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Second Order Effects
…the key driver of non-linear venture returns
When I first started making direct pre-seed venture investments in 2016, the most important thing I learned from my mentors at First Round Capital and Dorm Room Fund was the importance of investing in companies who have a view on the second order effects of what they’re building. Until that point in my career, much of my investment training was in pricing linear outcomes, for example:
If growth is x% and rates are y%, the price we should pay is $xM, OR
If the price of oil increases, we’ll likely make money, but if it goes down, we’re going to lose a lot.
Investing in venture is different. To be successful, we need to live in the future and build the products and services that that future needs. Being right about that future (and ideally non-consensus and right) is the main driver of outsized returns. In these situations our companies are first to market, compound their (business and technological) advantage, and are often writing the playbooks for entire new industries.
Often times we see founders building first order companies that don’t take a view on future states of the world. Examples of this are:
“We are building software to allow landscapers to communicate with their customers over SMS.” OR
“Our battery technology allows us to extend the life of cell phones by 20%.”
These can be good businesses and great investments but rarely become venture-scale (i.e. 100x+ return potential in 10-15 years). The biggest venture outcomes are almost always paradigm-shifting (Google, AirBnB). They create new opportunities that didn’t exist before (eBay, Etsy, Amazon). And the founder often has a vision for the future that few can see, and they seem almost crazy to be building what they are (SpaceX, Tesla). The public company versions of the companies we know now look nothing like they did at the seed stage.
As early-stage investors, the biggest risk we take is not in core technology, team, or market, but in being right about different future states of the world. When we invest, we prioritize founders and teams that can articulate that clear vision for the future and pair it with a pragmatic plan for how their business can be THE big winner when their vision becomes reality. This dynamic is one of the reasons why I love venture. We get to dream about the future and play an active role in creating it.