119. Economic Theory in Venture Capital, Part 2 (Mark Suster)

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Today we cover Part 2 of Economic Theory in Venture Capital with Mark Suster of Upfront Ventures. In this segment we address:

  • What are your impressions of what Bryce Roberts is doing at Indie VC?
  • How have your thoughts on investment psychology and economics been influenced by The Black Swan by Nassim Taleb?
  • What other principles of economics, that we haven’t touched on, have informed your investment philosophy?
  • In light of today’s topics, what are the key things you’re looking for in startups?
  • Can you talk about Defy Ventures and your experience visiting California State Prison and the impact that Defy is having?

Guest Links:

Key Takeaways:


1- Competing with non-consumption

This concept centers on launching an inferior product that is cheaper and at lower margin. But in solving a problem that hasn’t previously been addressed, you become good enough to access a far greater customer base in a range of applications that were not a part of the target market. Mark said:

“If, you want to build something that has massive scale and grows very quickly to a multi-billion dollar company… then what you need to think about is how do I build a product that appeals globally to massive amounts of consumers.”

Here he gave the example of a Sony Walkman. The industry laughed at the product because the fidelity was so low. But it allowed a greater number of consumers to listen to music in places they never previously could.

So, how do you build a business with 10x multiple of value with a product that has much lower capability than existing options? Mark’s advice here was not to try and be all things to all people. Most incumbents will have way too much capability and way too many features, thus will have to charge a high price to all whereas a smaller company with a more narrow focus, can be much better at addressing that specific problem for a cheaper price.


2- The Incumbents Failure to Respond

The inability for incumbents to react to disruptive innovation is related to deflationary economics. Take an industry with:
-Big profits
-Fixed prices
-A really high-cost solution

and if a startup offers something at a significantly reduced cost, the incumbents just can’t compete. It becomes very hard to kill the existing business, so the incumbents are not incentivized to innovate. If they do, they remove revenue and margin from their cash cows. Mark said “it’s impossible to do from behind the moat.” So, very similar to my experience doing M&A for Danaher, what Mark suggests is for incumbents to take equity positions with early stage companies. This way when disruption occurs, the incumbent has a position, yet doesn’t cannibalize their own business.


3- A Simple Heuristic for Growth vs. Profits

Mark’s input here was there is no right answer and every situation is different. But he did give us a simple framework to think about when balancing growth vs. profit. When a business is not profitable, Mark looks to see if they are investing in marketing, expansion, product development. If so, they are enabling growth and sacrificing short-term profitability. They could be profitable if they pulled back on these growth efforts. But they have access to capital and the ability to expand. Whereas companies that don’t have access to capital can not finance efforts that drive them to negative profit. In these cases, business should focus on being profitable. So, his simple advice is: If you have access to capital, focus on growth; if not, profitability.


4- It’s All About People

When discussing Mark’s lessons from Nassim Taleb he talked about how economics are not purely rational but rather influenced by human behavior and psychology. Here’s where he cited the narrative fallacy. When one builds an understanding in their mind, based on observed events, that shapes their opinion of the future. And we all ascribe stories and narratives to make sense of the world where, in fact, many data points are just random.

So this has influenced Mark’s macro-approach as an investor. His process is simple.
1- He first needs to eliminate the ideas that clearly won’t work
2- He needs to back the most talented people he has access to b/c the most talented work the problems every day and adapt to market conditions the fastest. There will be more success from working with the most talented people rather than thinking you know the outcome of markets and finding the entrepreneur who’s vision maps to your opinion of the future.

So, operationally, Mark asks himself:

How do I get in front of as many entrepreneurs as possible?
And then be smart enough to choose the 2 out of 1000 that he should back?
And then be talented enough to figure out how to supplement their teams with what is missing?
And then be good enough that downstream VCs or large companies trust me when I say that the team is uniquely positioned and capable of solving this problem?

Mark is not trying to predict the future. He’s trying to bet on the jockeys that will be best positioned to respond, react and capitalize on what the future holds.

Tip of the Week:    Red vs. Blue in VC

*Please excuse any errors in the below transcript

Nick: Interesting. You know, we recently had #Bryce Roberts on the program talking about #Indie VC and their model.

Mark: Yep

Nick: Have you had a chance to kind of look through that?

Mark: Of course. I am very good friends with #Bryce, I love #Bryce.

Nick: #Bryce is great. Yeah, you know, I think it’s relevant for the growth versus profitability discussion, but just kind of want to get some of your high level thoughts on, on this, this new approach and this new model?

Mark: Frankly, it’s just a different kind of business and a different kind of founder. There are some founders that should chase the tens of millions in venture capital and grow as fast as they can. There are some models and businesses and founders who shouldn’t. And the problem is there haven’t been enough capital solutions for people like that. And I love that #Bryce is out there trying to provide capital to people who want to take a different path. And growth for growth sake and loading on tons of venture capital is not for everybody and it’s not for every circumstance. And so there’s many great businesses that are built initially a little more slowly with less capital requirements.

Nick: Got you. You know, you’ve written in the past about #Nassim Taleb and, and The Black Swan. How have your thoughts on investment psychology and economics been, been influenced by that book?

Mark: Well, so he wrote The Black Swan. He wrote Fooled by Randomness. I think he wrote something about fragility and anti-fragility, I don’t remember what that book was called. So a bit like #Clayton Christensen, #Nassim Taleb is not a betread. But The Black Swam, not the movie but #Nassim’s Taleb’s book, is very important. What we as humans, and I may just make one more recommendation to your listeners, before you buy that, buy the book ‘Thinking Fast and Slow’ by #Daniel Kahneman.

Nick: Yep, yep

Mark: What we as humans are particularly bad at doing is recognizing our own weaknesses, our inability to really process and understand information. So we are subjected to something that #Nassim Taleb talks about. That #Daniel Kahneman, who pioneered the field of, I don’t know what you call it, psychological economics, there’s a term for it, I’m just not thinking of it right now. But understanding that economics is not purely rational but influenced by psychology. But by how people think, by human behaviors, which are not always rational. The ideas in both those books is that you’re subjected to something called the narrative fallacy. The narrative fallacy is you build in your mind something that happened in the past, you connect a bunch of data points, and then you extrapolate a line in the future of what is going to happen. And, you know, the past often isn’t predictive of the future. The narratives that we form in our minds often aren’t right. And that’s why even #Nassim Taleb talked about fooled by randomness. So basically it’s this. Let’s say you have monkeys, and monkeys throw darts at a dart board to pick stocks. And you’ve got 10 monkeys throwing darts at a dart board to pick stocks. At the end of the year, one of the monkeys will look smart and one of the monkeys will look dumb. Now when I tell you this story, you’re going to say of course it was just random. But we don’t do that. We look back and we say monkey number 3, wow, that’s a mother* smart monkey, like I want to back monkey number 3.

Nick: Sure. There’s a lot of angel investors like that.

Mark: Yeah. When in fact a lot of what happens is actually random. And so we ascribe certain stories and narratives to believe what we believe and try to make forward looking decisions. So I preach at our partnership, not to be too smart. And I really believe that. Of course you need to be smart, but don’t be, as we said in England, too clever by half. Don’t think you know all the answers. Our journey as an investor, in my opinion, first of all is to know what ideas just won’t work because we have fundamental understanding of markets. But beyond that, is to back the most talented people that we have access to because super talented people are going to be working the problems every day and are going to design solutions and adapt to market conditions. And they still may fail. But there’s going to be more successes from working with the most talented people you have access to than in thinking that you know the outcome of markets and therefore funding people that map to your view of how markets are going to break out. It’s just not how venture capital works. So I like to say venture capital is about human capital. We are, if you want to say it, I’m a glorified HR person. My job is, and I have nothing against HR people, but like I just want to be really clear, my job is to figure out how do I get myself in front of as many talented potential entrepreneurs as I can who think I’d like to work with that person because I think they will be additive to what I’m doing. And then I want to be smart enough, not to figure out their businesses, but to meet a thousand of them and know which two to back. How do you do that? Like it’s, you have to see a lot of large numbers of people until you know that. Then I want to be talented enough that I can figure out how to help them surround themselves with whatever is missing in their dna to build great teams. And then I want to be talented enough that people at big companies or downstream VCs trust me enough when I tell them this is a uniquely talented team, that they’re willing to spend time and decide whether that’s true for themselves or not. But through everything from how I source deals to how I sell companies, it’s a people business.

Nick: I’m with you. I, I’d say from my own experience backing really talented entrepreneurs makes work so much more fun.

Mark: I mean, that’s certainly true. But here’s the problem in this. Because I work with a lot of VCs, is there’s just a lot of people in our industry who think they know better. So their starting point is I know what’s going to happen in computer vision, so I want to find a team and I’m just going to tell them what to do.

Nick: Mmhmm

Mark: There are a lot of people who think like that in our industry. And I think, you know, I think, I think it does a great disservice overall to the, to the business.

Nick: Interesting. Any other major economic principles that we haven’t touched on that have sort of informed your investment philosophy?

Mark: Well how much is to understand economics, you know, I think, understand accounting, understand the difference between, you know, underlying operating profit versus gross margin, understand what gross margin actually is. A lot of people in the industry don’t understand gross margin. Understand truly customer acquisition costs, what does it cost for you to onboard a customer? Understand the true definition of lifetime value, like how do we figure out how much money we’re going to make from the customers that we do sign up over time, calculating it based on profits derived. And you don’t have to have all the answers to how you’re eventually going to make your millions. But you need to start with hypothesis. You need to build a plan. And then you need to constantly ask yourself how are we doing against plan. And if you’re not doing well against plan then you have to say is it our performance or is it our plan? And the reality is there’s probably a bit of both. And over a course of years if you keep refining both, you will just get better as an operator. But the people who spend no time thinking about economics, I think mostly don’t build hugely successful companies. There are exceptions. But there, I just don’t think there’s many.

Nick: So in light of today’s topic, what are some of the key things you’re looking for in startups?

Mark: You know, I guess I’m a little bit of a broken record on the topic of 70% of what I’m looking for is just the quality of the founders. Just team. And what I want to know is do you have the intellect? Do you have the drive? Do you have the curiosity? Do you have the commitment? I don’t want to fund things that you get a 3x and you sell in 9 months. It’s of no interest to me. I’m not saying that’s not interesting to a founder. But I want people who want whatever they’re building to exist because they have a deep seeded missionary need for this product to be in the marketplace. And if they make money as a result of it, it’s a by-product of their irrational need to build what they’re building, and that they’re driven to do that. I want to back leaders, people who can attract talent to join them when that talent shouldn’t actually join them, who can inspire investors to give them money when no rational investor would give them money. I want to back people who have internal fortitude because you take a lot of punches in the face to be an entrepreneur and you’ve got to wake up every morning, pull up your socks, put on your smile, show up at your office and stare down everyone in your office who might be feeling stress or pressure, tension, and motivate them. And that’s really hard to do. I’ve been there. It’s depressing and lonely and, you know, it’s a very personal lonely journey. You can’t walk around and tell all your colleagues hey guys, you know, I have to own up to the fact that I’m secretly scared to shit that we’re going to be out of money in 4 months and I haven’t really figured out exactly how we’re going to make our business work. You can’t do that or you’ll have exactly zero employees. So you’ve got to swallow your own insecurities, you’ve got to surround yourself by mentors and a network of people who are supportive and that you can be open and vulnerable with. And they’ve got to be people out of your immediate ecosystem of co-founders or investors, so you can truly be open and vulnerable and overcome your insecurities. And that’s what I’m looking to back. I’m looking to back people who aren’t quitters. I’ve had companies that were unbelievably fast growing and then had one market shift which completely chopped off our heads. And then they have to step back from it and say well, I’m going to have to take 3 steps backward, I’m going to have to fire 60% of my staff, it’s going to be terrible, my life’s going to be terrible. I had these beautiful offices, now i’m going to have to go take crappy ones. But you know what? I’m going to make this work. And when I meet people like that, I do the same thing. I roll up my sleeves, I tell my wife I’m going to be up till 3 tonight, I apologize, you may not see me for the next week, but we’re in this * together and I’m going to help this company get through it. And just knowing before I write the first cheque that I’m dealing with somebody that I think has my cultural values matters, it’s everything to me.

Nick: You know, #Mark, I was pretty moved by your post about #Defy Ventures and your experience visiting California State Prison. Do you mind briefly just touching on your experience and the impact that #Defy is having?

Mark: Sure. I’d be happy to. Thanks for asking. So #Defy Ventures, started by #Catherine Hoke, goes into prisons and it designs a six month course to teach them how to be CEOs of their own life. CEOs of their own life. The goal is to give people an economic plan to launch a business when they get out of prison. And that economic plan is not to create startup apps like technical products, not to create a competitor to #Google or #Salesforce, but to create cash flow businesses. The faster they’re into cash flaw, the faster they can earn legal money. None of these people want to go back to prison. None of these people want to go back to illegal activities. But what happens is when you get out and you try to be on the straight and narrow, and you’re not earning what you need to earn, and no one will hire you because you’re a formerly convicted felon, which a legal disclosure requirement, you know, you end up getting tempted back into it. The recidivism rate, the rate at which people in the United States go back to prison after getting out, after having a felony, is 76.6%. 76.6% of all people who have come out of a felony prison offense in the United States, after 5 years are back in prison. You can’t have society that exists like that. So #Defy Ventures recidivism rate on a smaller example set, but we think at scale it can still perform well, is 3%.

Nick: Wow

Mark: 3.2% to be exact. And so what they do is they first work with prisoners to take responsibility for the mistakes you’ve made in life. To take responsibility and to forgive yourself and not to feel shame. And most of these people have never been talked to like this. Most of them grew up, and I know from working with them, in broken homes, in poor neighborhoods, with a single parent, with some level of alcohol or drug abuse, with some level of physical violence. A vast majority of them have either parents or cousins or uncles or aunts have been imprisoned. Prison becomes a way of life in these communities. And you have to break that cycle. So part of it is understanding themselves and their personal journey. The second bit is getting them to forgive the people who have done wrong to them because none of these people are, not none but most of these people are not solely responsible for their journey. I heard a guy sit and tell me when he was 8 years old, his uncle handed him a gun and said cover me. And he’s like that was my entry into life. And you’re, you know, two feet away from a guy staring you in the eyes telling you about how his uncle gave him a gun at 8 years old. And he’s like I knew it was wrong but it’s what my whole family did. What was I supposed to do? Tell my uncle I’m not into guns, I’m not into violence. So that on-boarded me into this life.

Nick: Jeez

Mark: And that’s the journey you hear over and over again. So the second thing is forgiving those people who have done wrong to you. Third thing is teaching you the basic skills that you and I have that other people haven’t been taught. They teach them how to manage a bank account. They teach them how to do a budget. They teach them how to do job interviews. They teach them like the basics of networking. And then the final thing is they actually create a business plan. And what we do as we go into prison is we help them judge their work business plan. We help them think about pricing. We help them think about marketing. We help them think about sales. We help them think about cost. And then as these people get out of prison, their job is to launch companies. So they’ve had 1100 people graduate so far, who have created 150 startup businesses that employ 350 ex-felons.

Nick: Wow! And is that just in, in California or ?

Mark: Oh, no, no, no, no, no. It’s across the country now. They’re launching in, I think they’re launched or launching in Illinois. They’re in Wisconsin. They’re, or they’re, they’re planning on launching in Wisconsin. They’re in New York. They’re in Texas. They’re in Oregon. I think right now they’re in about 10 or 12 prisons. Their goal is to roll out to every prison in America. And any amount of inspiration I can give from talking about it or writing about it pales in comparison to actually going. It’s one of those things in life you just can’t understand. Nobody can explain it to you. But I took billionaires into prison. I didn’t tell other prisoners they were coming. But I took billionaires into prison. And I had never spent time around prisoners. And then you’re a foot and half from someone staring them in the eyeball, telling them stories about your life. And they’re telling you stories about their life. And you start to realize that we’re all human. We’re all the same. They have different conditions, different childhood, different insecurities. They have different honestly opportunities in front of them than we do.

Nick: Sure

Mark: But they’re human. And, and they’re craving real human interaction. Many of the people I work with have been in prison for 15 or 20 years. I mean, you’re not talking about people in for 2 years. Many of them were incarcerated in their teens. In their teens. And they don’t hide behind what they did. They don’t say I was wronged and the system screwed me. They say I did bad things. I, I take accountability for that. That’s part of the program. But when you go into prison and you deal with these people as humans, one thing I can promise you because I’ve done this now with many executives, at the start of the day you start apprehensive and scared and what are these people and my god they have a lot of tattoos. And by the end of the day you’re sitting at a table with them, eating a piece of pizza, and telling stories and you forget that they’re prisoners.

Nick: We’re all just people.

Mark: And you will not leave prison without crying. I don’t care if you’re a guy, a woman, I don’t care if you’re tough, if you’re soft. You will not leave prison without crying.

Nick: So it sounds like for folks that want to get involved across the nation there’s opportunities. Is it, is it best just to go to #Defyventures.com?

Mark: Yeah. #Defy Ventures. I think it’s, I think that’s the URL. If you just google #Defy Ventures you’ll find it. And there’s plenty of places where if all you want to do is donate, you can donate. It costs $50 per student. Is it $50 per student? I’m sorry, $500. $500 per student for a 6 month program. So whether you can give $20, $50, $100 or $500, every bit goes towards helping the prisoners get through the program. They have very low overheads. And if that’s all you want to do, you can do that. But I think you will get more than you will give if you go into prison because you will discover something you probably don’t know, which is how our system actually works. And we can vilify anybody we want, we can make these people into monsters. But if you sit and talk with them, at least you’ll understand their journey better. And it’s very hard to vilify humans when you’ve actually met them and talked with them. And look, I’m not going to say 100% of the people are being direct. I’m sure there’s a certain amount of, certain percentage of them put their airs and graces and can spin a yarn like anybody. But that’s true whether you’re a prisoner or not, you know.

Nick: Sure

Mark: But you, you feel humanity in prison.

Nick: Well, I can certainly say for myself I appreciate the fact that you took the time to, to write about this. And it certainly provided a, a window into who you are as a person and, and not just an investor. So I appreciate the fact that you wrote about it and that other folks like me could get some exposure to you and, and also the impact that #Defy is having.

Mark: Thank you.

Nick: #Mark, if we could address any topic related to startups or venture, what topic do you think should be addressed and who would you like to hear speak about it?

Mark: You know, I think we need to apply startup ideas to bigger problems that we need to solve for the country and for the world. You know, I backed a young entrepreneur named #Rebecca Kantar who has a company called #Imbellus. You know, #Imbellus is and goal is to change education in America. And she has a plan for getting there. Her plan for getting there is to offer products to corporations. You know, the first plan is to use game based assessment to help figure out how to align human potential with your needs as a hiring manager. You know, through things that can’t be memorized, through not rote memorization but understanding human potential. Ability to deal with abstract information. Ability to work in groups. Ability to problem solve. And if you can do those things in corporate America, could you get colleges to start to think about how to onboard high school students who have those skills and attributes. We know that the way we teach today is to the skills of the 1950s. You sit down, you have chalk and talk, teacher in front of a class who tells you, you know, about your math tables, tells you about science problems. And then you go home, you do a bunch of homework and you show your teacher what you did. But the real world is working in projects with teams and solving things together that are more abstract. And yet we don’t teach children to have those skills. So if you could get colleges to care more about that, to care more about that when they make their own selection. And move aways from tests that were designed, standardized tests, designed for, you know, 60, 70, 80 years ago. Then you could get teachers and principals and superintendents who wanted to teach high schoolers differently. And if you could teach high schoolers differently, you could start to make an impact on how we onboard the skills in America for the future. Because I can tell you if we don’t, China will just simply kick our ass.

Nick: Mmhmm. #Mark, what startup investor has inspired and influenced you most and why?

Mark: Historically, #Bred Feld, for a lot of reasons. Number one, because he was the first open and transparent blogger that I knew. 

Nick: Yep

Mark: When I started my first company, you felt like every VC had a black book of, you know, all their, you know, their, their plays. And entrepreneurs weren’t allowed to know how it worked. And I’m like, god, #Brad’s giving away the shop. He’s telling everyone how all this works. And, and so I just kept thinking to myself if I could work with anyone I want to work with #Brad. So when I started as a VC I thought well, if I wanted to work for #Brad because he’s open, maybe I should just be open. So that, you know, foundation that was important. Number two, I think he doesn’t care what other people think. Way too many people in the industry are driven by validation from other people. He has the conviction of his own ideas. He wants to fund bigger problems. He wants to get involved with things that have a social impact, but also are good economic businesses. He says things that other VCs don’t say. Like, I’m syndication agnostic. Okay. What the * does that mean? Like, VCs always say I’m stage agnostic. That means I don’t mind if I do seed or, you know, A or growth. I’m stage agnostic. I’ve never heard anyone say I’m syndication agnostic. And syndication agnostic is saying I don’t form my sense of self worth by saying that I’m partnering on deals with super fancy people. Either I have deep conviction over founders and businesses and ideas and I’m willing to fund it or I don’t. Now I want to work with smart interesting people. And I know that by partnering I add to the skills of the board and the team and relationships. But I’m not driven by it. I’m driven by my own sense of conviction and by the founders that I support. And, you know, there aren’t many people who say that. #Brad was helpful to me in ways that, you know, nobody realized. It is like when I started asking other VCs hey, I know I have to go raise funds now that I am managing partner. Like how do I do that, who do I talk to? What LPs should I talk to? And VCs are very protective of that information. And so, you know, there weren’t a million people rolling out the red carpet to say here’s five people you should speak to, let me introduce you, I’ll help you, here’s what they’re going to care about. And, you know, because a lot of VCs are closed. And #Brad opened book Feld, said let me introduce to a few people. And so that kind of pay it forward mentality drives me today. So now that I’ve been a VC longer than many VCs in the industry,  I try to help VCs at every turn I can with how do you fundraise, who should you talk to, how do you construct a portfolio, how do you onboard managers, how do you build a brand, and all this stuff #Brad helped me with. So, you know, he’s probably been the most influential.

Nick: He’s got to be one of the most helpful people I’ve ever interacted with. And he’s just got a way of cutting through the bs faster than, than anybody else.

Mark: Well, he’s genuine. And, you know, if I could define one thing I care about in life but certainly in entrepreneurs and other VCs and people that work at #Upfront and other VCs that I work with, is authenticity. #Brad is who he is and I love that.

Nick: Yup. Yup. I traded notes with him this morning and he’s the first, first person to give me the most clear feedback and, and the most direct feedback on sort of my path forward with #New Stack and, and some things we’re thinking about. It was some of the best feedback I’ve gotten. Okay, and then, #Mark, just to wrap up here,  what’s the best way for listeners to connect with you?

Mark: Listen, there’s a couple of ways. I blog at #bothsidesofthetable and people put comments there. And I do respond to comments, I do notice who puts comments. If I’m honest it was a little bit easier when I was using WordPress because the plugin they had to discuss was a little bit easier for me to comment on. I think Medium is getting better at their commenting system. They’re not where I need them to be. Although I love Medium as a product. I’ve loved using it. But I do read those comments. And I have built many authentic relationship including #Ryan Graves, original CEO of #Uber, now I think global head of operations. #Tristan Walker, who I funded at #Bevel, first met him through my blog. #Sam Rosen who’s the founder of #MakeSpace, first met him on my blog. So you start to see the same kind of names, then you get to know them. Twitter, you know, I’m @msuster on Twitter. I read almost every tweet at me. Some, one or two days I’ll get super busy and miss it. but I read almost every tweet. Often if someone says something interesting, I’ll scroll over their name, look at their backgrounds, see if it’s someone interesting. And you start to recognize the names over time. I’m also on Snapchat msuster. I’m actually getting more adoption on Snapchat than I ever did on my blog. It’s great in that there aren’t many people putting out content on Snapchat, like real thoughtful content. And so I’ve developed a pretty decent following of people there. And because it’s video and it’s not highly produced, and you’ve got to see me with whether I’m, you know, clean shaven and in a nice shirt or a sports cap and it’s the weekend, I just am who I am on there. And people engage with me there. So I think that’s really for me, on Facebook also I have a public profile on Facebook. And I tend to, I engage with people. Now the worst way is email. I hate email. Email is a productivity killer. Email is a to-do list that I have that you get to add to whether I want you to or not. It’s an obligation. And I hate it. And I want to abolish it. But I still have to do it. I’m just not a slave to it. So if people email me, there’s a decent chance I miss it, even from important people. I do my best not to, but I got to be authentic and work on things that are important for portfolio companies or meeting new companies or whatever and I just can’t be a slave to email. But that’s the best way. Again a long answer, short question.

Nick: Well, #Mark, this has been a huge thrill for me. Thanks so much for, for your ongoing transparency, for spending the time with us today. And, and for sharing your thoughts.

Mark: Thanks for doing it, #Nick. I really appreciate it.