VC Fundamentals: Blue vs Red Oceans, Power Law Returns & Fund Structures – E569

Jeremy Au shares how venture capital evaluates startups, using examples from crypto confusion, post-WWII VC history, and power law returns. He explains why founders often misunderstand their market type, how tech repeats old cycles, and how VCs structure investments. Speaking practically, he highlights why founders must communicate clearly and how VC math rewards big winners and tolerates many losses.

1. Founders often believe in Blue Ocean, but many are in Red Oceans. Almost all founders think their idea is unique, but many just add features.

2. Red Ocean founders should expect slower, efficient growth. VCs advise Red Ocean founders to grow carefully, accept slower returns.

3. Blue Ocean founders must clearly explain their differentiation. VCs become jaded and need clear explanations to believe in new categories. 

(00:58) Jeremy Au: In general, VC is a startup. (01:00) Every startup founder kind of believes that blue ocean in that sense. So, what I mean by that is every startup founder is saying, "I'm building something new that the world doesn't exist." As we talk about the world perspective from a VC perspective.

(01:09) 'Cause Red Ocean means, for those who understand, Red Ocean means it's highly competitive. There's a lot of similar companies; there's a lot of incumbents. You're competing with them. Blue Ocean is you're creating a new category. You're creating a new space that has very little competition.

(01:21) But I can tell you that almost all founders think that Blue Ocean, does it make sense? So, that's a self-awareness part, right? And so from a VC perspective, we're judging that. I think to directly address your question here as a result is what happens if a founder thinks they have a Red Ocean product?

(01:35) It's pretty unlikely. 'Cause again, every founder thinks that they're like, 'man, a bakery with Bitcoin.' Of course, this is a Blue Ocean product. We accept Bitcoin. There's no other bakery that sells Bitcoin. And now we do. And I think it's a joke by then we saw that quite a few of them pop up, right?

(01:49) In Singapore, were like, we're differentiated because we accept Bitcoin as a point. But then from a VC perspective, external perspective, a lot of people are like, hey, but actually accepting Bitcoin is a feature. (02:00) It's still a bakery; you're still a food place. So, you never escape your country.

(02:03) Cool thing they added onto it, right? So yeah, I think if you are a startup founder and you know that you're Red Ocean, you probably will be like, you should accept money that's from like, family officer s, from private equity, from slower rate of growth, because you still can make money in a Red Ocean market.

(02:21) It's just that your rate of growth is gonna be slower. Does it make sense? But also, so in general, a Red Ocean market means, but if you're the best in that Red Ocean, it just means that you eventually you make money, but you make money slower and then as a result, you're forced to be more efficient over time.

(02:34) Yeah. And then the second thing is that from a Blue Ocean perspective, is that we want to make sure that we are thinking about portraying ourselves and explaining the Blue Ocean. Because VCs after seeing a lot of Red Ocean companies tend to over index and say everything is a Red Ocean thing.

(02:50) So, they get very cynical and jaded. So, if you Red Ocean thing, actually what happens is that people are very bad explaining why this is a cool thing. When people explain Bitcoin to me back in the (03:00) day, and I never got a Bitcoin chain, and everyone's ' Jeremy, Bitcoin is a way that replaces currency.'

(03:06) And I'm like, that makes no sense at all because we have plenty of currency and a volatile asset that goes up and down is not a good system for a currency, right? Because for currency you need a military, sorry. When you have currency, you need a court to protect your currency. 'Cause otherwise people steal from each other, blah, blah, blah.

(03:27) And in order to have a court, you need to have military force to back up your court. Otherwise, you have a useless, powerless court who cares about some random islands court system that says Jeremy needs to pay back this person. For that, I say forget about it. I don't care about this thing. I'll just continue living in Singapore because there is no territory.

(03:46) But now obviously, what we see is that Bitcoin has got to the point where they say they've gotten enforcement court actions from Singapore, so you're supposed to be a global currency that no government was part of. But now they ask who? They ask the USA to bail out and (04:00) liquidate and force the creditor claims for FTX, right?

(04:03) And so now they're gonna pay back about 110%. Sam Bankman-Fried, he's in a US prison right now. Alright? So again, this global currency that had no government to me, when they explained it to me, I said it makes no sense. So, I was a hundred percent correct.

(04:16) I said, back then I said, Bitcoin will not work as a currency because at the end of the day, it will be something that has to work with the government in order to protect itself. However, I was wrong. What someone should explain to me was like say, 'hey, Visa and MasterCard take a ton of money as a gatekeeper, right?

(04:36) of the transaction fees taking 5%, 10%, whatever it is. If you try to watch from all the Philippines, they're trying to take 20% of the fee. With Bitcoin, that costs to go to zero because for the first time ever, if I send you a JPEG, then you can copy paste a million of those JPEGs. You know that's not currency, right?

(04:54) Because you can adulterate the currency, you can clone and cheat. But now when I give you one (05:00) Bitcoin, you know that you receive one Bitcoin. I definitely minus the way one Bitcoin. So, this is a way to, it's a good way to transfer money. Now, if somebody explained to me back then I would be like, bam! I'll be the best crypto bro since 2008.

(05:13) But too bad, nobody explained to me. Everybody was talking to me about this utopian world where everybody uses Bitcoin, and nobody goes to see the government anymore. And I was like, that's not my thing, right? So for me, I made a mistake. I didn't understand crypto from that perspective, right?

(05:25) And so right now we see crypto is often used for regulatory arbitrage, right? So, we're like, 'hey, we wanna transfer money from point A to point B without paying this or that.' We see a huge amount of that happening. Hopefully that helps Blue Ocean. The Red Oceans VCs. Founders must learn to grow slower and more capital efficient and understand their Red Ocean.

(05:46) True Blue Ocean founders have to translate and explain to people why it's a true Blue Ocean. Because VCs are very jaded people. We're now gonna go into the VC fundamentals, the first VC came to existence. His (06:00) name was Georges Frédéric Doriot. He is called the "father of venture capital". So, in 1946 with this company called American Research and Development Corporation, he would later found INSAIT, our wonderful MBA school that you see in Singapore and France in 1957. Okay. So small world here, right?

(06:18) And what was interesting was that in 1946, he founded this. Company because World War II had just ended. So, the American government said, 'we want to help people who are returning from the war soldiers to set up new businesses.' So, we want you to administer loans and other financial support to do these businesses so they can set up the businesses that they want.

(06:39) And Silicon Valley came to existence around this timeframe. Silicon Valley didn't exist during World War II, but after World War II, you had a hub. You you have? He had great Universities. He had defense spending, had a wonderful climate for people coming back from the war who were all coming back to set up businesses.

(06:54) And he only struck it rich in that sense with the first VC investment in 1957. So, he was (07:00) deploying capital for about 10 years in a row, right? And he invested $70,000 in this company called Digital Equipment Corporation Minicomputers. A computer was the size of a whole room. So, the whole room, this whole room would be a considered mainframe, right? And then they created something called the minicomputer. So, the mini computer basically was the size of a fridge. Okay? So, they created this crazy idea, which is why don't we take all the computing power in a room and make it smaller and more accessible with a fridge sized thing that you can pocket it next to your desk.

(07:31) So, this company eventually, in 10 years time, eventually would have $38 million IPO. So, they didn't raise a lot of money. And today, million dollars miles are very small, but didn't absorb a lot of capital along the way. And as a result, that $70,000 check created 500 times return for this check. Okay and now we are saying this is that basically that $70,000 check doubled every year for 10 years.

(07:55) So, $70,000 check became worth $140,000, which became (08:00) $600,000 became 1.2 million, 2.4. And this kept growing like that for 10 years in a row. And that's an interesting story. So that check was a type of the company that started to come to existence because this was the same time that all of this technology, all the r and d that went into World War II for encryption, for computing, for fighting the Germans, Japanese, all that computing power was starting to be converted for B2B and B2C purposes instead of industrial warfare purposes.

(08:28) And fast forward another 20 years. Eventually this would lose two microcomputers. So, this was called a mini computer. A microcomputer is the kind of computer that's in front of you. The computer in front of you is by their standard is called a microcomputer. Okay. But what's interesting of course, is that we're now going back to mainframes.

(08:48) The world goes back cyclically. We're going back in time. If you use ChatGPT is being done in a data center, right? So, A Frame, which is a giant data center. So, there's a kind of interesting piece here, which is there's always (09:00) this idea, which is do we wanna decentralize computing power so that all the computing power can be done in this computer that you have.

(09:05) But if you use ChatGPT, all that search. It's being done by mainframe, a data center that is in the US with all these GPUs, et cetera. We're going back to that world where the hub is very strong and your computer is a dumb terminal, is only an output count pool graphical version of what's actually being computed somewhere else, as we talked about, is that if you do a Google search right now, not even an AI search, a Google search has the same amount of processing power as.

(09:34) What was needed to send the Apollo mission to the moon. Okay. So, every time you do a Google search, you're like, wow, I sent a whole mission to the moon. And that's only about 20 plus years ago, not that long ago. So, this guy caught the first wave of technology companies and now today, capital is considered to be a profession.

(09:51) So back then nobody knew what was going on. He did it. And he was like, wow, I was lending money and helping all these servicemen, but suddenly I'm making a ton of money. And then it took (10:00) a while for people to understand what's going on. But today, VC is now a well- known profession. Obviously, we have institutions like Sovereign Wealth funds Temasek, you have your Dubai the Saudis, et cetera.

(10:11) Obviously, venture capital, which is focused on high- speed growth. Obviously, some of you wanna do private equity and growth equity in your banks. And then we'll talk about that. And obviously we have the public equities, right? The stock, public stock market where everybody can invest. You and me can invest using Robin Hood or some kind of day trading app.

(10:27) And so, what's important for you to know is that for those who are a little bit more financially oriented a public equity is that this company is full of public information, and I can invest in Apple or who are the other public companies go grab or go to? All the, those financials are public right now.

(10:44) I can invest in them. Private equity means that these companies are private. The information is private, the financials are private, their growth is private. The team private is a lot of proprietary information. So private equity companies make money because they take on medium risk. What they're saying is, I (11:00) see a company that's privately information, but.

(11:03) Here's my secret, right? And I used to work with Bain Capital as part of Bain Management consultant. What the Bain Capital team knew was that even though nobody really understands this company, we know that this company can become two to three times more valuable, right? In the next few years because there's opportunity, or we can do mergers, or we use.

(11:20) That, whatever it is. But from their perspective is there's a lot of upsides that can be created if we take control and buy over the company. And then we do all the changes that a previous management was not willing to do. And so as a result, private equity will own the majority of the company, normally at least 51%, if not all of it.

(11:40) And then they'll try to basically buy over it to make sure they have control. And then their goal is to target about 15% annualized returns. Okay, so that's the target for private equity. Then for venture capital is that we are considered to be high risk. So, we are gonna make 20 investments, which is different for private equity.

(11:59) (12:00) Private equity is maybe doing two or three investments right, per vehicle. And then we expect only one or two of these 20 companies to generate 20 to a hundred x returns. So huge return profile, not so again, private equity is you buy three companies and each of them will grow two to three x. But you don't expect any of them to fail.

(12:18) If any of them fail, you're fired. And venture capital, we expect a thin or 19 outta 20 to fail, we'll expect one to succeed. And we normally take a minority investment. We only take 20% of the company. So, we basically saying we don't over overall, we believe that a founder, whoever is, no matter whether he or she's young, we expect that person to run this company during this timeframe.

(12:39) And the goal is that we can target 25%. Net return on a annual basis. And what I'm trying to explain here is this, is that when we talk about private equity and the most investments, more of you would look at it from a normal distribution, right?

(12:53) Half will perform above average, half will perform below average, and maybe 10% will perform really well, and 10% perform really (13:00) badly. So, this is how most things are happened in life, right? Maybe you show that for height, you show that for weight, you show that for whatever it is. But what's very different about the VC life is that something called 80- 20.

(13:11) So, it's called a "power law distribution", which is that this bell Curve demonstrates the distribution of it, but not the outcomes of something. So, for example, we talked about was we said more startups actually look like this. If I put all startup performance, it'll look like a bell curve, but the thing is, only this 5% of startups will become billion- dollar companies, and then these companies will generate a small number, will become

(13:38) 10 to a hundred- million- dollar worth companies and the rest will just be zeros. Does make sense. So, what I'm trying to say here is this represents that. And so, most of you, when you go to consulting or finance, a lot of you be trained to use the 80- 20 rule, which is if you look at customer complaints, right?

(13:52) Most people who go to a restaurant, the experience like this half above average, half below average, but 20% of people would generate (14:00) 80% of complaints. Because only people who are very frustrated or very used complaining will generate most of the complaints in this system.

(14:06) So, something to be thinking about is that power law basis. And so what we're trying to say is that VCs are really looking for home runs. We're not trying to look for people who are average, above average. Excellent. Now we're looking for the best. So, we're looking for companies that have a high growth rate.

(14:21) They can return between 10 or 200 x. Reasonable valuations. If I can come in earlier and cheaper, if I can pay $750,000 to buy 20% of the company instead of $1 million, I'll take it, right? And so that's why VCs work hard to talk to founders early. 'cause they wanna make that early investment when you need more capital, right?

(14:41) For example, Sequoia invested $60 million in WhatsApp in 2011 and 2012. And Facebook acquired WhatsApp which then had $450 million, 40 users in three years. So, they invested in 2011. In three years, they got four 50 million users and they were growing about a million users per day, and they got $16 million for the (15:00) acquisition.

(15:00) Okay? So, Sequoia has a result. Earned $3 billion from $60 million, okay? But basically it was in, a lot of it was in Facebook shares, which also went on to grow a lot as well, right?

(15:10) And so basically this generated 50 x returns in three years, right? So that's quite a cool amount of money if you think about that, right? You put $60 million and then you get $3 billion back. Pretty cool. So, I think a lot of people really like this thing, and that's why people find, like they get excited 'cause they're like, wow, I wanna be a VC who wants to be a banker, who wants to be a private equity person?

(15:30) I want to be like Top Gun, I wanna be the fighter that looks for these home runs, right? Looking for, sleepy whole businesses that need to be, have cost efficiencies. So the way to think about it as a result is that VCs have three major roles that you should think about that are limited partners.

(15:45) The general partners and the startups. Okay. So every VC fund has limited partners. These are the people who put money into VC funds. So, I'm an LP in two VC funds. I put money into these VC funds. Both of them are focused on (16:00) why Combinator startups. And the reason why is because I don't have time to meet all the Y company, just startups.

(16:05) I'm not based in San Francisco. I can't meet them. I don't feel like I'm smart enough to. Assess which one is the best one? A lot. So, I've invested as a limited partner, and I have limited legal liability. So even if things go wrong or there's fraud or whatever, that happens, it's not my fault. I only put money into the VC fund.

(16:23) Right? And me and a group of all other LPs basically put in 99% of the capital. So, assuming that this is a hundred million dollars fund, we put $99 million of capital into there. And then the partner in the VC fund expected to put 1% as a GP commit. So, they expect to have some skin in the game as part of the VC fund.

(16:41) Now the general partners receive this money, and they have unlimited legal liability. So, in other words, they are in control of the investments. I expect them to do the due diligence. I expect them to do their work. I expect them to work hard and make sure they govern the companies well. And these general partners are being paid about 2% of this fund.

(16:59) (17:00) So, what I mean by that is. I put in the fund has a hundred million dollars. The GPS will, as part of their management fees, get to deploy $2 million as part of their budget every year for 10 years. So out of a hundred million dollars, you can imagine they get $2 million budget per year to help them run the fund.

(17:18) And then when they invest, and let's say we talked about example in WhatsApp, when that large growth happens to it. When it's uplift, 80% of it will go back to the limited partners and about 20% will go to the GPS for running the fund. So it's like a commission structure basically.

(17:34) So, a lot of you will go into the finance world. A lot of you will hear the phrase. Two and 20. And that's very much the standard norm. So private equity funds, VC funds a lot. You hear that all the time. Two and 20. That basically means I get 2% every year of the total sum to help me run my expenses for 10 years, and I get 20% of the upside.

(17:52) And then eventually after the a hundred million dollars that gets deployed into 20 startups, right? And then 18 will eventually close or go (18:00) home, and one or two of them will become a unicorn. and then when the money. And they exit successfully, and they make lots of cash. Then the money goes back to the gps and the gps give them money back to the limited partners. So that is the structure of these VC funds.