September 2012I've done several types of work over the years but I don't knowanother as counterintuitive as startup investing.The two most important things to understand about startup investing,as a business, are (1) that effectively all the returns areconcentrated in a few big winners, and (2) that the best ideas lookinitially like bad ideas.The first rule I knew intellectually, but didn't really grasp tillit happened to us. The total value of the companies we've fundedis 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 ourexpectations about variation. I don't know whether these expectationsare innate or learned, but whatever the cause, we are just notprepared for the 1000x variation in outcomes that one finds instartup investing.That yields all sorts of strange consequences. For example, inpurely financial terms, there is probably at most one company ineach YC batch that will have a significant effect on our returns,and the rest are just a cost of doing business. [1]I haven'treally assimilated that fact, partly because it's so counterintuitive,and partly because we're not doing this just for financial reasons;YC would be a pretty lonely place if we only had one company perbatch. And yet it's true.To succeed in a domain that violates your intuitions, you need tobe able to turn them off the way a pilot does when flying throughclouds. [2] You need to do what you know intellectually to beright, even though it feels wrong.It's a constant battle for us. It's hard to make ourselves takeenough risks. When you interview a startup and think "they seemlikely to succeed," it's hard not to fund them. And yet, financiallyat least, there is only one kind of success: they're either goingto be one of the really big winners or not, and if not it doesn'tmatter whether you fund them, because even if they succeed theeffect on your returns will be insignificant. In the same day ofinterviews you might meet some smart 19 year olds who aren't evensure what they want to work on. Their chances of succeeding seemsmall. But again, it's not their chances of succeeding that matterbut their chances of succeeding really big. The probability thatany group will succeed really big is microscopically small, but theprobability that those 19 year olds will might be higher than thatof the other, safer group.The probability that a startup will make it big is not simply aconstant fraction of the probability that they will succeed at all.If it were, you could fund everyone who seemed likely to succeedat all, and you'd get that fraction of big hits. Unfortunatelypicking winners is harder than that. You have to ignore the elephantin front of you, the likelihood they'll succeed, and focus insteadon the separate and almost invisibly intangible question of whetherthey'll succeed really big.HarderThat's made harder by the fact that the best startup ideas seem atfirst like bad ideas. I've written about this before: if a goodidea were obviously good, someone else would already have done it.So the most successful founders tend to work on ideas that fewbeside them realize are good. Which is not that far from a descriptionof insanity, till you reach the point where you see results.The first time Peter Thiel spoke at YC he drew a Venn diagram thatillustrates the situation perfectly. He drew two intersectingcircles, one labelled "seems like a bad idea" and the other "is agood idea." The intersection is the sweet spot for startups.This concept is a simple one and yet seeing it as a Venn diagramis illuminating. It reminds you that there is an intersection—thatthere are good ideas that seem bad. It also reminds you that thevast majority of ideas that seem bad are bad.The fact that the best ideas seem like bad ideas makes it evenharder to recognize the big winners. It means the probability ofa startup making it really big is not merely not a constant fractionof the probability that it will succeed, but that the startups witha high probability of the former will seem to have a disproportionatelylow probability of the latter.History tends to get rewritten by big successes, so that in retrospectit seems obvious they were going to make it big. For that reasonone of my most valuable memories is how lame Facebook sounded tome when I first heard about it. A site for college students towaste time? It seemed the perfect bad idea: a site (1) for a nichemarket (2) with no money (3) to do something that didn't matter.One could have described Microsoft and Apple in exactly the sameterms.[3]Harder StillWait, it gets worse. You not only have to solve this hard problem,but you have to do it with no indication of whether you're succeeding.When you pick a big winner, you won't know it for two years.Meanwhile, the one thing you can measure is dangerouslymisleading. The one thing we can track precisely is how well thestartups in each batch do at fundraising after Demo Day. But weknow that's the wrong metric. There's no correlation between thepercentage of startups that raise money and the metric that doesmatter financially, whether that batch of startups contains a bigwinner or not.Except an inverse one. That's the scary thing: fundraising is notmerely a useless metric, but positively misleading. We're in abusiness where we need to pick unpromising-looking outliers, andthe huge scale of the successes means we can afford to spread ournet very widely. The big winners could generate 10,000x returns.That means for each big winner we could pick a thousand companiesthat returned nothing and still end up 10x ahead.If we ever got to the point where 100% of the startups we fundedwere able to raise money after Demo Day, it would almost certainlymean we were being too conservative.[4]It takes a conscious effort not to do that too. After 15 cyclesof preparing startups for investors and then watching how they do,I can now look at a group we're interviewing through Demo Dayinvestors' eyes. But those are the wrong eyes to look through!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 affordto take more risk you should. What would it mean to take 10x morerisk than Demo Day investors? We'd have to be willing to fund 10xmore startups than they would. Which means that even if we'regenerous to ourselves and assume that YC can on average triple astartup's expected value, we'd be taking the right amount of riskif only 30% of the startups were able to raise significant fundingafter Demo Day.I don't know what fraction of them currently raise more after DemoDay. I deliberately avoid calculating that number, because if youstart measuring something you start optimizing it, and I know it'sthe wrong thing to optimize.[5]But the percentage is certainlyway over 30%. And frankly the thought of a 30% success rate atfundraising makes my stomach clench. A Demo Day where only 30% ofthe startups were fundable would be a shambles. Everyone wouldagree that YC had jumped the shark. We ourselves would feel thatYC had jumped the shark. And yet we'd all be wrong.For better or worse that's never going to be more than a thoughtexperiment. We could never stand it. How about that forcounterintuitive? I can lay out what I know to be the right thingto do, and still not do it. I can make up all sorts of plausiblejustifications. It would hurt YC's brand (at least among theinnumerate) if we invested in huge numbers of risky startups thatflamed out. It might dilute the value of the alumni network.Perhaps most convincingly, it would be demoralizing for us to beup to our chins in failure all the time. But I know the real reasonwe're so conservative is that we just haven't assimilated the factof 1000x variation in returns.We'll probably never be able to bring ourselves to take risksproportionate to the returns in this business. The best we canhope for is that when we interview a group and find ourselvesthinking "they seem like good founders, but what are investors goingto think of this crazy idea?" we'll continue to be able to say "whocares what investors think?" That's what we thought about Airbnb,and if we want to fund more Airbnbs we have to stay good at thinkingit.Notes[1]I'm not saying that the big winners are all that matters, justthat they're all that matters financially for investors. Sincewe're not doing YC mainly for financial reasons, the big winnersaren't all that matters to us. We're delighted to have fundedReddit, for example. Even though we made comparatively little fromit, Reddit has had a big effect on the world, and it introduced usto Steve Huffman and Alexis Ohanian, both of whom have become goodfriends.Nor do we push founders to try to become one of the big winners ifthey don't want to. We didn't "swing for the fences" in our ownstartup (Viaweb, which was acquired for $50 million), and it wouldfeel pretty bogus to press founders to do something we didn't do.Our rule is that it's up to the founders. Some want to take overthe world, and some just want that first few million. But we investin so many companies that we don't have to sweat any one outcome.In fact, we don't have to sweat whether startups have exits at all.The biggest exits are the only ones that matter financially, andthose are guaranteed in the sense that if a company becomes bigenough, a market for its shares will inevitably arise. Since theremaining outcomes don't have a significant effect on returns, it'scool with us if the founders want to sell early for a small amount,or grow slowly and never sell (i.e. become a so-called lifestylebusiness), or even shut the company down. We're sometimes disappointedwhen a startup we had high hopes for doesn't do well, but thisdisappointment is mostly the ordinary variety that anyone feelswhen that happens.[2]Without visual cues (e.g. the horizon) you can't distinguishbetween gravity and acceleration. Which means if you're flyingthrough clouds you can't tell what the attitude ofthe aircraft is. You could feel like you're flying straight andlevel while in fact you're descending in a spiral. The solutionis to ignore what your body is telling you and listen only to yourinstruments. But it turns out to be very hard to ignore what yourbody is telling you. Every pilot knows about this problem and yetit is still a leading cause of accidents.[3]Not all big hits follow this pattern though. The reason Googleseemed a bad idea was that there were already lots of search enginesand there didn't seem to be room for another.[4]A startup's success at fundraising is a function of two things:what they're selling and how good they are at selling it. And whilewe can teach startups a lot about how to appeal to investors, eventhe most convincing pitch can't sell an idea that investors don'tlike. I was genuinely worried that Airbnb, for example, would notbe able to raise money after Demo Day. I couldn't convince Fred Wilson to fund them. They might nothave raised money at all but for the coincidence that Greg McAdoo,our contact at Sequoia, was one of a handful of VCs who understoodthe vacation rental business, having spent much of the previous twoyears investigating it.[5]I calculated it once for the last batch before a consortium ofinvestors started offering investment automatically to every startupwe funded, summer 2010. At the time it was 94% (33 of 35 companiesthat tried to raise money succeeded, and one didn't try becausethey were already profitable). Presumably it's lower now becauseof that investment; in the old days it was raise after Demo Day ordie.Thanks to Sam Altman, Paul Buchheit, Patrick Collison, JessicaLivingston, Geoff Ralston, and Harj Taggar for reading drafts ofthis.
