119. Economic Theory in Venture Capital, Part 2 (Mark Suster)

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Today we cover Part 2 of Economic Theory in Venture Capital with Mark Suster of Upfront Ventures. In this segment we address:

  • What are your impressions of what Bryce Roberts is doing at Indie VC?
  • How have your thoughts on investment psychology and economics been influenced by The Black Swan by Nassim Taleb?
  • What other principles of economics, that we haven’t touched on, have informed your investment philosophy?
  • In light of today’s topics, what are the key things you’re looking for in startups?
  • Can you talk about Defy Ventures and your experience visiting California State Prison and the impact that Defy is having?

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Key Takeaways:


1- Competing with non-consumption

This concept centers on launching an inferior product that is cheaper and at lower margin. But in solving a problem that hasn’t previously been addressed, you become good enough to access a far greater customer base in a range of applications that were not a part of the target market. Mark said:

“If, you want to build something that has massive scale and grows very quickly to a multi-billion dollar company… then what you need to think about is how do I build a product that appeals globally to massive amounts of consumers.”

Here he gave the example of a Sony Walkman. The industry laughed at the product because the fidelity was so low. But it allowed a greater number of consumers to listen to music in places they never previously could.

So, how do you build a business with 10x multiple of value with a product that has much lower capability than existing options? Mark’s advice here was not to try and be all things to all people. Most incumbents will have way too much capability and way too many features, thus will have to charge a high price to all whereas a smaller company with a more narrow focus, can be much better at addressing that specific problem for a cheaper price.


2- The Incumbents Failure to Respond

The inability for incumbents to react to disruptive innovation is related to deflationary economics. Take an industry with:
-Big profits
-Fixed prices
-A really high-cost solution

and if a startup offers something at a significantly reduced cost, the incumbents just can’t compete. It becomes very hard to kill the existing business, so the incumbents are not incentivized to innovate. If they do, they remove revenue and margin from their cash cows. Mark said “it’s impossible to do from behind the moat.” So, very similar to my experience doing M&A for Danaher, what Mark suggests is for incumbents to take equity positions with early stage companies. This way when disruption occurs, the incumbent has a position, yet doesn’t cannibalize their own business.


3- A Simple Heuristic for Growth vs. Profits

Mark’s input here was there is no right answer and every situation is different. But he did give us a simple framework to think about when balancing growth vs. profit. When a business is not profitable, Mark looks to see if they are investing in marketing, expansion, product development. If so, they are enabling growth and sacrificing short-term profitability. They could be profitable if they pulled back on these growth efforts. But they have access to capital and the ability to expand. Whereas companies that don’t have access to capital can not finance efforts that drive them to negative profit. In these cases, business should focus on being profitable. So, his simple advice is: If you have access to capital, focus on growth; if not, profitability.


4- It’s All About People

When discussing Mark’s lessons from Nassim Taleb he talked about how economics are not purely rational but rather influenced by human behavior and psychology. Here’s where he cited the narrative fallacy. When one builds an understanding in their mind, based on observed events, that shapes their opinion of the future. And we all ascribe stories and narratives to make sense of the world where, in fact, many data points are just random.

So this has influenced Mark’s macro-approach as an investor. His process is simple.
1- He first needs to eliminate the ideas that clearly won’t work
2- He needs to back the most talented people he has access to b/c the most talented work the problems every day and adapt to market conditions the fastest. There will be more success from working with the most talented people rather than thinking you know the outcome of markets and finding the entrepreneur who’s vision maps to your opinion of the future.

So, operationally, Mark asks himself:

How do I get in front of as many entrepreneurs as possible?
And then be smart enough to choose the 2 out of 1000 that he should back?
And then be talented enough to figure out how to supplement their teams with what is missing?
And then be good enough that downstream VCs or large companies trust me when I say that the team is uniquely positioned and capable of solving this problem?

Mark is not trying to predict the future. He’s trying to bet on the jockeys that will be best positioned to respond, react and capitalize on what the future holds.

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