David Cummings on Startups

Ask Investors How They Think About Zeroes

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David Cummings

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Over the years I’ve invested in a number of venture funds as a way to learn about venture in general, dive deeper in selected startups, and see what’s out there. One topic that’s popular now in VC fundraising decks, but was non-existent five years ago, is the firm’s historical loss ratio.

A historical loss ratio is represented as the number of previous investments that the venture firm has lost money on, most commonly going to zero (an investment that’s completely worthless). I’m not an insider in the venture and limited partner industry, so my guess is that a paper became popular arguing that the better venture returns came from firms that didn’t lose money very often on individual deals (update: here’s a paper). Venture capitalists that have to work hard to raise money from LPs (most firms!) have glommed on to this theory and worked hard to paint themselves as good at not losing money.

Of course, more focus on limiting the downside can be inverted as more focus on limiting the upside. The greatest returns in venture don’t come from limiting the downside, they come from the positive outliers — the power law of distributions.

Personally, it’s more interesting to attempt something with a 1 in 50 chance of succeeding as opposed to something with a 9 in 10 chance of succeeding, assuming the upside is correspondingly larger. Yes, we want to control our own destiny, but we also want to take big risks that have the opportunity for big impact.

Humans are conditioned to feel more pain from losing money than gaining the same amount of money. Losing hurts more than winning.

As an entrepreneur, it’s important to understand where a potential investor stands. Is the investor more oriented towards maximizing upside, or minimizing downside? Don’t know? Just ask.

There’s nothing wrong with having a low or zero loss ratio — there are many paths to success. I know a number of excellent investors and entrepreneurs than minimize the zeros and execute incredibly well.

Ask investors how they think about zeroes and you’ll understand a critical part of their core psychology.

Comments

3 responses to “Ask Investors How They Think About Zeroes”

  1. Peter Cowen Avatar
    Peter Cowen

    Great point. Highlights the fearless mindset of a true VC (who okay to win big and accept writeoffs) vs a follower and markedly contrast the view of private equity firms (who have rapidly become aggressive medium stage SaaS investors). Your other key point is that more recent VC funds are Often concerned about short term optics while leading funds are unburdened from this filter

    Reply
  2. harveyesq Avatar
    harveyesq

    Great article, David. I’m sure you’re well aware, but for the uninitiated, Fred Wilson wrote that loss ratios around 40% are standard for him—and in fact, the best fund he ever worked on was literally at that ratio—40% of the companies went to 0. “Loss ratios are not really indicative of performance of a fund. That comes form the winners and how big they are.”

    Here’s the article: https://avc.com/2013/11/loss-ratios-in-early-stage-vc/

    Thanks for the informative post. Look forward to more!

    Reply
  3. Scott Irwin Avatar
    Scott Irwin

    Hi David,

    I really like your content and wanted to reach out.  I’ve gone deep in bottoms-up SaaS – started a conference and a fund targeting these companies.  The fund is a control, growth strategy and is the result of my previous experience as a venture investor. We use a shared services model to unlock growth that was often not realized prior to our acquisition.  Specifically, we deploy experienced, Silicon Valley-trained operators across multiple companies to fill the Go-To-Market execution gaps that subscale SaaS companies typically suffer from.  The team has operating experience from Zendesk, Pipedrive, SurveyMonkey, and Playdom among others.  We have invested in similar startups like Dropbox, Pipedrive, PandaDoc, Autopilot, etc.  We tested the model over the prior eighteen months, learned a great deal, and proved the ability to consistently deliver predictable, capital-efficient growth.

    Would you be up for connecting?  Incidentally I’ve been speaking with Rigor and think very highly of Calendly (though I funded an upstart competitor, calendar.com).  I think we’d have a bunch to chat about!

    Best, Scott – https://www.linkedin.com/in/mscottirwin/

    Reply

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