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 someone published a paper that become popular arguing that the better venture returns came from firms that didn’t lose money very often on individual deals. 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 highest alphas in venture don’t come from limiting the downside, they come from the positive outliers — the power law of distributions.
In a recent venture deck I saw a famous Warren Buffet quote as the only content on a slide:
Rule #1: Never lose money.
Rule #2: Never forget Rule #1.
Seeing this was an immediate turn off. It’s much more interesting, and intellectually stimulating, 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 focused on maximizing upside, or minimizing downside? Don’t know? Just ask.
Ask investors how they think about zeroes and you’ll understand a critical part of their core psychology.