E354: Why Most VCs Misunderstand Peter Thiel’s Power Law

0:00So tell me about the last round interview you had with Peter Thiel right before you joined Founders Fund. I don't know if they still do this, but at Founders Fund, you basically go and you meet everybody who works there. There's not that many people who work there at any given time. It's around a dozen people. And then your last round interview is you go, or it used to be you would go and you'd have breakfast with Peter. I remember walking into his place when he was still living in San Francisco. Obviously, he's not anymore. and we had this two-hour amazing conversation and you know this is sort of after a decade of reading his stuff and you know being deeply engrossed in the gospel of peter so this is like it's an incredible moment for a young a young eric 28 at the time and we're talking about zero to one and founder psychology in different markets and being contrarian versus being consensus and the trade-offs therein, et cetera, et cetera.

0:57Very heady stuff. And I asked him some question. I don't remember what it was, but he sort of does one of his textbook pauses where he just stops and thinks for around 15 seconds. And he looks at me and he goes, you know what, Eric? We're just trying to make good investments. It's really all we're trying to do here. And that was an incredibly profound moment because I, like many other people in Silicon Valley, had been sort of operating under the premise that there is a magical way of selecting these unicorn companies. And that way of thinking about the world, those frameworks were unrelated from the fundamentals of the actual business.

1:38You read enough Paul Graham essays, you read Zero to One, maybe you get into the archives of Max Levchin's blog. I mean, Max is a great guy. You should absolutely read those blog posts. but you start to believe that you can have this portfolio of companies where 19 will go out of business and the 20th of your 20 companies will be a thousand x that that makes your entire career and that was sort of the first time i started to think about this concept of wait a minute maybe what we need to do is return to the basics of investing double click on that all adventure is driven by a couple premises that are true but only in hindsight The first premise is this premise of the power law.

2:20The number one driver of returns in your portfolio is sort of the only thing that matters. It's far more valuable than the next two or three companies combined. True in retrospect, it says nothing about how to select for that type of returning company. The second sort of premise that we all operate under is that the founder basically matters more than anything. There's a whole bunch of Twitter debate. I'm like, is it the founders, the market? reality is it's both great founders wind up finding or creating great markets again absolutely true if you look on a historical basis it says nothing about how to actually select for a founder who has what it takes to to go the distance chris stixon talked about this idea of this concept of an idea maze and you know it's it's it's this concept that founders who truly know their space and are obsessed with their space can walk through sort of every possible scenario, thousands of iterations out into the future in ways that you or they never even thought they could iterate upon.

3:24And the reality is the most efficient way to navigate the idea maze is to think an awfully lot like a value investor and think about what are the modes of this business? What is your business model? What does the market look like? Try to really understand a little bit what the future looks like as far out as you can look. And through that process, two things will happen. One, you will quickly understand if you are impressed with this founder. And the opposite of that, the founder will quickly understand whether or not you are someone they want to work with. Expert calls have always been one of the most powerful ways to build conviction.

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6:07I think they're fundamentally different ways of driving it sort of the same truth. It's sort of, you know, the blind men feeling different parts of the elephant, so to speak. Mike Maples has created incredible track record at the early stage because he has this way, like a lot of investors from sort of that vintage of early stage VCs of saying, hey, I'm going to have your back from day zero. And even Mike Maples, I would bet, I've never sat in a pitch with him, I've never met Mike Maples, but I would bet - Previous podcast, guys. Oh, awesome. Wow. I would bet that during his first one to four meetings with the founding team, he's still asking the same fundamental questions.

6:44What are you building? Why are you building it? What makes you tick? How are you eventually going to make money, even if it's not for the next seven years? You know, he's still probably asking the same question because the only way to filter for somebody who can credibly build a movement is to ask them some very tough questions grounded in reality. To your point, he said that 70 % of his best companies pivoted. So what do you do with that? When you invest, you're not investing in that business idea. You have to invest in the founder because if 70 % of them will pivot, it's about the founder and not the business at the early stage.

7:18That might be a result of his strategy and his style of asking the screening questions. Like when I think about sort of the top four or five best investments I've made historically, I don't think any of them have pivoted. And these are, you know, at this point, anywhere from sort of one to$60 billion companies. Some of that might be, there are different archetypes of founders. There's not an infinite number of archetypes, definitionally, but there are many types of good founders. And I think one archetype is this person who is fundamentally driven by starting companies. Jack Dorsey is sort of this persona.

7:58He was starting companies early on in his career. He started several that are famous and have gone on to great success. That is different from somebody like Palmer Luckey or Trey Stevens who, you know, have sort of a singular mission that drives him forward. And it's clear from day zero, you know, when Trey and Matt Palmer and Brian, you know, set out to start Andrill, they said, we are going to fix this problem. Come hell or high water. Like this is the most important problem to protect the West that we can think of. And nothing will come in our way of solving that. So you're a lot less likely to pivot if that is the case.

8:35So Energy, another great example. You could say they pivoted. Man, you know, I was there in those seed and series A pitch meetings. They were talking about AI from day zero. Now we may not have believed them. We may have thought they were just like a cute little Bitcoin mining company. But it was in the pitch deck and it was explicitly said at every meeting. You know, this is the direction of travel. So you were in the earlier days of Founders Fund. And last time you chatted, you said that every partner was completely idiosyncratic, completely different from every other partner. And everyone from the team was fundamentally different.

9:07What did you mean by that? I joined, I think it was around a billion dollar fund. When I left, it was around a three billion dollar fund. By the time I left Founders Fund, Cyan Bannister had left. Ken Howery had left. Kevin Hartz had left. Jeff Lewis had left. Luke Nosek had left. So it was a substantially different place sort of from the beginning to the end. I think everybody at Founders Fund has a completely different strategy for selecting for effectively what become the world's best startups. Give me an example of that. I could talk about every one of these people because they're all so awesome in their own unique way.

9:42Trying to think of who the most contrasted are. Let's start with Napoleon Todd. Napoleon, extremely analytical, extremely data-driven, has what it takes to probably be a managing partner at any growth fund in the world. That is a wildly different approach than somebody like a Brian Singerman had when I was there. Brian, I don't think he's ever looked at a spreadsheet. I say I don't think he's ever looked at a spreadsheet because that's what he told me. Or at least not. He didn't look at a spreadsheet when I was there. But Brian has this incredibly impressive way of filtering for authenticity. He can sit down with effectively any founder and with an incredibly high bar, tell if this person is authentically driven in a way that will allow them to work on this for the next 15 years not the next two years not the next seven years for the next 15 years if there are any similarities within the founders and partners it's it's twofold you know one founders one has never fired a founder that's number one that's sort of the core tenant that you have to believe.

10:49What does that mean? The quantitative way of explaining this is the best returning companies in the world are led by founders. And they're led by founders. They've never fired a founder from the board. Correct. Correct. They've never pushed a founder out. I mean, the lore is... And that's part of the pitch. That is part of the pitch. It's in the name. It's in the name. I mean, that is sort of the founding mythos of Founders Fund was there was the PayPal, Max and Peter and Luke and Ken started PayPal and merged with elonsx.com to create this big PayPal entity. There were some board shenanigans.

11:22I'm not super familiar with what they are, but I think it's extensively documented. Somebody tried to effectively fire Peter. And when they sold PayPal, Peter and Ken and Luke got together and said, we're gonna start a venture fund where this never happens because that would have been the most value destructive moment in the entire company's history. this is a company that had a ton of life and death moments venture capital is obviously this recurring game of game theory it's not just about the latest round the latest founder so it makes sense why not firing founders might make sense as a sustainable strategy you could you could use it to get into the next company if you took every deal in its own is there not times to fire founders i'm not talking about fraud or sexual abuse or some obvious answer but strategically does it not make sense to fire founders?

12:12I think by the time you're having a conversation about firing a founder, you have made the wrong choice. You have not properly underwritten the deal. The vast majority of alpha in venture capital comes down to deal selection. And founders, what I have found, founders are attracted to VCs that are credible and have conviction. And don't fire them. or at least have a track record of not firing yeah firing founders that's always a nice to have yeah right it's a well it's a nice to have and i think it's an imperative if you want to have one of the best portfolios in the world i mean even look at sort of the most valuable companies in the world right now how many of them are still in some way actively run by a founder i mean obviously nvidia obviously meta in some way in some ways alphabet um although obviously obviously they have a professional ceo but they have a entire history of having a professional That's my razor for whether I keep my positions when they go public.

13:10Is the founder staying on? That's like 80 % of it. Is the founder still leaving it? Yep. Yeah. Includatively makes sense because every business has sort of a stated market size. And that stated market size is tied to a series of products, which is tied to a whole bunch of teams working really hard on those products. And if you want truly uncapped upside, you have to continuously reinvent yourself and create new products and create new markets. And the only way you're going to do that efficiently at scale with a level of aggression that you need to really dominate these markets is if you're founder led.

13:44Founders fund at least position themselves or market themselves as we give money to founders and stay out of their way. For the most part, yes. You know, again, this is one of those things that it totally depends on the personality of the partner you're working with. Keith Reboi was there when I was there. Keith has a very different style, super hands-on. At least when he was at Founders Fund, and probably today I think he would still say he's never fired a founder, but he would select for a type of founder that wanted him to be very involved with the business. They wanted that active membership.

14:19They wanted him on the board. They wanted him as a thought partner, thinking strategically about a whole slew of issues that Keith could see around the corner for. And what Scott Nolan would say, and I've since adapted this into my own sort of elevator pitch for founders, is if you think I can run your business better than you can, I should not be investing in this company. I want to invest in founders who have such conviction in what they're doing and are so well-researched in it. And this is the tough part. They are so in touch with reality that everybody agrees. I'm effectively here to be a sounding board to help them think through problems but fundamentally not run the business Is there an age aspect to that?

15:02I could see a 25 year old founder that found himself running a$10 billion company might need some help versus a 45 year old founder may have some tricks up their sleeve It's a really good question It depends on the tactical problem you're talking about and most importantly how good of a product and company you've built because because the best companies in the world are not necessarily the nicest places to work at, and they're not necessarily the environments that are the most professional and doing things that seem really clean. They're oftentimes, I don't want to say all the time because I don't know every company in the world, but they're oftentimes some of the messiest environments, and they can afford to be messy because they have something else, a product, a distribution channel, a sales team, whatever it is, that is so good, it enables them to color outside of the lines and mess up pretty much everything else, and they're still going to succeed.

16:02People say good founder, and some people confuse good founder with good person or good founder and nice person. What does it mean to be a good founder? I know it's the most basic question in the world, but what are some characteristics? I have this sort of ideal founder in my mind, and it's sort of my original mentors, Max Lepchin.

16:26And it's such a tough question, because in some ways, every great founder is singular. There will only ever be one Max. There will only ever be one Steve Jobs. There will only ever be one Peter and Zuck, et cetera, et cetera. And yet there are these ways that feel like you can really easily make a 45-minute MBA lecture about. You have to be tenacious. There's some raw IQ element. You have to be good at convincing people to join your team. I do think these are all sort of obvious. And then I think the one thing that maybe is not obvious or at least more controversial is I do think you need to have a really good sense for product strategy.

17:17And effectively what that means is you can A-B test your way to a really good, really big company, but I don't think you will ever be able to A-B test your way to one of the biggest companies of all time. The biggest companies are category definers, which by definition means there is no playbook. And yes, yes. And A-B testing is effectively a reversion to the mean, which is an incredibly powerful tool and an incredibly logical thing to do. But it will more likely than not get you to a local maximum. I guess I've never thought about this, but A-B testing is the exact opposite. It's like this arc between A-B testing and first principles.

18:02They're opposite of each other, but they both get you to a certain place. But first principles is the one that actually creates the power laws. it creates the power law in the global sense. Like I think you can run a strategy where you invest in companies, maybe at early stage, certainly at later stages, certainly in private equity, you can run a strategy where your power law company, like the best company in your portfolio, provides really good returns to LPs, but is not necessarily the next meta. To play devil's advocate on that, have you ever been involved in a lot of great companies? Have you ever seen 100X where somebody A-B tested or Uber for dogs or, you know, whatever this derivative idea and get to 100X?

18:46Is that even possible? I've never seen it. 100X. I mean, I don't have that many 100Xs. I have a few.

19:00I've seen it once.

19:06critically they did not use a b testing for the product they used a b testing as a tool in their tool belt but i'll never oh man i'll never forget this company i invested i did see around this company called hugo insurance keith was on the board and they launched their um beta test in california this must have been 2019 i want to say and they had there was some magical number for CAC. I can't remember what it was, but let's just say it's$250 per user. The company for contacts is basically instant car insurance. It's on-demand car insurance. So you can get car insurance for a 24-hour period instead of signing up for a six-month cycle.

19:45It's like the original Metro Mile. It's more like the general. It's more like the general because the gap they identified was basically saying, hey, there's a whole category of people who don't have car insurance and a lot of them are working gig jobs and maybe they need to drive for a three-day period, but they don't have their own car that they're just using every day. So economically, it doesn't make sense for them to sign up for a one-month or six-month period of time when they're just gonna be using this thing for a few days and they just wanna stay within the bounds of the law. So the flip side of that is you can price the risk much higher and it's still a good deal for those drivers because they're concerned about the absolute dollar amount.

20:24They're not concerned about the like, price per hour driving that's you go really good idea like that is an idea that you don't get to by a b testing your way you get it through sort of deep relationships with the customer really thinking hard being super creative about what can we offer to this user base so they launched this beta test and customer acquisition costs again i don't remember the exact numbers but it comes in way higher than the target it was like five to ten times higher it was multiple thousands of dollars. We had this board meeting. David, the CEO, super cool head, sort of presents the data, says, here's where the numbers came out.

21:04I'm like looking at Keith, Keith is on board. I'm like, oh man, these are like way over what we thought they would be. Keith and I are sort of like, hey, it's time to, you know, really think deeply about whether or not you guys have the right product. And David does not skip a beat, says, no, no, no, we have the right product. I am confident we have the right product. So this is the anti-A-B testing thesis.

21:33There are these seven parts of the conversion funnel, and we just need to A-B test and iterate our way on each of them. Ironically, that's first principle, which is it may seem unreasonable, but if 0.2 times 0.2 times 0.2 times 0.2, then the math works, so therefore it is reasonable. Yes, yes, exactly. Exactly. Keith and I are basically saying, if you can do that, great, but you will be the first founder we've ever seen sort of take something from such a super high CAC to such a low CAC. And sure enough, you know, three months later, next board meeting, CAC comes back and it's like 50 % of what it was, but still way above the mark.

22:12and then three months later it's 50 % lower and now it's 2x above the mark and the next board meeting it's just above where it needs to be but not quite there and long story short, it just hit sort of the target and just kept going down. When I look at that, I think Moat. Who else is going to go through all these machinations to get to this low CAC? That's a great business. Yeah. You know what? I never actually thought about it like Moat. I just thought about it like... It's hard work as a form of Moat. Hard work and... Compounding as a form of Moat. And this is the exact type of founder personality where I look at that and say, there are all these points on that journey where I would have given up in some way.

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