Epistula #6: Decoding Greatness
Deciens’ methodology behind selecting companies creating enduring value
In the dynamic world of venture capital, the desire to be the best is a recurring theme and a frequent subject of conversation at Deciens. A question we often consider: what truly separates companies that achieve greatness and sustain it over time from those that never reach such heights or only experience temporary success?
We want to share our firm’s evolving view on this subject by delving into what makes a given company great, including our definition of greatness, its indicators, and its antecedents. Further, we’ll detail how our strategies for sourcing, picking, winning, supporting, and exiting investments enable us to distinguish the best from the rest, attaining material ownership only in the most exceptional companies.
The Nature of Greatness
As part of our inquiry, we recently spent time reviewing the following chart published in the September 2023 issue of Morgan Stanley’s Fintech Monthly, discussing what separates the companies on the right (what we want) from the ones on the left (what we don’t want):
We realized a stark contrast exists. The companies on the right are capital-efficient monopolists – they grow without needing external financing, compounding their equity for shareholders while sidestepping competition. Conversely, the companies on the left struggle to achieve market dominance and do not become household names.
Amazon.com shares fell 95% in 2001, Apple almost went bankrupt in 1997, and Nvidia has suffered three 80%+ drawdowns in its history. Despite these challenges, the hindsight desire to have invested in Amazon, Apple, and Nvidia at their lowest points is universal. We want to acquire stakes in top-tier companies when their prices are most favorable and maintain these investments over the long haul, throughout business cycles.
Redefining the Hunt
Most venture capitalists operate as if there are a finite number of great companies created in every unit of time and want to secure investments in as many as they can. They tirelessly scour the world, trying to talk to as many companies as possible to filter for the few companies they believe will be great while discarding the rest. When they find a company that they think will be great, they fight for the right to invest in it because the cost of missing out is so high. They are on the hunt, and winning is all that matters.
However, this hunt is rarely driven by a strong set of beliefs around what it means to be great. Rather, for most VCs, great companies are simply those that can attract a lot of deal heat, are in hot sectors (e.g., crypto in 2021, AI in 2023/24), use cutting-edge technologies, have archetypal founders, etc. Their view of greatness is, lamentably, not driven by first principles.
Deciens flips the script. We have a much simpler approach. We want every company we work with to be great based on our definition of greatness. So, what is our definition of greatness?
In corporate finance terms, a great company can compound its equity at high rates of return, well above its cost of capital, for many years, net of the dilutive impact of equity capital issuances. All companies and, by extension, equity investments must meet this canonical definition or they are, definitionally, value-destroying. However, the vast majority of companies can never meet this definition. For most, they can compound above their cost of capital for a couple of years at best, with their growth rates asymptotically approaching their cost of capital. Even once-“great” companies often find themselves sliding toward mediocrity, unable to engage in a self-renewal process that maintaining greatness requires.
The Four Pillars of Greatness
The history of venture capital is filled with outlier companies that seem to defy this seemingly inexorable slide toward mediocrity and oblivion – the power-law winners that generate the lion’s share of economic and social value in our industry. Over the past several years, we have undertaken an extended research project to understand what separates those companies that can sustain themselves from those that cannot. Our research has pinpointed four criteria we believe are required for a company to deliver sustained value to stakeholders and achieve greatness:
Increasing returns to scale;
Ever-deepening moats;
Winner-take-all or winner-take-most markets; and
Very large markets.
For Deciens, a company must exhibit the potential to have all four qualities to be considered for investment. Possessing one or two of these qualities is commendable but not nearly sufficient for a fighting chance at greatness. These criteria, along with the right deal structure and a founding team of exceptional character, form the basis of our investment philosophy.
Let’s dive deeper into each of these pillars.
Increasing returns to scale:
Having increasing returns to scale is the most important feature. As a company grows, it should leverage scale advantages to improve efficiency and performance, resulting in compounded benefits for itself and its stakeholders. Basically, a business must (in one or more ways) get better as it gets bigger.
Scale advantages can manifest in various areas across manufacturing, advertising, capital markets, distribution, and all other facets of a business. Hopefully, a company has many different types that improve at an increasing rate. Many of the businesses we invest in benefit from the returns to scale of tooling, network effects, and multi-sided marketplaces. In each of these cases, the returns to scale appear to have the special property of being autocatalytic, further feeding upon themselves. We pay increased attention to opportunities that seem to have such advantages, and actively avoid deploying capital to those that don’t.
Ever-deepening moats:
Moats allow companies to create unique value that new entrants cannot naturally replicate. This translates to the long-term ability to defend and expand margins and maintain pricing power while fighting the deflationary forces of technology. These deflationary forces – advancements in computing power, open-source software, AI-driven development, etc. – continuously erode long-term equity returns by lowering the barriers and costs for new entrants to introduce and sustain tech-based products. This trend drives a race to marginal cost unless a moat acts as a bulwark, allowing a company to preserve its profit-making power.
Skilled founders can develop a variety of moats to create durable businesses. Our portfolio showcases companies with moats in areas such as network effects, data assets, economies of scale, regulatory advantages, and brand recognition. Not by coincidence, many companies have several overlapping moats that reinforce one another, contributing to their growth over time.
In our view, equity holders should prioritize the number of years a business can grow rather than the speed of growth. A business that can compound its equity at good rates of return, with little dilution, over an extended period is a better investment than a company that has to raise equity continuously to sustain itself. And even worse is a business that burns out after a few years (by definition, a bad long-term investment). Long-term ownership in the right business pays manifold dividends. In the never-ceasing category of incentives matter – for many VCs and LPs, a company’s value cannot be marked up unless a third-party equity-financing event happens. So, to get paper marks, they push companies to raise new equity, even if it is severely dilutive and value-destructive to the company and its shareholders. Thankfully for Deciens and its LPs, the world of financial services supports many such businesses.
Winner-take-all or winner-take-most markets:
We also want to invest in businesses that are winner-take-all or winner-take-most. This is related to two issues we have seen. First is that monopolies or near monopolists can extract the greatest economic profits for the longest periods. Conversely, businesses in highly competitive market spaces often require immense capital simply to compete.
We find that companies in winner-take-all-or-most spaces can enjoy the tremendous benefits associated with being much more capital-efficient. Those benefits flow directly to us (as a capital-constrained investor) and, by association, to our LPs.
Very large markets:
The final criteria – the market size being large – seems straightforward. If Deciens is going to invest an incredible amount of energy and capital over a long period, we want to make sure that the juice is worth the squeeze. If the prize is not large enough to deliver material returns to LPs in a successful case, then it is not a good use of resources.
But we have seen time and time again VCs pass on investments because of the belief that the market opportunity is too small to justify the resources – only to then be surprised at the scale the opportunity turns out to be. The best founders can create markets much larger than understood or imagined. VCs are also notoriously bad at market-sizing exercises, and markets shift in ways that VCs are terrible at predicting. Finally, just because an investor cannot measure the market size with precision does not mean it is not material. This is why, of the four criteria, we are least dogmatic about market size.
Playing a Different Game
People often suggest that our approach to investing makes us contrarian. While we do not aspire to cut against the grain, we know that venture capital is full of highly competitive firms staffed by brilliant and ambitious people. We have no desire to compete with them in their game, a game they are great at, with rules they define and seemingly endless resources.
Warren Buffet was once asked, “How do you beat Bobby Fischer?” He answered, “You play him in any game except chess.” Echoing Mr. Buffet's strategy for outsmarting the chess legend by choosing a different battleground, we apply this philosophy to investing.
We think that by having a set of first principles that we believe in – about business quality and other aspects of investing – and sincerely following them, we are playing a fundamentally different game from our peers. A game where we can exceed our already elevated expectations.
