The Second Quartile

As I have written about here on AVC many times, early stage venture portfolios produce a wide range of outcomes. A few investments produce the vast majority of the returns while many investments return nothing. Managing a portfolio with power law dynamics is a challenge.

At USV, we tend to make 20-25 investments per early stage fund.

The best four to five investments per fund will usually produce greater than 80% of the total returns of a fund (the top quartile). This is where you might imagine that we spend all of our time, but the truth is that these investments generally go well and while we certainly do everything we can to help these companies, they often do not demand a lot of our time. When they do require a lot of our time, it tends to be situational.

There will be roughly ten investments per fund that will return maybe 5% of the fund (the third and fourth quartile). We spend a lot of time on these investments and it is difficult work that I have written a lot about over the years. The time and money we spend on these investments is not rational but we do it anyway.

And then there is the second quartile that will produce roughly 15% of the returns of the fund.

I find that it is this cohort of investments that is the most challenging to manage. The companies in the second quartile are usually very good companies but they lack the explosive value generation characteristics of the top quartile. They tend to have a harder time attracting top talent and financing their businesses at attractive valuations. We often do insider-led rounds for companies in the second quartile as the venture industry is hard wired to invest in the top quartile, particularly the later stage/growth investor community.

But there is a lot of value in the second quartile. The exits in the second quartile tend to be in the $100mm to $500mm range which is not a small amount of value to anyone other than a VC managing a billion dollar fund. The founders and management teams that are building these companies stand to make a lot of money if they execute the opportunity well. And an early stage VC can make a lot of money too. At USV, we tend to own between low to middle teens and twenty percent of our portfolio companies at exit, so the proceeds at exit to us of an investment in the second quartile cohort can be $50mm or more. A few of those and that is the difference between a 3x fund and a 5x fund for us. So managing the second quartile is super important.

But 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, but always come down to “it’s just not exciting enough to us.” You will have to talk your management team off the ledge countless times. 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. You will wonder if you have lost your objectivity.

And then one day, you will get an offer from a buyer to acquire the company for hundreds of millions of dollars. And then all of that effort and conviction will have been worth it.

The tech sector’s obsession with the billion dollar companies emerging from startup land is irritating to me. That narrative ignores a lot of great companies and terrific work being done by founders and management teams. And it makes it harder to build a company that isn’t in that top cohort.

I understand why the attention is focused on the big winners to the detriment of everything else. But I can assure you that is not how we operate at USV, and it is not how the best early venture capital firms operate. When you start a company, you want to find an investor who will be there with you through thick and thin. Do yourself a favor and 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.

#VC & Technology

Comments (Archived):

  1. William Mougayar

    Have you seen many companies migrate from one quartile to another, specifically from the 3/4 Q to 2 Q for example? Curious if you actually “rank” them in a given Quartile internally, or it is only an exit time kind of stamp classification.

    1. pointsnfigures

      Or, do the lower quartiles suddenly find something that allows them to scale and become first quartile. We read consistently how the unicorns fall-it’s a rare occurrence to read how persistence paid off and they built a unicorn after everyone said they were ugly.

      1. JamesHRH

        The dreaded P-word.

      2. sigmaalgebra

        The LPs and VCs are looking for the exceptionally good, but they are locked into a consensus of processes, backgrounds, etc. that are common, ordinary, and not exceptional at all.So rarely does anything exceptionally good come out of the LP/VC world, and when it does we can suspect a lot of luck.Elsewhere in our society, we are awash in exceptional accomplishments.E.g., the all-time, grand, unique, unchallenged world champion of technology is the US DoD. Well, sure, that doesn’t do much directly for IPOs for information technology startups.But here’s what the LP/VCs miss: That DoD work beautifully illustrates processes for how to do astoundingly powerful “secret sauce” and sometimes powerful secret sauce itself. Then those processes and some of the secret sauce should at times be powerful for the key technological advantage of a successful startup.How? Find a commercial need where the first good or a much better solution is a must have for enough people and revenue per person to make a successful business and where the secret sauce is the key advantage.Simple. Obvious. Really, why people major in STEM fields in college and grad school and, really, why in US academics the STEM fields are so well funded.But the LP/VC system looks only at revenue, like commercial bankers, and ignores secret sauce. Thankfully for US national security, the US DoD is really good at evaluating and exploiting secret sauce.

        1. pointsnfigures

          I disagree a bit. I don’t think that LP/VC focus on revenue in the main. They are unlike every commercial banker I have ever met. Yes, many are just part of the herd, but the lasting VCs are not. They make bets against the herd. I think revenue is a proof of concept, but it’s not a be all end all. Seed stage VC is all about betting on the team.

          1. sigmaalgebra

            Right, VCs are not exactly like commercial bankers, but apparently enforced by their LPs the VC follow the rule of commercial bankers, private equity, etc. and never but never make a financial investment in anything but a financial asset. Stop. Done. End of sentence, paragraph, and communication.LPs and VCs will bend this rule a little to regard traction significant and growing rapidly as enough of a substitute for revenue and earnings.Revenue? Really the word is relaxed a little and is “traction”. They invest in traction. Everything else can help but with a dime still won’t cover a 10 cent cup of coffee. With rare exceptions, they won’t invest in a sole, solo entrepreneur — we can both guess just why. Heck, even Y-Combinator is clear that they don’t like solo founders.There is no, there cannot be, any e-mail, phone call, foil deck, high end, warm introduction, etc. that will get a response from any of the top few hundred VC firms without traction. Really the VCs want to see the traction and the company before the company contacts the VC.That’s fine: In part it means reduced competition for me. I very much wish I’d discovered that before I sent 2000+ e-mail messages.I’ve done a lot of successful projects and seen up close and been part of a lot of really successful projects, but what I learned about doing projects is 100% completely lost on US LPs/VCs. Period.Why? Hint: LPs are essentially all MBAs, and I taught MBAs in a relatively good B-school. Yup, they don’t know how to do technology projects.So, I decided to do a project I could bring to nice profitability on next to nothing. I’m doing fine. I have been slowed by some unpredictable, external things not related to my project. For the project itself, that work has been fast, fun, and easy for me.The LPs/VCs can do whatever they want. I just wish I’d known the truth without having to learn it from 2000 worthless contact efforts. The rule is simple: No traction, no interest. Fine. Totally okay by me. I just wish I’d known. In fact, better than okay by me: Their brain dead approach to high technology projects means that I will have much reduced competition.I was slow to learn the truth because (A) I have an excellent, essentially world class, background in doing technology projects and know with rock solid certainty that the VC way is a totally brain dead way to pursue technology, especially highly valuable new technology, and the US DoD with its long list of fantastically successful projects solidly agrees with me and so do the low VC average ROI figures and (B) VCs commonly claim to be interested in new, advanced, disruptive, valuable technology. Right, for (B), they are like a woman interested in a man’s smile and laugh as long as he has at least $100 million in cash and no debts. If his heart is about to give out but not before the wedding, that’s okay, too.In US VC information technology VC land, pre-seed venture funding without traction is much more rare than hen’s teeth.If the VCs were involved in the Manhattan Project, then they would have said, you test one and if that works then for 1/3rd we will chip in for the gasoline for the Enola Gay.Thankfully for US national security, the US DoD and NSF know very well how to do high technology projects.Commercial relevance? Again, in the commercial world, find a problem where the first good or a much better solution will be a must have for enough people and revenue per person to make a nice business and where some secret sauce technology is the crucial enabler of the “first good” or “much better”. If the commercial need and the technology are really good enough, then the rest should be routine.What do the VCs need to do? They need to do the same as everyone else who is successful backing high end technology projects — evaluate the technology. That is one step the VCs flatly won’t take. First, nearly never do they know how to do or even how to direct such work. Second, no matter how the evaluation comes out, it’s irrelevant because all that is really relevant is traction already significant and growing rapidly. Technology is at most a nice to have, with a dime won’t cover a 10 cent cup of coffee.So, an entrepreneur who does his research, development, technology, and software on his own won’t get any competition from VCs. Then for doing such work for minimal bucks, proceed mathematically — that’s a LOT cheaper than trying to make some new hardware device.Mathematicians need mostly just pencils, paper, and sometimes coffee. Then write software. Now the software and computer hardware situations are in a miraculous situation — the AMD FX-8350 8 core, 64 bit, 4.0 GHz processor I hope to order tomorrow will cost a bit under $125. Software? A $100 copy of Windows 7 64 bit Professional. .NET Framework? Free. Comes with IIS. SQL Server and Windows Server? Free for three years in the BizSpark program and, then, keep it forever (typically limited to editions a few years old — fine with me). Lots of open source software.My 24,000 programming language statements in 100,000 lines of typing based on .NET need more testing but so far look ready for production to about $1 million a month.It’s a dream: See a problem; stir up some applied math for a good solution; type in some code for the core math, UI, etc.; get a server; go live; get publicity, users, and run ads; get revenue.If the revenue amounts to anything the VCs would care about, then that revenue will be too much for me to be willing to accept a VC check and term sheet. VCs and I can’t reach across the table, not in the past, the present, or the future. We are just not in related lines of business. I’ve learned that lesson.

    2. JamesHRH

      Can’t imagine anyone pulls out of the 4th.

    3. PhilipSugar

      Here is the better question William: How many have you seen go from the 2,3,4 Quartile into the 5th Quartile (A big fat Zero) because the VC flailed.For me I have seen a lot. You know me I tell Entrepreneurs no tears. As Bob Marley says: No woman, no cry. You take your place and realize it. But I have watched value destroyed, as you can tell it’s my biggest issue where Entrepreneurs and VC’s diverge. If you are ruthless and short sighted it is actually the smart move.If I was ever going to do a fund (and I’m not) I think there is a place to take these companies off of the VC’s hands and manage them. The reason why that isn’t a great idea is that too many VC’s will hold out the hope for a homerun and good ones will do that work as well, so you are really left with not much.

      1. pointsnfigures

        @philipsugar:disqus Yuppp to “because the VC failed”

        1. PhilipSugar

          I say flailed and the extra l is important. That is where I have seen flailing.Everybody says oh we know only 20% will work out like we want, but very few act that way with the 8 of 10 that don’t.

  2. JamesHRH

    1st Q – attracts LPs2nd Q – attracts Founders3rd & 4th – attracts VCIt’s crazy how much stress can be caused by a lack of alignment ( 1Q funding for a 2Q company ).One of my goals in life is to eliminate the word irritating from my day to say goings on.Amy thoughts for a replacement?

  3. DJL

    I have seen this mentality trickle all the way down to the local angel networks. Somehow a deal is not (as you said) “exciting enough” unless they see a path toward a $1B exit. And we are talking about VERY early stage. It seems less about making money than being part of an existing story that lights up the tech headlines. Great post and reminds us all that there is real work going on behind the headlines.

    1. LE

      unless they see a path toward a $1B exitI think also at play is the general idea that if the investor can’t wrap their head around why it wouldn’t be a $1b exit you actually might have an advantage.In other words if the idea is new, strange, different, complex such that success can’t be easily or typically ruled out you actually stand a better chance than if it can. Swing for the fences with uncertainty.So to take a non-tech example if I say “I want to open a string of Italian Restaurants” I would have a harder time than if I said “I want to open a chain of “Vo Pha Fna” bowl dish quick meal that I saw on a recent trip to Thailand. [1] And by the way customers can only pay by app, no cash accepted.…In real estate it’s well known that people are more likely to buy a fresh listing than a stale listing. The stale listing has signals and information that the fresh listing does not. So in the case of an investment the lack of information that an investor can rely on becomes an advantage not disadvantage. [2][1] This is entirely made up and I am not someone who would ever open a restaurant. And if I did it would be Italian or Chinese since I know that will work with the right execution.[2] Opposite of what happens in what I call traditional business.

  4. Girish Mehta

    Howard Marks’ very first memo back in 1990 has a interesting data point regarding The Second Quartile. It is tangential to your post however, because you are of course referring to the second quartile within a portfolio, while he was referring to the second quartile performance across funds.He was struck by this point from a pension fund manager of one of the highest performing funds over the previous 14 years – “we have never had a year below the 47th percentile over that period or…above the 27th percentile. As a result, we are in the fourth percentile for the fourteen year period as a whole” .Said differently – a fund that was solidly in the second quartile for each of 14 years in a row, was in the top 4 percentile for the 14 year period overall .This is a pattern that gets repeated in investing. People who make extraordinary high returns over one cycle then lose extraordinary amounts in the subsequent cycle. While those who deliver consistent above average, but not extraordinary, returns end up near the top in the long run.Or, extending the point more broadly – Getting rich in a very short time is different from staying rich for a very long time.Attached is the link to Marks’ memo from 1990 -https://www.oaktreecapital….

    1. PhilipSugar

      I have a friend who left a very large mutual fund company because he would beat the market by a small percentage, never more than around 100 basis points and never less than 10 basis points. He was told that was not their goal. He left with $5B under management, the next person came in killed it the first year and then tanked the following. All of the money left, and the fund went away.

      1. Girish Mehta

        Career risk is a powerful force that much of society operates under…this includes fund managers. If you can identify where it is operating and distance yourself from it, you have an advantage.

        1. jason wright

          musical chairs. there are never enough chairs when the music stops.

        2. PhilipSugar

          That is why having an investor whose fund is not successful is so toxic to a company.

    2. Tom Labus

      Note to Bitcoin investors.

      1. Girish Mehta

        The very last sentence was directed exactly there.

      2. jason wright

        I’m getting the vibe that you are short on ‘Bitten’.alt token prices are a proxy for bitten’s price, and Bitten’s price is potentially a proxy for alt token utility. I see the two ‘halves’ as indivisible (at the moment). perhaps I’m wrong.

        1. Tom Labus

          Long term bull but too unstable right now. When emphasis is on blockchain apps not bit price

          1. jason wright

            :)it is volatile, but I think that is a native characteristic of the process of distributing the token more widely. it’s a rough ride, but a necessary one to reach the next stage. we have to be patient.Edit 17:09 GMT;I also sense that this is a time when the big bright spotlight is shining so intensely on crypto that there’s a big danger of not seeing that next new technology that is emerging in the dark shadows over in the far distant corner where no one is looking at the moment.Also, I do think that most of the value and most of the authentic utility will eventually be absorbed by one or two (or three) new protocols. My hunch is that one will emerge from China, and that it may be the beginning of the end for the division between the ‘western internet’ and China’s internet (the GFW).Arthur Breitman points us in the direction of new protocols. Tezos is an idea for that future, but it is compromised in my opinion my decisions that are too short sighted in thinking and strategy (the money side of it, as usual).

          2. sigmaalgebra

            > that next new technologyIgnore any such thing. That concept is far too thin and empty for any value.Value takes much more detail than that.If some “new technology” is really valuable, then likely it is buried deep in the “secret sauce” of some one startup and not of general interest at all.There can be terrific value in technology, but not anything like> that next new technologywhich reminds me of the ad with “Which is better, a liquid or a powder?”.Any answer to the question is just worthless.E.g., we have “the Internet”. Okay, I confess, assert, that it’s bigger than wood, stone, copper bronze, boats, iron, sailing ships, steel, steam, steam ships, rails, chemical engineering, electricity, movies, radio, oil, autos, airplanes, electronics, TV, the transistor, and lasers. Still a startup in “the Internet” new technology was always too vague to have any value.

          3. jason wright

            then you won’t need to be looking.

          4. sigmaalgebra

            I certainly won’t be “looking” for “new technology” in the popular media.When I want “new technology”, I get rested, think of a problem to be solved, get a clipboard with a stack of blank copier paper, a special Japanese 0.5 mm mechanical pencil with a lot of soft lead, a big, soft eraser, some of my favorite math books and notes, and a handy stapler, pop open a cold can of diet soda, put my feet up, and think.Then I write out some math, commonly at least somewhat new, usually based on some advanced pure math prerequisites, and usually quite powerful. I have a rock solid track record that proves I can do that, commonly quickly, successfully, on demand.E.g., some guys had an optimization problem some big banks wanted solved. They had seen the pop culture media stuff about “simulated annealing”, written some code, ran for days, quit when tired, and still had no idea what they had.They sent me the problem, 0-1 integer linear programming with 600,000 variables and 40,000+ constraints. I looked, put my feet up, did some derivations, typed in some code, and got a feasible solution guaranteed to be within 0.025% of optimality in 900 seconds on an old, slow PC.Arrow, Hurwicz, and Uzawa worked in optimization and constraint qualifications for the Kuhn-Tucker conditions. For one question they couldn’t answer, I had already found an answer and later published it in JOTA (Journal of Optimization Theory and Applications). Right, Arrow won his prize long ago, and Hurwicz won more recently. The work was fast, fun, and easy for me. It was part of some work I did in grad school some pleasant evenings over two weeks, sitting in bed next to my wife while she watched TV.That’s how I find MY “new technology”.I’ve done such work lots of times, several times with no writing at all: E.g., I did the first, intuitive version of my Ph.D. dissertation on an airplane flight writing nothing.For the last paper I published, I had the main idea resting in bed, staring at the ceiling. It’s a nice paper. It’s hiding safely in plain sight. It’s by far the best solution for a really severe, expensive problem in all of high end computing and networking and more and worth a $500 million startup, quickly. I did the work to improve on our work on that problem with AI — my work totally blows the doors off AI, makes it look silly.Why not do the startup? The work will need some infrastructure software, some early joint work with some high end customers (I already gave a talk at the NASDAQ server farm in Trumbull, CT), a polished product, and some high end marketing. So, that would be maybe 10 relatively well funded (e.g., quite a lot of travel) person-years of effort. Then get the money back in the first few sales. And sell to nearly every high end server farm or network in the world. Nice business. No high end CTO will be free to be without it. It’s ready to go, complete with rock solid theorems and proofs, peer-reviewed, and with running prototype software with nice results on some real data, and a nice, new algorithm to make the computations fast. The solid state disk drives will do wonders for the work. It could be called high end AI, but that would be an insult to my work. For the VC/LPs, all that and a dime won’t cover a ten cent cup of coffee. For the money, my current project is much easier to do and potentially worth 1000 times as much.That little project is a nice example of where VCs are missing out on a nice, fast, simple, rock solid, very high technological barrier to entry, some significant network effects, low risk $500 million. Why? Because they won’t look. Why? Because no matter what they see, without “traction” they are not free to invest.For my current startup, the secret sauce new technology was done with the diet soda and feet up approach. It’s now in production quality software and works great, just as envisioned.Likely tomorrow I will order the first of the parts for my first server, AMD FX-8350 8 core processor with a 4.0 GHz clock, about 16 GB of 1333 MHz ECC main memory, several 500 GB SATA drives, etc. Right, one generation out of date — deliberately! I will run Windows 7 64 bit Professional, Windows Server 2008, some relatively old version of SQL Server, IIS, and the .NET Framework, and my software. At one point, some solid state disk drives will do wonders for the speed of execution. But I can get to revenue of $1 million a month with SATA drives.”New technology”? Fine. Coming right up. From the public media? Not a chance!”New technology”? We were talking about “new technology”, right? And, sure, implicitly, in information technology, right?So, this new technology takes in data, manipulates it, and puts out results. And we want it new, powerful, and valuable, right? We dream that the encryption behind block chain is such. And some people dream that some high end, empirical curve fitting is such although they confess that they don’t understand the results they have so far.Well, the data manipulations are necessarily mathematically something, understood or not, powerful or not, new or not. Well, for new, powerful, understood manipulations, definitely the totally blow the doors off everything else, make everything else look at best like baby talk, is to proceed mathematically. But, sure, for that need to be a mathematician. Really, need some selected, advanced pure math and some selected applied math and some experience. There are not many such people in information technology startups! But, that’s where the good, new stuff stands to come from.

          5. jason wright

            in the popular media? by definition that is the last place (other than a desert) to look.

          6. Julius

            Hello graycat,Your tech sounds amazing. How much longer until your startup has a website?I so much want you to succeed. I just fear that few clients and investors will recognize the genius when they see it.Not understanding -> Fear of the unknown -> Fight or flightSo get somebody who can explain the magic to the mortals and do professional marketing and PR. Otherwise your very fine results may not find the public they deserve.By the way, thanks so much for the book recommendations!Luenberger’s “Optimization by Vector Space Methods” was a real treat. Now I’m half way through Neveu’s “Bases mathématiques du calcul des probabilités” (in French).Please keep it coming. And maybe synthesize your many comments into a PDF. So that I can forward a link with your recommendations to a friend. Right now I have to send a hundred links with a few nuggets each.

          7. pointsnfigures

            @TomLabus:disqus and I agree. Heard this song before. Read this book before.

    3. jason wright

      Howard Marks, Minority Report. They were better at predicting the future than he was.

    4. TeddyBeingTeddy

      Gotta wonder how much VCs rely on the “greater fool” theory when it comes to exciting any companies that burn cash…

    5. ShanaC

      So why isn’t this a method of venture capital investing

      1. Adam Sher

        That quote from the article is Howard Marks quoting something written by a pension fund manager. A pension fund or endowment has a much longer time horizon (forever in the case of endowments), and they are not constrained by a 10 year fund life. Pension fund required return rates are typically in the single digits, which makes it more reasonable to solve for not losing capital versus beating the S&P 500.The most successful funds over a long-term horizon are open-end funds (e.g. Ren. Tech. Medallion Fund, Berkshire Hathaway). Hedge Funds also are commonly open-end, and a subset of these funds are the closest alternative to a typical 10-year PE/VC fund. Mutual Funds follow this format, and are more restrictive in the types of investments, and amount of fees the fund managers charge. In other words, it’s more lucrative to chase unicorns and collective your 2% management fee and other fees along the way.

  5. PhilipSugar

    This is a great post. You have never invested in one of my companies but I have talked to entrepreneurs that you have and your reputation has been built by the eye dropper and not lost by the bucket. I will also give a shout out to the Foundry Group who last year did a huge solid for an entrepreneur I know firsthand. This is one area where the VC and Entrepreneur interests can really diverge.There are people that will say you are not doing your “fiduciary” duty by not sharpening your elbows cramming down founders, replacing founders, or just killing the company.I assure you they are wrong, and you know this.I have seen more value thrown away here. The thing is this: as you say for you 80% of your value is coming from the first quintile, but if you are in the second or third quintile as an Entrepreneur 100% of your value is coming from your company. And I assure you as an entrepreneur we all think we are going to kill it, but sometimes, it’s just a long slog.I’ll end with a story. The PA Teachers Retirement Fund called me out of the blue for a reference. The asked me about a VC that had very sharp elbows. I kept giving the wrong last name and saying I really liked the person, they kept correcting me, and I kept getting it wrong, until they said, oh, I get it.

  6. Chimpwithcans

    Thanks Fred, for one of your “views into the trenches” posts – great stuff.

  7. Tom Labus

    Mega funds can’t even look at these guys. They need a grand slam at every at bat. Not happening.

  8. sigmaalgebra

    Yes, just what venture firms are doing is often a mystery and a cause of entrepreneurs not trusting the firms.You will put more money into them than you want to. Of COURSE: That was in the recipe before the pie went into the oven: The VC definitely wanted entrepreneurs desperate for VC cash. So, the VC didn’t want a sole, solo entrepreneur who was growing based on retained earnings, had 50,000 users a week and $20,000 a month in revenue with nearly no expenses. E.g., they didn’t want another Plenty of Fish.Instead, the VC wanted a team of several, with significant traction, say, to pick a random number, 100,000 users a week, growing rapidly, but desperate for cash — five co-founders, each married, each wife pregnant, in a high rent area. That team also wants nice commercial office space, the latest in workstations with several large screens, desk chairs at $2000 each, company supplied iPhones and laptops, lots of business travel expenses, catered lunches — Chinese, Italian, American, Mexican — etc. And there are big legal bills, big bucks for the monthly BoD meetings, etc. At’s a lots a cash a!But apparently there is another reason forYou will put more money into them than you want to. Apparently the limited partners (LPs) are highly conservative types working hard to avoid any blame and to keep their back sides protected. They know that if they stay in the middle of the pack, then they can keep their jobs. So, they follow the usual recipes. For VC, as in the recipe, they put a little of the money they manage in VC.But there, they are still following some old rules: Basically they want to follow a traditional rule in investing and especially commercial banking: Only put money where there are already solid financial assets. For VC they are willing to bend a little and count traction significantly high and growing rapidly as a barely good enough substitute for a suitable financial asset.What they are missing out on is essentially all the means of project evaluations common and solid in projects in science, technology, and engineering where project funding decisions are made on paper, just paper.Like one investor strongly explained, he makes business investments in businesses.Those are the LPs’ decisions to make.So, maybe what’s left for VCs is companies with promising plans, a good team, traction significant and growing rapidly, good hope of a good exit in 5-10 years, and desperate for cash. Then pour in a lot of cash, let the company grow like vegetables with MiracleGro poured on, and hope for a big exit.To me, that’s strange business, and a strange, even bizarre, way to do business, but maybe if look long and hard enough a good VC can find enough of those to make some money. Okay.But that situation starts to explainYou will put more money into them than you want to. ForThe tech sector’s obsession with the billion dollar companies emerging from startup land is irritating to me. And that obsession looks super incompetent and foolish: I don’t know how many $1+ information technology (IT) exits there have been in each of the last few decades, but it’s easy to count with shoes still on the number of famous $1+ billion cases. So, let’s do that: Intel, Microsoft, Cisco, Google, Facebook, Amazon.Tesla? That company is just nonsense based on the nonsense about “global warming” and supported by government subsidies based on nonsense. Now that we have an adult back in the White House, Tesla is on the way to the place from whence it came, the dumpster.Uber? It’s a taxicab company that loses big bucks and in too many foreign countries hires drivers that believe that any female in a skirt should be raped and killed and do just that. Obviously those drivers just do not understand and, instead, strongly from their culture, honestly believe, with no doubt at all, that any female alone and in a skirt SHOULD be raped and killed and feel allowed, empowered, justified, welcome, and even obligated to do just that.Uber has no significant business advantages — brand, network effect, technology. And Uber has no significant barriers to entry. Really the taxicab business is a geographically local business so that no matter what Uber does around the world it can be attacked by competitors or politicians in each geographical area. Nowhere in the world will Uber get any good vibes. At this point their brand name is below the bottom of the barrel. Uber’s a really bad joke.To get another one of those Intel, …, Amazon companies, the VCs need to up their games. As it is, for this goal, each of way too many VCs is just sitting out in a field with their hat upside down hoping that another Google will just fall out of the sky and land in their hat. To borrow from a tuna ad, “sorry Charlie”, except for blind luck, that’s not how good things are created.the venture industry is hard wired to invest in the top quartile, particularly the later stage/growth investor community. Here they are not really hoping for another Google and, instead, are trying to be like KKR — private equity (PE). Sometimes the PE people make money.I understand why the attention is focused on the big winners to the detriment of everything else. Depending on the definition of “big winners”, that’s tough to understand. We’re looking at, what, success rate — a Google or two each decade? That’s too rare to count on without something more effective than sitting in a field with a lucky hat upside down.Then there isYou will work harder to recruit new talent. That thought is common but, really, is next to delusional. Why? For IT, the whole concept of “talent” is uninformed, misinformed, ignorant, just plain wrong, and next to delusional.One of the main situations is: There are in the IT industry today maybe 10,000 narrowly focused jobs. E.g., backup and restoration of SQL Server. Actually I’m wrong: At a big site, that takes a team, and some small part of that team is a full time job.But I’m over simplifying: At a serious site, backup and restoration more generally are biggies, with lots of tiny specializations.Did I mention 10,000? That might be too small.Then along comes some hiring manager and their recruiter — maybe really sweet Sandra, Seven Sisters psychology major, high school Homecoming Queen, dreaming of Mr. Right with a big pile of stock options — looking for “talent”. By that they mean they have one of those 10,000+ specializations and seven tiny topics where they want any candidate to have heavy, recent experience and expertise. Not easily finding such, they say that there’s a “talent” problem.BS.The joke, not so funny, is that they are looking for “talent” under 30 with 15 years of full time experience in each of seven topics the oldest of which is only five years old. Not really a joke.This silly, sorry situation is now so famous that there’s a good parody”If Carpenters Were Hired Like Programmers”at…and…If the company, hiring manager, and recruiter had even as much as a weak little hollow hint of a tiny clue, and about 28 pounds less elitist arrogance, then they would have no “talent” problems at all.Here’s much of the solution — really a much stronger solution than needed — to the “talent” problem: (A) Hire people with good STEM field college educations, some good computer usage experience, and good skills in technical writing in English. Look at the college transcripts and writing samples. (B) Have a training program in the basics of the tools the company is using and wants the “talent” to be able to use. Grade the results, and keep only the people who do well. (C) Then have an apprenticeship program, and keep only the people who do well. (D) When there are technical questions, typically just about details of industry products, e.g., from Cisco or Microsoft, then call for technical support, likely paid. Pay up, get the answers, and move on. That works about 99+% of the time, and for the rest should be able to find other solutions or do without.(E) Also, make sure the hiring manager is competent and not just playing games, e.g., goal subordination.Really, to nearly anyone with enough brains and real world insight to do well in IT, a company with a “talent” problem is obviously so incompetent they should be avoided. At best they are not hiring for a job but only for a “gig”. If they are not willing to value a good, broad background and train, etc. for details, then they should be avoided.”Talent” problem? BS.Sure, build a company worth $100 million to $500 million and sell it. Fine. Good business.But: Do this away from the high rent areas. For “talent”, be a little patient and follow (A)-(E) above.Done.

  9. Kirsten Lambertsen

    I love this post. A lot. Great touchstone to carry into 2018 🙂

  10. jason wright

    not sure about quartiles, but if you like cycling in this quarter of the year in the northern hemisphere at 0 degrees Celsius then I have to ‘insist’ that you invest in an Assos Bonka jacket. Unbelievable performance. a total revelation. here endeth the advert. awesome ride today.

  11. Adam Sher

    Fred, thanks for sharing USV’s perspective on this. There are some other funds I’ve come across that focus on developing the talent of its portfolio companies, and that focus is a big competitive advantage. This is actually easier to do at a large fund because the management fee can be spread out. It inevitably creates costs centers at the fund level in order to provide executive coaching, portfolio and industry networking, etc… Some funds are taking this a step further and providing complexed, back-office services at the fund level, which [allegedly] allows them to handle accounting, HR and legal much more cheaply and then allocate pro-rata shares down to the portfolio companies. We’ll see if this results in meaningful savings and if future buyers underwrite lower G&A expenses.

  12. Adam Sher

    Open-end funds should be able to handle the 2nd quartile better than close-end funds. The pressure to exit creates a big conflict between investors and managers, and limits the market of investable companies. I wonder if open-end funds will increase in popularity.

  13. bfeld

    Great post. Every VC should read it slowly.

    1. fredwilson

      Thanks Brad.

    2. LE

      Every VC should read it slowly.Why? It gives the VC who operates that way an advantage. I am not a VC (and I am not looking for money for sure) but I’ve never looked at business from the angle of helping competitors. Not that I think they would read this and make any changes in how they operate. Because they might not agree with that philosophy (and nothing wrong with that).That said different businesses operate under different models.Example: Lately I am getting terrible delivery service from Amazon and having more problems even at Whole Foods. Yet they (Amazon) are thriving and in particular Amazon/WF still has me coming back to buy more even given the multiple bad recent experiences I’ve had with them. So who has the last laugh?

      1. PhilipSugar

        Because as a VC you work with other VC’s. Working with an ahole sucks. I know we disagree on this.I think Whole Foods will struggle. Aldi and Lidl are some strong competition and even Acme and Kroger have gotten much better.Amazon is so damn convenient that I’ll put up with their crappy customer service, bad drivers, and overlook the fact that they literally slave their warehouse workers.But you know who has stepped up? BestBuy.

        1. LE

          Ok so then where does the rubber meet the road? [1]I didn’t read Fred’s post and equate not sticking around with being an ahole. I had a guy who did consulting for me years ago who told me at one point (early 00’s) ‘Sorry I can’t do your work AOL is more important’ (he worked at the time for AOL). Later he lost that job and I advanced him $3000; for whatever reason he needed the money. I have helped him with some of his personal problems in many many ways. My point is I didn’t hold it against him for doing what was in his best interest at the time. Not saying it didn’t bother me it did of course. And that was early on in our ‘relationship’. I told the story of a big customer years ago who left us right after we bought the ‘big’ machine to do their work. Didn’t like that but I didn’t think they were ‘aholes’ for making a business decision. So w/o knowing details the point is what Fred (or Brad) is doing is great but honestly it’s a business decision they are making which is great for people they are investing in then they should use that to their advantage in securing deals. That is my point. Not spread the good seed and get others on board with the same thinking.Aholes: Will either Fred or Brad not invest along those aholes? The point at which I decide to do business with someone is totally dependent on a) How much I need the business and b) How much money is involved. My dad would never have made a living if he hadn’t been able to deal with aholes in his business. I remember very clearly the aggravation (and you have no idea how much that was it literally killed him).And part of my point is you are simply not going to tell someone who is an asshole to not be an asshole and certainly not by writing a post or talking to them over coffee whatever. There will be no ‘aha’ moment.[1] Theory vs. practice

          1. PhilipSugar

            When it comes to employment people have to do what’s right for them. Same for buying stuff.Don’t know if you’ve ever dealt with VC’s as investors.As he states 4 out of 5 things are not as hoped. (and that is a really good percentage)He has to deal with other investors because if a company keeps raising money it’s very likely they do an outside round. As a matter of fact he states that in last resort they do an inside round.Now I do not equate a VC investment as a marriage. The VC is the Sultan with a harem (money and portfolio)But you have said you were in a toxic marriage and the best 55% of your wealth was getting out of it.When things don’t work out some VC’s can be VERY toxic.As Bob Dylan sung:And now I know you’re dissatisfied With your position and your place Don’t you understand It’s not my problemI wish that for just one time You could stand inside my shoes And just for that one moment I could be youYes, I wish that for just one time You could stand inside my shoes You’d know what a drag it is To see you

          2. ShanaC

            From the perspective of the people in the harem, it’s a marriage where everyone is jockeying for status.Maybe that’s why harem could be toxic. Same for badly run vc firms – you end up pitting company against company

          3. PhilipSugar

            Nailed it that is right. Girish also pointed out career risk. If a VC has no companies in the 1st quintile you are screwed. Let me be clear this is a compliment: Fred can take the time to work with the 2nd and more importantly be gracious with the 3rd and 4th because he is good enough to have a big 1st quintile.

        2. LE

          Worker on Sunday shows up to deliver an Amazon package. I see him on the cctv sitting in the truck checking his cell phone blocking my car which is in front of my door. After watching the security camera for 4 minutes he drives away. I think ‘oh I guess I didn’t have a package in his truck’. I then get an amazon notice ‘sorry you were not there’. I roll the NVR back. He had walked slowly to my door tried to turn the handle and walked back to the truck. Never knocked. I know this because I can hear that from my office. That is the 3rd time that happened. They are really that bad.But you know Koch don’t give a damn. He is the one at Sun Valley, not me.The Koch is a reference to an old SNL skit about Ed Koch mayor of NYC at the time of the skit.

          1. jason wright

            Why do they do that? Get a Ring?

  14. Tim Mullen

    This is brilliant Fred, thanks so much for sharing. As a lesser known family fund I feel we spend a lot of time with the 2nd quartile, including all the activities you mention in your post. They do definitely test your patience and nerve; I can’t remember how many times we’ve heard similar comments around the fact it’s not exciting enough. I am a firm believer in your points around the ever-elusive billion dollar company. I’ve found it can kill early stage companies that have a really good idea but may never progress because they get overlooked by investors seeking the next Facebook or Uber. It’s always about the bigger, more disruptive idea with a company that is doing stratospheric growth. Strong consistent growth never seems enough. I also sometimes wonder if early stage investors have any idea about what it takes for a company, especially in Australia, to reach the billion dollar status. It’s a shame because it takes the focus away from those companies doing a great job and replaces it with hype. And it’s that hype among the same circles of investors that allows the perceived ‘next big thing’ to keep getting more capital. All the while the 2nd quartile companies continue to get overlooked. Also the 3rd and 4th for that matter where even a $50m exit would be a great result for founders and the early stage investors who backed them. After all, $50m is better than no return at all, the latter of which is a far more regular occurrence during early stage investments.

  15. jason wright

    Why do I get the vibe that this has been written for one particular entrepreneur to read and contemplate? It has that feel about it.

  16. dan_malven

    Fred,Well written, thank you. What this post sparked in me was how the collapse of the sub-$500M market cap (i.e. micro-cap) IPO market has failed the overall innovation economy. These companies in the 2nd Quartile used to be, and should still be, micro-cap IPO candidates. They are good companies, producing innovative products that are changing their industries, have values in the $100M-$500M range and have long-term sustainable 20-30% per year growth potential. Public buyers should be able to get exposure to these companies. But they can’t, because no one is getting them public. There are a variety of reasons for that, which you have written about and are subject of another post, but whatever the reasons are the fact remains that public buyers can’t get exposure to them. And more importantly to the economy as a whole, as you have written here they consume tremendous amount of time of the high-quality early-stage VCs. Those companies should matriculate to public market shareholders earlier, and free up the time of the VCs to go fund more early stage companies.I know you’re a believer in this. And so is Bobby Franklin at the NVCA, and several other innovative VCs. And we’re doing our part too…we have an LP that is a publicly traded merchant bank with expertise in reverse-mergers and DPOs, and they’ve done it very successfully in the insurance market (having created 5 of the existing 15 public insurance companies with sub-$500M market caps….all of them are real companies that have grown nicely as public companies). They became an LP of ours to help our portfolio get exposure to the public-money financing options, and I’m introducing them to other VCs that might have some in their portfolio too. I’ll probably be introducing them to you in the near future.

    1. Sudha Lakshmi

      Hear, hear!

    2. Michael Tedesco

      The AIM market in London is showing promise to fill this void. The $100M – $500M public market in the US is dead and not coming back, due to regulatory and other reasons IMO. Savvy PE with vertical expertise are exploiting this arbitrage.

    3. PhilipSugar

      You tell me how to help and I will…my name at the gmail service

  17. Joshua Baer

    Texas has a lot of companies that fit your “second quartile” description and they face all of those same problems.

  18. Donna Brewington White

    So glad that I did not miss this post. A gem and classic Fred Wilson wisdom.When I read posts like this, I also try to relate it back to my business (executive search) and often come up with interesting parallels. But I think I know enough not to make too close of a connection.You mention the difficulty that the second quartile companies have in attracting top talent. Of course this gets my attention as well as my empathy.One thing I’ve learned is that good talent has different facets and sometimes those companies that are trying to attract the talent that would be more fitting for one of the top quartile companies are overlooking some of the best talent out there for their business.One way these companies can best compete is with a well-crafted story. Perhaps the lower quartile companies have to work harder to create the story but sometimes their stories are actually even better and more compelling, especially to the right person.I have experienced several instances where my client was able to engage the interest of a person who was being pursued by or was already employed by a more prominent company due to resonating with their compelling story.

    1. awaldstein

      Stories are what make the world we live in Dona.

    2. PhilipSugar

      I think if you are talking management talent and you want really experienced people that is true.I think if you are talking technical talent that is also true in NY, SF, etc. That is why I think it is so hard to start companies there.But I firmly believe that I can find great talent and more importantly grow it as well, and not for a “homrun” company.You have to pay well, have good people, have good process, have a good environment, invest in training for every employee every year at an event they pick, invest and search hard.The thing is that it’s not just finding good people it’s keeping them. The first three months you learn how we do things. Is that the only way? No but I believe that at a company everybody has to do things the same way. That is something I will not tolerate. I have fired somebody over not indenting code the right way, it was not a mistake they were doing it on purpose to express their individuality. We can have individuality in shirts, backgrounds, religions, size, shape, personality etc, not when we are doing work.The next three months you do work but every single bit is reviewed and discussed.What this means is that for each new employee I invest one year of pay (six months for them and six months for the person working with them) and get no productivity.But then I have a kick ass employee. Losing them is a tragedy. You know it’s funny I had somebody say I’d never send somebody to a Microsoft Event it gives them a chance to leave, don’t you make them sign something to promise not to leave for a certain period of time or pay it back?I think it is a great place for my people to find others!Attitude is everything.I have lost one person in the last decade. She left because her husband was promoted to SVP and she had to move. She cried on her last day she felt she let the team down (I don’t have remote workers, again not the only way but my way) Of course I told her she did what was right for her and her family and she was always welcome back and we let her give three months notice.Again not the only way but my way if you leave for another company I pay severance but do not accept notice and you are not welcome back ever.

      1. Donna Brewington White

        The thing is that it’s not just finding good people it’s keeping them.This is where the rubber hits the road in the “war for talent”!Phil, I have learned so much from you over the years. It is not surprising that you have nailed this.I empathize with CEOs of young companies because it can be really hard to focus on managing the team when you are wearing multiple hats running a business, and trying to hold things together, but it is critical.There are companies with strong funding and a brilliant concept that I have had to walk away from as a client because the CEO treated people poorly once they were on board and would not take feedback. In one case I later heard that the investors finally intervened.When hiring some of the initial team there is not always the precedent to know what type of boss the CEO will be but I am doing more due diligence before taking on a client. The way the CEO treats me as a partner should always be my first clue.Another company not so exciting but in four years has not lost one of the six people I have found for them and they are in a very competitive industry and not the sexiest company in their space. But now when I recruit for them, their retention has become part of the story. That is a strong indicator that they must be doing something right!Transparency during the recruiting process and beyond is one of the greatest factors in keeping good people. People seem to be willing to go a great distance and through all sorts of challenges with a CEO that they trust and believe in.

        1. PhilipSugar

          I have always said my legacy is the people I’ve hired and what they’ve gone on to do.Don’t get me wrong I know my policy of not coming back to the same company seems harsh, but I truly do not begrudge anybody growing into a new role at a new company, you just have to be sure it’s right.My job is to make sure that you never think it is right. That is pay, that is treatment, that is culture. Culture defines atmosphere not the other way around. You can try and buy all the foosball tables you want but they don’t define atmosphere.You know my story of when the employees built an arcade machine without my permission because that was their culture and they set their atmosphere.There are tons of aspects to culture but it starts at the top. You can bitch up but never down. Everybody is respected. Nobody complains to somebody about somebody else unless they do it to their face. And when we recruit somebody we tell them what they are in for, we don’t “sell” them. This is their life. You know I first started joking with our acquiring company about calling it Talent and Culture not Human Resources. But they are right, it is Talent and Culture. Grow their talent and provide a good culture.Your job is give your best effort AND help your fellow employees do the same.My job is to help you grow and provide a good work environment.The way you keep people from leaving is not to make it hard to leave, it is to make hard to want to leave.This is why turnarounds (I have done) are so hard. You have to have people leave, and those that stay wonder if they are going to be the one that will be asked to leave.You have exactly one shot to do that right and pulling it off is super tough.

          1. Donna Brewington White

            So many pearls here.For instance, this: The way you keep people from leaving is not to make it hard to leave, it is to make hard to want to leave.

  19. Narendra Bhandari

    ROI is the principal indicator of the performance of an investment. Performance of the individual quartiles within it are all parts of it? Having said that, I have two questions.One, why discuss quartiles only? What is their relevance, without knowing an overall ROI? Performance is a relative term.Two, how does this ROI compare with its industry ROI? Here are some examples:1. TNA (midcap): About 51% in 2017).2. TQQQ (large cap, aggressive): About 100% in 2017.3. DDM (Dow Jones): About 55% in 2017.4. FSTVX (Fidelity’s total market equity index fund): About 19% in 2017).Narendra

  20. Sudha Lakshmi

    Suppose for a moment that the public markets could be made more hospitable to smaller companies: imagine a sort of growth market with longer-term investors and less regulatory overhead. Would at least some of the companies in your second quartile be open to going public on such a market instead of angling for a late-stage round or an acquisition? Would USV, as an investor, be open to these companies exiting in this way rather than via an acquisition? As you say, there’s still a great deal of value in this cohort of companies, and even if they’re not exciting enough for later-stage VC, maybe there’s more than enough there to whet the appetite of the public-market investor!

    1. PhilipSugar

      I long for those days. I am not sure how old you are but in the early nineties the goal was to hit $20mm in revenue and profitability and then go public with great firms like Alex Brown in Baltimore or Robinston Stevens in SF.They would throw marvelous conferences where CEO’s would share their vision. There were wonderful companies like Aspen Technology, Wonderware, Intuit, so many others that were just great.Then you would see where you go from there.Alas it seems those days are over.

      1. Sudha Lakshmi

        Let’s bring those days back! 🙂

        1. PhilipSugar

          Maybe that is my next calling. Alex Brown was so great. I did not know Robbie Stevens so well.

  21. Mark Montgomery

    Good work, FredMy comment when sharing on LI fyi:An important post by Fred Wilson on VC that will unfortunately likely be missed by those who need it most. While not limited to VC, mandates more generally are among most corrosive influences in capitalism because it takes a top down approach rather than a market based (needs) approach.This is also why entrepreneurs and investors without such constraints typically out perform all others. In this case Fred zooms in on the second quartile investments which are the type the economy really needs badly across more geography, but they are usually never born or flipped too early due to the VC model, esp. in very high cost cap centers where big wins are needed to keep regional bubbles inflated.

  22. Mike Rowan

    I’d imagine the management and other talent from your Second Quartile success stories often provides next investment opportunities. Result – the early investment/trust/commitment you and your partners have put in will potentially driving profit multiple times over.

  23. Steven Kane

    As I have said many times before, thank you sir.

  24. Ryan Sachtjen

    Let’s pretend you had the ability to predict the future. You are reviewing a company to be included in your fund as one of the 20-25 companies. You know this company will fall into the second quartile. Do you make the investment? What are the drivers to this decision?

  25. Tim Schigel

    Well done Fred! Totally accurate and on point.

  26. bmartyna

    Not mentioned is the fact that billion dollar exits are much more market/timing sensitive, especially if the exit is an IPO. The hold period definitively affects IRR. Not so much for the $100M to $500M exits, which depend on an acquirer who may be largely indifferent to the public markets (other than considering dilutive/accretive calcs).

  27. Manish Singhal

    Great post. What are the typical characteristics of a 2nd quartile companies. How do you prevent yourself confusing them with the 3rd or 4th quartile?

  28. S R Jeyashankher

    Great post!Would you have suggestions on how to think about this and manage this as an entrepreneur? Especially as a first time early stage entrepreneur, it generally feels like you don’t know which quartile business you are in (until you do, I’m told!).

  29. fredwilson

    We will. But not every day. That would be boring

  30. jason wright

    “Coinbase is, in my opinion, becoming the biggest problem in the crypto-space.”is Coinbase now a fractional reserve operation? from its behaviour this is my conclusion. Does it have the capital to cover the market? I suspect it does not.if the crypto ecosystem had white blood cells they would be all over Coinbase.