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Updated by Nick Kellet on Nov 13, 2015
Nick Kellet Nick Kellet
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Growth Research

A VC: Growth

Paul Graham has penned a longish and excellent essay in which he postulates that growth is the single defining characteristic of startups and the thing that all entrepreneurs must focus on. Paul is slowly but surely building a body of...

Startup = Growth

A company that grows at 1% a week will grow 1.7x a year, whereas a
company that grows at 5% a week will grow 12.6x. A company making
$1000 a month (a typical number early in YC) and growing at 1% a
week will 4 years later be making $7900 a month, which is less than
a good programmer makes in salary in Silicon Valley. A startup
that grows at 5% a week will in 4 years be making $25 million a
[10]Our ancestors must rarely have encountered cases of exponential
growth, because our intutitions are no guide here. What happens
to fast growing startups tends to surprise even the founders.Small variations in growth rate produce qualitatively different
outcomes. That's why there's a separate word for startups, and why
startups do things that ordinary companies don't, like raising money
and getting acquired. And, strangely enough, it's also why they
fail so frequently.Considering how valuable a successful startup can become, anyone
familiar with the concept of expected value would be surprised if
the failure rate weren't high. If a successful startup could make
a founder $100 million, then even if the chance of succeeding were
only 1%, the expected value of starting one would be $1 million.
And the probability of a group of sufficiently smart and determined
founders succeeding on that scale might be significantly over 1%.
For the right people—e.g. the young Bill Gates—the probability
might be 20% or even 50%. So it's not surprising that so many want
to take a shot at it. In an efficient market, the number of failed
startups should be proportionate to the size of the successes. And
since the latter is huge the former should be too.
[11]What this means is that at any given time, the great majority of
startups will be working on something that's never going to go
anywhere, and yet glorifying their doomed efforts with the grandiose
title of "startup."This doesn't bother me. It's the same with other high-beta vocations,
like being an actor or a novelist. I've long since gotten used to
it. But it seems to bother a lot of people, particularly those
who've started ordinary businesses. Many are annoyed that these
so-called startups get all the attention, when hardly any of them
will amount to anything.If they stepped back and looked at the whole picture they might be
less indignant. The mistake they're making is that by basing their
opinions on anecdotal evidence they're implicitly judging by the
median rather than the average. If you judge by the median startup,
the whole concept of a startup seems like a fraud. You have to
invent a bubble to explain why founders want to start them or
investors want to fund them. But it's a mistake to use the median
in a domain with so much variation. If you look at the average
outcome rather than the median, you can understand why investors
like them, and why, if they aren't median people, it's a rational
choice for founders to start them.DealsWhy do investors like startups so much? Why are they so hot to
invest in photo-sharing apps, rather than solid money-making
businesses? Not only for the obvious reason.The test of any investment is the ratio of return to risk. Startups
pass that test because although they're appallingly risky, the
returns when they do succeed are so high. But that's not the only
reason investors like startups. An ordinary slower-growing business
might have just as good a ratio of return to risk, if both were
lower. So why are VCs interested only in high-growth companies?
The reason is that they get paid by getting their capital back,
ideally after the startup IPOs, or failing that when it's acquired.The other way to get returns from an investment is in the form of
dividends. Why isn't there a parallel VC industry that invests in
ordinary companies in return for a percentage of their profits?
Because it's too easy for people who control a private company to
funnel its revenues to themselves (e.g. by buying overpriced
components from a supplier they control) while making it look like
the company is making little profit. Anyone who invested in private
companies in return for dividends would have to pay close attention
to their books.The reason VCs like to invest in startups is not simply the returns,
but also because such investments are so easy to oversee. The
founders can't enrich themselves without also enriching the investors.
[12]Why do founders want to take the VCs' money? Growth, again. The
constraint between good ideas and growth operates in both directions.
It's not merely that you need a scalable idea to grow. If you have
such an idea and don't grow fast enough, competitors will. Growing
too slowly is particularly dangerous in a business with network
effects, which the best startups usually have to some degree.Almost every company needs some amount of funding to get started.
But startups often raise money even when they are or could be
profitable. It might seem foolish to sell stock in a profitable
company for less than you think it will later be worth, but it's
no more foolish than buying insurance. Fundamentally that's how
the most successful startups view fundraising. They could grow the
company on its own revenues, but the extra money and help supplied
by VCs will let them grow even faster. Raising money lets you
choose your growth rate.Money to grow faster is always at the command of the most successful
startups, because the VCs need them more than they need the VCs.
A profitable startup could if it wanted just grow on its own revenues.
Growing slower might be slightly dangerous, but chances are it
wouldn't kill them. Whereas VCs need to invest in startups, and
in particular the most successful startups, or they'll be out of
business. Which means that any sufficiently promising startup will
be offered money on terms they'd be crazy to refuse. And yet because
of the scale of the successes in the startup business, VCs can still
make money from such investments. You'd have to be crazy to believe
your company was going to become as valuable as a high growth rate
can make it, but some do.Pretty much every successful startup will get acquisition offers
too. Why? What is it about startups that makes other companies
want to buy them?
[13]Fundamentally the same thing that makes everyone else want the stock
of successful startups: a rapidly growing company is valuable. It's
a good thing eBay bought Paypal, for example, because Paypal is now
responsible for 43% of their sales and probably more of their growth.But acquirers have an additional reason to want startups. A rapidly
growing company is not merely valuable, but dangerous. If it keeps
expanding, it might expand into the acquirer's own territory. Most
product acquisitions have some component of fear. Even if an
acquirer isn't threatened by the startup itself, they might be
alarmed at the thought of what a competitor could do with it. And
because startups are in this sense doubly valuable to acquirers,
acquirers will often pay more than an ordinary investor would.
[14]UnderstandThe combination of founders, investors, and acquirers forms a natural
ecosystem. It works so well that those who don't understand it are
driven to invent conspiracy theories to explain how neatly things
sometimes turn out. Just as our ancestors did to explain the
apparently too neat workings of the natural world. But there is
no secret cabal making it all work.If you start from the mistaken assumption that Instagram was
worthless, you have to invent a secret boss to force Mark Zuckerberg
to buy it. To anyone who knows Mark Zuckerberg that is the reductio
ad absurdum of the initial assumption. The reason he bought Instagram
was that it was valuable and dangerous, and what made it so was
growth.If you want to understand startups, understand growth. Growth
drives everything in this world. Growth is why startups usually
work on technology—because ideas for fast growing companies are
so rare that the best way to find new ones is to discover those
recently made viable by change, and technology is the best source
of rapid change. Growth is why it's a rational choice economically
for so many founders to try starting a startup: growth makes the
successful companies so valuable that the expected value is high
even though the risk is too. Growth is why VCs want to invest in
startups: not just because the returns are high but also because
generating returns from capital gains is easier to manage than
generating returns from dividends. Growth explains why the most
successful startups take VC money even if they don't need to: it
lets them choose their growth rate. And growth explains why
successful startups almost invariably get acquisition offers. To
acquirers a fast-growing company is not merely valuable but dangerous
too.It's not just that if you want to succeed in some domain, you have
to understand the forces driving it. Understanding growth is what
starting a startup consists of. What you're really doing (and
to the dismay of some observers, all you're really doing) when you
start a startup is committing to solve a harder type of problem
than ordinary businesses do. You're committing to search for one
of the rare ideas that generates rapid growth. Because these ideas
are so valuable, finding one is hard. The startup is the embodiment
of your discoveries so far. Starting a startup is thus very much
like deciding to be a research scientist: you're not committing to
solve any specific problem; you don't know for sure which problems
are soluble; but you're committing to try to discover something no
one knew before. A startup founder is in effect an economic research
scientist. Most don't discover anything that remarkable, but some
discover relativity.Notes[1]
Strictly speaking it's not lots of customers you need but a big
market, meaning a high product of number of customers times how
much they'll pay. But it's dangerous to have too few customers
even if they pay a lot, or the power that individual customers have
over you could turn you into a de facto consulting firm. So whatever
market you're in, you'll usually do best to err on the side of
making the broadest type of product for it.[2]
One year at Startup School David Heinemeier Hansson encouraged
programmers who wanted to start businesses to use a restaurant as
a model. What he meant, I believe, is that it's fine to start
software companies constrained in (a) in the same way a restaurant
is constrained in (b). I agree. Most people should not try to
start startups.[3]
That sort of stepping back is one of the things we focus on at
Y Combinator. It's common for founders to have discovered something
intuitively without understanding all its implications. That's
probably true of the biggest discoveries in any field.[4]
I got it wrong in "How to Make Wealth" when I said that a
startup was a small company that takes on a hard technical
problem. That is the most common recipe but not the only one.[5]
In principle companies aren't limited by the size of the markets
they serve, because they could just expand into new markets. But
there seem to be limits on the ability of big companies to do that.
Which means the slowdown that comes from bumping up against the
limits of one's markets is ultimately just another way in which
internal limits are expressed.It may be that some of these limits could be overcome by changing
the shape of the organization—specifically by sharding it.[6]
This is, obviously, only for startups that have already launched
or can launch during YC. A startup building a new database will
probably not do that. On the other hand, launching something small
and then using growth rate as evolutionary pressure is such a
valuable technique that any company that could start this way
probably should.[7]
If the startup is taking the Facebook/Twitter route and building
something they hope will be very popular but from which they don't
yet have a definite plan to make money, the growth rate has to be
higher, even though it's a proxy for revenue growth, because such
companies need huge numbers of users to succeed at all.Beware too of the edge case where something spreads rapidly but the
churn is high as well, so that you have good net growth till you run
through all the potential users, at which point it suddenly stops.[8]
Within YC when we say it's ipso facto right to do whatever gets
you growth, it's implicit that this excludes trickery like buying
users for more than their lifetime value, counting users as active
when they're really not, bleeding out invites at a regularly
increasing rate to manufacture a perfect growth curve, etc. Even
if you were able to fool investors with such tricks, you'd ultimately
be hurting yourself, because you're throwing off your own compass.[9]
Which is why it's such a dangerous mistake to believe that
successful startups are simply the embodiment of some brilliant
initial idea. What you're looking for initially is not so much a
great idea as an idea that could evolve into a great one. The
danger is that promising ideas are not merely blurry versions of
great ones. They're often different in kind, because the early
adopters you evolve the idea upon have different needs from the
rest of the market. For example, the idea that evolves into Facebook
isn't merely a subset of Facebook; the idea that evolves into
Facebook is a site for Harvard undergrads.[10]
What if a company grew at 1.7x a year for a really long time?
Could it not grow just as big as any successful startup? In principle
yes, of course. If our hypothetical company making $1000 a month
grew at 1% a week for 19 years, it would grow as big as a company
growing at 5% a week for 4 years. But while such trajectories may
be common in, say, real estate development, you don't see them much
in the technology business. In technology, companies that grow
slowly tend not to grow as big.[11]
Any expected value calculation varies from person to person
depending on their utility function for money. I.e. the first
million is worth more to most people than subsequent millions. How
much more depends on the person. For founders who are younger or
more ambitious the utility function is flatter. Which is probably
part of the reason the founders of the most successful startups of
all tend to be on the young side.[12]
More precisely, this is the case in the biggest winners, which
is where all the returns come from. A startup founder could pull
the same trick of enriching himself at the company's expense by
selling them overpriced components. But it wouldn't be worth it
for the founders of Google to do that. Only founders of failing
startups would even be tempted, but those are writeoffs from the
VCs' point of view anyway.[13]
Acquisitions fall into two categories: those where the acquirer
wants the business, and those where the acquirer just wants the
employees. The latter type is sometimes called an HR acquisition.
Though nominally acquisitions and sometimes on a scale that has a
significant effect on the expected value calculation for potential
founders, HR acquisitions are viewed by acquirers as more akin to
hiring bonuses.[14]
I once explained this to some founders who had recently arrived
from Russia. They found it novel that if you threatened a company
they'd pay a premium for you. "In Russia they just kill you," they
said, and they were only partly joking. Economically, the fact
that established companies can't simply eliminate new competitors
may be one of the most valuable aspects of the rule of law. And
so to the extent we see incumbents suppressing competitors via
regulations or patent suits, we should worry, not because it's a
departure from the rule of law per se but from what the rule of law
is aiming at.Thanks to Sam Altman, Marc Andreessen, Paul Buchheit, Patrick
Collison, Jessica Livingston, Geoff Ralston, and Harj Taggar for
reading drafts of this.