181. Cram Session, Episodes 130-136 (Nick Moran)

181. Cram Session, Episodes 130-136 (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:

Transcribed with AI:

0:03
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.

0:22
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.

0:42
In the next segment, we have the takeaways and tips from how Amazon Fitbit and snap one where Apple pebble and Google did not with Ben Einstein.

0:57
All right, that was a great interview with Ben, thanks so much to him for coming on the program. Let’s recap the key takeaways. key takeaway number one is called narrow customers low expectations, then looks for companies solving a specific problem for a specific customer over those that are solving something a little bit for everyone. We discussed the comparison of Google Glass and snap spectacles, one with broad focus the other narrow. Interestingly, from an engineering standpoint, they are nearly identical radios, molded plastic lenses, batteries, buttons and sensors. But glass tried to be all things to all people in very general use cases. Whereas spectacles was designed for a single purpose with a very specific function. So Google created really high user expectations. Whereas snap set user expectations very low. And setting these low yet targeted expectations allows one to delight customers instead of disappoint. Ben reviewed the first thing that snap did really well. They chose a specific type of person Gen Z for their customer. The whole experience was streamlined for a very specific group. The product was also very specific in its design and function so as to appeal to the group. bold colors sold on demand in interesting vending machines, leveraging both scarcity and FOMO. We also compare the launch of Siri with Echo. These products were similar in nature, but scope was very different. Apple went broad targeting all customers with high expectations. They integrated Siri into all new phones with many features. Whereas echo went with a physical product that sits in one place and has simple to understand functions. Launching as a platform in series case, versus launching as a product in echos case. Echo set low user expectations and increase them over time. And Ben reminded us that Amazon is often under the radar, under marketing and over delivering. Their algorithm is designed to delight people by creating much better experiences than the expectation. And Ben acknowledges that startups cannot compete directly with companies like Apple and Amazon. In his example, he said that there were 1500 people working on the echo before launch. But what startups can do is change the game create unfair advantages by focusing on a specific problem. startups do have an advantage. They are small, flexible, and can approach problems in unique ways. We also discussed the second thing that snap did really well with the spectacles, which we will cover and key takeaway number two, Crossing the Chasm with benefits, not features. Ben has noticed a recurring issue with failed hardware startups. They are too focused on features over benefits. Here we reviewed the example of Fitbit versus pebble. Fitbit chose something that the mass market cares about health and fitness. And they built a brand around the fitness use case. The product website and even retail locations reflect a lifestyle brand, where pebble focus their marketing on what it is that bit focused on what it does. Ben said companies that sell low cost consumer electronics must be solving a problem that early and late majority populations identify with. The technical rich feature sets in pebbles case appealed to the innovators and the techies, but they could never cross the chasm and reach the market majority. These customers don’t buy for the tech they buy for the benefit. This is evident in each company’s website. Pebbles featuring their E paper watch with the statement. Be Fit and smart fit bits featuring a woman running in the rain with the statement. Find your fit, benefit oriented brand marketing evokes emotions. And this is how the success stories have reached the mass market. Okay, and then key takeaway number three is called just saying no to crowdfunding. Ben is the first investor I’ve spoken with that is down on product based or donation based crowdfunding. He said it’s a focus issue. The founders are focused on this Finding a video that converts rather than creating a product that delights. Ben said that quote, it’s so much more powerful to have someone give feedback on how their experience actually was using a thing, versus someone buying into the idea of a thing, which almost inevitably will let them down and quote, he wants to hear founders talk about the 10 people that are using and loving the product. He wants to see videos of excited users talking about their experience. From his standpoint. 10 real delighted users are much more powerful than 10,000 non users that hit the back this campaign button. And Ben did suggest that the most important part of this is an intense focus on how you can learn as fast as possible as early as possible before you ship. Okay, let’s wrap up with a tip of the week. And this week’s tip is called a thesis begins with a moat defensibility. switching costs, barriers to entry. We hear these terms often when discussing startups. It’s not only important to build something of value, but value that can be protected. Many in venture capital referred to this as the moat. Renowned investor, Terrance Yang was asked recently, as an investor, if you could ask founders only one question before making a funding decision. What would it be? And Terence his answer? How are you building a unbreachable moat protecting a very valuable castle. There are different types of factors that can create a moat, some internal, others external, an external example would be regulation. In a previous life. I have dealt with regulatory agencies including the FAA while working in aerospace and defense, and the EPA while working in the water industry. In both cases, the regulations were so onerous that getting a product to market was a multi year regulatory process. We even employ lobbyists to work on our behalf. While this puts strain on our new product development efforts. It also created enormous barriers to entry protecting the value of products in market. There are also internal factors that create Moats. These are factors that reside at the company or product level. Union Square Ventures has a thesis to invest in companies with network effects. Big surprise central to their thesis is a moat network effects drive more user value, raise entry barriers and increase switching costs. The problem with external factors is they often do more to limit innovation rather than promote it. External factors favor the incumbent, whereas internal factors favor the innovator. We can argue the merits of internal versus external moats, but it’s certainly easier to exert control over those factors that are in house. If the moat exists at the product level, you own the moat? If you’ve hired a band of brigands to build and manage your castles moat, you may own the customer, but the master of the moat owns you. Now as an investor, instead of looking for startups with a variety of different moats, what if your thesis had a built in moat? What if the very category of startups you invest in creates enormous barriers to entry brand equity and high switching costs? This is why I invest in smart hardware. Today, Ben mentioned a quote from Brad Feld, I don’t invest in hardware, I invest in software wrapped in plastic. There’s a big difference between a dumb gadget that collects dust, and a smart device that gets more useful over time. shelfwear is to SAS as the gadget is to smart hardware. There are a number of different reasons why I invest in smart hardware. I’ve developed a smart hardware product. I love the business model. I love the annuities, I love that there’s constant pressure to create more customer value. I love that a sale is the beginning of a customer relationship and not the end. But the thing I love most is that the smart hardware moat is incredibly wide and enormously deep. Not only is it exponentially more difficult to do smart hardware than software alone, thus raising entry barriers, but the connection and brand equity that consumers feel for physical products far exceeds that of virtual products. The reason for this is that smart hardware benefits from many principles of behavioral economics. These principles serve to deepen the relationship with the customer. a sampling of principles that are far more powerful for physical products than virtual includes the sunk cost fallacy, the default effect, escalation of commitment, the status quo bias, perceptual contrast, social proof in the consistency principle. All these factors make the customer more likely to buy to use to promote and to convince themselves that they’ve made a great purchase. Doesn’t have to be hardware. Absolutely not. But should emote be fundamental to startup strategy from day one. You know my position and it founders must face this when designing their business. Why shouldn’t investors when crew writing their thesis

10:06
in the next segment we have the takeaways and tips from the importance of storytelling VC EQ and the LP GP dating game with Trey Hart

10:21
Okay, lots of fun in that discussion with Trey. Let’s recap the key takeaways. key takeaway number one is the general partner limited partner dance. We kicked off the conversation by discussing the importance of storytelling. This transcends the LP GP relationship, and even the venture business. one’s ability to synthesize their experience and craft a compelling narrative is essential in relationships and in sales. Ultimately, a VC pitching an LP is a sales process. Both capital and expertise is for sale. Tray emphasize the importance of timing during this engagement. He said that one needs to know when a sale is going to happen. The people that stand out are those that understand the cadence of fundraising best. They need to know when to push and when not to push. And the reality is that a lot of LPs don’t know what they’re looking for, which can put a lot of stress on the GP. Tre suggested that the most important component is framing the conversation. He aims to have an open and transparent meeting where the LP is clear about what he’s looking for, so as not to string along the GP and waste everybody’s time. As he said, There are way too many people to meet in this business. It would serve everyone to clarify intentions upfront and engage under the right pretense. Okay, key takeaway number two is called GPS, that standout trade thinks of GPS in two groups. Number one, those that are easy to give money to but are hard to get into. And number two, those that are hard to give money to, but are easy to get into. In the LP community. This is what separates the bad from the good and the good from the great trades cited. Lindell Ekman, as someone who has routinely given money to the ladder and enjoyed tremendous success doing so. The best in the LP business are those that make money by giving to managers that are yet unproven. I’d venture to guess that it’s a similar parallel with GPS giving money to entrepreneurs. Proven founders often raise at very high valuations early on limiting return upside. While first time founders may be much harder to assess. The upside opportunity is higher for those GPS that take the risk. Hence, the return profile for the earliest stages in venture capital are often the highest. Trey said that the truly great GPs have mastery of stage sector or geography. And in some cases, all three, a few unique characteristics that he’s looking for include an actual track record unique relationships within the geographic center of investment, and also how integral a part of the ecosystem the GP is to all the most important things that spin off, including companies, entrepreneurs and technologies. And finish this point tre said that northern is trying to invest as much around those clusters and centers of influence as possible. Okay, and then key takeaway number three is called GP red flags. In any engagement, Trey’s looking for cues that GP may have an integrity issue or an emotional intelligence issue. The following are red flags that he’s observed over the years. First, do they push too hard too early trying to close the sale before a relationship has developed. Next, do they misrepresent their track record? One of the most difficult parts of being an LP is figuring out who truly led investments and deserves credit, misrepresentation and inflating one’s accomplishments rarely has a positive outcome. Next, we have GPS that do all the talking. They don’t bother to find points of commonality, whether it’s family, hobbies, background, investment, philosophy, et cetera. The points of commonality are a great way to establish rapport and build a relationship. Remember, this is going to be a long term relationship. One where it’s not easy for the LP to get their money back if they have second thoughts. And finally, tree mentioned that with the good ones, you’ve got to make sure they’re not having strategy drift, and that they have a team succession plan. And I’ll leave you with a quote from Trey on a clear disqualifier. He said, when you’re trying to make judgments where you’re thinking, I don’t want to give people money. If I think there’s an integrity issue, you’ve got to trust your gut, because it’s almost always right. Okay, let’s wrap up with a tip of the week and this week, it was called what winning looks like in VC. In today’s interview, we quickly discussed the key metrics by which venture fund managers are measured. I’d like to use this week’s tip to review what each of these metrics are, who values each of them, and why some can be manipulated while others can’t. The metrics we will review include DPI TVI IRR follow on in bulge bracket follow on. And in the case of the first three, I will use definitions from Silicon Valley Bank. First we have dpi. This is the ratio of cumulative distributions to limited partners divided by the amount of capital contributed by the limited partners. The nice thing about this metric is that it compares actual dollars distributed to LPS against the dollars they invested. It’s a true cash on cash multiple. The drawback is that it’s typically not usable until later in a funds life. It’s rare for a new fund to have exits and cash distributions very early. So the metric doesn’t paint a clear picture early on. From my discussions with a range of folks in the industry, it appears that a three to 5x DPI puts you on the big board. Next, we’ve got TVP AI. This is the sum of cumulative distributions to limited partners and the net asset value of their investment divided by the capital contributed by the limited partners. So this metric accounts for both cash distributions to LPs and the net asset value of existing investments that they have not yet exited. In theory, it sounds great. But the problem here is that paper valuations in venture are pretty unreliable, some may go to zero, others to the moon, and yet others may languish in the private markets for many years, delaying an exit and cash distribution. It’s also worth mentioning that neither of these first two metrics account for the time it takes to return capital, which leads us to our next metric IRR. internal rate of return is the annualized effective return rate, which can be earned on invested capital, ie the yield on investment. This determines the time adjusted yearly rate of return. Many great firms are in the 20s many not so great are in the low single digits. On paper, this would seem like the best metric for assessing winners. However, it’s an easy metric to manipulate. GPS can do a number of things to inflate their IRR. Namely, they can borrow money from a bank at low interest, invest that capital in a startup, and then call the capital from the fund much later. This effectively reduces the time between when the capital was invested. And when the distributions are made. If you reduce the time component, then the IRR goes up. I’ve even heard of cases with early exits, where the capital isn’t officially invested until after distributions are made. This causes some firms to show doctored IRR that are very, very high, particularly early in the funds life. Okay, the next metric we have is follow on. This is simply a percentage that represents the number of companies that have received follow on funding versus the total number of companies invested in. This metric can be used to assess series A follow on ratio, Series B, et cetera, depending on how mature investments are. And the final metric we’ll discuss is bulge bracket follow on. This is a key metric that I hear about more often lately. Great institutional investors don’t care about follow on alone, they want to see the percentage of follow on by the best performing a and b investors. If you’re a GP, how many of your investments received funding from Sequoia Excel Bessemer, KPCB, etc. When assessing funds very early in their lifecycle, this can be a helpful signal that shows both quality of investment relationships with top firms and outcome potential in discussions with a wide range of LPs, including high net worth ultra high net worth family offices Fund of Funds sovereign wealth, foundations, pensions and endowments. My big takeaway is that there is no silver bullet each type of LP and each individual LP looks at different metrics. Trey likely has his own priority, and even cited the merits of dpi as it can’t be easily manipulated. Many high net worth retail investors also tend to prefer cash on cash multiples over IR RS or follow on. Regardless, each GP must measure them all and be measured by each. Those that optimize for one at the expense of the others may not be raising a fun two.

19:24
In the next segment, we have the takeaways and tips from dispelling conventional wisdom with Eric Paley.

19:35
Wow, I think that was one of my favorite interviews of all time. Thanks again to Eric Paley for joining us on the program. Let’s recap the key takeaways. key takeaway number one is called capital as a magnifier. Before we got into the study, Eric first reviewed the fundamental principles of raising capital. He said that VC is a magnifier of whatever you have, it can magnify the good things or the bad. There is pressure for VC Use to deploy capital in increase their assets under management. They want to raise fast and deploy fast, which is great for strong businesses that are undercapitalized. But for those that haven’t determined how to grow in in a creative way, capital only magnifies their problems. While growth is the best way to assess if the market cares about your product, companies often throw money at things that aren’t working. founders and investors are equally culpable. The founders are chasing growth and the investors are pushing for it. Yet scaling things that don’t work only damages the long term potential of the business, and it becomes very hard to unwind. Remember that money has no intelligence, it’s just a multiplier of the good or the bad. And the results of Eric’s IPO study showed no causation or even correlation between the amount of capital raised and the exit outcomes. Just because one can raise 20 million on an $80 million pre doesn’t mean they wouldn’t be better off taking 10 million on a $40 million pre. Even though the founders suffer the same dilution for each capital is not the driver of successful outcomes. It is merely an enabler. Okay, key takeaway number two is called the pro rata founder impact. He spent a lot of time discussing the impacts of pro rata. Let’s first address the situation for founders. When early investors have additional dry powder, it sounds great to entrepreneurs, is presented that this helps reduce the funding burden in future rounds. However, what often happens is that when things are going really well, there’s no scarcity of capital. And in fact, allowing investors to take their pro rata presents a difficult challenge for many founders, I just went through this situation with a founder doing a Series A, there was so much demand for the round, that he was feeling the pressure from all sides to limit their follow ons. So unfortunately, when things are going well, this is not a positive. Now, let’s look at the other side, when things are not going well. When a startup is struggling, and the founder really needs follow on money, the VC typically has much less interest in participating. It’s their right to participate, but it’s not an obligation. So when things are going great, the founder doesn’t need the follow on and when things are going poorly, they need it and can’t get it. Let’s look at one scenario where capital reserves can be an asset. If the early investor preamps, the series A sets the price and invest the capital, this can provide a lot of value. It’s a significant time saver for the founder. Rather than take 100 calls and find a lead. They’ve got an early lead and a large commitment. However, very few firms do this. early investors are not incentivized to price a new round. Remember that a pro rata entitles the investor to maintain their equity percentage and even increase that percentage with super pro rata. So no matter where the price ends up, they know what percentage they’re entitled to, thus eliminating the incentive for them to lead. Okay, key takeaway number three is called the follow on impact for investors. Alright, now that we’ve reviewed pro rata and follow ons for founders, let’s transition over to the investor side. So conventional wisdom is that following on with your winners is the best way to drive returns. As Eric articulated, if you look at incentives in the industry, it’s obvious why this is conventional wisdom. Fund managers are rewarded by having large amounts of assets under management, which drives them to deploy more capital. and easiest way to deploy more capital is to double, triple or quadruple down on your existing portfolios. If you’re reserving $4, for every initial $1 You invest, your weighted average cost basis is a series B investment. If you look at the average price you paid for equity in startups, the price is much closer to a later stage valuation. And many of these firms consider themselves to be seed firms expecting seed stage multiples. This also increases risk significantly as the fund ends up with a much more concentrated portfolio. The majority of dollars invested will be in a small number of perceived winners. And if these don’t work out, it’s catastrophic to the portfolio. The range of outcomes has much fatter tails, with some funds doing really well while others lose the majority of their committed capital. Contrast that with a diversified portfolio where the manager stays at the seed stage and invest more money in each company at this stage, and also makes many more investments. Those that argue the merits of following on often present the fully optimized portfolio where they fall down to the winners and they passed on the losers But the data suggests that VCs are actually very poor at distinguishing between their winners and losers when making follow on investment decisions. Another negative is that these seed turned Series B investors are only investing in their existing portfolio at these later rounds. Without realizing it, they’d become Series B investors that only have access to a very small number of companies being funded at B. If access is everything in venture, why would an investor limit yourself to such a small slice of the market? According to Eric, this would mean that every firm believes that their series B graduates will outperform all the other series B companies getting funded. A final counterintuitive aspect is that pro rata investors want to invest more money when the price is higher. So while typically investors want the best price, those already in the deal put more money in when the price is high. Eric told us the situation with his company Brontes, where a previous investor wouldn’t leave the deal at 30 million, because they thought the price was too high. But when someone else decided to lead at 50 million, they wanted to make an even larger investment.

26:13
The final point that Eric made on the problem with pro rata is that from a return standpoint, the first check in is always the check with the highest returns. For those really looking to improve their returns and not just assets under management. Maybe the focus should be investing more early instead of late.

26:32
Okay, let’s wrap up with a tip of the week. And this week’s tip is called What killed sprig. If you’ve been following tech media this week, the big news was that sprig is shutting down. We’ve spoken a number of times about sprig with Sunil Shah and others on the program and routed the company for its incredible rise from fledgling food delivery startup to the next on demand unicorn. Different from many other food delivery startups sprig was full stack. They created the recipes, their chefs prepared the meals, they had a fleet of delivery folks often pedaling around the streets of Chicago. Their well crafted meals were a hit amongst the busy urban professionals looking for a healthier alternative to take out. In a way they had created their own restaurant with no dining option and the guarantee of delivery in less than 20 minutes. Personally, I value delicious hot meals. I often like to eat dinner at home. And above all, I don’t want to spend an hour cooking something mediocre, or waiting for cold unhealthy delivery. For those reasons I was an immediate sprig convert. During the first couple of weeks of use. I was impressed. The food was pretty good. Not always hot, but quick and satisfying. I recommended sprig to friends they recommended to their friends, and a lot of people in the extended network were beginning to use sprig. Then slowly, I began ordering less frequently. Eventually I stopped altogether. As I spoke with friends, it seemed like they went through a similar cycle. Everyone was excited at first and then slowly stopped using the service. As I reflect on my churn story, a few things come to mind. Number one, delivery was inconsistent. Most nights the food arrived in less than 20 minutes. But there were a couple of scenarios where they had issues and it took over an hour. As you can imagine this was both confusing and frustrating as the app showed a delivery person doing circles around my building. While I convinced myself I was going to starve. The second thing that comes to mind in my turn story is that delivery was awkward. sprig made a decision that I thought was really smart. They disallowed the customer from paying a tip. I thought this was brilliant. As I always find it awkward to figure out how much to pay a delivery person 20% of the meal price 20% of the meal price plus a few bucks is the delivery charge already included in the cost. I’m often confused and they made a smart step in the right direction. The problem I still felt guilty and awkward not paying a tip. Despite sprigs insistence on not paying a tip. Delivery remains an awkward exchange. The third thing that comes to mind in my turn story is that interruptions changed my behavior. While I was still using Spring, they had an unplanned break in service. I’m not sure how long the pause was because I never came back. I believe it may have been a couple of weeks, but in that time my habits quickly changed. I found other solutions for dinner and never found a compelling reason to reengage with sprig. And this last point relates to the single biggest reason why I left sprig and never returned. Ultimately, the food just wasn’t great. It started off strong, pretty warm, seemingly fresh, well crafted, but over time it started showing up cold. Often the meal was pushed to one side of the paper bowl. It was served in presenting a displeasing, sloppy appearance. And worse yet, I started receiving meals that just weren’t that good. In a way it was anticlimactic. They came out of the gate strong with delicious meals, then between recipes, ingredients, appearance and temperature. They just didn’t taste very good. If the meals were fantastic, early, and remain fantastic. I would have dealt with the delivery issues and interruptions, but it wasn’t and I churned per the interview today, it’s pretty clear that the unit economics for Sprague were upside down. They could not create and deliver meals to customers for less than their cost. To Eric’s earlier points. They were magnifying problems throwing money at scaling a system that didn’t work. And I imagine that these problems were exacerbated by capex that outpaced CRVs when customer acquisition cost is high, and lifetime value is not scale is not a solution. I’d imagine that CEO Goggin biani and sprigs investors plan for much higher customer lifetime value. But bad product is the ultimate equalizer. The minute the customer experience becomes unpleasant, give them a reason, and they’re gone.

31:35
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.