Pretty much my experience so far.
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
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 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.
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.
I have invested millions of dollars directly in over 100 startups over the last 25 years. Many more through Venture funds and other syndicates. I am often asked how I decide to write the check. Well here is my process which has produced a 3.5X return on capital (so far). This is my process for an investment of $50K or less. The process for larger checks is the same but requires a higher confidence score (>90%). This is basically an investment specific application of my Next Right Action decision framework which I use for all decisions.
If you like the approach, join my Syndicate and invest with me.
Minority investments are bets. Bets are by definition risking capital with incomplete information. You should bet when you have a high degree of confidence in a positive outcome (10x capital for an Angel investment) based on a sufficient amount of incomplete information you have at the time of the decision (bet). You should not bet if you don’t have the basic information to form a hypothesis with a high degree of confidence. You should not make any bet when you are not willing to loose 100% of your money (even a small chance of an existential threat is too much). You should bet when you have sufficient information to form a reasonable hypothesis with a high degree of confidence.
In many games, like poker, collecting the basic information can be very challenging. For the angel investor, the company should have all the basic information in a 20 minute pitch or call with the CEO. They may be bluffing, and you have to adjust your confidence level if you detect that.
The process takes less than an hour to collect all the information and make a decision. Remember my Next Right Action framework is Problem, Explore, Hypothesis, Action. For an investment the problem is “Should I write a check?” Explore is diligence, collecting the basic information. There are only two Hypothesis, invest (confidence > 80%) or not invest (confidence < 80%). And only one binary action. Invest or not invest.
So most of my time on an angel investment is spent in “Explore” to collect the basic information to produce the confidence interval which will drive the action decision. There are three steps.
- Read the pitch deck.
- Hear pitch from CEO (or read investment memo from the lead investor)
- Rank deal on 5 (weighted) key start-up risks. Write check if deal scores > 80% confidence of a 10x return.
The first two steps are self-evident and take 30-45 minutes. It is important to talk to the CEO or at least a lead investor you trust who knows the CEO well because 50% of the confidence interval is based on your trust and confidence in management’s truthfulness and ability to execute.
While you may hear many different approaches to investing from thematic, to momentum, to the shotgun, etc., I look at the 5 major categories of risk and score each based on my confidence (from 1-10) that the company is weak (1) or strong (10) in this area. Management is weighted 5x for 50% of the weight, terms are weighted 2X for 20% and the rest are equal-weighted for 10% each. Max score is 100. If funds are available, invest in companies with a score of 80 or more (>80% confidence). Pass on all rest.
5 Key Start Up Risks
Management: The start-up bet is first and foremost a bet on management. They run the company. Management’s ability to execute over time in a fast-changing environment is the single biggest predictor of success or failure.
I only invest in CEOs who have a resilience practice of some sort. Startups are a firehose of problems and opportunities. Management needs some “reset” practice that puts them into flow doing some non-work thing so that the subconscious can make sense of the work stuff. And your system 2 can get a break from work. Burning the brain on work 100% of the time is a well-worn path to burn out. I don’t want management to burn out. For me, meditation, mowing the yard, going for a walk with my kids, surfing, fixing the motorcycle, and riding the bike give me the reset. Most great leaders had some kind of resilience practice. For Seneca, it was writing philosophical letters to friends and family. For Epictetus, we can infer it was weight lifting. For Marcus Aurelius, it was hunting and possibly wrestling. For John Cage, it was mushroom hunting. For David Sedaris, it’s walking back roads and picking up trash. For Herbert Hoover, it was fishing. Reading, boxing, biking, surfing, swimming, puzzles, coding, journaling, golfing – whatever it is, management need something to take your mind off work. It is a critical skill.
Management of a startup is a “wear many hats” problem. You must LOVE the firehose and thrive on figuring shit out. I started my first company after a career as a programmer. I had never hired anyone, raised money, signed an office lease, created a sales and marketing organization, or basically any of the things that would take up 90% of my time as CEO. I wore all the hats and figured that shit out. I hired a very smart programmer with a PHD and put him on bug fixes. He complained about fixing other people’s code and just wanted to write his own. He was out of his comfort zone and didn’t want to even tilt his hat a little. Not the right mentality for a startup.
Prior success in similar stage startups is a plus. Success at a big company and the first time in a start-up is a minus. Look for obvious holes in management. Technical founder when it will be a sales-driven company? Given that every management team will need to grow, how ready is access to top talent? Is the stage and company attractive to top talent? What is the culture like? Will the CEO share responsibility, or is it a follow the leader culture? Who are the “fundable” management team members? the more fundable team members, the higher my confidence in management.
Examples that Increase Confidence in Management:
- Prior startup success through superior execution
- Resilience practice
- Meritocracy culture driven by KPIs and dates
- Multiple “fundable” management team members
- Management with proven track record of attracting A team members
- Management is thoughtful, accountable, and trustworthy
- Management can explain prior failures and what they learned
Examples that Decrease Confidence in Management:
- First time CEO out of large company as mid level decision maker
- Strategic positions missing (CTO in tech driven company)
- Follow the leader culture.
- “B” players in key roles
- Lacking recruiting network
- Management relies on market projections and external indicators for goals and drive
- Management has not displayed growth from prior failures
1: First time CEO from Big company, used to be a CFO. Weak technical co founder, no marketing team, consumer sales channel.
5: Second time CEO (prior success) with new team in a market tangential to what they worked in before with tier 2 investors backing them.
10: Third time CEO with two successful exits working with a complete management team that she has worked with before and known for more than 10 years in a market they have competed in before and been backed by tier 1 Venture capitalists prior.
Product. What stage is the product in? Can it be built? Is version 1 the right set of features? Are they building the product they are passionate about. I recently heard a pitch from a company who had a clear vision of a transformational product. But it was too hard to build so they wanted to start with a different product to”make money now” and build their vision later. Pass. Build your dream product. Build it in logical stages sure, but don’t do the easy thing. Tesla wanted to build electric cars for everyone but the market wasn’t ready. So they build electric cars for rich people and started building the supply chain and innovations to drive toward a car for everyone. It was a logical path to the promised land.
Single product companies also tend to loose to platform companies over time. If your product fills a small niche in an ecosystem, and customers start to want it, eventually others with deeper customer ties in the ecosystem will copy your product and replace (or buy) you. Facebook is a platform not a product. Slack which started as a product has become a platform and is now much harder to dislodge despite others in the ecosystem copying the features (microsoft, facebook, etc.) Products that have network effects are superior to products without network effects. Products that require other users to be useful, that reward connecting new customers, etc. are superior to products sold to individuals one at a time.
If the product is creating a blue ocean, expanding a market instead of competing for one, my confidence goes up. What was the market for ride hailing services before Uber? The product created the market. The product/company that creates a new product category ends up with a far greater share than the followers. Invest in product category creators, not competitors in crowded markets.
Every product must fundamentally remove some friction in the market. The core invention should depend on technology which is innovated in the company. Amazon used technology to fundamentally reduce friction in retail. It took traditional retail with their physical locations as their primary assets a long time to adapt, and most did/could not follow because their core assets were not based in technology.
The 10x rule applies. A new product must be 10x better to get people to change. Back in the early days of search I used AltaVista and Yahoo. When Google launched, I tried it and the results were 10x better. I switched and never looked back. What will be 10X better than Google? Hard to imagine, especially since Google understands the 10x rule and keeps going.
Examples that Increase confidence in Product:
- Clear MVP with short term product roadmap that fits in the funding window.
- Customer demand, especially wait list, for MVP
- Measurable metrics on friction reduction from product.
- Network affects apply – product is a platform
- Product creates a blue ocean (its own market)
- Category creator
- Clear product milestones, questions within the funding window
- Efficient customer feedback loop to development
- Very short, limited scope development sprints
- Product is in the power position in the value chain.
Examples that Decrease confidence in Product:
- Scale of MVP too large and complex.
- Building an “easy” product for short term $$, not transformational product
- Product has only a few feature differences from competitors
- Product innovation not key to competitive advantage (sales channel is, or marketing, etc.)
- Category follower
- “fishing expedition” product development
- Long, complex development and release process
- Product not designed for customers to leave it easily
- Product is an add-on or incremental product to others in the value chain
1: Complex product vision with long development cycle going against established competitors with limited innovation (10-20% better) and easy to copy innovation.
5: 2-4x better specialist product in emerging market with some traction, little opportunity for protection or branding or network effects, enterprise sale.
10: Leading platform company with huge viral component, virtuous cycle already going and proven, creating market demand for new product category, clearly reducing market friction by an order of magnitude or more, clear customer pull for product, proprietary, protectable technology key to innovation.
Market. How big is the market for the product? Does the existence of the product expand the market (see Uber)? Does the market have a clear leader? Do customers show a willingness to buy innovation? Why now? What is the mega trend that the existing competitors are missing that the company sees that they can capitalize on now. The fact that a market is growing at double digits a year is not a reason to be in it. Why does this market need YOUR product NOW? Is there a clear path to $$? Does the company have an active pipeline? Is there a thin edge of the wedge to get into the market? How do you get to market? Direct to consumer? Enterprise? use a Chanel? influencers? Is there a Blue or Red (competitive) ocean market? What mega trends that you see in the market are you betting on? Are these trends long term or short term? Betting on market rebound from COVID is short term. Betting on Moores law is long term. The expansion of work from home is long term. Telemedicine is long term. Selling to hospitals is short term.
There also has to be a product/market fit. The right product at the right stage of the market. A very innovative product in a market which doesn’t buy innovation will languish. Determine the switching costs in the market. Is it easy for customers to switch? or Hard? How much of the product/market fit has been proven by the company to date? How long will this take? The product/market fit should also be exploiting a long term dislocation or trend also. I remember talking to lots of start ups who wanted to do banking for the emerging cannabis market using existing banking infrastructure and taking the new market risk for higher fees. Banking is an incredibly efficient business and traditional banks were prohibited by regulations to be in it. But those regulations could change quickly and the arbitrage would disappear quickly. Since the start ups did not bringing innovation to the market, simply taking risk, their market would evaporate quickly. I passed.
Examples that Increase confidence in Market:
- Blue Ocean, product innovation creates new market space
- Efficient, cost effective channels to customers.
- Many diverse market segments (industries, customer sizes, etc.)
- Positive CAC:LTV which can scale
- Way customers like to buy matches way customer sells
- Customer revenue goes up with product purchase.
- Customers proven desire to embrace change, new products
- Consumers can pull product into Enterprise (apple)
- Proven product/market fit
Examples that Decrease confidence in Market:
- Customer concentration (small number of customers control most of market)
- Many look alike customers
- Customers change adverse
- Enterprise market for SMB focused startup and vice versa
- Few or expensive clear leveraged channels to customers
- Too large geographic market for startup (world wide for small company)
- Enterprise only sale.
- Way company wants to sell is mismatched with how customers want to buy
- Customer revenue not affected by product.
- Risk adverse customers
- Unproven product/market fit
1: Small market not growing (<$1B) with customers averse to change. Like selling software to municipalities or healthcare.
5: Growing market (> 10%/year) with clear leader (s) taking 70%+ share and a few concentrated customers. A few possible new segments but all very small, company has early traction in some of these early markets and customers.
10: Product creates its own market demand. Many market segments, company innovation expands market to 10x or more new customers. Customers show proven desire for new product or service, can switch quickly. Can prove positive CAC:LTV very easily. Clear leveraged channels to reach customers.
Regulatory. Many investors never consider the potential regulatory hurdles facing startups. Uber faced serious ones. So do everyone in Healthcare (the FDA). Facebook and Microsoft did not until they got huge. While some investors see regulatory hurdles as a positive (healthcare) because they are expensive to get over and may come with market exclusivity and ability to print money for some time (drug discovery), i see regulatory hurdles as generally negative for the investment decision. You can have the most innovative product in an amazing market and the regulators can tell you you cant sell it, or could stop you from selling it (see Uber in California recently or AirBNB). A complex regulatory environment or unclear regulatory framework lowers my confidence that the company can clear the regulatory hurdle. How many biotech companies have consumed $100M investor dollars and failed to get approval for their drugs? Most. Take the recent interest in psychedelics. Lots of investor and consumer interests. Very murky regulatory framework, in fact criminal penalties for getting it wrong. Until the framework or mega trend toward clear regulations are in place, I am unlikely to invest directly in products. In unclear regulatory markets like psychedelics, it is often better to invest in the early media properties, or unregulated parts of the market very early (I have one of those).
Examples that Increase confidence in Regulatory:
- No clear regulatory body
- Clear lack of regulation of similar products
- Many similar products in market without regulation.
- Clear, inexpensive mature regulatory framework
Examples that Reduce confidence in Regulatory:
- Regulatory “grey area”
- Company success depends on regulators “looking the other way”
- Growing trend toward regulation driven by existing bad actors
- Existing, clear regulatory body
- Many level of possible regulation (city, county, state, federal, etc.)
- Immature regulatory framework subject to sudden shifts.
- Politicians attention in market likely to cause knee-jerk regulation during black swan event.
1: Product clearly requires complicated, expensive regulatory approval. Like an FDA approved drug.
5: Regulatory framework unclear, but others are selling into the market, regulation may come but it has not yet and profits could be made before regulation comes. Like early stem cell therapy, Hemp products, supplements. No clear regulatory body yet.
10: No obvious regulatory hurdles on the horizon. Facebook and Microsoft early. Many companies selling unregulated products into markets, or completely new product in new market.
Terms. What are the terms of the deal. This includes price, pro rata rights, share class, co-investors, is the deal “hot”, and more. I recently found a company with an 8 management team, a 10 product, 10 market and 8 regulatory but the terms were 2. The company was based in Canada (where Americans have problems owning shares), they were selling common shares without any pro rata rights, no top tier investors (all retail) and was over priced relative to traction and comps. If the terms had been 8 or above I would have likely invested $500K. With crappy terms, I invested $50K.
At every point in the life cycle of a company investors should expect higher returns for higher risk and this should be reflected in the terms. In poker this is called “pot odds”. What is the expected return for the capital I am putting in versus the odds of that return? If I have a 20% chance of winning and I am getting more than 5:1 on my money (basically the return odds outweigh the win odds) I should make the bet even with low odds of winning because the implied return will be worth it. In the very early stages, pre-seed, seed, you should have a very high confidence of a 10x or better return. At $100M valuation, with a-lot of risk washed out of the business, you should expect a 2-3x return. The terms should reflect the risk/reward gamble you are taking.
I put co-investors into the terms section. If they have already committed to the terms of the round. If I am following other smart investors who have approved the terms, it increases my confidence that the terms are fair and appropriate. I also check the “smart” investors check size against their bank roll. A common tactic of unscrupulous companies is to name drop smart investors with “undisclosed” investment sizes. Active investors may write small checks just for laughs and may hot have really engaged in diligence or verifying the terms. I looked at a deal once that was touting Peter Thiel as an investor (he put in $250K). The size was so small relative to Thiel’s bankroll that it didn’t improve my confidence in the deal that much (but I am sure other investors were swayed).
Positive investor terms include low valuation versus comparable stage companies, low valuation versus mature companies, pro rata rights, preferred shares, capped notes, interest on notes, redemption rights, voting rights, top tier, smart co-investors and a trusted partner doing diligence.
Negative investor terms include common shares, high valuation relative to comps, a “hot” deal where you are pressured to decide quickly, uncapped notes, and lackluster co-investors.
Examples that Increase confidence in Terms:
- Terms approved by credible co-investors who performed significant diligence.
- Preferred shares
- Pro Rata rights
- Valuation at a discount to comparable stage companies recently
- Limited investment allocation due to oversubscription of Terms
- Pari Pasu preferences (for early investors)
- Redemption rights
- Minority blocking rights
- Weighted anti dilution
- Revenue traction implying low multiple vs public comps
Examples that Decrease confidence in Terms:
- Lack of Tier 1 co-investors
- Premium valuation to comparable stage companies
- Common shares
- lack of pro rata rights
- Stacked preferences (last money in, first money out)
- No minority voting rights
- Ratchet on later rounds without weighted anti dilution
- Revenue traction implies high multiple vs public comps.
1: Small investment into a late stage company trading at a premium to public comps. I actually saw one of those on Angel list from a top syndicate.
5: Reasonable valuation relative to stage and traction, without pro rata rights and few followable co-investors.
10: Sub $10M valuation, preferred shares, pro rata rights for company with >$1M revenue growing > 100% a year, profitable with amazing co-investors. I have actually done a handful of these terms.
So there it is, my high level framework for making Angel Investments. This is by no means exhaustive, but it is directional. The key is to quickly assess the 5 risk areas and determine a confidence level that the investment can deliver a 10X return within 5 years. If > 40 (80%), I write the check.
If you like the approach, join my Syndicate and invest with me.
Way back in 2005, I was at the forefront of moving from technology to renewable energy investments. I wrote a special letter to SNS subscribers about it all. I was definitely early into renewables, and I was right, but it has not been a smooth road. The major piece I mis-calculated was the effect of technology on the core oil/drilling business and how that resource could be extended. Basically, I missed Fracking, but everyone did. Doesn’t change the fundamental limited nature of that resource, but did slow down renewables a bit. The technology acceleration in cars actually went a bit faster. Fun archive read.
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ANY OTHER UNAUTHORIZED REDISTRIBUTION IS A VIOLATION OF
Publisher’s Note: Martin Tobias is the quintessential entrepreneur. I’ve now known Martin for a decade or more, and I am continually impressed by the energy, focus, intelligence and sincerity he brings to each new venture. Martin’s contribution this week is particularly interesting for three reasons. First, he has spent the last couple of years at the well-known Seattle firm Ignition Partners. As you’ll discover, he had to go through a personal transition to get from bits to barrels, from venture investing in software and wireless to an operating role in an industrial firm. This change was radical and so inspiring that I asked him to spend a few paragraphs describing it himself. Second, Martin’s efforts will directly promote increased climate sustainability on a local, regional and perhaps even national scale. And, finally, as world events such as Hurricane Katrina continue to drive oil toward the SNS $100/bbl figure, finding alternatives to this fuel is both timely and provides direct assists to our economy and security. It might even create Martin’s next fortune.
I gave a speech at a Digital Divide conference in Seattle a few years ago in which I suggested that cleaning up diesel emissions was the single most simple and dramatic thing we could do to reduce air pollution. At a time when it is becoming painfully clear that small airborne particulates, such as those in typical diesel transport emissions, are causing real deaths among the very old and very young in our cities, the importance of solving this problem grows. And while firms like Detroit Diesel continue to work on the engine side of the equation, firms like Martin’s Seattle Biodiesel will be cooperatively hastening this process, taking it out of the amateur fast-food-chain days, and bringing it into the days of global mass production, and a reduced dependency on fossil fuel.
As Martin notes, there may be nothing else today which is more important. – mra.
From Bits to Barrels
By Martin Tobias
Having been a longtime subscriber to SNS and participant in FiRe, I should really blame this mess all on Mark. Yes, now that I think about it, that makes all the sense in the world. It is ALL MARK’S FAULT. Without the brain damage (and I mean that in the most complimentary way) of SNS and FiRe, I doubt this tech geek would have ever become CEO of a biodiesel company. I would have been happy living in the world of bits without much of a larger world view. Someone else with good intentions was worrying about the barrels, right? But I am getting ahead of myself.
In the Beginning…
There was a fairly typical tech-geek trajectory. In high school, programming Timex/Sinclairs in the drugstore to loop profanity on the screen, using a cassette deck as “mass storage” for my TRS-80, breaking a toe dropping my Kaypro “luggable,” president of the Science club… you get the picture.
In college, Marketing/Computer Science double major, COBOL/FORTRAN programming using a card reader, winning a NEC TV for selling the most dot-matrix printers, selling the first Leading Edge PCs to the university, copying research papers off Compuserve, being the first student to take an essay test on a computer (the Zenith Lunchbox portable with 5.25 floppy and fold-down keyboard), an HP 12C always in my shirt pocket, thinking the IBM AT was the “ultimate PC.”
Accenture came knocking right after graduation and pressed me into five years of programming IBM S/38s and AS/400s, until Microsoft saved me from the suits. After six years of serious hard work around the world on various missions, I opted for more pain and started my own software company in 1997. Loudeye Technologies (LOUD) went from napkin to 450 people and IPO in less than three years. (Ah, the good old days.) After a much-needed break, I wanted to get back to helping start companies (the fun part), and I have been doing so as a VC with Ignition Partners ever since.
So there I sat, just over a year ago, listening to yet another wide-eyed software entrepreneur tell me how he was going to be “the Google of XXXX,” or was it “the Microsoft of XXXX” – no, it was the “Cisco of XXXX” – oh, I forget. Suddenly, David Byrne’s “Burning Down the House” came into my head:
Watch out you might get what you’re after
Cool babies strange but not a stranger
Then “Once in a Lifetime”:
And you may find yourself living in a shotgun shack
And you may find yourself in another part of the world
And you may find yourself behind the wheel of a large automobile
And you may find yourself in a beautiful house, with a beautiful wife
And you may ask yourself – well…how did I get here?
And you may ask yourself
Where does that highway go?
And you may ask yourself
Am I right? …am I wrong?
And you may tell yourself
My god!…what have I done?
Well… how did I get here? Where does that information superhighway go? After a lifetime of solving software- and computer-related problems and looking over that horizon for what was next in that field, I was suddenly left wanting. A strong desire to build something REAL took hold of me. When the PC was in its infancy, there were many very tall mountains to climb, and climbing them made a big difference in the world. While there still is a lot of work to do, the path seems fairly well laid out, and there are plenty of very smart people on that path.
So where does the world need help? What is the #1 issue that will define this nation, and in fact much of the world, over the next 10 years? Energy.
There I sat, a lifelong Republican tech-geek software venture capitalist, wondering how I could make a dent in the nation’s energy picture. The next day I started canceling meetings and rescheduling my life around figuring out what new energy technologies were going to make a difference in the near term (as in: in my lifetime). It became immediately clear that looking at barrels and BTUs from a bit-and-byte perspective could possibly lead to new solutions.
The Big Energy Picture
Today we use fuels of all types for primarily three forms of work/energy: (1) to generate electricity (natural gas, coal, hydro, nuclear); (2) to provide direct heat (natural gas, wood, oil); and (3) for transportation (oil). Electricity has replaced a long list of mechanical activities (manual typewriters, screwdrivers, adding machines, watches, etc.) and continues to increase its share of the total, primarily due to the exponential growth of new electronic items in our daily lives.
We have multiple fuel sources to generate electricity and provide direct heat. Scaling up production in those areas is largely within our control (as a nation, we know the way, although we may not have the will). For transportation, there is only oil (well, okay, 99% oil, 1% electric buses/trains, bicycles, skateboards and rollerblades). Therein lies a problem, and quite possibly, an opportunity.
I may be an outsider on energy issues, but here are some assertions this outsider will make:
- We don’t have an “energy crisis,” we have a “petroleum crisis.”
- Americans are fundamentally convenience-oriented and do not have the appetite for wholesale transportation platform change.
- Non–petroleum-based fuels that work in today’s engines (no platform change) offer the fastest route to petroleum independence.
Petroleum has a monopoly on transportation. A small handful of global oligopolies control the production, distribution, and consumption infrastructure and technologies. The DOJ should take notice. The U.S. is by far (4x China, but they are growing faster) the world’s largest oil consumer, at over 20 million barrels per day – nearly $500B per year at today’s prices (http://www.eia.doe.gov/emeu/cabs/topworldtables3_4.html). We import more than 12 million of those barrels. After a brief flirtation with small cars and alternative fuels in the early ’80s, Americans went back to the well with a vengeance in their SUVs. We are punch-drunk at the bar, with a heroin needle in both arms, yelling “Drinks for everyone!”
This is an industry built on technology (combustion engines and mechanical drivetrains) well over a century old. Transportation is an incredibly inefficient use of energy. Less than 2% of the energy that starts out as crude oil ends up propelling me to work in the morning. Cars, trucks, and airplanes combined (http://www.ecobridge.org/content/g_cse.htm) are the #1 cause of global warming, contributing 36.5% of the carbon in our air (yes, more than power plants [36%], but just barely). World oil discoveries have been dropping every decade since the ’50s.
Worldwide demand is today roughly equal to supply, at just over 84 million barrels per day (http://money.cnn.com/2005/08/30/markets/oil.reut/index.htm?cnn=yes). A recent oil shockwave scenario (http://www.secureenergy.org/shockwave_overview.php) showed that as little as a 4% reduction in oil production (terrorist, boycott, civil unrest, weather, whatever) would increase prices over 170%.
Supply/demand is so tight that any disruption at all can cause a price spike. Down in the Southeast Gulf states, where over 25% of American crude comes from and over 40% of our refining capacity resides, Hurricane Katrina has just inflicted over $26B in property damage (early estimates) and put a significant amount of our production/refining capacity offline or under repair. What will be the energy costs to the economy from that disaster? While some in Europe are making a concerted effort to address oil consumption, Americans sit idly by in our SUVs while the sucking sounds from China and India are only getting louder.
In the last decade, less than 1% of the more than $500 billion spent on venture capital went to alternative energy companies, and most of that went into long-term bets on the “hydrogen economy.” Very little of what has been funded will show any tangible benefit to our energy picture in the next three to five years. Existing players have ZERO incentive to innovate; they are making too much money! Here is an industry ripe for change.
Yet it ain’t going to be easy. Here is the bit-head way to parse the transportation industry: There are three major platforms in transportation, each built around a unique protocol (incompatible with the others): Gasoline, Diesel and Jet Fuel [kerosene]. The standard for each platform is open and defined by international bodies (ASTM, E.U., etc.). Each platform has been optimized for a specific set of applications:
Gasoline: passenger transport and light trucks
Diesel: heavy equipment and machinery, distributed electricity generation, heavy trucks, boats, some passenger cars, and railroads
Jet fuel: flying airplanes.
Each platform is supported by a large, integrated network of very mature refineries, pipelines, terminals, trucking companies, and retail locations. A huge ecosystem of companies (GM, Ford, Chrysler, GE, Cummins, etc.) support each platform with a wide variety of hardware and software offerings as well as a world wide network of sales, service, and support for their products. The platforms are worldwide, employ tens of millions of people all along the value chain, have been adopted by nearly every person on the planet, and enjoy significant government support in every country at all levels. Makes you want to jump right into the fray, doesn’t it?
So Why Biodiesel?
The vast majority (http://www.energy.ca.gov/gasoline/whats_in_barrel_oil.html) of each crude barrel of oil consumed in the U.S. is refined into gasoline (140B gallons/year), diesel fuel (50B GPY), or jet fuel (40B GPY). To reduce our transportation grid’s near-total reliance on distillate products from crude oil, you can attack the problem from either production (substitute fuels, use existing vehicles and distribution system – a backward-compatible version upgrade) or consumption (substitute vehicles, fuel, AND distribution system – the platform upgrade). Natural-gas buses are an example of the latter. Implementation requires a whole new fleet of vehicles, a new fueling infrastructure, scaling up production of natural gas, etc.
Despite years of evangelism and vehicle research, natural gas is still not a practical option for anyone except a few scattered (okay – Los Angeles), very centralized fleets with centralized fueling. It is like getting someone to switch operating systems or hardware platforms. Lots of pain awaits. What about all your favorite old applications? A drive to the beach house for the weekend? Oops, can’t – no natural gas stations out there. A quick jaunt to the mountains with a carload of friends for some snowboarding? Oops, can’t – the natural-gas car doesn’t have enough room or power.
Fuel cells for transportation are an even uglier platform upgrade. You need new vehicles of all types, new wholesale and retail distribution systems for the hydrogen, service and support infrastructure, and, oh yeah, an energy-efficient way to reform massive amounts of hydrogen from a cheap, renewable source. So why are Big Oil, Detroit, and Pres. Bush selling us that song? Good old-fashioned Fear, Uncertainty, and Doubt about change to the current platform. “Be happy with what you have today and place all your faith in a future upgrade.” I have seen this movie before: “Everything will be fixed in Longhorn [the next MS operating system], so don’t bother me to fix anything in the current version.” No, I don’t believe anyone selling a platform upgrade is serious about solving our dependence on oil anytime soon.
What it is going to take is a version upgrade. An upgrade of either the fuel or the vehicle would allow you to leverage the existing infrastructure investment. Since gasoline is the largest liquid-fuel market, you would expect the first traction for upgrades to come in that market segment. The Prius is a vehicle version upgrade for the gasoline platform: some new technology in basically the same form factor that is plug-compatible with existing infrastructure while providing unique new benefits (lower emissions and higher fuel economy). This is just the first baby step in the siliconization of the automobile. If you want details on how “the electric power train is overwhelmingly superior to the mechanical – five orders of magnitude better on every key metric,” read The Bottomless Well by Huber and Mills.
Ethanol (made from plant starch) is a plug-compatible fuel version upgrade that is replacing an older flawed technology (MTBEs) as a gasoline additive of up to 10% (3B gallons were mixed into the US fuel supply last year). A higher blend of ethanol (85%E, 15% gas), when combined with an automobile version upgrade (flex fuel vehicle – basically a computer timing upgrade), will yield even greater reduction in petroleum usage and more environmental benefits.
Alas, I have never been much of a hardware engineer, so no upgrading the vehicle for me. The ethanol industry is fairly mature and is mainly a capital deployment business today. While there is the promise of some technology change on the horizon (cellulosic production from the whole plant instead of just the starches: http://www.eia.doe.gov/oiaf/analysispaper/biomass.html), the first commercial plant has yet to be built, and it will still take more R&D and 10 years to make a difference. The market also has a natural cap on it, in that no more than a 10% ethanol blend is backward-compatible with all existing gasoline engines (the 85% blend requires a new car with the new computer program). What about jet fuel? Humm, redesign a jet to be more fuel-efficient (already a top design criterion), or convince airlines to take a chance on a new, untested fuel? Looks like another LONG road.
That leaves the diesel platform. Most of the early advances in the gasoline platform do not transfer. Ethanol can’t be mixed with diesel effectively. Hybrids are okay for light commuting, but have been a total failure in heavy-duty applications. The city of Seattle tried some hybrid diesel buses and found that dragging the extra weight of the electric engine and battery packs up and down the hills resulted in WORSE total fuel consumption than straight diesel. The much-trumpeted Lexus Rx 400h just turned in 10% worse mileage over a 5,200 km road trip test against the Mercedes ML 320 CDI – all diesel: http://www.b100fuel.com/archives/2005/08/mercedes_ml_320.html.
While America turned away from diesels for consumers (as I did after an underpowered, dirty 1980 VW Rabbit diesel experience), relegating it to heavy industry, Europe embraced clean diesel technology, and today diesels power more than 50% of the consumer vehicles (in addition to the heavy industry). Europe also developed an alternative fuel in the form of biodiesel: http://www.biodiesel.org.
Biodiesel is a one-for-one replacement for petroleum diesel that can be made from a variety of vegetable oils, animal fats, and waste grease. Biodiesel is backward-compatible, with 100% of the existing fleet (minor fuel hose replacement in much older vehicles) and fueling infrastructure. It is biodegradable and nontoxic. It can be blended in any ratio with petroleum diesel or used in its “neat,” 100% pure form (as I have been doing in two cars for over a year). 100% biodiesel is renewable, carbon-neutral (the plants consume the equivalent amount of carbon that comes out the tailpipe), with lower emissions of all types across the board (although the scientists are still debating NOx).
In Europe, they make almost a billion gallons of biodiesel a year out of rapeseed. In America, soybean farmers have been driving the development of biodiesel, largely because they have an extra 1B gallons of soybean oil a year. The National Biodiesel Board has done the hard work of getting the fuel certified as an “alternative fuel” under federal guidelines and is carrying the torch for more government support of the industry. Last year, America made about 30 million gallons of the stuff (less than 0.0005% of our diesel consumption). Coincidentally, Seattle consumed over 10% of that and has the highest per-capita biodiesel consumption in the nation. The analysts project the market growing at over 100% a year for the foreseeable future.
The basic chemistry for making biodiesel is pretty simple. Vegetable oil is a triglyceride molecule that looks kind of like a three-legged stool. A glycerin molecule is the seat, and three ester (fatty acid) molecules are attached at the legs. The chemical name for biodiesel is methylester [alcohol] (you can also make ethylester, but I digress).
Those of you who didn’t sleep through chemistry class (as I did) have already figured out that what you have to do is detach the glycerin molecule from the esters and re-attach a methanol molecule to each ester leg, and voila! You have biodiesel. I have done it using salad oil in a blender (makes great margaritas afterward!). The glycerin and biodiesel separate like oil and water (different specific gravities), and after a little more cleaning, your biodiesel is ready to use. If you are going to sell it commercially, it must pass a battery of tests defined by the American Society for Testing and Materials (www.astm.org).
So if there is a more environmentally friendly, renewable, ready alternative to diesel that is easy to produce, what is the problem? You could just as easily ask why everyone isn’t running Windows XP or the latest version of Office. Even backward-compatible version upgrades have issues. There are bugs in the new code that need patches. There may be field-compatibility issues with the many various configurations in the field. In biodiesel’s case, there are more issues. While soy is the largest crop in the world, soy is a fairly inefficient oilseed crop, at less than 14% oil. If one were to grow a crop primarily to produce vegetable oil to make biodiesel, one would not choose soy.
The first American refineries have been built by the same Austrians and Germans that are building the European refineries. They use first-generation technology that is highly engineered and very expensive per pound (think IBM mainframe). Good old American ingenuity and PC-style economics have yet to take hold. Even with recent crude oil spikes, it still costs more to make a gallon of biodiesel than it does to make a gallon of dinosaur diesel. Only government subsidies get the prices close to parity (in some locales, even less than diesel).
So I say to myself, “If someone could make a series of inventions (in crops, process technology, etc.) that lead to being able to make a gallon of biodiesel cheaper than a gallon of dinosaur diesel (with crude at, say, $45/barrel), well, that someone would have cracked a nut that really needs cracking.” This may be one of those rare cases in which one can do something good for the world and put a little jingle in the pocket, too.
So here I am, Chairman and CEO of Seattle Biodiesel, charging up the hill again. Last time I made it over the top, but the weight of the arrows in my back caused a bloody and painful trip back down. This time I am better prepared and plan to take it a bit slower and with laser focus. This mountain is worth taking. I invite you to join the climb. Mark, thanks for encouraging me to take the first step.
About the Author
Martin Tobias is the CEO and chairman of Seattle Biodiesel and a venture partner at Ignition Partners. Martin joined Seattle Biodiesel to drive strategic direction in May 2005, after investing in the company in late 2004 following a multiyear search for the right alternative energy investment. Seattle Biodiesel is a personal investment for Martin.
Martin has been with Ignition Partners since 2002, working with the infrastructure software and networking team. He has invested in over two dozen startups (some personally) and currently serves on the boards of Cloudmark and IP Fabrics. Prior to Ignition, Martin spent 15 years in operating roles in technology companies.
Martin was the founder, CEO, and chairman of Loudeye Technologies Inc. (LOUD), a pioneer in digital media production, distribution, and applications. Under his leadership, the company raised over $175M (including an IPO) and grew to be one of the largest providers of digital media enabling solutions for the Internet. Prior to Loudeye, Martin spent six years with Microsoft in operational management roles and four years with Andersen Consulting (Accenture). Martin received his bachelor’s degree in Marketing and Computer Science from Oregon State University . He holds two technology patents. Martin and his wife, Alex, were profiled in the 1997 Harley movie Biker Dreams and are involved in a number of charities through the Martin and Alex Tobias Foundation.
I would like to thank Martin for taking the time out of his brand-new career to provide us with this multi-layered view of how, and why, he plans to change the world. If I had to pick a new path for this (or any) country to pursue in its pursuit of energy independence and pollution reduction, I’d pick someone just like Martin to lead the charge. We’re all lucky he’s involved, and I hope his decision, and future work, inspires other SNS members to achieve related goals.
Your comments are always welcome.
Mark R. Anderson
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SNS is the most accurate predictive letter covering the computer and telecom industries. It is personally read by the top managers at companies such as Intel, Microsoft, Dell, Compaq, Sun, Netscape, and MCI, as well as by leading financial analysts at the world’s top investment banks and venture capital funds, including Goldman Sachs, Merrill Lynch, Hummer Winblad, Venrock and Warburg Pincus. It is regularly quoted in top industry publications such as BusinessWeek, Newsweek, Infoworld, Institutional Investor, Wired, the Financial Times, the New York Times, and elsewhere. SNS Conference Corp. is the host of the annual Future in Review (FiRe) Conference, now headed for its third year. SNS is also parent to Project Inkwell, a consortium of global vendors and interested parties dedicated to accelerating the deployment of appropriate technologies onto K-12 desktops.
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Mark Anderson is president of Technology Alliance Partners, and of the Strategic News Service(tm) LLC. TAP was founded in 1989, and provides trends and marketing alliance assistance to firms leading the convergence of telecom and computing. Mark is a Seybold Fellow. He is the founder of two software companies and of the Washington Software Alliance Investors’ Forum, Washington’s premier software investment conference; and has participated in the launch of many software startups.
A past director of the WSA, Mark chairs the WSA Presidents’ Group. He regularly appears on the Wall Street Review/KSDO, CNN, and National Public Radio/KPLU programs. Mark is a member of the Merrill Lynch Technology Advisory Board, and is an advisor and/or investor in Authora, Ignition Partners, Mohr Davidow Ventures, Chameleon Technology, and others. Mark serves as Chair of the Future in Review Conferences, of Project Inkwell, and of The Foresight Foundation. He is also President of Orca Relief Citizens’ Alliance.
Disclosure: Mark Anderson is a portfolio manager of a hedge fund. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the position that his fund takes may change at any time. Under no circumstances does the information in this newsletter represent a recommendation to buy or sell stocks.
On September 12th, Mark will provide the Opening Keynote for the EdNET 2005 Conference, September 11 – 13, 2005 at the Hyatt Regency La Jolla in San Diego, on the subject of “SNS Project Inkwell: Helping Technology Transform Education.” On October 13th he will discuss 2006 predictions for the Portland, Oregon Business Journal annual predictions breakfast. On October 16th – 18th he will host the next SNS Project Inkwell meeting at the Black Point Inn, near Portland, Maine. On October 26th he will provide the keynote address for the Rustic Canyon annual venture capital partners’ meeting in Pasadena.
In between times, he’ll be bucking hay again, twisting and lifting those 75-lb. bales in a complex motion designed to keep horses and goats and chiropractors fed throughout the winter.
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