Vicious and Virtuous Cycles

I’ve been reading *Good to Great* recently and they talk a bit about the Flywheel and the Doom Loop, systems within companies that feed on themselves to help them either grow or decline .

I’ve been thinking a lot about how this applies in investing and fundraising dynamics as well as to the core operations of a company.

A few years ago I saw this foreign incubator that wanted 30% equity from all it’s participants. I remember thinking that even as a brand new startup I wouldn’t even consider going with them.

My guess is that they did some analysis of what their likely returns would be, determined that to make their money back or the return they wanted considering traditional exits in their country, etc. they needed to get X% of the companies they invested in right off the bat. It was harder to get returns in their market, and deal flow wasn’t super great in that geography, so they had to make sure they got a bigger percentage of the company.

Their existing disadvantage lead them to react by imposing restrictions and conditions on their money that caused good companies to be scared away, making their situation even worse.

It would have been smarter for them to focus on being ruthless about the companies they let in and make sure they get those couple of successes by giving them excellent terms, not onerous ones.

It would have been smarter to optimize for the best case scenario instead of optimizing to guard against your losses.

But this requires them to actually pick the best companies, it requires them to put themselves out there and make a few big bets, instead of hedging their bets and making sure they get a large percentage of a bunch of mediocre companies.

This thinking dooms them to get worse and worse companies until I bet one day they don’t exist anymore as they are part of the underbelly of Venture Capital that causes the asset class to return around -2%.

Angel investing groups like Kieretsu Forum do the same thing. They charge startups 8k to pitch their investors. Now, these are investors who likely don’t have anywhere near as much to add to a company as an A16Z or Sequoia, a traditional VC firm, but to pitch them you need to pay 8k. You pay zero dollars to pitch a normal VC firm.

They rationalize it as necessary to pay their own bills and support their organization and the pitch process. I imagine this is because the angel investors aren’t willing to pay themselves to support the organization.

But it scares away other good companies. I guarantee you Uber wasn’t about to come and pay 8k to pitch investors like that. And we didn’t either, and we had no problem raising our last round. Anyone with any sort of real demand from investors won’t shell out 8k.

The only companies they get are awful ones with nowhere else to go, which then don’t return enough capital to their investors, which means that the angel investors aren’t willing to pony up money themselves to help Keiretsu Forum exist purely because it gives them such amazing deal flow (because the deal flow suck), so they charge more money, making it even less appealing, etc.

Before you know it they only get bad deals and it’s basically a meet and greet for middle managers from Yahoo to get together and play angel investor.

They got stuck in a vicious cycle that ruined their deal flow and their purpose as an organization: I don’t know Kieretsu Forum’s internal stats but I haven’t seen them in any Facebooks, Dropboxes or Ubers lately.

A different type of cycle I’ve been thinking about is one I’ve noticed with Uber.

I was talking to a friend recently about why it was that Uber was valued so much higher than Lyft, Didi Kuadi, Grab & Ola Cabs (combined!).

The conversation started out with me pointing out that $10 billion dollars is a lot of money (that’s how much Uber has raised) but not that much when you consider BART runs a $200 million dollar deficit per year, and the wider ground transportation industry is $450 billion per year industry worldwide. Add that to the fact that Uber has Uber Eats now, is experimenting with delivery and courier services and I’ve heard rumblings about them going into Healthcare, and the $10 billion looks like a pitifully small amount of money. I commented that the $10 billion wasn’t enough to dominate in their target market (they are way behind in India and China to start) let alone the other verticals that they were planning on going into, all of which have equally well capitalized startups (Postmates, Seamless, Doordash, etc.)

But what I also started thinking about was how these promises and these expansions into all these other markets created a virtuous cycle, a flywheel, when it came to their fundraising.

Think about who will get a higher valuation: “Hi guys, we are Lyft, we want to just do transportation in the U.S. that’s all,” or “Hi guys, we are Uber, transportation is just the beginning, we are already in 200 cities around the world but we are really a logistics platform and that means delivery of doctors and food and everything else.”

Even if it is unrealistic to think that they will make a huge dent in these other markets, they pitched the BIG vision, bigger than just transportation, and they were able to get the biggest funding rounds, which allowed them to post the highest growth, which allowed them to get even bigger funding rounds, which fed on itself.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.