Grays Sports Almanac for Venture Capital proposes a new risk management model for venture capital. In this investment hypothesis, I outline why a venture fund might beat the odds by purchasing 2,208 to 4,416 warrants on startups. Startups would operate under a governance framework called the Founder Friendly Standard, which gives entrepreneurs control of their companies. In exchange, the venture fund would have the option to exercise warrants for 15 years—purchasing discounted equity only in the startups that become successful.
Beat the odds with a new asset class of warrants on the Founder Friendly Standard.
Credit Suisse discovered that companies where founders have a large ownership interest—like Nike, Alibaba, Berkshire Hathaway, and Google—outperform their peers by 400 basis points per year. Credit Suisse calls these companies the CS Family 1000. They are an “asset class with a compelling investment case” (Klerk et al., 2017).
I hypothesize that Credit Suisse’s investment case can be extended to startup companies. You could do it by combining two pieces of financial technology: warrants and the Founder Friendly Standard. These two technologies can create an asset class that may work like a “Grays Sports Almanac” for predicting the future companies on the CS Family 1000.
An asset class of warrants on the Founder Friendly Standard enables time travel.
Legendary investor, David Swenson, writes, “Investment returns stem from three tools regarding portfolio management: asset allocation, market timing, and securities selection” (Swenson, 2009).
Venture capitalists are known for securities selection. 90% of the returns for the venture capital industry come from selecting portfolio companies that grow up to earn $100M+ in revenue. The odds of selecting a startup that becomes a $100M+ revenue company are between 1 and 2,208 and 1 in 4,416 in any given year in the United States (Kedrosky, 2013).
Venture capital fails to outperform the public markets over time (Mulcahy, 2013). While venture capitalists may be skilled at selecting promising companies, being wrong can be expensive. Venture capitalists typically select less than 100 investments at a time. The odds of generating a successful return are still 1 and 2,208 to 1 in 4,416. Therefore, I think that securities selection is a losing bet for venture capital.
I hypothesize that venture capital can beat the odds with asset allocation and market timing. A new kind of asset class would need to be created: 15-year warrants on companies on the Founder Friendly Standard. A fund would buy 2,208 to 4,416 of these warrants. The fund would exercise the warrants after they’ve crossed into the money by many multiples. As a result, the fund would travel in time, purchasing equity at early day prices.
See also: I'll be the Sean Parker to your Mark Zuckerberg How we discovered the Founder Friendly Standard.
To beat the odds, the new fund would need to make 22x to 44x more investments than the typical venture capital fund. To close deals this quickly, the new fund would leverage the Founder Friendly Standard. The standard gives control of a company to it founder. It speeds up investment deals and pulls forward the CS Family 1000 investment case into new startups.
Founder-controlled, customer-funded companies have the best odds of moving up the power curve of economic profit.
Credit Suisse observed the companies on its CS Family 1000 list take a long-term view on funding. They are likely to use cash from customers to fund growth and dividend payments (Klerk et al., 2017).
As a result, CS Family 1000 companies pay steady dividends, even during economic downturns (Klerk et al., 2017). This contributes to the CS Family 1000’s appeal as an asset class. As Robert D. Arnott points out, dividends have been the main drivers of investment returns over the last 200 years (Arnott, 2003).
"Dividends and the three dwarfs" from #RobArnott proves why consistently delivering net profit beats wishful "hockey sticks." Net profit leads to dividends which outperform cap gains yields (unsupported by dividends) by 8.3X. Inflation beats them by 2.3X. https://t.co/mp1a7XTrmX pic.twitter.com/kcCug6jPAM
— Eisaiah Engel (@eisaiah_e) April 2, 2018
Companies who adopt the Founder Friendly Standard are committing to founder-control. Investors are not likely to agree to founder-control unless companies have significant customer traction. Necessarily, companies who adopt the Founder Friendly Standard will be customer funded in the beginning.
Prepayment from customers or “customer funding” is best for founders and investors, explains Professor John Mullins from the London School of Business (Mullins, 2014). Professor Mullins has published five books, dozens of case studies and more than 50 articles that dispel the myth that companies need investors (London Business School, 2018). In fact, 74% of the companies who had initial public offerings from 2004 to 2016 were not backed by venture capital (National Venture Capital Association Yearbook, 2017).
A recent book from McKinsey explains that figuring out your odds of success and improving them—while there is still time—is key to “moving up the power curve” of economic profit (Bradley, Hirt and Smit, 2018). Here is what the power curve looks like from this article by McKinsey:
On the far left of the power curve are the companies returning exponentially less economic profit. On the far right are the winners. Moving to the far right requires executing big moves. The challenge is getting agreement on what those big moves are. This is the social side of strategy. It’s where many companies fail.
Similar social challenges exist in startups. Professor Sam Garg from the Hong Kong University of Science and Technology found that entrepreneurs and venture capitalists have different motivations which can result in “principal problems” (Garg, 2017). Principal problems slow down a company’s ability to execute. This is why I think venture capitalists lock in their odds when they invest—despite their best efforts to change portfolio companies’ strategies in the future.
Based on my experience as an entrepreneur and later as an employee of large companies, I think that founder-controlled, customer-funded companies have the best combination of management flexibility and runway time to figure out their odds and improve them.
How to deliver maximum returns from founder-controlled, customer-funded companies.
While companies on the Founder Friendly Standard will be customer-funded, I see a window of time when $1,000 to $5,000 of seed capital could create value for the companies and investors. The window of time happens when the company is just getting started.
- Spanx started with $5,000 (Tulshyan, 2012).
- Electronic Data Systems started with $1,000 (Guinto, 2013).
- Subway started with $1,000 (McCreary, 2018).
Startups on the Founder Friendly Standard could sell warrants to raise $1,000 to $5,000 of seed capital. One way it could work is attorneys who are certifying if companies meet the standard could buy the warrants. The attorneys could sell half of each warrant to a fund like the one proposed earlier. The fund and the attorney could separately exercise their halves of each warrant in the future. The rules for exercise might be pre-determined in the warrant agreement itself. (E.g. “Over the next 15 years, the purchaser will have the right to invest within 90 days of the share price reaching $5.”)
In summary, this investment hypothesis proposes that venture capital can beat the odds by traveling in time with a new asset class and a new fund. The asset class is 15-year warrants on Founder Friendly Standard companies. The investment fund purchases 2,208 to 4,416 warrants. It uses asset allocation and market timing strategies to exercise warrants only after investment cases are proven. The new fund delivers returns from organic growth with these three features:
- Lower fees – Reduced legal expenses and management fees because the Founder Friendly Standard requires investors to be hands-off.
- Longer investment horizon – Returns paid for 30+ years from steady dividends with low fees rather than pushing for fast, high-risk, high-fee exits as venture capital does today.
- Optionality – Reduced risk from the fund waiting to purchase equity until clear winners emerge from the pool of 2,208 to 4,416 warrants.
Arnott, R. (2003). Dividends and the Three Dwarfs. Financial Analysts Journal, [online] 59(2), pp.4-6. Available at: https://www.cfapubs.org/doi/pdf/10.2469/faj.v59.n2.2510 [Accessed 2 Apr. 2018].
Bradley, C., Hirt, M. and Smit, S. (2018). Strategy beyond the hockey stick. Hoboken, New Jersey: Wiley, Kindle Location 437.
Garg, S. (2017). Venture Boards: Distinctive Monitoring and Implications for Firm Performance. Academy of Management Review, [online] 38(1). Available at: https://journals.aom.org/doi/10.5465/amr.2010.0193 [Accessed 13 May 2018].
Guinto, J. (2013). A New Startup, EDS. [online] D Magazine. Available at: https://www.dmagazine.com/publications/d-magazine/2013/november/dallas-1963-eds-and-h-ross-perot/ [Accessed 26 Jun. 2018].
Kedrosky, P. (2013). The Constant: Companies That Matter. [ebook] Kansas City, MO: Ewing Marion Kauffman Foundation, p.5. Available at: https://www.kauffman.org/what-we-do/research/2013/05/the-constant-companies-that-matter [Accessed 14 May 2018].
Kedrosky’s exact quote is, “…anywhere from 125 to 250 companies per year that are founded in the United States (out of roughly 552,000 new employer firms that open each year) reach $100 million in revenues in a reasonable timeframe.” I have divided 552,000 by 250 and 125 to find the lower bounds of 2,208 and the upper bounds of 4,416 in my odds calculation.
Klerk, E., Bhatti, M., Kersley, R. and Vair, B. (2017). The CS Family 1000. [ebook] Zurich: Credit Suisse AG Research Institute, pp.4-6. Available at: http://publications.credit-suisse.com/index.cfm/publikationen-shop/research-institute/the-cs-family-1000-en/ [Accessed 26 Jun. 2018].
London Business School. (2018). John Mullins | London Business School. [online] Available at: https://www.london.edu/faculty-and-research/faculty/profiles/m/mullins-j [Accessed 26 Jun. 2018].
McCreary, M. (2018). How a 17-Year-Old With $1,000 Started Subway and Became a Billionaire. [online] Entrepreneur. Available at: https://www.entrepreneur.com/article/313130 [Accessed 26 Jun. 2018].
Mulcahy, D. (2013). Six Myths About Venture Capitalists. [online] Harvard Business Review. Available at: https://hbr.org/2013/05/six-myths-about-venture-capitalists [Accessed 26 Jun. 2018].
Mullins, J. (2014). The customer-funded business. Hoboken, NJ: John Wiley & Sons Inc.
National Venture Capital Association Yearbook. (2017). [ebook] Washington, DC.: National Venture Capital Association, p.29. Available at: https://nvca.org/download/5080/ [Accessed 26 Jun. 2018].
Swensen, D. (2009). Pioneering Portfolio Management. New York: Free Press, Kindle Locations 1053-1054.
Tulshyan, R. (2012). Spanx’s Sara Blakely: Turning $5,000 into $1 billion with panties. [online] CNN. Available at: https://www.cnn.com/2012/12/04/business/sara-blakely-spanx-underwear/index.html [Accessed 26 Jun. 2018].