167. Cram Session, Episodes 113-119 (Nick Moran)

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Welcome back to TFR for another Cram Session. In these special releases, we have aggregated the takeaways and tips from previous episodes. In this installment, we will be recapping the following episodes:

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welcome to the podcast about investing in startups, where existing investors can learn how to get the best deal possible. And those that have never before invested in startups can learn the keys to success from the venture experts. Your host is Nick Moran, and this is the full ratchet.

Welcome back to TFR for another cram session. In these special releases, we have aggregated the takeaways and tips from previous episodes. If you’d like a focus refresher on previous topics covered, stay tuned for this cram session.

In the next segment, we have the takeaways and tips from the next great startup ecosystem with Chris Olson one of the most fun conversations for me discussing the emerging opportunity in the Midwest. Let’s recap the key takeaways. key takeaway number one is called why the Midwest. When Chris made his first visit to Columbus, Ohio, he met cross checks founder Sean Lin and Chris told Sean, Silicon Valley is the only place you can find and retain key talent. It’s the only place you can scale a large organization. It’s the only place you can get the smart money you’ll need to grow. And it’s the only place where people will understand what you are building. And Shawn turned to Chris and said, You’re wrong. John went on to ask Chris How many customers are located within a stone’s throw of us how many engineers can be hired on a 500k seed round, and how much office base can be had at $1 per square foot. It was at this point that Chris and Mark Kwame began researching the data on the Midwest, they were looking for key ingredients that made for thriving startup ecosystems, ingredients, including the number of engineers coming out of university, the macro economic size of the economy, the proximity to customers, and the number of billion dollar companies being built. And here’s what they found. The Midwest graduates more engineers every year than anywhere else on the planet. It graduates more CS students than any other region or country. It also has the fifth largest economy in the world. We’ll call that California is eighth. It receives 25% of all research dollars. And finally, looking at exit data. When Chris asked himself to name the billion dollar companies built in the Midwest over the past five years, he came up with four or five names were in fact there are 52 of them, accounting for over $400 billion of shareholder value. Upon finishing the study, it was clear to Chris that while Silicon Valley has accounted for the majority of value in tech over the last 15 years, the value over the next 15 years will come outside of the valley. Okay, key takeaway number two is called why now. One of the first questions one must ask is Why haven’t the large VCs acknowledged the data and developed a major presence in the Midwest? According to Chris, there were three main reasons. The first from his standpoint is that a lot of venture funds have a farming approach. They set up shop, claim their turf, and meet every company in their plot. Whereas drive has taken a different approach. They don’t farm they actively go out into the region and cold call every company that fits their thesis. The second reason is that firms are operating on an antiquated assumption. In the first few decades of the internet startups had to be physically close to technology, the technology, the talent in the ecosystem had to be dense and geographically co located. Whereas now that’s not the case. startups can access, build and deploy global tech products from anywhere. And so Chris asked the question, if you don’t have to locate yourself next to technology, where should you be located? And Shawn Lane had given him the answer. A startup should locate as close to the customer as possible. Remember that customers are the ones that fund every successful business in the long term. Investors may only fund the company for the first five years. And the third and final reason why major VCs haven’t located to the Midwest is that the data lags. VCs tend to use data to drive decisions, which is inherently backward looking. Of course, you haven’t seen as many billion dollar companies in the Midwest as the valley. But with the time horizons of this business, one won’t find out if they’ve missed out on the opportunity for five to 10 years. And even now it has already started. Chris’s study found that entrepreneurs today are building more billion dollar companies in the Midwest than in the past 50 years combined. And remember Christmas recollection from talking to Sequoia founder Don Valentine down share that the establishment thought he was crazy. In the 70s, to be building a venture firm in California, up to that point, the startup funding activity was located in Boston. His peers told him that the only place you could do startups, the only place Tech was happening was in Boston. There weren’t enough smart people or infrastructure to do a startup in California. It’s crazy to think that the pioneers of VC in the Valley were very much the contrarians of their time. Okay, and key takeaway number three is called Lessons and observations after three years. The first major lesson was one of deal flow. When drive first launched, the valley establishment assumed they’d be chasing their tails trying to put $250 million to work. In fact, not only to drive quickly find great companies to deploy the first fund, but they’ve gone on to raise a subsequent larger fund to invest in the high quality deal flow they’re seeing. Speaking of deal flow, Chris mentioned that in their first year, they saw 1800 companies. In their second year they looked at 3000. And last year, they reviewed 3500 companies. For reference, Marc Andreessen has stated that they look at around 4000 companies per year. This is an astonishing an incredible amount of high quality deal flow that they’re revealing. Okay, the second lesson here was one of startup relocation as opposed to seeing companies moving from the Midwest to California. Chris is now seeing entrepreneurs relocating their business to the Midwest. And the third major lesson that Chris learned is one of engineering retention. Here he cited the example of exact target from Indy, and how he Ascot Dorsey, how he outran the many well funded Valley based competitors. And Scott said, I have the same engineering team I’ve had since the beginning. The guys who wrote my first line of code are the guys that wrote my last line of code. And secondly, I’m so close to my customers that my CTO would go out and visit a customer every single day. Engineering turnover in Silicon Valley is a major problem and averages between 30 and 50% per year, Chris has observed in his portfolio, engineering turnover around 12%. From drive capital standpoint, the time for funding in the Midwest is now and they are already seeing it play out. Okay, let’s wrap up with a tip of the week and this week’s tip is called voc makes visionaries. On today’s episode, we talked a lot about customers. Chris emphasized the importance of being located close to those customers, spending time with them, and understanding their needs better than any company does. It is the customers that will be the primary funding source for every successful business. We don’t often think of customers as a source of capital, but they are the primary and sustaining source for companies that are built to last. I’ve spoken many times in the past about Voc or voice of customer, the simple acronym that represents the practice of visiting listening to and observing the target customer. It is frequent and focused efforts to understand a customer that makes for some of the most valuable businesses. And we discuss building a culture of customer obsession in the interview with Steve Blank. We also covered how founders don’t have to be Oracle’s yet can look like excellent predictors of the future by intimately knowing their customer. When I was developing my last product, I had over 500 discussions and visits with customers. And in the first year presenting our new concept, customers were confused. By year two, they were intrigued. And come year three, they became obsessed. I even had customers that tried to convince me to leave the prototype with them. They wanted it so bad, they take a glorified breadboard over a production unit. But that wouldn’t have been the case had we not conducted over 500 Voice of Customer discussions, the product requirements improved and the product capabilities were better aligned with customer needs. And yet despite the tremendous customer data, the engineering team frequently pushback on customer feedback and new requirements. They often refuse to believe the customer input and quantitative data that had been collected. And ultimately, this was my fault. While initially I thought it was the product managers responsibility to know the customer and define the product. The real job was to create an atmosphere where the entire development team could know the customer and define the product. My job was to include them in the process. Have them visit the customers make them ambassadors of Voc and it’s this intense customer awareness that creates the best product insights and creativity. You’d be surprised how many conversations started with me saying to the scientists and engineers, we need x and their response would be we can’t do X. Yet after spending time with customers. The development team would be saying to me, we need x and can figure out a way to do it. As mentioned in the takeaways, Scott Dorsey cited customer focus as a reason for surpassing their Valley counterparts, his CTO would go out and visit a customer every day. So how customer focused are your product people? Are the engineers a part of the process, one doesn’t need to know the future to be a visionary. They only need to know their customer.

In the next segment, we have the takeaways and tips from index investing, mastering deal flow and seeing everything at series A with Galen Mason and Brian Axelrod. key takeaway number one is called discovering opportunity in the deal flow. As attorneys in the venture industry, Galen, and Brian quickly realized that they and other service providers across the ecosystem had early access to nearly every deal. This is a major information and access advantage. But the service providers didn’t have the means to cut large checks into these companies. While the investors that did have the means are unable to get access to this volume of deal flow. Therein was the value if they could connect the key points of access with the major sources of capital, everybody wins. And in parallel, they brought down the entry barriers for service providers to participate. Maybe your standard service provider can’t cut a 100k check per deal, but maybe they can cut a 100k check into the fund that invests in all qualifying deals. In this way these service providers could participate, help the companies they work with share in the upside of their clients and get diversification across a very risky asset class. And this cell tower network of service providers as they call it includes real estate HR services outsourced CFO, venture capitalists, wealth managers, lawyers, accountants, web design and insurance. The final note here that they mentioned is that the key service providers that seem to get earliest access to deal flow includes lawyers and outsourced CFO. OK, key takeaway number two is called an index fund with ongoing value. Gailen and Brian are employing an index like strategy, they are attempting to invest in every credible series a deal in their region. Recall Jerry Newman’s comments from the episode on non unicorn investing that if one were able to invest in every venture deal, they would yield a percentage return in the low to mid 20s. Now that spans all geographies and all stages, but it’s still an astonishing figure, and the guys here have chosen the Midwest in the series, a stage for their index. Are they going to be a top performing fund? Nope. But will they have much more diversified exposure to venture in their core region? Absolutely. If you’re an LP seeking 10x returns, this is not the fun for you. However, if you’re comfortable with a diversified more modest return, you believe in your region as an underserved area, and you want to support the tech ecosystem through investment, SPC may be a great fit. OK, key takeaway number three is called mechanics of the model. The first step for Galen and Brian was to build a network of service providers in their startup ecosystem. Then the service providers that work with early stage companies as clients begin referring deal flow to the SBC managers. Also, those same service providers become the core base of LPs in the fund. And then the guy has put referred deals through the following checklist criteria. Is the company in the Midwest? Is the round being led by a credible institutional investor? Is that institutional investor investing 500k or more? Is the round size a million dollars or more? Is it a preferred equity round? And if the answer to each of these is yes, SPC invests, if not, SPC will make introductions to other investors that may help the startup fulfill this criteria. And their involvement of course does not end upon investment. They provide unique ongoing value to the startups they invest in. They have the cell tower network, they know each of the service providers and how they can provide value. When a startup needs office space, financial help, talent acquisition help legal or development work. They can call on Galen and Brian for intros to the provider. That’s the best fit for what they’re doing. Okay, let’s wrap up with a tip of the week and this week’s tip is called hubs and spokes product and channel Innovation.

I speak with many investors and entrepreneurs every week. Most investors get in touch because they want advice on how to differentiate. While I love to connect with others in the industry that are investing, I can save us all a lot of time right now. I cannot tell you how you’re special. What I can do is talk you through the thought process of how one differentiates. And in our business, it’s simple. Number one, how do you provide unique value that others don’t? Ie What is your product? And number two, how do you connect with promising startups before they’ve closed arrays? IE, what’s your channel? That’s it, value and deal flow. GALEN and Brian, get it. While you can criticize the index approach as much as you want. It’s clear that they do offer value, and they see a lot of deal flow. The big issue I see is that folks often neglect one of these two things. And more often than not, it’s number two related to channel. There is a parallel here with startups that we are investing in. Every startup has a product strategy and a channel strategy. And the best startups are just as innovative on the channel side as they are on product. Let’s consider an example. Were Dropbox in box the first companies to attempt file storage, sharing and access from the cloud. Of course not. But it’s clear that they were the big winners. While I think they both did a nice job on the product side. He was their channel marketing strategy that really accelerated growth, Dropbox on the consumer side and early pioneer of viral marketing and box on the enterprise side, employing a hub and spoke strategy. I’ve spoken many times on the program about the innovative water analytics product that I launched. The existing water testing process was a 30 minute 15 Step chemistry procedure requiring expert precision. And we developed a product that allowed an unskilled worker to perform four procedures in less than five minutes with only one step. And while the product is to thank for creating incredible customer excitement, it’s not what got us to 100 million of revenue in the first year. It was the channel strategy that led to a Fast Furious revenue ramp. While conducting 500 Plus customer meetings during development, I learned a great deal about users, and not just what they buy, but also how they buy. On one such visit. A customer at one of the largest water municipalities in California casually mentioned that they’d require around 100 units, but that their network would need more than 1000. It turns out that if you look at a map of large urban water treatment facilities, it looks very much like a series of hubs and spokes. The largest facility in the area, exports their water to smaller facilities that export their water to the consumers tap. And unbeknownst to me, each of these constituents follows the leader so to speak, whatever processes and products the hub is using is then adopted by all the spokes. So one modest sale to a major hub yielded a waterfall of customers connected to that hub. After this realization, we proceeded to include all the major urban hubs in our voice of customer testing, when the customer is a part of, or at least feels like they’re a part of a new innovative product creation. He become your top evangelists. Long before product launch, we seeded the market with an aggressive Hub and Spoke strategy. We put as much effort into an unprecedented channel strategy as we were putting into the product. The reality is that some of the worst products when big because they own the channel to the customer, and some of the best products fall down because they can’t reach the customer. Do you want to invest in startups that are focused on just one of the two? Or would you rather invest in startups that are equally innovative on the product as they are on channel? And at the end of the day, we must all look in the mirror when the best startups are choosing their investors, what do you think they’re looking for?

In the next segment, we have the takeaways and tips from economic theory in venture capital with Mark Schuster. key takeaway number one is called competing with nonconsumption. 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 into a multi billion dollar company, then what you need to think about is how do I build a product that appeals globally to a massive amount of customers? 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 a 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 far too many features. Thus, they have to charge high prices to all whereas a smaller company with a more narrow focus can be much better at addressing that specific problem for a cheaper price. key takeaway number two is called 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 they don’t cannibalize their own business. key takeaway number three is called a simple heuristic for growth versus profits. Marc’s input here was that there’s no right answer, and every situation is different. But he did give us a simple framework to think about when balancing growth versus profit. When a business is not profitable, Mark looks to see if they are investing in marketing, expansion and product development. If so, they are enabling growth in sacrificing short term profitability. They could be profitable if they pulled back on all these growth efforts, but they have access to capital and the ability to expand. Whereas companies that don’t have access to capital cannot finance efforts that drive them to negative profit. In these cases, businesses should focus on being profitable. So his simple advice is, if you have access to capital, focus on growth, if not profitability, okay, and key takeaway number four is called it’s all about people. When discussing Marx lessons from Nazim, to lead, 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 shape 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 marks macro approach as an investor. His process is simple, he first needs to eliminate ideas that clearly won’t work. He then needs to back the most talented people he has access to, because 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 entrepreneurs whose vision maps to your opinion of the future. So operationally, Mark asked himself, how do I get in front of as many entrepreneurs as possible, and then be talented enough to figure out how to supplement their teams with what’s missing, and then be good enough that downstream VCs or large companies trust him when he says that the team is uniquely positioned and capable of solving the problem? Mark is not trying to predict the future. He’s trying to bet on jockeys that will be best positioned to respond, react and capitalize on what the future looks like. All right, let’s wrap up with a tip of the week. And this week’s tip is called red versus blue in venture capital. Based on the title, you’re probably thinking this is a post about politics. It’s not. This reference is to red oceans and blue oceans as discussed in the book blue ocean strategy from authors Melbourne and Kim. And I touched on this concept previously in a post called Finding the whitespace. But I’d like to put a finer point on it here, and there is no topic that applies more directly than disruptive innovation. In the interview Mark mentioned the goal for disruptive technology is to compete against nonconsumption. His position is that startups should focus on developing inferior products that can access a much larger number of customers across New applications. And this point was also discussed in detail in the book. A red ocean is one where the market is set, there’s a certain volume of customers that purchase a product at an average price, the market is well established and does not fundamentally change. Thus, the strategies employed by large players in these marketplaces are one of share gain. Every player is trying to take market share from their competitors. It’s a competitive bloody fight for more market share. Hence, the ocean is red. Blue oceans, on the other hand, are emerging markets. They’re not yet fully established, the number of customers and the price a product can command are both in flux. And there are no direct competitors. The fight is not one of competition, but rather awareness. Companies fortunate enough to be playing in a blue ocean have the only product of their kind. By introducing non consumers to their product, they grow the market itself. This is why at new stack, we talk about companies that are creating new markets or fundamentally redefining the market they’re playing in every market is price times volume. If you’re familiar with Mecco maps, imagine a Mecco. If not think of a stacked bar on a chart. Each stack within the bar represents a competitor with market share. In a red ocean, the size of that bar is fixed. So if you want more revenue, you’ve got to take it from others. With a blue ocean, the market is completely redefined along both price and volume. Prices significantly lowered, allowing access to a huge volume of customers that previously didn’t purchase a product for this problem. The original target market is now only a small percentage in relation to the total customers accessible. And in addition to new types of customers, you get to add application adjacencies as well. So you take a narrow customer that uses a product in a limited way. And you allow masses of customers to use a product far more than they had previously. Mark’s example was the Sony Walkman. A software example that just popped in my head is GPS. Remember the days of Garmin, placing that egg shaped plastic device on your dashboard for turn by turn directions. I thought it was great at the time. But I only had one and only used it in one of our vehicles. And I travel a lot. I never had an army when I really needed help with directions. Then along came Google Maps for the whopping price of free. I always have my smartphone on me and now can use turn by turn GPS navigation in my car in my wife’s car when I’m with friends when I’m out of state. When I’m walking around Chicago’s loop, or when I’m biking the trail systems in the area, the number of applications has exploded, making me a much more frequent user of GPS. And the total market accessible has changed by an order of magnitude. Folks like my parents who claimed they would never buy a Garmin are now everyday users of Google Maps. By lowering the price and easily accessing mass market consumers in a frictionless way, the market for GPS has been completely reinvented. Now, I wouldn’t suggest that every startup adopt a free pricing strategy for their products in order to create blue oceans. We all don’t have the same economic luxuries of Google. But one can see why investors look for disruption in early stage startups. The Innovators Dilemma is real. Large corporations continue to shrink their r&d departments. Innovation behind the moat can destroy the margin profile for an existing p&l. While incumbents may be forced to play in the red, where will you play

that will conclude this cram session installment jump on the TFR website at full ratchet dotnet today to sign up for the newsletter and receive all the info on special content episodes and the best articles written on startups every week. Until next time, over prepare, choose carefully and invest confidently. We’ll see you next time.