Is the cult of the founder still as strong as it has been?
Isaac: The past 15–20 years of the rise of consumer internet has been largely about getting behind the Larry Pages and Mark Zuckerbergs of the world, boy geniuses who built the next consumer app in their dorm rooms and made billions of dollars. But since 2017, we’ve seen a curbing of that idea.
Now, with people such as [Uber cofounder and former CEO] Travis Kalanick and [WeWork cofounder and former CEO] Adam Neumann, we’re seeing the limits of that type of thinking. I think there’s going to be a real reckoning. Employees are pushing back. There’s been a generational change in how they’re viewing executive and company behavior. Employees want the products and the software that they’re building to live up to the ideals that they joined the company for in the first place. That’s new for the CEOs. [Facebook cofounder, chairman, and CEO] Mark Zuckerberg isn’t used to getting an internal letter leak to the press that pushes him to change his policy on political ads. GitHub isn’t used to having to drop contracts with US Immigration and Customs Enforcement because its employees don’t feel comfortable with that. There’s a real sea change there.
Kaplan: If you ask venture capitalists what they look for in an early-stage investment, a big chunk say they invest in the founder as opposed to the business. We surveyed 600 venture capitalists and most said they bet on the jockey, not the horse. They’re looking for people who know their industry, who have passion—an ability to energize and motivate people—and who can take an idea and really push it. My research suggests that, on the margin, they might be better off prioritizing the business, because that typically changes less than the people. At Uber, Kalanick is gone, but the business is progressing. Google, Amazon, Facebook, Starbucks are essentially the same businesses they were when they started; the people sometimes change. Sometimes they don’t.
Venture capitalists do three things: First, they source the deals. Second, they evaluate and select the deals. Third, they sit on the board, where they monitor and advise the company after the investment. That’s when they’re trying to figure out if the company is doing the right thing. That is your first line of defense against bad behavior.
Do startups need to have corporate-governance rules from day one?
Marcello: The founders we work with often build an advisory board before they even create the company, and a lot of the times we’re working with young people who are starting these companies, and they need advisors who have deeper experience, who know the industry, who know the work that needs to get done to really guide them along the way. So we start talking about issues like that very early. In the cases of Uber and WeWork, one of the things that stood out to me was what happened with the voting power that Kalanick and Neumann had, which made it harder for the board to make changes at the CEO level. That’s something to think about as we broaden the discussion around culture and responsibility among startups.
Kaplan: What’s puzzling about this is that the venture model really is to have good governance, where they have the board, and if things don’t go well, they get control. These situations where the founders retain control, which happened at Google, and Facebook as well, are really not the typical model.
Isaac: One of my sources keeps telling me that you have to play the game that’s on the field, meaning the control that the venture capitalists are giving up is part of a wider trend, especially given the wealth of capital flowing into Silicon Valley. There’s a ton of different family offices, Fidelity is investing, and all this money is moving down to as early as they can get in, because companies are staying private longer. What do you have to do to get into that deal? I think this is going to shift, but right now there’s just so much money in there that they have to continue giving up that control.
How much do founders and funders think about what a company’s culture will be like if it grows very fast?
Marcello: We do have that conversation with the founders, so that they think about the future and what their venture will look like as a big company. For example, one thing we talk about during the growth stage is when to bring in a human-resources person, which seems simple, but in Uber’s case, they waited a long time to do that. We talk about some of those structural things you can do with a company to try to keep people on their best behavior and to establish practices and protocols, so that as you scale up, you have systems in place.
Kaplan: It’s tricky, because the culture that gets you started and makes you successful can at some point get outgrown. More than half of venture investments lose money, so having a successful venture investment is hard. Venture capitalists make more than 60 percent of their returns on the 10 percent of deals that earn more than five times their money. So venture capitalists make their big money on investments like Uber and Slack. And so what happens when these things start scaling and going really well? Everybody’s drinking the Kool-Aid. It’s very hard to go from being a scrappy startup to where you’re getting bigger and you have to put in some of the structures that Starr mentioned. And if the board pushes on it and the founder pushes back, the founder has a lot of power because the company just skyrocketed. That dynamic makes it hard.
Isaac: The problem for Kalanick was that he wanted to keep that startup feel even when Uber was at global scale and had hired more than 10,000 people. The best CEOs know that you can’t operate the same way when you’re in a garage or with 50 people, and there’s a point at which you bring in more experienced hands or people who have run global businesses with tens of thousands of people around the world.
Truly disruptive startups often have to operate in legally murky areas, because they are challenging rules that have been shaped by big incumbent companies. How should disruptive startups navigate this gray area?
Kaplan: That’s a risk-return question, and each person answers that differently. In the past several years, we’ve had a number of students who wanted to start cannabis companies. That was risky. But because the regulation and the law went their way, some of those people did extremely well. The one thing I do tell them is never to do anything that is going to send you to jail.
Marcello: In that case, regulatory hasn’t caught up yet. Many entrepreneurs see an opportunity in that gray area. There’ll be a period of time when there is this opportunity, and then regulators will catch up, and the circumstances will change. There is this concept of the entrepreneur as disruptor, and the issue of what’s allowable with the disruptor title on. We talk a lot with students about coachability, and I was thinking about marrying that with the concept of the disruptor. When you’ve worked for years with entrepreneurs, you see coachability as a signal for whether they will be the persuasive successful founder. Do they take advice? Do they listen to feedback? What are they like to work with? We can often correlate those factors to people who are able to raise money, find a cofounder, and hire people. The entrepreneur as disruptor would speak against that; it would say that it’s OK to not be coachable, to be a maverick, or not necessarily to take all the advice.
How has the entry of large international funders such as SoftBank and Saudi Arabia’s Public Investment Fund changed the startup funding formula?
Isaac: The SoftBank phenomenon has been the most fascinating shift in dynamics in Silicon Valley over the past few years. They have this $100 billion fund that they have to invest within five years. That means parking enormous amounts of capital into a number of startups, and they can’t do small strategic investments. That means they plunk $1 billion into WeWork or DoorDash or other companies. That has repercussions in a number of ways. It creates a level of indiscipline because when you have unlimited money, you don’t have to worry about building a business. You can always go back to the capital faucets, and SoftBank seems to be pouring it out. [SoftBank founder and CEO] Masayoshi Son is hailed as a visionary, but the big question for me has been, is he a genius or totally nuts? I honestly don’t know.
Kaplan: This was something where it’s closer to totally crazy than visionary. If you look at the amount of money going into VC funds every year in the United States, it’s $40 billion. So a $100 billion fund—$20 billion a year, over five years—increases the amount of venture money by 50 percent in one fell swoop. It didn’t make sense when he raised it, and you’re seeing the fruits of that. It’s a little bit like what happened in the dot-com boom. There was more money then—it was worse—but you still have a destabilizing force with the Vision Fund. The Vison Fund raised the valuations on those companies and others. The companies then spend a lot of—too much— money. It’s actually great for the consumer: they get free delivery. But at some point, it is not sustainable and it breaks down. And the really good news is that it hasbroken down. The Vison Fund will take a huge loss on WeWork, which is terrific. Uber is a little different. It’s a real company. I’m somewhat optimistic that it will be cash-flow positive someday. But is it worth $45 billion? We don’t know. Lyft is actually about cash-flow neutral now, so I’m sure the potential is there. But the point is that the Vision Fund inflated the private-company valuations, and the other venture capitalists felt they had to follow. And so you created an unhealthy treadmill. I think now it’s been broken. You’ll have more sanity, which is a very healthy thing.
Marcello: Some startups may be focused on getting a huge, no-strings cash injection, but what our founders think of as success and what inspires them is building something real, having it have an impact and actually touch people’s lives and solve whatever problem they’re trying to solve.
Isaac: Ship some of those out to San Francisco, please. That is not the mentality out west.
Kaplan: We had two startups in the New Venture Challenge competition at Booth at about the same time that had very different outcomes. One was Grubhub, in 2006. They started and stayed in Chicago; they tried to find business and revenue models that made money; they grew; and they became cash-flow positive, which they still are. At last count, Grubhub was worth almost $4 billion. The second example is Bump, which won our competition in 2009. Bump was one of the top-10 iPhone downloads in the world in 2009. They went to the Bay Area and they were not encouraged to make money; they were encouraged to get users. They ended up selling to Google for a modest amount, and they never earned a dollar of revenue. So those are two extremes. You can do the west-coast model, but at some point you have to make money. In the midwest, startups tend to focus on making money earlier. They’re very different philosophies.
Is profitability becoming a more important criterion for startup investors?
Kaplan: I always tell my students “CIMITYM”—cash is more important than your mother. If it doesn’t produce cash, your business will fail. At some point, you have to make money. Sometimes it takes a long time—as with Amazon, but it always had that path to profitability. Lyft is reporting that it’s going to go cash-flow positive in the next year or two. Uber has a different business model. It’s broader, so it’s a bit more ambitious and they’re going to be losing money for longer. So that’s what you have to decide as an investor: Does the company have that path?
Marcello: When you teach entrepreneurship, you have a lot of students who see these models that get talked a lot about in the media: startups in Silicon Valley, where you don’t have to make money right away if you get enough users and build your base. Every year, we see a number of business ventures with that model saying, “I’m going to be the one who makes it.” But it’s really hard to do. It’s hard to find investors, in the midwest at least, who have seen a lot of those types of startups be successful here. Often we will advise them to talk to investors in Silicon Valley or on the east coast to get other perspectives. It really is hard to build a business that way—to hope at some point in the future that revenue will be generated.
Kaplan: That’s why people look at indicators such as the lifetime value of a customer relative to the customer acquisition cost. These metrics give you a sense of whether you will make money over time on each customer. If you do, it is OK to pump a lot of money into getting customers today. That type of analysis is true here in Chicago and on the west coast.
Isaac: In Silicon Valley, a path to profitability is looking more attractive than it probably was before, particularly because everyone looked at Uber’s initial public offering and saw the very grim reality that this was not a $120 billion company—the valuation was way out of whack with what the public markets thought it was. Those days of tech-company public overvaluations are coming to an end, or at least tamping down—not at the earliest stages, but once you get to the D round or later-stage capital, when they start to think about going public. And that’s probably a good thing. But it will be hard to get around the idea that new startups should chase users first, and money will come after that. You can’t really beat that out of the heads of people in Silicon Valley, because that’s going to be what [cofounder of Silicon Valley VC firm Andreessen Horowitz] Marc Andreessen says, it’s going to be what the Zuckerbergs of the world say: it works for their businesses so it can work for you.