Fred Wilson has been investing in tech companies since the late 1980s. We take a look at some of his most important lessons on product, management, and investing.
At the helm of Union Square Ventures, the venture capital firm he started in 2003, Fred Wilson has backed some of the most successful internet startups through the years — with at least one billion-dollar exit in his firm’s portfolio every year since 2011. Among those wins were Twitter ($14.2B return), Indeed ($1.4B), and Etsy ($1.78B return).
Here we’ve collected 11 of Wilson’s most essential lessons on venture investing, social media, and managing companies from his posts on avc.com and other writings.
1. Keep your vision simple at the beginning
Pick something simple to execute, nail it, then build on it with another relatively simple move, nail that too, and keep going.
When entrepreneurs pitch to investors, it can be tempting to paint a grand portrait of the future: not just a vision for their product, but a 5-year roadmap and go-to-market plan that culminates in huge hockey stick growth and creates a multi-billion dollar business.
Fred Wilson urges entrepreneurs to think more simply.
Building a startup isn’t like Olympic sports where “the way to win” is to perform the most elaborate, technically challenging sequence of moves, Wilson tells founders. Instead, they should think like a beginning diver, and strive to “execute a simple dive and hit the water perfectly.” In other words, build something that excels at doing one thing and go from there.
Wilson points out Twitter as an example of how a well executed simple idea can grow into something massive. At its core, Twitter is a status broadcasting tool. When it first got started, its function was letting users share what they were doing or thinking.
Twitter’s modern iteration can serve a whole host of different purposes. For example, it has branched out into video via streaming partnerships with media companies like BuzzFeed and The Verge.
These capabilities — and the idea that Twitter would have become a virtual streaming platform — were far outside Twitter’s scope in its infancy. Starting simple gave the product time to get there organically.
Another good reason for the “start simple” approach is risk. Early-stage companies are up to their eyeballs in it. Building a needlessly complex product adds even more risk, and can make the already difficult work of running a startup impossible.
And companies nearly always have the chance to iterate.
“Unlike sports like diving or skating,” Wilson advises, “You don’t have just one or two or three attempts to win. In startups, you get to show your stuff every day, all the time.”
If the first version of a product doesn’t reach its full potential, the company can always expand on it down the road. But if the team tries to pack every possible feature into the first iteration and fails, the wasted time and money cannot be recovered.
Rather than trying to dictate the way users interact with their product from the beginning, the team should gradually learn what users need and adapt accordingly.
2. Early revenue growth isn’t always a positive — instead, focus on market fit
“Early revenue traction, often driven by a passionate founder, can be a nasty head fake. Try not to fall for it.”
For a startup founder, solid revenue traction can seem like a tonic against the uncertainty of the startup business. If people are buying the product, that must mean the team is doing something right.
Wilson argues that early revenue — especially from a high volume of sales — can be actively misleading.
What matters in the long run is whether the company has a solid product that solves a problem for its customers. Strong revenue figures might mean the team has gotten there — but they might not.
Having a charismatic founder and some clever marketing can compound the problem:
“A hard charging sales oriented founder/CEO can often hide the defects in a product … Because the founder is so capable of convincing the market to adopt/purchase the product, the company can get revenue traction with a product that is not really right.”
Wilson recalls a company that fell into this very trap and ended up selling itself in a fire sale. In its early stages, the company grew revenue quickly, which attracted a considerable amount of outside financing. The company used that financing to grow its staff.
However, it had high customer churn, and all of that financing couldn’t reduce the rate of turnover. Despite the high growth numbers, the company failed.
Wilson’s March 25, 2013 post explains Stanford professor Mark Leslie’s concept called the Sales Learning Curve, which illustrates the problem here. Before a company can sell a product efficiently, it needs to understand how its customers will use that product, and if customers will continue to get value from it over time.
After launching a product, “the organization may need another six months, a year, or even longer to get to product market fit,” Wilson cautions, and the founding team can shoot itself in the foot by plowing ahead on sales before getting there.
Once a company has product/market fit squared away, it will have space to grow the staff and iterate on the product. If one strategy does not pan out, the team can go back to the drawing board and try again.
Wilson recalls that his firm has had “portfolio companies build revenue models that did not line up well with the strategic direction,” but that “these kinds of mistakes are usually not fatal.”
“Not finding product market fit,” however, “is fatal.”
Nailing down product market fit first gives the team room to experiment without jeopardizing the company’s survival. Starting that process too early because the company is making money can do much more harm than good.
3. Social networks are most effective when bundled with other services
“Social networking does work, particularly when it’s deployed as a feature of a web service that offers an important function beyond the social network itself.”
The first wave of hype around social media began to fade around the early 2000s. The number of social networks had grown quickly, overloading users with too many different profiles to manage. Many speculated that platforms like Friendster and Orkut ultimately failed because people couldn’t juggle more than one or two social networks at a time.
Wilson, one of social networking’s biggest boosters, would not admit defeat. Instead, he used the struggles of that era to develop a thesis that has guided his investment in social media in the years since: social networks work just fine, as long as they are tied to another service that creates value for users.
Flickr, for instance, combines a photo-sharing site with a social network. Another example is Linkedin, which acts as a résumé database and job site built on a social network that helps companies and workers connect.
As information technology demands more of users’ attention, the need to build social networks this way will only increase. In the internet of 2025, users will almost certainly have less time and patience to juggle different profiles.
Further, Wilson explains that building a social network around a specific service lets users curate their social graphs in accordance with that service. The group that a user most wants to connect with on Tumblr is not the same group that works best for Etsy, and so on.
Allowing users to curate their social circles helps keep social networks from getting too noisy. Any given user will have several social graphs, and keeping them distinct helps avoid the kind of overload that almost brought the whole concept of social networking down in the early 2000s.
4. Second order network effects create powerful businesses
“We asked ourselves, ‘what will provide defensibility’ and the answer we came to was networks of users, transactions, or data inside the software.”
“Software alone is a commodity,” Wilson wrote in a 2014 blog post. The only way to build a defensible business model, he argues, is to own a network of users, transactions, and/or data.
Imagine you’re an entrepreneur who gets fed up with the long wait at his dentist, Wilson says. Being the inventive type, you build and sell a piece of software that helps dentists manage their practices better, and you wind up building a successful company.
But over time, other companies build the same sort of software for less money. The margins get smaller and smaller, and your work gets harder. Eventually, an enterprising group of dentist/coders bands together to build an open-source version that out-competes them all.
Now imagine that instead of selling a piece of software, you build a social network for dentists. You allow patients to build their own profiles with all their dental records and appointment bookings, which makes booking and new patient onboarding 10x easier. You first monetize with native ads, and then by taking a cut of each transaction: dentist and patient; patient and “providers of consumer dental health products;” and dentists and “providers of dental equipment and products.”
“Dentistry.com ultimately grows into a $1B revenue company and goes public trades at a market cap of $7.5B,” Wilson writes, “Wall Street analysts love the company citing its market power and defensible network effects.”
These are common patterns seen over the last few decades. Software companies either find themselves racing to the bottom on price, ultimately to find that they can’t compete with free, open-source software — or they find a way to monetize the network.
Monetizing the network happens because of what Wilson calls “second order network” effects. Each user brings his or her own social circle to an application, and when those applications are collected in a network, each user’s social circle adds value.
This way apps do not need to compete to own and control their networks. They all benefit when a new app ties its user base into the network they share — the way that each dentist benefits when a new user signs up for “Dentistry.com” because their potential customer base has just expanded.
Wilson mentions Facebook as one of the first instances of a second order network effect taking off. By allowing third-party developers to build applications on top of Facebook’s network, the company has encouraged a second network to grow on top of the first.
Within USV’s portfolio, social game developer called Zynga uses the same principle. In addition to developing its own games, the company allows third-party developers to make use of its network. That network then funnels users in both directions, from the existing collection of apps to the newcomer and vice versa. Wilson notes that in the network’s first week, it sent 75,000 clicks to third-party apps, while those apps sent 32,000 clicks back to the network.
Individual games may come and go as users’ tastes change. The network is durable, and as long as Zynga can monetize it, the company can withstand disruptions that would make a commodity-based approach unworkable.
5. Social networks need to add value for the single user
“It might seem odd that systems designed to leverage interactions between people can have (should have?) single person utility. But I strongly believe they should.”
Because social networks draw so much value from connecting users, it’s easy to see the individual user experience as window dressing. Wilson warns against this. Creating a solid single user experience, he argues, not only helps build the user base that drives a social network, but helps the network endure once the novelty wears off.
In other words, the social network needs to be valuable for the service it provides, not only because your friends are on it.
Any new service needs to be an interesting place even for its first users. “Big open data rich social platforms are interesting places,” Wilson explains.
Wilson often praises Foursquare for its high marks on this score. He uses the app because the lists automatically geosort depending on the user’s location, and because its map view can serve as a walking map of a neighborhood or city.
He notes that the service has no shortage of competition. A person looking for restaurant, bar, or museum “can use Foursquare (a USV portfolio company), you can use Yelp, you can use Google or Apple maps, you can do a Google search, or you can stop someone on the street and ask them.”
Part of what differentiates one service from another is user history. The longer a person has been using a particular app, the more data it has and the better the recommendations it can make. The rest is single user utility. This is what allows Foursquare to compete with older, more populous services like Google Maps.
Foursquare, Wilson points out, does not just collect a large database, it puts that data to good use. It includes, for instance, a “places people go next” feature that tells a user where others tend to go after leaving the place he or she has just left.
What’s more, strong single user utility can help add staying power to a social network when conditions in the marketplace change. Hype can rapidly pump up a social network, but it can tear that network down at least as fast as users move on to the next big thing. Often, swings of that sort are driven by changes outside the company’s control.
Once the buzz around a social network dies down, good single user utility can help retain users that might otherwise have jumped ship. “If I get great single person utility from your service,” Wilson explains, “it is less likely that I will follow my friends out of it when your service ends its stay on the hype cycle.”
6. Spend the most energy on the middle of the pack in your portfolio
“The second quartile will try your patience and your conviction. These investments often take longer to realize. And you will have to take endless calls from friends in the VC passing on the investment for all sorts of good reasons.”
Fred Wilson has observed that most venture capital portfolios obey "power law dynamics": a few high performers outstrip the returns of the rest of the pack by a mile.
Out of 20-25 investments, he says, the top 4 or 5 will produce 80% of the returns. The bottom 10 or so will produce roughly 5%. The ones in the middle, the second quartile, will produce around 15%.
At first blush, the top tier would seem to merit the most attention. Surely the companies that generate 80% of the returns deserve 80% of the VC’s time and energy.
Wilson disagrees. It’s the middle of the pack that’s crucial, he argues. Even though working with those companies will often demand the most effort, those are the opportunities where VCs like Wilson can have the most impact.
“You will have to talk your management team off the ledge countless times,” Wilson warns. “You will work harder to recruit new talent. You will put more money into them than you want to. You will struggle to get the business profitable.” He does not see that as a problem. As trying as it might be to sweat over a company you don’t expect to become the next Google, it’s necessary.
Companies in second tier might not be the $1B behemoths that make headlines, but they still tend to have exits in the $100M to $500M range. A firm like Wilson’s, which tends to own roughly 20% of each portfolio company at exit, can walk away from that sort of deal with around $50M. “A few of those,” Wilson observes, “and that is the difference between a 3X fund and a 5X fund for us.”
Top quartile deals will end up being more valuable, and Wilson can still add value to those kinds of companies; but for the most part, they can move along without as much intervention. Those companies are going to get big with or without Wilson’s help — like Twitter, for example. For those in the middle though, a VC putting in the effort can mean the difference between a modest profit at exit and a total failure.
On top of that, shepherding these companies to success is vital to maintaining a good reputation as a venture capitalist. To land some of those massively lucrative deals that end up in the top quartile, a VC will need founders to believe that he or she will put in the effort if the going gets tough.
Wilson urges founders looking for good investors to “look at how the firms you are talking to behave toward their second and third quartile portfolio companies. That will tell you all you need to know.” The talented entrepreneurs that make the most money for a VC are likely to take that advice.
7. Invest in bits, not atoms
“When you are investing other people’s money, you need to be mindful of where the timelines are shortest and the path easiest. And that has been bits for the totality of my investing career.”
Wilson made a bold statement about the future of tech in the new economy in a July 2009 interview: “Every industry that is based on knowledge or information or some other form of non-physical matter (atoms vs bits) is going to fundamentally transform.”
In other words, atoms make up the physical world (clothing, food, etc), while bits (digital information) make up the non-physical world. Wilson’s investment thesis revolves around massive industry transformation, and the best way to find the wild successes is to invest in digital products, or “bits.”
As evidence, Wilson points to some of the disruptions that happened in the early days of his investing career. Since the 90s, he has focused on industries like media and financial services that could be “end to end digital.”
When it comes to atoms, this digital transformation takes longer and can have real setbacks. Self-driving cars have become a prime example of how difficult it is to revolutionize when atoms are involved. Though the industry holds a lot of promise, it is taking longer than expected to catch on, and there have been many challenges. That makes self-driving cars a bad bet for a VC, who needs to not just be right, but be right at the proper time.
That’s not to say that Wilson doesn’t believe in innovation through “atoms.” He does — but that innovation needs to happen deliberately, one piece at a time. In the self-driving car example, human lives and physical capital are at stake. Moving fast and breaking things is a great way to spark a public backlash.
“Who wants to get into the back seat of the first self driving car and let the car do its thing?” he asks. “Not me.”
Instead, he argues, successful self-driving cars may come out of a steady escalation in new features like machine-assisted lane changes and parallel parking. No one will choose to get into the first self-driving car. Customers will start buying cars that are a little smarter, one piece at a time, until the car is driving itself and barely anyone notices the difference. That process can turn out a valuable technology, but it is unlikely to make much money for an early-stage VC.
On top of that, products built on bits lend themselves to an open-source business model.
Getting a team of engineers to build something that works, Wilson points out, is easy. The real costs come into play once the product becomes popular and users start to demand continuous support.
Companies like Red Hat, MySQL, and MongoDB have prospered by putting out the original product for free and then charging for support. “This approach,” Wilson advises, “can be mimicked by anything that is made of bits, not atoms.”
8. Investors need to love their losers
“I am not suggesting that a high loss ratio is indicative of good performance. It is not. But it is indicative of risk taking, and importantly, taking your lumps and moving on.”
In November 2013, Wilson reported that his 2004 fund had a “names” loss ratio of roughly 40%. In other words, 9 out of 21 companies in which the fund invested would end up worthless or nearly so.
That is fine by Wilson. In fact, he has called that fund “the best venture fund I have ever worked on.” The lesson he draws from the USV 2004 fund can be counterintuitive: if you do everything right as an early-stage investor, many of the companies you back will fail. That high rate of failure means you are taking the right amount of risk, and you are not clinging to companies that will never work out.
Running a startup is a tough racket. A fund that doesn’t take risks on startups is likely giving up on winners by being too cautious. In a July 2017 blog post, Wilson points out that only 20% to 30% of companies move from the first round of funding to the second, and roughly half drop off at every stage thereafter. He caveats that some of this is companies being sold off or becoming profitable, but “most of the churn is companies failing.”
For Wilson, running a successful fund is not about steering clear of those losing investments on day one. It’s about doubling down on companies that show promise while cutting off the ones that do not before they waste too much of everyone’s time and money.
Wilson indicates in an April 2016 blog post that the losses on those 9 companies were easily swamped by the gains from 5 investments where the fund raked in double and triple-digit returns. Making the hits count is much more important than trying not to miss.
What’s more, Wilson warns that a low names loss ratio could mean that a fund doesn’t know how to write off an investment that can’t be salvaged. As long as the fund continues to spend money propping up flagging companies, those companies will not look like failures on paper. But at they end of the day, they cost the fund much more than they would have if they had been allowed to fold.
In the same 2016 post, Wilson points out that the 2008 fund, while unlikely to outperform its 2004 predecessor overall, did improve on it in one regard. While both funds saw a 40% names loss ratio, the 2008 fund lost only 20% of the money it invested. USV did this by taking what Wilson calls a “loving your losers” approach. It spent more time with struggling firms so that it could identify the duds quickly and “get the founders and other investors to see the light early.”
9. Exercise discipline about how many companies you take on
“This is not spray and pray, this is not following the herd, this is not momentum investing. This is thesis-driven, active early stage investing, which has always produced the best returns over time and I believe always will.”
In July 2018, Wilson reportedly surprised a fellow venture capitalist by revealing that he had made only 1 investment so far that year. It’s not a sign of fear or anxiety — the deliberateness of the investment pace is a central part of USV’s success.
For Wilson, going slow and keeping the active portfolio narrow ensures that the team is thoroughly thinking through each company they back. On top of that, it lets them stay in the loop with every one of those companies after making a deal.
Given USV’s time frame, making more than 1 or 2 investments per partner per year would quickly overburden the firm. Because USV waits 7 years on average to sell off its stake in a company, that pace would leave each partner with 7 to 17 companies on his or her plate at once. “The low end of that range is quite manageable. The high end of that range is not,” he warns. “I have been there.”
Wilson sees early-stage venture capital as “a service business in which the entrepreneur and the company they started is our customer.” As such, it requires a commitment of time and attention that doesn’t allow for the crowded portfolio his firm would get at a faster investment pace.
Exercising discipline helps USV keep to its thesis-driven approach. Many larger firms prefer to do “thematic investing,” identifying broad areas like mobile or social networks and then building a portfolio around them. Wilson warns that this approach can lead to “bucket filling,” as each partner snaps up droves of companies that fall under his or her theme without giving enough thought to each deal.
Instead, USV narrows its portfolio to a straightforward statement about where its partners believe innovation will happen over the next 5 to 10 years. Doing business this way prevents the firm from acting too much on impulse or following the herd when the market takes a liking to a new technology.
The firm works tirelessly to fine-tune its thesis, issuing periodic revisions to adapt to changes in the world. Seeing all that time and energy pay off requires that partners keep each other laser-focused, even when companies that do not align with the thesis look tempting. Wilson admits that, left to his own devices, “I could pull the trigger on a new investment every month, maybe even more frequently than that. But my partners remind me all the time that we have to pick our shots carefully.”
10. A crisis can help a company grow stronger
“Change is hard to bring to an organization and a time of crisis is often a perfect time to make some changes that you have wanted to make for a while.”
Wilson’s blog is replete with advice on how to deal with failure, both as a founder and as an investor. Given the tumultuous nature of startups, focusing on putting out fires makes sense. But Wilson also explains that a well-managed crisis can be good for a company in the long run.
“Crisis is what brings clarity and focus,” he argues. “You get punched in the gut, you get back up, you take care of business.”
A crisis might mean losing a major customer, getting a flood of bad press, or losing key team members. To recover from that sort of event, the company will need to adapt. If the management team does its job well, the strain of the crisis will pass, but the improvements to the company will stick around.
He cites Brewster.com, a USV portfolio company that helps users manage their contact lists, as a successful practitioner of this approach. When it began, Brewster.com offered a secondary address book that promised to keep users’ contacts up to date. The company soon discovered that it could not find much of a market, so it tweaked the product over time until it developed an app that worked unobtrusively to update users’ existing address books.
All the while, the company took care to keep “its headcount and expense structure under control so it had runway to evolve and improve their product.” That sort of discipline, Wilson argues, can turn a crisis from a damaging blow for a company to a pathway for success.
Changing important parts of the organization can be difficult, especially once a company has been up and running for a few years. Wilson warns that “normal operating conditions can lead to an organization getting fat and happy. A crisis can shake things loose that need to be shaken loose.”
Brewster was later bought by FullContact, where its self-updating address book was integrated into its parent company’s product.
A good response to a crisis, though, needs to come from the top. “If the leader is down for the count,” Wilson cautions, “the team doesn’t have a chance.” Having someone seasoned at the helm makes a big difference here. A CEO who has seen a crisis or two previously is less likely to panic when something goes wrong.
He identifies 2 approaches for dealing with a crisis: the pivot and the grind.
A pivot takes place when a company’s new product hits the wall and the company changes course, launching a different product informed by the lessons from the original. Flickr, Twitter, Slack, and Kik all overcame crises this way.
When a company opts for the grind, it buckles down and iterates its original product until it lands on something that works. This approach, Wilson makes clear, is not the same as clinging to a bankrupt idea and burning through money. In fact, keeping the company lean is critical to making the grind strategy work.
11. Growth isn’t always worth it
“I would encourage all entrepreneurs and leaders out there to embrace the idea of getting profitable sooner than you might think you can or should. It’s good for your companies and it is good for you.”
Rapid expansion can be good, Wilson warns startup founders, but it has a price.
Wilson gives his own rule of thumb for how fast early-stage companies should grow in a February 2015 blog post: a company’s annual growth rate plus its operating margin should be at least 40%. In other words, if a company is getting 60% bigger every year, it should aim to lose no more than 20 cents on every dollar of sales it brings in.
He admits that there is “no magic” to the 40% number, but that the rule is valuable because it is a reminder that growth at all costs is not always the right way to go — especially if you’re losing a lot of money on each sale.
Rapid growth without adequate margins can leave the company with significant burdens later on — like too many staff members — making things harder once it’s time to start making money. In fact, Wilson indicates that some of the companies in USV’s portfolio actually grew faster once they tightened their belts to become more profitable later on.
Furthermore, not all types of growth are alike. Wilson makes a point of distinguishing between “organic and sustainable” growth and “temporary stimulated” growth. Building the management team or developing key pieces of technology might be worthwhile in the long run. Pumping up the customer base with a new marketing push might not be if those new customers don’t stick around once the company pivots to make money.
Moreover, whether or not a company can make that pivot to profitability will depend on how the company has been fostering growth. Companies like Amazon, Salesforce, and Workday made little or no money because they invested in things like new data centers, R&D, and logistics. They could have reversed course to start turning a profit at any time.
The companies in USV’s portfolio, Wilson points out, approach growth in different ways. Etsy, for example, ran negative margins to fuel explosive expansion and then turned around to reap the rewards years later. Indeed.com became profitable early and reinvested its own cash rather than eating losses and raising capital to expand as fast as possible.
Neither approach, for Wilson, is preferable in every case. “Profits are critical to the health of a business,” he advises, “but that doesn’t mean a healthy business has to currently [be] profitable.”
Source: CB Insights