The Thin Edge of Angel Investing

Thanks Zecca Lehn, for the fun conversation on your Posit2ive podcast!

Listen to Episode here

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EPISODE32: A Thin Edge in Angel Investing

Tobias, Angel Investor from the Northwest [7/15/2021]

Note: References with links are listed at the end of the show notes.

INTRO:

1:00 Talks about his love for things that solve problems, stemming back from his childhood. Talks about the drive Entrepreneurs have to try things that others won’t do. Shares experience with beginnings of downloadable software. Has started over 3 companies. He’s an investor in startups, and also a Limited Partner.

SECTION1: Reducing Friction

3:20 Shares his thesis driven approach to investing in startups that he believes correlate with higher returns. Points to software as a friction reduction inherent in software – uses his IPO investment in Amazon. Talks about the comparison with Walmart versus Amazon, and how software was the value creation for the consumer–Amazon 3x rate of growth of Walmart for 20 years. He was also an early investor in Docusign, and how fax was the way to make digital signatures—which were not even legal in many states.

6:30 Shares how some investors are actually taking a passive money strategy in venture, by being so crowd driven. We discuss the new market approaches, for examples like Uber and Docusign – where a market didn’t even exist. Reducing a pain point, with low friction that create categories, gets Martin excited; he also sees the real outsized returns this way. Discusses the need for a thesis to be counterintuitive and right.

13:00 Shares his experience helping to build the largest biodiesel refinery in the world with Emperium Renewables. Also talks about the struggle with competition with the oil industry. Also shares some of the economics surrounding tax credits in biodiesel, and how the subsidies flipped in 2009. Discusses the levered price per barrel of oil, and how it impacted the clean-fuels market.

SECTION2: Software

18:00 Talks about his experience starting Tipper as a follower to Groupon. Learned the difficulties of operating to compete with the industry leader. Talks about 7 meta themes of software (see links below for incisive.vc). Uses the software-eats-industry example of Uber eating the taxi industry—talks about the complexity of some companies not being this disruptive.

22:00 Talks about weightings in his investment criterion. Discusses management as a primary signal to decide on a company. Talks about companies failing because of poor execution, and has developed a measurement system for gauging Founders. Highly encourages rebooting for Founders—e.g., meditation, nature hiking, and other relaxation techniques. Shares the need to focus on platform before feature, and another thesis about American laziness using the Amazon example.

SECTION3: Counter Intuitive & Right

27:00 Shares connection Upgrade Labs, and how influencers are able to drive attention to products in a new way in the BioHacking market. Shares biohacking opportunities, such as his investment in Levels. Shares real estate example of WeWork, regarding the software-eating idea as not working, because of promotion as a software company, that wasn’t adding scalable attributes (like a REIT).

34:00 Talks about his investment process at the earliest stage. For outsized returns, he points to the need to go with more thinking. If everybody believes the same thing, the returns will be lower—in Martin’s view. Shares his story about reviewing Levels, and the non-diabetic masses. Shares how he spoke with all of the competitors. And his experience with the CEO Sam led him to invest. Talks about coachability as a possible weakness. Looks at the structure of the org, and how the people in the pressure cooker may feel about the structure. He likes people with startup experience, and not necessarily people from large tech firms.

Talks about his Goldie Lox State: Where innovation and customer adoption are leading to significant growth – can be PreSeed or PreIPO. Looks at innovation is the driver for leading the charge of growth – with Bird example without innovation. Shares his view on opportunities going forward out of the pandemic.

SOURCES:

-Martin Tobias [LinkedIn]: https://www.linkedin.com/in/martintobias/

-Incisive Venture: https://incisive.vc/

-E8 Angels: https://www.linkedin.com/company/element-8-angels/

-Anderson Consulting story: https://en.wikipedia.org/wiki/Arthur_Andersen

Echosign Acquisition: https://venturebeat.com/2011/07/17/adobe-acquires-electronic-signature-startup-echosign/

-Emperium Renewables: https://www.seattletimes.com/business/local-business/imperium-renewables-biodiesel-plant-sold-to-iowa-company/

-Upgrade Labs [Bio Hacking]: https://www.upgradelabs.com/

-Peter Attia podcast: https://peterattiamd.com/podcast/

Aquired podcast on WeWork: https://www.acquired.fm/episodes/the-wework-acquisition-with-dan-primack

-Juiceroo story: https://fortune.com/2017/04/19/juicero-investors-hands

TEDFAV: Emotions are guesses

The brain is one big sense making, pattern recognition machine. We expect emotions to be different. That they “just come up” or are “real” or “just happen”. Yet the science tells us that emotions are just another case of the brain sensing certain things and matching those things to patterns I understands. Emotions are patterns also. Favorite quotes: “There is no emotion is a facial movement, it is our interpretation of that movement that creates the emotion.” This from a neuroscientist who has put sensors on people’s faces to try to detect emotions in facial movements. There are none. Your own emotions are guesses at the pattern you brain makes. “Emotions that seem to happen TO you are actually made BY you.” “If you change the ingredients that your brain uses to create emotions, you can transform your emotional life.” Basically neuroscientists confirming 2000 years of Stoic philosophy.

A Nerd in a Football School

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In the Fall of 1980, I had it all figured out. I was a Junior at Medford Senior High School, the big leagues. My GPA was perfect and I was looking forward to my AP classes, science club, and the debate team. I grinned when I found my locker, #B69. Chad, the Varsity football captain grunted and elbowed me as he opened his locker, #B68. Calvin Klein’s Obsession assaulted my senses as I turned to see the most popular girl in the school, Mandy, the Captain of the Varsity Cheerleaders, primping in a mirror on her locker, #B70. My stomach churned. An icepick entered my eye and buried itself deep in my brain. You see, I was a nerd in a Football school.

Football is no joke in Medford, Oregon. A couple of years before, the small town of Medford had two highschools with about 300 kids per class. And Portland always kicked their butt in Football. The town fathers had had enough and split the schools into 9/10 (Junior High school) and 11/12 (Senior High School), effectively doubling the pool for Varsity sports. The plan worked, Medford Senior High School ruled the rankings in AAA Varsity sports across the board.

The entire social hierarchy of the town revolved around Varsity sports. Junior High had felt like a continuation of middle school. Senior High was where the action was. And I had finally made it. Or had I?

Chad scowled at me and slammed his locker. Mandy ignored me. I wondered if I could escape into my locker. Instead, I quietly closed mine and shoved off to Debate class.

We had a new Debate Team teacher, Terry Rose. Mr. Rose was a fireplug of a guy. Well built and confident. Owned oil wells in Texas. Had shot a tiger in Africa once. Been a speechwriter for a President. Came to Medford to retire, grow some pears and teach.

After class, I stopped by his desk.

“Welcome to Medford”

“Thank you. How are you, Martin.” What? Did he know my name?

“Good,” I paused. “But I have a locker problem.” I just blurted it out. Why? What does he care?

“Really? Tell me about it.” And he leaned back in his chair, inviting me with his hand to the chair beside the desk. What the hell? No teacher has ever given me more than platitudes.

“Uh, well it’s complicated.” I sat down and hugged my backpack. “I am stuck. Literally boxed in. Don’t know what to do. You see, Chad, the football captain has the locker on my left, and Mandy, the cheerleader captain has the locker to the right. They are the two most popular people in school. And who the hell am I? I hate football. Cheerleaders are way too energetic, they scare me. I feel paralyzed. What am I supposed to do?”

“Not making a decision is a decision. Find your own path. And stop paying attention to what other people are doing, it just makes you annoying.”

I sat in confused silence. Mr. Rose smiled. The bell rang.

“Uh, ok, thanks” I offered and shoved off to science club.

What the hell was he talking about? Not making a decision is a decision? Hadn’t he ever been stuck? Don’t care what other people are doing? Isn’t that what high school was about? Life is about?

The words simmered in my brain over the next few months. Eventually, they started to make sense. Engines fired up. Gears started turning. I ran for President of the Science Club. And won. I entered the state debate competition. And won. I cracked a joke to Mandy. She laughed.

My path started to open up before me. Senior year, my picture was in the yearbook with the caption “Most likely to invent the time machine.” In college, I double-majored in business and computer science just as the personal computer market was getting started. Turns out, the world needed a few more nerds like me.

I saw Chad at the reunion. Assistant Manager at the grocery store. Still driving the Camero. Mandy married a dentist and plays tennis on the weekends.

I found my own path. For the last 40 years, whenever I am stuck, Terry whispers in my ear: “Not making a decision is a decision.” And I figure out what to do next. What the next right action is. How to keep going down my own path. One foot in front of the other. Not caring what other people think. Thank you, Terry, where ever you are.

Karma is real

I received a message on LinkedIn yesterday. It read:

Martin! It has been like 23 years since we met in Silicon Valley. I so enjoyed our connection. You still in digital media? How have you been?”

A couple clicks reminded me of our connection and the memory popped into my head of a couple of drinks at a conference reception. Didn’t think anything of it at the time. One of the maxims I keep top of mind is:

Respond with Kindness

Martin Tobias

I remembered our conversation. He was pitching me a start up and I showed curiosity and was impressed by his authenticity and passion. While I didn’t invest, I gave him kind attention. Apparently he appreciated it and remembered for 23 years.

Respond with Kindness. It will pay you back 100X.

Reframing a guiding principle today.

“I hope you don’t get what you want in life, because then you are Fucked.”

Martin Tobias

For over 20 years, this phrase has been one of my guiding principles. Today I am softening it.

Why soften it? I want my guiding principles to be in the positive frame, not the negative. While this has been great click bait and jolts the system, it does so by triggering a visceral emotional reaction: “What do you mean not get what I want? Isn’t that the point of life?” That reaction is why I like the principle, but I don’t want to relive the negative shock every time I hear it.

While I haven’t figured out exactly how to reframe this principle, something along the lines of :

  • “Process goals are what you want in life”
  • Process goals trump outcome oriented goals.
  • I hope your goals support your values.
  • The [[good life]] is a process not a goal.

Basically, the value of the positive frame in most things I do has risen in my value stack, and I am reframing whatever I can in that way. Give it a try.

My Angel Investment funnel

Over 8,000 companies received pre Series A funding in 2019. 2020 is on pace to surpass that. How does one separate the signal from the noise? Over 25 years of Angel Investing, I have made every mistake there is and built a process from all that learning. This is the process I use to select deals for my Angel List Syndicate. Here is how I do it.

The top of the funnel is not every possible deal, you must apply a filter. The first filter is my personal network built over decades as an LP in over a dozen Venture funds, Angel investor in over 100 companies, CEO having raised over $500M for my companies (and all those venture and banking relationships), Founder of the Angel network Element8, and all the management and investor relationships over that time. From that network, I see thousands of deals a year.

The second filter is the Meta Themes I have found deliver outsized returns when present. They are listed below. If you want to get into the weeds, there is a very detailed dive into it on my blog.

  • Software eats everything
  • Great founders figure shit out
  • Disruptive innovation creates new markets
  • Platforms win
  • Americans are lazy
  • Invest only when I can be helpful
  • Invest along other very smart, committed people.

After screening hundreds of deals through the Meta Themes, less than a hundred get the concentrated diligence process and end up with a weighted score. With every check I write of any size, I want to have a greater than 80% confidence in a 10x return on my capital. If you want to get into the weeds on the ranking algorithm, head over to this blog post. There are 5 major risk areas for every startup. I assign a confidence level from low (weak, unprepared, or insufficient) to high (easy, will crush it). The five components are:

  • Management (50% weight)
  • Product (10% weight)
  • Market (10% weight)
  • Regulation (10% weight)
  • Terms (20% weight)

Less than a handful make it through to writing a check. My check size goes up along with my confidence interval. I usually write checks up to $50,000 between 80-90% confidence. Over 90% confidence, I will write checks up to $1M either alone or with friends and other smart investors. These are typically the deals that go through my Syndicate.

PS: Major Errors I have made.

While there is likely a whole post on errors I have made in the course of decades of Angel investing, the major ones that have cost me the most capital are listed here (in stack ranked order).

  1. Weak management. Management that can’t execute and pivot over time. Most management have nice looking resumes, but until you dig deeper and understand how they execute and the kind of culture they create, you won’t understand if they are up to the startup challenge. Everyone has an idea. The winers out execute everyone else.
  2. Underfunding. Most startups run out of money before they find a product/market fit. Many startups fundraise hand to mouth, never gaining enough capital to mitigate the big risks of the business. Underfunding can also be caused by overspending by management on the wrong problems at the wrong time (see above).
  3. Big Market, unclear entry strategy. I have fallen in love with large market size numbers, we all do. Without a clear product path to enter the market with some sustainable advantage, the market size doesn’t matter. Without product/market fit, the size is irrelevant. Also, if the “market” is already big, there are likely lots of competitors, a red ocean. There are better returns creating a new market with your product.
  4. Me to products. Never invest in a follower. Unless there is some geographic, language, or market reason. There has been alot of money made copying innovation from the US in Europe for example. But copying a product in the same market tends to lead to low returns for investors. Invest in the leader, category creator.
  5. Following investors without personal theme fit. I started out Angel investing with an “any good deal” strategy. How did I decide if it was a “good deal”? If other “smart” investors were in it. You will never know why other investors write checks, or even if they are “smart”. Plenty of “smart” people put money into Theranos. They all lost their money playing the momentum of others without doing their own thinking.

My Meta Investment Themes

In addition to being asked how I decide to invest, I am often asked WHERE I look for investments. The short answer is where I have an ADVANTAGE. Some kind of information, insight, or talent advantage that is not available or at least non-obvious to others. The long answer is the rest of this post.

If you like my approach, consider investing with me through my syndicate.

I love games of all sorts. Sometimes I play games without even understanding the rules being at a clear disadvantage. Tennis with my daughter who played on the Varsity team. SlapJack (whatever that is) with my 9 year old. Wall sit competitions. “Who can hit the softest” with my 5 year old. When the stakes are low and there are other benefits to playing, count me in.

As the stakes rise, especially into the tens of thousands in Angel Investing, I want an advantage. This is why I stopped actively trading public stocks. I had no advantage against the professional traders in the market. While I am approaching the 10,000 hour level in poker, I rarely sit down at a poker table full of professionals, I would be at a serious disadvantage over time.

Having far exceeded the 10,000 hour rule over decades of Angel investing, I have found an advantage when I follow these seven Meta Themes. I search for investments that fit 5 or more of these Themes. While I occasionally do invest with a looser fit, (say in an extremely strong founder outside technology), approximately 90% of my Angel risk capital is deployed in line with these Themes.

  • Software eats everything
  • Great founders figure shit out
  • Disruptive innovation creates new markets
  • Platforms win
  • Americans are lazy
  • Invest only when I can be helpful to company
  • Invest alongside other very smart, committed people

Software eats everything.

Great software significantly reduces market friction and creates new markets and value. Bezos is right: “Your margin is my opportunity”. Amazon’s software ate retail. Ebay’s software ate the classifieds business. Online banking software ate retail banking. Uber software ate the taxi market. Redfin’s software enables efficiencies that they pass onto customers while remaining profitable. Software “eats” another industry when it delivers greater value at lower cost. In eating an existing industry, the best software can actually grow bigger babies. There are 100x more people hiring drivers through Uber than anyone who ever took a taxi. I buy stuff on eBay which is NOT available locally, new purchases that are impossible without eBay. This is especially true when your competitors’ core assets are not software or technology based.

I have a friend who started shorting Amazon around $300 saying Walmart was much more profitable and had better physical assets. Yea, but those physical assets were costly, not scalable, and created friction in the retail process (get in car, drive, check out lines, etc.). Amazon’s core assets were software which fundamentally reduced customer friction allowing Amazon to grow sales much faster than Walmart. Software won. Investors in Amazon have been rewarded with orders of magnitude greater returns than investors in Walmart (a $10K investment in both in 2000 would yield approximately $100K for Walmart and $9.2M for Amazon) by mid 2020 (a $10K investment in Amazon’s seed financing would be worth over $1B).

Not all software “eats” another industry. Many software companies are competing against other software companies. That is not eating, that is competing in a red ocean. These can still be great companies, but the greatest software companies “eat” an inefficient, slow industry.

I recently invested in a company that has replicated the therapeutic effects of most drugs and over the counter medicines (anything with a non-covalent bond method of action) in software. They have double blind placebo controlled scientific proof that it works, and patents. Yes, software may eat one of the most profitable industries on the planet, pharma. Didn’t see that one coming did you? I was looking for it.

Investing in “software eats…” ideas tends to produce superior returns.

Great Founders figure shit out.

“Everyone has a plan, until they get punched in the mouth,” Mike Tyson said. A startup founder is going to get punched in the mouth over and over again. Great founders can take the punches and figure out how to win anyway.

Management commands a 50% weight in my decision process for a new investment because of this Theme. A start-up is a journey through a land of incomplete information with limited resources. Opportunities abound and resources are limited. Great management is skilled as guiding the ship through the journey. This is a constant decision process, under pressure of where and how to allocate limited resources. Great founders pivot often. They attract other great people. They inspire customers. They modify their original plan to meet the engagement they find in the market.

I often ask founders to explain a failure (or two) as well as a success. How a founder talks about failure and success is very instructive. During the failure, were they animated, doing every next right action they could think of? Or paralyzed. Are they accountable for their part, or do they put blame or not credit on others? How much did their actions contribute to the success and how much was right place right time? Many founders from successful companies overvalue their contribution to the prior success and underestimate their own role in failures. I avoid these founders. Great founders are very self aware of their strengths, weaknesses, and those of their team. Great founders are very accountable for their actions.

Disruptive innovation creates new markets.

How big was the ride share market before Uber? The cell phone market before iPhone? Premium coffee before Starbucks? Streaming video before NetFlix? Great innovation allows people to buy stuff they never thought they needed. This is the Blue Ocean Strategy. While the “Software eats…” theme is looking for technology companies disrupting traditional businesses, this theme is looking for innovation to OPEN NEW MARKETS.

So I look for category creators. The first brand to reach scale in a new category, or the early start up who could possibly create a whole new category. This is related to the “winner take most” fact behind category creators. The followers of Ebay, Amazon, Netflix, etc. all have crumbs compared to the category creators.

Platforms win.

Platforms exploit network effects and investments in integration to create outsized value and make replacement very difficult. Amazon is a platform. Microsoft is a platform. Facebook is a platform. Slack is a platform. Zillow is a platform. Adobe is a platform. Apple is a platform. Google is a platform. Cisco is a platform. SalesForce is a platform. Shopify is a platform. Coca Cola is a platform. Cargill is a platform. A platform is any company which has very deep customer relationships, controls multiple parts of the value chain, has a shared infrastructure across multiple product lines, has an ecosystem connected to products and services, and continues to deliver new innovation into the ecosystem.

Very few start-ups ever reach platform scale. Those that do are deliver orders of magnitude greater returns to their investors.

Most start-ups are solving a niche problem. These can be great investments and I have made good returns with best of breed companies with a single product. And the absolute best returns have come with companies that were able to become platforms. So I keep an eye out for those.

Americans are lazy.

While I would like to believe consumers are rational and make considered choices, I have found that whatever product enables the the consumer to be the most lazy usually wins. Even if it is more expensive. If it is less expensive, you have a unicorn. Why drive to Walmart when you can One Click Amazon from your couch? Who go to movie theatre when you can sit in your underwear on your couch? Drive through coffee that costs 100x making it at home? Starbucks crushed that.

While this is somewhat true across the world, this theme is on steroids in America. Americans are always looking for the easy, quick solution. The One pill, The One Diet. The One Click purchase. While there is much snake oil sold this way (don’t invest in those), the companies that actually deliver a quality product that enables laziness tend to win.

Invest only when I can be helpful to the Company.

I have found Angel investing to be a two sided conundrum. The best companies can easily raise money, so why would they take mine? I have more opportunities than capital, so how do I convince the best companies to take my money? While a company may look great in the deck, if I can’t come up with three ways to help the CEO before my call with him, I will pass. Being helpful to the company will improve their chances of success, growing my investment. Startup companies always need help. Customer, employee, business development, product development referrals and review.

I recently invested in a consumer products company selling paleo baby food. While outside my normal technology focus and failing a number of my major themes (Software eats.., new markets, etc.), I had kids, a paleo influencer wife with a huge network, and some retail relationships for business development. I made the investment and delivered the influencer network and retail leads. The company exceeded their sales projections for the next three quarters and just closed an up-round at 3x the valuation I invested at. Being helpful is good insurance after the investment.

Remember, these themes are all about how to improve the odds that the Angel investment returns 10x or more. Investing in companies where I can be materially helpful improves the odds materially.

Invest alongside other very smart, committed people.

Lets unpack that a bit. There are three key words here: “alongside”, “very smart”, “committed.”

As an Angel I am rarely the lead investor. That means I am following other investors who have done some level of diligence. You are always “alongside” other people, so you better figure out who they are and if they have a track record of good decisions. The deeper their diligence, the deeper their relationship with management, the more confidence I have. Some Angel investors will blindly follow other name brand investors, and companies will often roll out their name brand investors to attract others. I am aware of this trick, and dig deeper. Figure out who you are in the boat with. People just along for the ride (momentum players), or thoughtful, driven people?

There are smart people and then there are Very Smart people. Bill Gates, Jeff Bezos, Elon Musk, Steve Jobs are all Very Smart. Very Smart people are the top 5% of smart people. When I was at Microsoft, when someone was called “smart”, that was translated “average” (everyone there was “smart”). But “Very Smart”? Ok, you better listen to her. Investing with smart people is a given, table stakes. Investing alongside “very smart” people has produced outsized returns for me over the years.

I always want to know the level of commitment from my co-investors. What is the ratio of their check size in this deal to their net worth or typical investment? The higher the ratio, the stronger the commitment signal. Also, how active are they? When was the last time the CEO spoke to them. I once looked a deal where the CEO was shameless flogging a name brand investor. During the call I asked the CEO when the last time he talked to the name brand investor was. “Actually never, one of his team made the investment.” Pass. That is not commitment. In fact it is dis-honest for the CEO to flog the name which signals a deeper issue with the CEO.

“Crowdfunding” platforms, while significantly increasing access to products and even angel deals at very low levels of risk capital, simultaneously put your investment alongside the masses of not so smart, not very committed novices. That is on reason I prefer the Angel List platform as a Syndicate Lead.

Summary:

These seven Themes are the top level filter every deal goes through in my Angel investing funnel. If a deal ticks 5 or more or a couple super strongly, I move the deal down the funnel to “how to decide”. These themes have given me and advantage over time and kept me out of investments where I do not have an advantage. While there are plenty of people making money in areas where I don’t have an advantage, they likely have animating themes in those areas which give them an advantage. For those areas, I invest in Venture Funds with competent managers. I can’t have an advantage everywhere.

If you like the approach, invest with me in my syndicate.

Remember Martin: There is nothing to believe

Why do I find the Stoic frame for answering the “how do I live my life?” question so useful? There is nothing to believe. No pretend friends. No magic underpants. No invisible hand. There are questions to examine yourself and others on the path to wisdom. There are practices which over time can reveal wisdom which makes progress toward “how to live my life?” In the end you have to decide for yourself through trial and error what works and what doesn’t. There are examples of what has worked for others, but there is no “perfect being” to emulate. Even deeply flawed people with whom you disagree on many things, can be a path to wisdom (Marcus Aurelius often quoted Epicurious a rival school). Test every piece of wisdom against your own experience and keep the ones that are useful. Practice of this process is how to answer the “how to live?” question, not hope for a perfect all encompassing answer handed down from above.