Exponential Capital: Achieving Exponential Growth the Right Way
I devote much of my life to deciding whether or not I believe a company will exponentially grow its value. On average, for every 100 companies I meet, we invest in about 4 that pass muster. For every company we invest in, there are probably 10 we don’t invest in which have capable founders solving real problems and are what I would call good businesses, loosely defined as businesses that are profitable, can grow, and are sustainable for at least the medium term. So, why so many passes? The answer is almost always related to exponential growth.
Good vs. Venture Scale
Due to its inherent riskiness, venture capital investing demands the highest potential returns. Another way to state this is that our cost of capital is higher than almost all other types of investors. While a real estate investment firm might be happy getting an 12% return on a property because their investors only expect 10% and a small business owner may be ecstatic to earn 15% annually on $100,000 investment in their company because a bank will loan them money at 8%, an entire VC portfolio needs to earn at least 20–30% (oftentimes more) to be deemed successful. Since many VC investments will fail completely, losing all or basically all invested capital, the ones that succeed need to drive way more than a 20–30% return; annualized returns on winning investments can be as high as 400–500%. Most venture firms expect a single winning investment to return their fund and then some and the only way that’s possible is if those companies grow at an exponential rather than linear pace. When making that investment however, it can be very difficult to discern whether a company is on a linear or exponential growth trajectory.
Going from 1 to 2 to 4 doesn’t look that different from going to 1 to 2 to 3
Going from 1 to 2 to 4 doesn’t look that different from going from 1 to 2 to 3, especially at the early stage. Traction is great and shows that a company can execute but past performance doesn’t dictate future returns. Strong growth numbers are a symptom of a scalable business; it’s not the other way around. I have seen many companies with a few months of strong growth fizzle out quickly since the drivers of their growth didn’t scale with additional resources. We have identified others that had just a bit of modest early growth that quickly scaled and surpassed the seemingly impressive numbers of the flash in the pan businesses (note: the growth rate of the growth rate is perhaps a stronger early stage signal than the growth rate itself). So, what then are the signs that a company can grow exponentially?
The Signs of Scalability
When I evaluate a company I consider two factors: idea and team, the latter being the more important of the two. Of the former, I can say that the most crucial factors are the size of the market and whether the business is solving a real problem. That part of the evaluation is relatively straightforward and the diligence tends to boil down to research and customer interviews. The real magic that I have witnessed from seasoned investors pertains to evaluating the team.
Many people have written extensively about what makes for a good team and there are numerous factors every investor considers but I’m going to zero in on the one that sets the best apart: capital and time efficiency. Exponential growth requires doing a lot with a little. The best founders don’t tell you about the ten things they need to do in the next month to grow their business but instead state the one or two focus areas that most efficiently advance them towards reaching their short and medium term goals (they will be able to very clearly articulate specific, actionable goals).
When pressed, they tell you why the other eight or nine are less important and back that up with data or otherwise strong rationales. The best teams don’t achieve 10, 100, or 1000x more than others by working 10, 1000, or 1000x times as hard or being 10, 100, or 1000x as talented; they simply focus on what scales which makes them 10, 100, or 1000x more efficient. If any founders are reading this, note that early stage investors often care less about your business’s KPIs themselves (Key Performance Indicators–metrics such as revenue or daily active users that speak to how well your business is performing at its core function) and more about how you think about and act upon them. It’s not about the growth rate but rather the mechanics of the growth; that’s where we discover whether the growth scales.
It’s not about the growth rate but rather the mechanics of the growth
Proving It Scales
I have stated before that time and capital are the scarce resources that founders must optimize. As an investor, time efficiency can be harder to grasp because a team could put 2–3x the time into customer acquisition for a couple months and drive 2–3x revenue growth. While that works in the short term and sends a very positive signal about a team’s dedication and work ethic, it’s generally not sustainable as sanity and emotional well-being are two things that should not be scarce at a startup. While time should be used efficiently, looking at a company’s use of capital can tell investors a more concrete story about a company’s operational efficiency.
One can try to demonstrate exponential growth by double or tripling a growth rate with the same number of employees and capital spend, but an equally good or possibly superior method is to maintain a given level of growth at 1/2 or 1/3 (1/10 and 1/100 aren’t unheard of, either) the cost, often best reflected as customer acquisition cost. To describe this another way, it can be better to take a step back and focus on making it cheaper to maintain an existing growth rate. This allows founders to think about unit economics while extending runway and is a legitimate alternative to going all out focusing on top line growth that may or may not be sustainable. Of course, its possible to pay attention to acquisition cost while principally focusing on KPI growth but in practice I’ve seen its more difficult to maintain acquisition cost discipline when growing in that manner.
If you go about trying to do the same with less, let’s say 1/3 the resources to maintain 20% growth, you do need to show that expending more resources will scale your growth (e.g. if you double by going back up to 2/3 your original expenditure you should double growth to 40%). This essentially boils down to showing that your customer acquisition cost scales. Significantly lowering that cost and then showing it scales sends a strong signal to investors that a company is both thinking in terms of scalability and proving that it can achieve it. Particularly in 2016’s investment climate, that is what will compel many investors to get over the line and pour fuel on what they can confidently believe will be a very, very large fire.
