You have an amazing blog on your hands—loves it!

Mr. Ellman, why did your “good friend up in Boston,” go with the 90:10 ratio as opposed to Pareto’s 80:20? I am 100% positive that your good friend has good reason, re: the rule departure, and would love to know why! When your schedule has a moment, would you please share…

Thank you!

Chris

In the larger sense no, we’re not taking a position on VC as an asset class with this post. The reason we’re not is because the binary pricing phenomenon that exists today is driven largely by the collapse in fixed costs required to build a certain type of startup. More specifically, consumer (or SMB-facing) web startups built primarily on open-source “tech lite” stacks (LAMP, etc…). For these startups the binary pricing emerges because only a minimal asset is generated by initial product development efforts. These are essentially engines for either consumer engagement or transaction monetization – in either case there is no equity value generated until good early evidence of uptake is present. Once a true ramp has begun, it is easy to understand and see the power of habit, network effects and brand-building take place and high value generated as a result. This is why binary deal pricing takes place – if we (and by we I mean investors generally) believe you have found a real vein of consumer engagement or the ability to monetize a particular time of transaction, we get very excited, but until that happens it’s unclear that a tractionless startup has anything of value.

This isn’t a position on VC as an asset class because despite the popularity of this type of startup within the social media world, they represent a relatively small portion of overall startup activity (and a much smaller portion of overall startup revenue and ultimate exit success). Most other categories of startup (software, bio-sciences, clean-tech, hardware, etc…) don’t follow these rules, require much more capital and creation of value prior to uptake, and so binary pricing doesn’t take place.

In the smaller sense, we agree with your statement as it pertains to the consumer web. There will be a few big winners and it will be competitive to get into those deals. As VCs fund numerous no-traction competitors to these winners, you’ll see evidence of venture’s inability to scale in this way.

However, every rule has its exceptions. Not all business can be launched on a shoestring (it cost AMZN $2bn to create AWS). This is especially true of infrastructure businesses – providing a buggy, if innovative, first release can mortally damage how you’re perceived.

In these cases, ie where the company brings a substantial amount of proprietary IP to the table, and aims to take away clearly appreciable pain, then there is strong case for a decent tractionless valuation. It’s almost as if the investment becomes a self-fulfilling prophecy, because should traction occur – and this goes back to the conviction over how much pain will be removed – then the company will have a defensible competitive advantage for quite some time.

I developed a revolutionary software to do network optimization automatically, and beyond the human capabilities of engineers. I ran out of money and need finance to build the company but I have the feeling that since I’m not in the business of social website stuff… It looks not so obvious to make vc’s understand that to enjoy doing facebook, youtube, received emails and do video-conference on your iphone, wireless carriers need my software to really provide that to you.Do you want to have a look into my company?