Vinod Khosla in a series of interviews over the past decade has referenced an observation of his that can be summarized in the following statement: 70-80% of VC investors add negative value to their portfolio startups. By “negative value,” Khosla does not mean that these investors are necessarily extracting value at the expense of their investments, but rather, generally speaking, these investors, through financing early-stage companies, gain influence over their portfolio companies that results in a hampered growth potential. In other words, venture capital managers, in Khosla’s view, generally disrupt their portfolio companies’ growth trajectory by assuming directorships and other executive functions that are divorced from on-the-ground business operations. As a seasoned VC with a career origin in founding one of the most influential technology companies in Silicon Valley, Khosla, while not directly drawn from a data set, still provokes analysis as it calls into direct question the ability of capital managers to provide value beyond checks to their portfolio companies. Further, it calls into question whether the sets of executive and strategic functions that are passed to VCs by way of investment can actually benefit the portfolio companies.
In my view, the problem space that Khosla mentions is contoured by the following dynamics: (1) the sharing of strategic and executive influence between VC firms investing in the same company; (2) the sharing of strategic and executive influence between a single VC firm and its investment; (3) the separation of operational and strategic decision-making from the capital owners; (4) the motivations driving VC influence over a portfolio company’s decisions. In essence, VCs can assume an unhealthy degree of influence over their portfolio companies’ business direction, which in turn can create an opportunity cost to their growth potential (and hence the “negative value” described by Khosla). Further, I wouldn’t characterize these issues as a direct result of any one particular force – misaligned incentives, informational asymmetry, operational negligence, and lack of domain expertise all contribute to poor decision-making and unhealthy influence on existing strategic decision-making processes. As such, given the breadth of possible contributors to the contours of the problem space, the solution space to this issue would be a framework for “closing the gap” between VCs and their portfolio companies rather than a set of one-off improvements to the investment experience.
The amount of high-risk, high-growth financing in American capital markets has grown tremendously, as allocators chase the explosive returns enabled by technology companies driving digital transformation. VC assets under management, by the end of 2020, were over $548bn in the United States, and by the end of 2021, that figure grew to over $621bn. However, there isn’t a consistent operating model for how VCs should engage with their portfolio companies, and while certain flagship firms such as Sequoia or Summit Partners can set a flagship-fund model for firm & portfolio organization, such a model becomes less useful (1) at the early stages of venture-financing and (2) given the variance of investment theses in VC.
In the early stages of a company’s development, where the business model(s) and product roadmap are just as much R&D efforts as the technology offerings themselves, a one-size-fits-all approach to governing the relationship between investors and their portfolio offerings is inherently unproductive – for example, how can an early-stage biotechnology company and an early-stage SaaS business rely on the same model of executive governance, when the operational jobs-to-be-done at this stage are so amorphous? Given the relative lack of industry definition as to what a successful investor-portfolio relationship should look like, and the proliferation of VC investors and investment mandates, Khosla’s statement should be at the top of mind for every player in this space.
However, despite the observable characteristics of the VC industry suggesting that a standard model for involving VC investors in the strategic & executive direction of a firm may be a futile endeavor, some firms have developed unique philosophies for addressing Khosla’s statement. In particular, Tribe Capital, a highly quantitative VC firm with over $1.6bn under management, operates under a unique investment thesis that squares supporting portfolio growth with the aforementioned dynamics that impact operational & strategic decision-making. The investors at Tribe Capital refer to this philosophy as “N-of-1,” and in my view, whether this was intentional or not on the part of Tribe Capital VCs, directly addresses the problem space Khosla observed.
In a white paper describing Tribe Capital’s investment in Carta, the Tribe Capital team lays out the following definition of “N-of-1:”
The phrase “N-of-1” has multiple meanings for us. It refers to companies or products that are capable of becoming much larger than what people expect early on. Their level of product-market fit is so strong that it carries the business through successive orders of magnitude of scale in ways that would have been unthinkable when they were getting started.
I take this definition to describe startups that don’t just have a strong 0-to-1 (product launch case) or a strong 1-to-n case (achieving continuous product-market fit), but rather also startups that have the potential for multiple, synchronous lines of business that go beyond their initial solution, customer segment, and/or business model (I like to think of this as a matrix of business lines). The investors at Tribe Capital, consequently, view their opportunities through the lens of an individual company’s ability to scale up new business models. The general arc of how investors at Tribe Capital do this can be broken down into the following principles (taken directly from the above essay):
1. Emergence of a new atomic unit of value — Every era has a raw “resource” (oil, idle cars/gig workers, friend graph, etc.) that when captured, catalyzes an immense wave of innovation within a sector. These are obvious and highly contested in hindsight but are largely non-obvious to incumbents at the time of discovery. Commentators often dismiss the initial market as “too small”. N-of-1 companies recognize this reorientation early and effectively build technology products that take advantage of external macro trends to capture an early foothold in acquiring the newly discovered unit of value.
2. Capture of this atomic unit of value — N-of-1 companies are able to translate their early foothold into a dominant position to acquire the newly viable atomic unit as fast as possible. Dominance over the atomic unit enables these companies to build category-defining businesses around the resource thus cementing their position for the long term. As a result, incumbents and newcomers quickly face uncrossable moats in their attempts to compete with the N-of-1 firm.
3. Transformation into a central utility — With dominance and control of the atomic unit, N-of-1 companies are able to rapidly extend their family of products. Once these companies create scarcity of the atomic unit, adjacent economic activity refactors around the companies leading to broader market disruption. An ecosystem starts to emerge because other companies of different types start to rely on each N-of-1 company for their own survival. The N-of-1 companies become immovable central fixtures — utilities. In doing so, N-of-1 companies transform from merely services to central utilities that power entire ecosystems.
While the actual mechanics of how Tribe Capital analyzes opportunities through this lens is not public, but if I were to try and reverse engineer the philosophy through examining their portfolio investments and what is outlined in this essay, the N-of-1 approach to analyzing investment opportunities has the following logical structure: (1) identify a new “value driver” in a contemporary economy, (2) capture that value driver as efficiently as possible through a service, and (3) expand into adjacent business activities with optimal efficiency, either by utilizing the captured value driver in a different context or by building off of it as if it were a startup.
How does this framework for viewing companies relate to the original stimulating statement about how VCs’ negative impact on their portfolio companies? If we examine this framework through the contours of the problem space, we can observe that, while it’s not a panacea for all forces that can lead to poor influence over a portfolio company’s decision-making and operations, it does inherently optimize for growth. In other words, rather than by fixating on optimizing for fund returns but rather by optimizing a startup’s ability to scale its business lines and achieve new forms of product-market fit by leveraging its unit of atomic value in cost-effective ways, Tribe has created a unified framework for helping their portfolio companies scale into lasting, profitable, and multidimensional enterprises.
With respect to Khosla’s statement, Tribe Capital addresses the underlying skepticism towards VC value-add by aligning its investment thesis with a growth framework to support their portfolio companies. How this framework manifests in tactical or operational support for their portfolio companies would require another investigation, but for the purposes of this analysis, Tribe Capital’s investment philosophy, in my view, revolutionizes the extent to which investors can exert positive growth influence over their portfolio companies. While all investors would claim that their theses or investment approaches inherently support portfolio growth, without definite and provable alignment between the deal sourcing strategy and the portfolio support strategy, it’s unlikely that investors will be able to work around the Khosla Dilemma.