Mobile is an entrepreneur.
2. Creation of an organization to pursue the opportunity
The best entrepreneurs realize they cannot achieve their goals without assistance and building an organization, so they need to articulate a vision for their organization, identify whom they need to hire into the organization, and use their communications skills to attract them into their organization.
3. Unconstrained by lack of resources
How often have you heard someone say “if only I had the time/money to start my own business…”? This is antithetical to the entrepreneurial approach which does not allow itself to be constrained by the lack of resources. You don’t have enough money to hire employees? Then offer a different mix of cash and equity to employees. You don’t have enough money for an office? Then build a virtual office with Skype and IM tools and rent meeting rooms for presentations.
4. Determination to succeed in the face of high risk
While the Valley centric press has done much to glamourize the startup process, the reality is very different. A startup has many risks to address early in its life cycle – technology risk, market risk, team risk – and has a high risk of mortality in its first two years. An entrepreneur needs a iron constitution to get through the early crepuscular days when the light at the end of the tunnel goals seem far away. Can you see previous evidence of the entrepreneur overcoming adversity? Interestingly from a VC’s perspective, we want entrepreneurs who are prepared to take on more risk than we are since they are putting all their efforts into one enterprise, while as VC’s we are building portfolios.
5. Ability to change course in the face of setbacks.
Coupled with the requisite dogged determination, the entrepreneur also needs to demonstrate an ability to learn from failure and try different approaches. WC Field’s “If at first you don't succeed, quit. No use being a damn fool about it” is a humorous reminder of this need to learn, although I would modify it to ““If after a few times of trying you don't succeed, try another way. No use being a damn fool about it”. The ability to listen to advice, discern the important from the unimportant and incorporate this feedback
Understanding the Odds
The “riddle that is wrapped inside an enigma” that I referred to earlier has two parts. The first is whether entrepreneurs take the leap of faith to start a company in ignorance of the odds they face or in spite of the odds they face. Before we explore this issue, let’s take a look at the odds facing an entrepreneur.
As I have discussed previously, venture returns are highly skewed, with only the top quartile generating returns significantly better than the stock market. Below is two decades worth of data courtesy of Focus Ventures showing this skewedness.
Given the 2nd quartile return of 10.4%, lets translate that into how this level of return impacts the founding entrepreneur. To do this we have to make a number of assumptions so I am going to use some typical averages for time to liquidity (5 years), paid in capital at liquidity ($20M), investor ownership at liquidity (80%), founder ownership at liquidity (3%) and preference structure (1x preference, fully participating). Based on these assumptions, an entrepreneur would earn less than $0.5M for his 5 years or less than $100,000 for every year he was building the business and making personal sacrifices to do so. Now half a million dollars is not to be sneezed at, but does it justify the risk associated with starting a business? So it does not seem like a financially rewarding proposition for the bottom 3 quartiles when you realize that entrepreneurs tend to work longer hours, at a higher tempo, and for less pay (at least initially). Given this analysis, it seems like the odds of making a reasonable living are 1 in 4.
Now let’s look at the odds of being very successful like Bill Gates at Microsoft, Larry Ellison at Oracle, Jeff Yang at Yahoo Pierre Omidyar at Ebay, Jeff Bezos at Amazon, Sergey Brin at Google, or Mark Benioff at Salesforce.com. According to the NVCA, over the past 10 years the number of venture backed companies each year has ranged between 2873 and 4451 from 2001 to 2004. Compare that to the number of venture backed IPOs every year, which ranged between 24 and 93 from 2001 to 2004, and the odds of being very successful are typically less than 1 in 100.
So given the odds of 1 in 4 of making a decent living, and 1 in 100 of being very successful, is it rational for an entrepreneur to take the leap of faith and start a venture backed business? If that were truly the calculus, the answer would be no. But I don’t believe entrepreneurs do the calculus purely in terms of risk and monetary reward. One of if not the primary motivation is the ability to control their own destiny. As VCs we should be thankful for this, otherwise we would not have entrepreneurs as the driving force of our business.
Managing Contradiction
The second part of the “riddle that is wrapped inside an enigma” is the need for an entrepreneur to hold two conflicting concepts in his head at the same time.
The first concept is that the entrepreneur believes he can be the 1 in 100 founder who creates a $500m outcome. He can take the leap of faith, pour his soul into the company, outperform their competitors through unwavering determination, and outwit the incumbents. The Greeks understood that single minded focus on victory was necessary for that victory, through their practice of burning boats after landing so that escape was not an option. In effect, we are asking entrepreneurs to ignore the world and follow their vision
The second concept is that the entrepreneur needs to constantly compare his vision to reality and course correct (see the fifth element of entrepreneurship above). This is equivalent to the Greeks not burning their ships, but assessing their chances against their enemy based on an objective assessment of skill, position and resources, and then deciding whether it is better to sail away and fight another day. So we are now asking the entrepreneur to listen to the world and adjust accordingly. As VCs we rarely stop to ponder that these are two conflicting concepts (some psychologists would say this is definition of insanity). In practice, we don’t ask the entrepreneur to hold these two concepts concurrently, but rather change from the former to the latter, but nonetheless this is an emotional u-turn that can take its toll.
As VCs, entrepreneurs are our customers (although many VCs will dispute this and say our LPs are our customers). The better we can understand our customers, the better we can serve them. Respecting how difficult it is for entrepreneurs to manage the inherent contradiction of entrepreneurship, in the face of overwhelming odds, is the starting point for a productive customer relationship. It behooves us as VCs to remember that.