I've invested in over 30 companies, including seed investments in Calm (company now valued at $1 billion) and TubeMogul (IPO, then acquired by Adobe). I've been seed investing since 2005 when I was a partner at Netservice Ventures.
I look for startups with the potential to re-arrange the value chain in their market and become a platform or point of aggregation for customers, and for mission-driven founders who can deliver 10x better products into a commanding position in a defensible market segment. Frequently, these startups are software-centered companies that are digitizing products and services in markets where products and services are not yet digitized.
My unfair advantage as an investor is that I've spent 20 years successfully honing and executing the core skills required to turn zero into one in software startups:
- Opportunity recognition
- Venture design
- Team building
- Customer development
- Product development
- Product growth
I prefer to invest at the seed stage once a company has the first signs of traction and ideally 40-50% month-over-month growth.
When I do an investment analysis, I'm looking at four main factors: market, product, founders, and price. At the same time, I'm also doing a series of wholistic thought experiments and reality checks. Taken together, these are the ingredients to solve the puzzle of whether this is a good investment opportunity or not.
Below is how I think about market, product, founders, price and reality checks in detail. If you'd like to know more about how I can help your organization, please send me a message. I would love to talk.
Software Eats the World
I have spent more than 20 years focused on software products and software businesses, and I firmly believe in the software eats the world hypothesis. To understand what this really means, it's worth repeating how Marc Andreessen unpacks it in recent interviews:
Any product or service in any field that can become a software product, will become a software product (i.e. if it can become bits, it becomes bits).
Every company in the world that is in any of these markets that this is happening, therefore has to become a software company.
As a consequence, in the long run, in every market, the best software company will win.
This doesn't mean I invest exclusively in pure software companies, but it does mean that potential investments should fit this hypothesis and will be judged on their abilities as a software company.
Digital is Different
Is the company digitizing products or services in a market where existing products and services are not yet digitized?
Digitization takes us from a world based around scarcity into a world based on abundance, unlocking massive opportunities for value creation and re-arranging of existing value chains.
- Zero marginal costs Making one additional unit and delivering it across the network costs nothing. Zero marginal cost is like an economic singularity similar to dividing by zero in math--as you approach it strange things begin to happen, ranging from digital near-monopolies to granting all of humanity access to the world's knowledge.
- Universality of computation Anything that can be computed in the universe, can be computed by the type of machines we already have today, given enough memory and time. Computation means taking information inputs, executing a series of processing steps, and producing information outputs. Which is essentially what a human brain does. In principle, a digital machine can do everything a human brain does.
While universality and zero marginal cost are each impressive alone, universality at zero marginal cost yield magical results with non-linear potential improvements for humanity similar to agriculture and industry.
What is happening in regard to digitization in the market this startup will play in? How will this startup use zero marginal cost, universality or both to provide value?
Value Chain Analysis
What used to be scarce but is now abundant? What used to be full of friction but is now no friction? And how will consumer behavior change? What is the new scarcity that the startup is going to claim?
How is the value chain arranged today and how can it be re-arranged to eliminate existing players or reduce their margins so that the total friction to a customer is lower but that the new point of friction is the startup—and that is why the startup can collect money?
Early stage investing is a bet and arbitrage on the state of the world today vs the state of the world tomorrow.
Platforms and Aggregators
Is the market structured in a way that a platform or aggregator can emerge to serve it? Could this company be that platform or aggregator?
Fighting customer inertia and adding new customers is very hard. Does this product represent a 10x improvement over the alternative? The bar is very high to get customers to switch from what they're currently doing–even if the product is better.
Are increasing returns built into usage of the product? Does the product get more valuable the more people that use it?
What is the complimentary asset this product is built on? Who owns it? Is it free to all? For example, Google's complimentary asset is the web. This is an excellent complimentary asset because it is freely available to all and is not controlled by any one player. By contrast, Zynga's complimentary asset was Facebook. This was a poor complimentary asset because Facebook controls the Facebook graph and could (and did) restrict Zynga's ability to use it.
What has changed so that now is the right time for this opportunity? What is the new path through the idea maze? Why will this path work where other paths have failed?
Why has this founder chosen this business? Is it a good match based on skills and interest? What evidence from the founder's past supports this?
Grit is perseverance and passion for long-term goals, and is one of the most important attributes of successful entrepreneurs. How committed are the founders?
What are this founder's chances of succeeding in this business...and in life? (borrowed from Jason Calacanis). What track record of succeeding can the founder show? How far back does it go?
No path is more difficult than the path of a startup founder. It requires incredible self-belief and the ability to remain unshaken even when everyone you talk to says no and tells you to quit. It requires a special kind of internal general optimism that borders on delusion–but importantly, is not delusion.
Ability to Learn
Startups often succeed or fail based on how fast they learn and iterate. As Naval Ravikant says, it's not 10,000 hours that creates an outlier–it's 10,000 iterations. Do the founders have a demonstrated and voracious ability to learn? What's the evidence?
Do the founders have an intuitive sense for what users want and use design thinking to navigate the user journey? Do they understand the difference between creating a killer user and a killer app? And why the mark of a great product is one that consistently makes users feel awesome–as if the user had superpowers?
Second Order Thinking
Do the founders think about second and third order consequences of an event? Or just the immediate first-order effects? How deeply do they think about the idea maze and charting the course through it? Do they "see around corners"?
Machine learning and artificial intelligence will be an increasingly important component of all products. How well do the founders understand AI/ML and how to use it?
Are the founders technical? Can they code? Even if they won't be coding, they need to hire others that will and must be able to evaluate and lead them.
What other unfair advantages do the founders have? What skills, access, knowledge or unique circumstances do they have that potential competitors don't?
Even the best deal is not a good investment at the wrong price. Here are two important high-level considerations for valuation.
Venture capitalists and seed funds and angel investors make or lose money on the journey from hypothetical value to real value. And when the spread between the two narrows, the money we make is less. When the spread increases, the money we make is more.
Real value is value as calculated for a business with customers, cash flow and profits. By contrast, early stage investors make decisions using hypothetical value, when a company might not yet have customers–or even a product.
It's easier to "drink the Kool-aid" in the world of hypothetical values than in the world of real values. In the world of real values, the numbers are right in front of you. What can be done, though, is to think about base rates and how large the gap between hypothetical value and real value might be for the deal.
Undervalued segments will produce better returns.
If it works, how big can this idea get? How big an impact can it make? What does winning look like in terms of revenue and my return?
Every investment must have a credible path to achieving a valuation of $1 billion or more (a unicorn). If this is not the case, the investment cannot be made. Early stage investors succeed or fail based on slugging percentage, not batting average.
Every deal needs to have a systematic set of lenses and thought experiments applied as reality checks to make sure you are seeing current and future states of the world as clearly as possible.
The best investment returns are when you are non-consensus right. Often these are ideas that seem bad or boring, but are actually good ideas. Peter Thiel famously uses a variation of this concept as the interview question "What do you believe that most people do not?"
The best deals have some form of scarcity to them:
- Scarcity of Attention Few people thinking or talking about this opportunity.
- Scarcity of Entrepreneurs Few entrepreneurs who could build this product or run this business.
- Scarcity of Capital Few investors interested in opportunities like this for any number of reasons (geography, industry, past poor performance, etc).
Scarcity of attention or capital will mean valuations will be lower and returns higher since it is harder to fund. Scarcity of entrepreneurs will mean less potential competition.
As Jerry Neumann describes on Why Venture is Hard, imagine a future world as the founders imagine actually happens. Is this possible? Can this state of the world actually happen? Why or why not? After considering whether it could happen, do you believe it will happen? How will others resist and push back? What obstacles will exist? Can the company overcome these obstacles?
What are the risks in the deal? What risks can be mitigated by diligence? What risks can be mitigated over time as we learn? What risks cannot be mitigated?
Who are the existing investors and what is their track record? Are they investing in this round? Who is co-investing and what is their track record? If top investors are not investing, why not? If top investors are investing, why are you able to invest?