What determines whether a business is genuinely suited for venture capital investment as opposed to other forms of financing?

Harry Stebbings · May 8, 2023

Tesla is a counterexample to the rule that a company with pure execution risk is unsuitable for venture investment, since it faced only execution risk on building and scaling a car at cost, not market risk about whether demand would exist

A greener, nicer, affordable car had guaranteed sufficient demand; the only risk was the ability to build and produce at scale within cost

35:28 Pure execution risk businesses like early tesla are suitable without market risk

Harry Stebbings · May 8, 2023

Everything is a hypothesis until there is a concrete transaction, so every new product carries market risk

Even a jumper business rests on a hypothesis that customers will value and buy the product

38:19 Every new product carries market risk since demand is a hypothesis until transaction

Chris Paik · May 8, 2023

Venture investors are primed to see market risk everywhere, but the vast majority of economic transactions occur in markets with no market risk even for a new entrant

Demand for something like ball bearings is fully validated and constant; money can still be made there through cost or quality advantage, but the demand question isn't open

38:39 Most economic transactions carry no market risk even for new entrants

Chris Paik · May 8, 2023

A business entering a market with well-understood demand and no structural product differentiation — like making polo shirts — is not suitable for venture even though money can be made

There is no market risk when demand is incredibly well understood and nothing about the product is structurally different

39:36 No market risk and no differentiation makes a business unsuitable for venture

Harry Stebbings · May 8, 2023

Venture-backability can come from structural difference in go-to-market, brand or meaning to the user rather than in the product itself

These are all part of the company, not just the product, and they can make a business venture-backable

40:01 Structural differentiation in gtm brand or meaning can make a business venture backable

Chris Paik · May 8, 2023

Venture-backability is routinely conflated with value creation; many companies create a lot of value without being suitable venture investments

40:19 Venture backability is distinct from value creation

Chris Paik · May 8, 2023

Venture encourages any and all forms of entrepreneurship because the industry benefits from maximum shots on goal, but some kinds of businesses simply won't work and it is not correct that everything be tried

Venture's business is picking winners from among attempts, so more attempts is strictly better for venture — but that incentive diverges from what is actually worth attempting

46:24 Venture industry incentives favor maximum attempts though not everything should be tried

Chris Paik · May 8, 2023

The glut of venture dollars leads VC to subsidize the building of companies that should never have been venture targets

Too much capital chasing returns pushes venture into funding zero-to-one value creation everywhere, which is not venture's job

42:19 Capital glut pushes vc to subsidize non venture suitable businesses

Chris Paik · May 8, 2023

Venture capital is only the right instrument for companies with a structural J-curve — those not revenue-generative at the start — not for companies that have revenue from day one

Venture's unique enabling function is funding a hole of development or product building that must reach scale before it can generate value; widget-making businesses have the luxury of revenue from day one and any J-curve they have is self-imposed by leaning into growth

43:14 Structural j curve not day one revenue is the right venture suitability test

Chris Paik · May 8, 2023 · hedged

Whether a company literally could not exist without venture capital is a good criterion for whether it belongs in the venture asset class

44:19 Existential need for capital is the right venture suitability test

Chris Paik · May 8, 2023

Tesla carried tremendous market risk, not just execution risk

It was impossible to say there would be hundreds of millions or billions of dollars of consumer demand for EVs; any big auto exec would have called it crazy given gas station infrastructure and other structural advantages of internal combustion, and even calling it a 'hypothesis' concedes demand was unvalidated

36:10 Tesla carried substantial market risk not just execution risk

Daniel Ek · Mar 8, 2021 · hedged

Tesla is a good analogy for this class of problem, and likely no one other than Elon Musk would have funded it

It targeted an industry most people had written off with technologies few thought about, yet the founders saw with high certainty that it should work; Musk was deeply active in it even when not on the management team

31:00 Extreme technology and market risk requires an exceptional committed backer like musk