20. Non-Unicorn Investing (Jerry Neumann)

Due Diligence Podcast DownloadNick Moran Angel List

Jerry Neumann joins Nick on The Full Ratchet to discuss non-Unicorn Investing including:

  • Jerry Neumann non-Unicorn InvestingCan you give us a brief overview of Aileen Lee’s study on Unicorns, the results and the lessons from those results?
  • You mention two main VC strategies for investing in unicorns…  An easy way and a hard way.  Can you describe each and why both are actually quite difficult to pull-off?
  • With regards to picking unicorns… Paul Graham  said that you shouldn’t spend time thinking about price, you should spend time trying to get into the right companies.  While that seems logical, why do you think this comment is contradictory?
  • Talk about why picking unicorns is so difficult and why you suggest picking a system that has the best odds over the long-term as opposed to picking based on outcomes?
  • There are four major elements to your system, the first being “Don’t look for Unicorns.”  Can you talk about this first element and the two things that you need to check off before investing in a company
  • The second item in your system is about the “flock” and building businesses or products around a fundamental, secular, technological shift.  What is the message here and why is support of a sector as a whole, by an investor, important?
  • The third element is about publicizing your focus.  Why is this important and what are some examples that you have done in the past?
  • The fourth and final point in your system is about investing in sectors that others may not want to invest in or may be confused by.  Can you talk about why VCs avoid certain sectors and how that can provide some opportunity?
  • And finally, you provide some portfolio management tips related to “the gambler’s ruin.”  Can you walk us through some of these tips when making “bets?”

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Guest Links:

Key Takeaways:


1- Aileen Lee’s study & Key Insights

 Her study found that:

  • 1 in 1538 venture-backed companies become unicorns
  • 39 total companies qualified as unicorns (ie. U.S.-based software companies started since 2003 and valued at over $1 billion by public or private market investors)
  • This amounts to .07% of consumer and enterprise software startups
  • The period studied spanned about 10 years from 2003-2013
  • It took ~7 years, on average, from founding to exit and
  • These were all venture-backed

and some of Jerry’s key insights from the study…

  • First, he notes that this effort didn’t consider all of the companies that come across a typical startup investor’s desk that don’t ultimately get venture-backed… so the percentage of unicorns per startup is much lower than even what the studied showed.
  • Venture investments resemble a power law…  the most successful startup exits account for the bulk of dollars returned
  • Ultimately, if you want to attract investors to your venture fund, you need to invest in unicorns and there are two strategies for doing so:
    1. You either establish the expertise, the network, and the reputation in a category to become the go-to investor for startups
    2. You index (ie. you invest in everything)
      • While the first item, becoming the expert, is difficult, the second item is much more difficult.  As a direct investor, it is nearly impossible and even via fund-of-funds, where you are losing percentage points, it is still very unlikely to be able to access every venture backed deal.
2- Two things required for any startup


     1) Pains vs. Gains


Jerry talked about the Pains vs. the Gains or the vitamin vs. the pain killer.  Is the product or service making peoples’ lives better (ie. the Gains) or does is it making customers’ lives less bad (ie. the Pains).  And here Jerry focuses on the pains.  He believes, as many other venture investors do, that people will go out of there way to seek out pain killers, whereas things that incrementally improve one’s situation may just be seen as a nice-to-have… not compelling a purchase.  And with regards to pain, Jerry talked about the mistake that he sees many students making, which is to focus on mild pain in a large market instead of what he advocates, which is focus on extreme pain in a niche market.


     2) Feasibility


Can the team build what they say they’re going to build?  Can they do it on time and on budget?  Do they know what they’re getting themselves into?  Technical aptitude and amount of money required can be quite difficult to estimate when evaluating startups for investment, but it is critical that the team and their plan has the potential to be a success.
3- Specific Sector Focus
So, while Jerry supports the strategy of becoming the investor-of-choice, like a Union Square Ventures, he does not think it is realistic for him to build that reputation in the near-term.  Yet, he thinks one can become the investor that startups prefer to work with by specializing in a certain sector.  This effectively gives them access to the top deal-flow in that area and allows the investor to make better decisions, b/c they become an expert in the sector.
Can a generalist investor compete with a firm like Sequoia?  It doesn’t seem likely to Jerry.  But can one of the top investors in the adtech sector compete for the best adtech companies?  In his opinion, yes…  If the entrepreneur recognizes that they would be an asset.
And this isn’t a strategy that advocates avoiding unicorns, it merely says don’t base your approach on trying to pick them.  It can be easy to look at companies in other sectors and pick a potential unicorn & a great idea because you may not know the complexities of the industry.  The problems that are being solved sound real and compelling, but the challenges in successfully deploying a solution to that problem are often completely unknown to the non-expert.


Tip of the Week:   The Angel’s Ruin