20. Non-Unicorn Investing (Jerry Neumann)

 

Nick:   New York VC Jerry Neumann joins us on the program today. He’s a veteran ad-tech and internet start-up investor, founder of Neu Venture Capital, and writes really great content over at his blog reactionwheel.net. Jerry, thanks for joining me today.

Jerry:   Hey, Nick, glad to be here.

Nick:   So can you kick us off with your background in how you first became involved in venture?

Jerry:   Sure. I’m actually an accidental venture capitalist. I was hired by a New York company, a large Fortune 500 company, almost twenty years ago. They wanted to build an interactive division, as they called it back then. Interactive. And they were loking for somebody who knew something about the internet and could help them buy companies in that field to build up that center of their business. Turns out, back in the mid-nineties, you couldn’t buy any good companies because the good companies would sell themselves, so we ended up investing in companies instead. And we became—we invested in about twenty-six companies in the nineties, did pretty well until about 2000 when the dot-com bubble burst and I went on my own after that.

I ran my own investing firm for a few years and then I started several companies, one of which got pretty big. And then when I left there, I started investing again about eight years ago.

Nick:   Was—the company that you started, was that in the ad-tech area?

Jerry:   It was. The company I started was about ten years ago, so it was kind of proto ad-tech. We were building a commodity style market place for consumer information. T idea being that people are selling your information. If there were a marketplace, you could sell your own information instead of have somebody else sell it, and you could profit from your own information.

Nick:   Interesting. So how long have you been doing Neu Venture Capital formally?

Jerry:   Uh, guess about seven years, eight years. Since 2008.

Nick:   Very cool. Okay, so today’s topic is about betting on ponies, not unicorns. So for those of you who are not familiar with Aileen Lee’s famous article on unicorns in TechCrunch, can you give us a brief overview of her study, the results, and the lessons from those results?

Jerry:   There’s this idea in venture capital that returns follow a parallel, right, so very few companies determine the outcome of your portfolio. You if you have thirty companies in for portfolio, you may have one or two that make all the money, and you may have a few more that don’t fail. Because of the skewed nature of these returns, you need to have one of these unicorns, one of these really high returners, to make a good fund. So in the extreme, if you weren’t invested in Google in the 2000s, then you weren’t one of the top venture firms. If you weren’t invested in Facebook, more recently, then you couldn’t have been one of the top venture firms. You need to have some of these billion dollar plus outcomes to be one of the top firms. So there’s this idea, this sort of binary outcome where you have billion dollar plus companies—start-ups that have become billion dollar plus companies, and then you have everything else.

So she went and she looked at fifteen hundred venture backed companies over the past ten years, and found that only thirty-nine of them had been valued at a billion or more, which shows you the kind of rough odds of trying to get one of these unicorns in your portfolio. So it was thirty-nine billion dollar or more exits and it was one thousand five hundred and thirty-eight companies that she looked at over ten years.

Some of the other statistics that I ended up using in my article were it took about seven years on average from founding to exit, and then when you look at the big companies, it was Facebook, it was Google, it was Amazon, it was Cisco, it was Apple. I mean, every decade had one really outsized return company.

Nick:   So, you start off your article—fantastic article—about sort of betting systems and the horse racing space, kind of analogizing it to venture space. So can you tell us a little bit more about some of your observations as a guest in that horse racing world?

Jerry:   Yeah, I know, I mean it was just kind of an interesting way to start the article to just kind of get into it. But I had a friend that worked for the Daily Racing Form way back when and I used to go to the races with him. The Daily Racing Form was a print publication. I don’t even know if it still exists. Where they published statistics on all the horse races around the country. If you were a serious horse racing aficionado, you would read it to find out which horses were doing well, and then when you went to the races, you would look at their past performance against different horses on different conditions and try to figure out “what are the odds that the horse I like is gonna win?” so you could make better bets. And everybody who worked for the racing form had these statistical models in Excel essentially where they would take all the previous racing for that horse and for all the horses is was racing against, and other horses, and conditions, and they would try to predict which horse would win and what the odds were. So they could make informed bets.

Nick:   Sure. Reminds me of Fantasy Football a little bit.

Jerry:   Except it was really money—well, I don’t play Fantasy Football with real money. Won’t say that on the air. But yeah, it was—people would put real money on the line. They’d go to the races and they’d bet quite a bit of money.

Nick:   So it sounds like each of these individual gamblers had their out sort of system, and their own statistical approach to making bets.

Jerry:   They did, and I think most of them came out about even. Horse racing is pari-mutuel, so you’re betting against the other people at the track, and potentially, if it’s networked, from other places, but you’re betting against the other betters not against the house. The house just takes its cut. So people would come home basically more-or-less even, less the cut, which is what you’d expect if you were betting randomly. So none of the systems I saw were great, and having a statistics background, none of them really made any sense to me either. They were more really hunches. Now I know there are people who could actually pick odds better than the crowd. People who are employed by the casinos in Vegas at the sportsbook, they can pick odds better than the crowd and that’s why they’re employed doing it. But for most people, you can’t pick better than the professionals. That’s who you’re competing against. You’re competing against professionals in a game like that.

Nick:   Right, it’s gonna be more anecdotally based instead of an exhaustive statistical approach. So, Jerry, you go on to mention two main VC strategies for investing in unicorns, and you tie it back to sort of this horse racing analogy. There’s an easy way and there’s a hard way. Can you describe each and why both are actually quite difficult to pull off?

Jerry:   Yeah, so if you think about the horse racing example and that most investors are analogous to the horse racers. I mean, in some sense you are competing with all the other investors to get into good deals and to price deals. You can’t expect that whatever your system is is going to be better than the average system. You can’t believe that, on average, you’re smarter than everybody else in the field. And since investing in a company is more of an option based system, there’s gonna be somebody, and generally the person who’s dumber than you, to invest higher than you in any given company. So how do you win? How can you make money if the dumbest guy in the room is the one setting the price and so the price is probably too high?

Well, there’s a couple of ways, I think, that professional venture funds—large, actual funds—have come down to in the past five, six, seven years to win is know real, proprietary deal flow. So, in the past, venture capitalists would win because they would see deals that nobody else would see. They’d have this propriety deal flow, they would see the deal first, they would put an offer in to invest before anyone else even saw it—or maybe even a couple of other firms saw it—so they could get  a good price. These days, where you have companies like AngelList and entrepreneurs that are much savvier about getting their company in front of a lot of people, it’s much harder to simply be one of the few that sees a company. 

So how do you make money is everyone sees a company and the person likeliest to offer the highest price is somebody who doesn’t know what they’re doing? Then you’ve got two strategies as far as I can tell. One is you either have a reputation among the entrepreneurs as being the investor that can actually add value. Most of them, you know, most people can add some value but if you’re not at the company with your sleeves rolled up day after day, the amount of value you can add as an investor is pretty limited. If there’s a venture firm where the entrepreneur thinks they can add outsized value, they’re probably more likely to go with that firm event at a lower price. Some of the really well known venture firms will come in and they won’t compete on price. They’ll say “Look, here’s our price. You can get a better price from somebody else. But your outcome will not be as good as if you went with us.” And if they have a record to back that up, entrepreneurs will still pick them. So you’ll see entrepreneurs picking Sequoia or picking Union Square Ventures even if they’re not the high bidder. And that’s because they believe that those venture capitals will help them get a better return for their company in the long run. And that’s a very rational strategy for the entrepreneurs and it’s a great place to be if you’re a venture capitalist. But there’s only a few firms that can really build that reputation as being better than everybody else.

So that’s one strategy, become the firm that is better than everybody else at some specific thing. Different firms have different sectors than they specialize in or different things they specialize in and the entrepreneurs will pick them for that. So the guys who started WhatsApp, they probably had their pick of investors when they were raising money. They picked Sequoia and the fact that it was Sequoia—I believe if it had been a different venture capital firm or a lesser venture capital firm than Sequoia, WhatsApp wouldn’t have sold for nineteen billion dollars. Part of that outcome is the fact that Sequoia was behind them.

Nick:   They’ve got that reputation and it’s probably well deserved, based on their track record.

Jerry:   Right, and now having sold WhatsApp for nineteen billion dollars, I’m sure that every other entrepreneur on earth that feels like they can get a meeting with Sequoia would like to get a meeting with Sequoia. So that’s strategy one. And that’s a hard strategy. Especially for smaller investors. How do you compete with Sequoia?

The second strategy that firms have started lately has been subject to a bit of ridicule, but I actually think it’s a good strategy… Is to invest in everything. Invest in every venture capital backable company you can find. So this is the five hundred start-ups type strategy–or the Y Combinator strategy—where you have hundreds and hundreds of venture capital investments. As Aileen mentioned in her unicorn article, if there’s only four unicorns a year… Well, alright, so you know if you’re doing a hundred investments a year, that you’re gonna have a pretty low hit rate when it comes to unicorns, but you also have a pretty good chance that you’ll be in whatever unicorn there is out there. So it’s sort of an index funds strategy, and it makes a lot of sense if you believe that average venture capitalist returns are gonna be pretty high, which they have been now and again over the past four decades. You get pretty good returns for the risk on average. But this way you smooth out this parallel return.

Venture capital returns over the past forty years have averages out at about twenty percent per year. Which is a great return, especially in this environment. But those returns have accrued almost entirely to the top core tile of firms. So the top twenty percent of firm, right. This falls out naturally from this parallel return on companies. Only a few companies are in the unicorns. So only a few companies have the outside returns, but those returns are so high that when you average them against the other eighty percent of firms’ returns, they still end up to be twenty percent. In the extreme, you can imagine that eighty percent of firms have a zero percent return, and twenty percent have a two or one percent return so it averages. I think I’m doing the math wrong there, you get the idea.

Nick:   Yep.

Jerry:   So, it’s great if you’re one of the top core tile firms, but if you can’t pick and you don’t know which core tile you’re gonna be in before you start. So you can just take your chances—and a lot of venture capitalists do that. They take their chances because it’s not their money anyway. So there’s no less than zero. Or, you can invest in everything and get the twenty percent. Now you’re not gonna get the five hundred percent. You’re not gonna have a Sequoia-like return, but you’re also not gonna get zero. It’s a rational strategy.

But that’s also hard. Because I see probably fifteen hundred to two thousand pitches a year and that’s a lot. I can’t possibly evaluate ten pitches a day. While I respond to every single pitch I get, eighty percent of them an immediate no. And my default is no, and if you get me to get to yes, then I’ll say yes. But my default is no. It’s not in my sector, I don’t know enough about the customers, you’re too far along, you’re not in the right geography—I usually invest in US and Canada… So I immediately whittle it down, and then that twenty percent, I’ll read the pitch, and then eighty percent of those I say no to. It’s like the only way I can keep my job somewhat sane. I’ll maybe serious entertain one pitch a week, meaning that I will talk to the founders, I will do the research. I don’t see how can do real due diligence on more than that. Just to be clear, I’m a one person shop. It’s just me. So if that’s the case, investing in a hundred companies a year… Investing in a hundred companies a year? I invest in five or six a year. Doing twenty times as that in a year is a daunting thought. The people who do it, well, they have a different process and more people… but they also have a more streamlined process.

You still have to get—you have to read the documents, you have to do some due diligence, you have to meet the founders. You’re not gonna invest in people you haven’t met. You have to build syndicates. This is a big use of my time is I love this company, I’ll give credit check for x, but I need to get another five hundred thousand dollars into this company. I’ve gotta build a syndicate. I’ve gotta call people, and convince them to invest alongside me. That sort of thing. Doing a hundred of those a year? That’s—you don’t have many of those companies that do that, right. It’s a lot of work.

But it’s a good strategy if you can do it. And I think, as I say in the article, if you are following either of those strategies, then stop reading. You’re doing a great job.

Nick:   Yeah, the index approach, I think can work. But to a certain degree, you’ve got to outsource some decision making and diligence. I can’t remember who I was talking to, but we were talking about the biggest challenges in venture capital and the most valuable resource and a lot of people talk about deal flow and raising the fund or finding LPs but I think, as you’ve articulated here, time is almost the most valuable resource that we all only have so much of. So you’ve got to pick and choose where to spend it.

Jerry:   Yeah. I know people for years have been saying deal flow is no longer a competitive advantage, and it’s not entirely true, but it is certainly becoming true. I think almost every good entrepreneur puts their company on AngelList even if they’re not raising on AngelList. They use it as the social network, so that they can send people to their AngelList page. Now I’m sure there is maybe ten percent of deals that are really proprietary, maybe the WhatsApps of the world that just go straight to Sequoia. And, you know, there’s probably another ten percent that’s proprietary that’s real technology stuff coming out of universities, stuff like that, where the entrepreneurs are not sophisticated enough to know that they can get their company in front of a lot more people. But deal flow, it’s just becoming less and less—I mean, I’ve noticed it even over the last year. If you’re not on AngelList looking at deals, you’re just not seeing as many deals. Basing your firm on deal flow, I think, is a mistake at this point.

Nick:   So I loved your comment about Paul Graham. So, with regards to picking these unicorns, Paul Graham said you shouldn’t spend time thinking about price. You should spend time getting into the right companies. And while that seems logical, why do you think this comment is contradictory?

Jerry:   So I should point out that I only pick on people that I like. [Both laugh] I actually think Paul Graham…he’s actually one of my favorite thinkers in the space. He did say at one point in some blog post that people—investors who are worried about price are focused on entirely the wrong thing and they should really only worry about whether or not it’s a good company. And the reasoning is that it is in essence a binary outcome. The company’s either a unicorn, or it’s not.

It’s an interesting comment, I think he’s entirely wrong for a couple of reasons. One, this is not really a dichotomy, like you can only focus on good companies or price. I think you can focus on both. It may be true that the good companies get bid up so high that you as a small investor have a choice of being either in the deal or not. And if that’s the case, then the only thing you’re focusing on once you decide you want to be in the deal is price, and if it’s a great company, then you shouldn’t worry about that. So point one is, it’s probably in most cases not this kind of dichotomy that it’s one or the other. There’s a case where it’s both.

And the second thing is, even if it were a binary outcome, if you’re an investor and you’re investing in fifty companies, binary outcomes turn out to be a binomial distribution. So price does matter. It’s kind of interesting to say that it doesn’t. If you invest at a pre-money of four million, than you’re gonna get a five times higher return than if you invest at a pre-money of twenty million. It’s just basic math.

So I’ve seen great companies that have really high evaluations and I have to pass. It’s just crazy. I don’t own enough of the company at my check size, to ever make any substantial amount of money if they sell at a reasonable price. And the second part is that it’s not really a binary outcome. That’s just not true in venture. And if you look at venture deals, a third of them make you money, a third of them just return your money, and a third of them fail idea, which is actually not far off from historical statistics. But the third that return your money actually make a reasonable difference to your return rate, and for a smaller investor is makes a ton of difference, especially angels, to your ability to continue investing. So if you get your money back, you can put it to work again. But even the third that make you money, some make you two X and some make you thirty X. There’s a wide range of returns. If you’re aiming for a twenty or thirty percent return per year, it doesn’t come just from the thirty Xs, it comes also from the two Xs.

So the idea that price doesn’t matter is kind of bizarre to me. It’s just simply not true. And I understand the appeal of the idea, but I think  Paul Graham is actually relying more on the fact that the pricing won’t be ridiculous and that if you’re following somebody else into a deal as an angel investor, whoever’s leading the deal may have a high price, but it’s not an irrational price. And—alright, fair enough—if you’re going into a deal with a major venture firm leading, then you can assume that the price is not ridiculous, you know, the way that when Excel invested in Facebook ad, a twenty or—what was it—forty million dollar values, whatever it was, in the early days. People were like “Wow! How can this start-up company get that high evaluation?” It was rational choice for them to do that, it may not have made sense to everybody else, but it made sense. But if you’re leading a deal, or the deal is not being led by a firm that knows what they’re doing, then there’s an awfully good chance that the evaluation is simply wrong. And so I think it does make a difference to figure out if an evaluation is just wrong. I mean, in the ad-tech sector, where I’ve done a lot of investments, I actually have a list of every exit for the past fifteen years. Every exit, even the ones that have evaluation and the ones that don’t and the ones that don’t, and the ones that have evaluation…there are no billion dollar private outcomes. Nobody has sold a company for a billion dollars or more in the private markets. There’ve been companies that have gone public, there are companies that have gone public and then went private and then got sold for a lot of money. Like DoubleClick—I think there was actually a couple billion dollar ones recently, but as of like two years ago, there had been no billion dollar ones.

The most you could really expect from an ad-tech company was seven hundred million, would be like the high end. And the kind of sweet spot for exits, the successful exits, was more like four hundred million. So in that case, the difference between a four million dollar pre-money, where after the dilution for further rounds, you’d expect maybe a thirty or forty X, and an eight million dollar pre-money, where you’d get a fifteen to twenty X, is huge! You’re getting half the return as you would—

Nick:   Could make the portfolio right there.

Jerry:   Right! And then given the fact that not all of them succeed, it totally makes a difference. I suppose if you think about parallels, where you could have essentially infinite outcome, you could have a two hundred billion dollar exit. Maybe it makes less difference. But I think it completely depends on the sector you’re in. Consumer things, like Facebook, it’s hard to know how big it could be. Other things like business to business or SAS, it’s fairly easy to know how big it could be, because the market’s still limited. So yeah, I think price is important. I think you need to have a good company and a reasonable price. I mean, I don’t negotiate on price, and I also don’t like investing in companies that have too low a pre-money. I don’t want to squeeze the founders down and have them have so little equity that they’d be better off going and getting a job. I want them to be incentivized to continue the company and be on the same side of the table as they are. If evaluation’s too high, it’s just too hot.

Nick:   Yeah. I don’t wanna beat the point to death, but you do mention as well that Paul Graham through the accelerator has back over six hundred and thirty companies, each at a two hundred and twenty-five K pre-money. So, it sounds like he’s getting the potential unicorns and he got a good price on those as well.

Jerry:   I know, that was a bit of a cheap shot, but…

Nick:   So, Jerry, 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.

Jerry:   So—I assume everybody in your audience has read Clayton Christensen’s book Innovators Dilemma, if they haven’t they should. It’s—there’s a lot of really interesting stuff in there and it’s probably one of the few works in innovation that’s backed by actual research, as opposed to just anecdote. But one of the things that he shows in a chart about two-thirds the way through the book is that companies in the disk drive sector—has this chart where, you know, two by two matrix of companies with emerging markets verses existing markets, and new technologies verses existing technologies. And most people start companies where there’s an existing technology in an existing market, right. Because you know there’s a market and you know how to do it and you’re just competing with everybody else in that sector. And that’s a pretty poor strategy.

But it’s also, interestingly enough, turns out that bringing a new technology into an existing market is not a great strategy either. The two strategies, and they have about the same outcome, that he found were dominant were the emerging market strategies. So either existing technology into an emerging market, or new technology into an emerging market, and both cases, they had like a thirty-eight percent chance of a company going into either of those sectors becoming successful, verses little less than six percent in the existing markets. So it’s a huge difference going into an emerging market verses an existing market. And I think most start-ups should want to go into emerging markets. Now the problem with emerging markets is, you have no idea how big they’re gonna be. It’s just—there’s no way to know.

So, how big is the 3D printing market gonna be? You know, if you think you have an answer, you probably have more of a belief. So when Steve Jobs was building the Apple Is, he believed that every household in America would have a personal computer. But that was a belief. It was not an analytical fact. There was no way to know at the time what personal computers would be used for. The first TV commercials for the Apple after they had gone public were “Oh it’s a home computer! Well what do you do at home? You cook! So what are you gonna use it for? You’re gonna use it to keep recipes on.” Apple had no idea what people were gonna use computers for. They had no idea how big the market was gonna be.

Nick:   Makes it. It doesn’t exist yet.

Jerry:   Yeah. And you’re building a market. You’re trying to figure out what people are gonna do with it and people are gonna figure out something to do with it if it’s a really useful technology. The problem is that if you can’t know how big the market is, then how can you know which company is gonna be successful? You can probably pick which companies are gonna be successful in markets that already exist, but those markets suck because there’s already a hundred other companies in that market. You’re competing with everybody. The markets that are emerging, you can’t know how successful that market’s gonna be so you can’t know how successful the companies in that market are gonna be. So you have this problem. This idea that you can do customer development and figure out what people want and then give it to them… Well if people already know that they want then you’re in an existing market already and you’re selling against the solutions they already have. It’s hard for those companies to be massively successful.

So to get these unicorns, you really have to get these companies going into a market which is unanalyzable. You can try to pick, you have this problem of the unknowable that you’re picking into, and then you’re also picking against a whole slew of venture capitalists that do this for a living. This is all they do. So the one thousand five hundred and thirty-eight companies that Aileen Lee analyzed in her article to find the thirty-nine unicorns, all of those companies were companies that had been venture funded. I can’t remember which venture database she used, but all of those companies had been venture funded. So it doesn’t count the other x companies, which is probably an order or magnitude larger that were not venture funded. But those companies are still the companies that use as an investor see. So picking thirty-nine out of one thousand five hundred and thirty-eight seems to be a difficult standard to achieve, but picking them out of a number that’s actually probably ten or twenty times larger is ten or twenty times harder. So yeah, I think the idea that you can pick…it’s a fallacy. It’s the kind of story that we tell ourselves to make ourselves sleep better at night.

Nick:   Yep. So this relates to the first major element of your system, which has these four elements, the first one being don’t look for unicorns, which I think you’ve just articulated why. Can you also talk about the two major things that you need to check off before investing in a company?

Jerry:   There’s two things. One, this is—well, we used to say “Well the dogs eat the dog food,” right. So if you have a product or a service that you’re selling, do your customers actually want it and will they use it? So, you know, kind of despite what I just said, you do need to sell your product to people who will buy it today not ten years from now and you need to find customers immediately who will use your product and even when you don’t know how big the market may eventually be, there needs to be some market, otherwise you’re just dead in the water. So that’s one, and I think people talk about Gains or Pains, right, so the gains are “Does it make your customer’s life better?” and the pains are “Does is make your customer’s life less bad?” I tend to focus on pain because, making your customer’s life better, that’s something they would love to have that’d be great, that’d be awesome, and when they have the money for it they’ll put it in the budget and maybe in two years they’ll buy one from you. The pains are the things that they need to have immediately because it’s painful.

 I can’t remember whose analogy it is, but it’s the analogy of taking vitamins verses taking painkillers. Vitamins, you know you should, and you will, maybe someday you’ll buy them and take them if you remember. Painkillers, you need them, you take them immediately. Then you go out to the store and you buy them because you need them and you take them. It’s not a lot of thinking about it. Finding pain is a much better solution because your customers will act to cure their pain much more quickly than they will to implement some potential gain.

Nick:   They seek out the painkillers whereas the vitamin pills are gonna be hocked on you by the sales guys.

Jerry:   Yeah, right, exactly. And then the other thing I—and I see this a lot among entrepreneurs and I teach entrepreneurship at the Columbia University and I see it among my students… They will find something that’s mildly painful but millions of people have this mild pain, right, and that’s nice. But people generally, they’re willing to put up with discomfort where they aren’t willing to put up with real pain and I think that’s a much better idea to find something extremely painful even if only to a few people, than to find something that’s mildly uncomfortable to a lot of people. There’s always counterexamples, but I think that’s a better strategy to start with. I do mainly business to business software, so my number’s maybe a lot lower than if you’re doing consumer, but if you find twenty customers who have a really deep pain in a certain sector, that’s a far better place to start than finding a thousand customers that has something that’s mildly uncomfortable. You’re selling a lot faster.

So pain is the first thing and the second thing is can you actually build it? Is it technically feasible for you to build your solution? And that may sound silly to say out loud but obviously we do that every time we look at a team. A lot of looking at a team is “Can these people actually build what they say they’re going to build? Can they do it on time and on budget?” and then even to a greater degree I’ve seen in a lot of companies “Do they actually know what they’re getting themselves into?”

One of the companies I invested in is a company called Bank Simple, they changed their name to Simple, and they were building a consumer bank accessible only over a smartphone. There’s no physical branches. It was an interesting proposition and I’ve seen that idea probably twenty times…but they were the only team that actually felt like they knew what they were getting themselves into. Every other team has thought that it would be relatively simple, to interconnect their iPhone app into the banking system. And it’s not. It’s a byzantine system. They had to interconnect with several different parties that had very old systems, no APIs. They had to go through a complicated process to make sure that the interconnection of the systems was actually going to work. There was a ton of issues. It took several years for them to get their first product up and running because it was so complicated. So, I think technical feasibility is more than just “Are they good engineers?” It’s knowing the ecosystem as well.  

Nick:   So Charlie O’Donnell was on the program and he talked about building an elevator to the moon. And the amount of competence he require from the team and the amount of money to get there and the time to do it is so great that it doesn’t pass the sniff test on if the team can actually pull it off.

Jerry:   Yeah. Charlie’s great. I think it’s—we do walk this fine line between wanting to do something technically ambitious and wanting to do something that you can actually do within a finite budget and time. And the best companies figure a way to get A to Z without cloistering themselves for ten years and requiring hundreds of millions of dollars. Then I think it’s you can have these stepping stones between, where you could find something of great pain to a few customers as step one, and then continue to build from there until to continue to grow something really technically ambitious. That’s the ideal. It’s rare that you see something like that, and it’s also rare that people actually end up at Z if they started at A thinking they’re going to Z. The elevator to the moon, it’s hard to see what the intricate steps would be.

Nick:   Coincidentally, I saw an article on Twitter just the other day about a Japanese contracting firm that is planning on doing just that. And delivery date’s in, I think, thirty-five years, and I couldn’t help thinking when I read that “Will this firm even be around in thirty-five years?” They may not.

Jerry:   I mean you look at Elon Musk and what he’s doing and most venture capitalists would have shied away from that stuff because of the enormous amount of money and time it would take, but he had a lot of resources. And you think about the old—I don’t know if the Japanese firms still do this—the 500 Year Plans. If you have an enormous amount of time and resources, you’re working at a completely different environment than venture capital which, as much as it dominates our thinking, is a very, very small industry. There’s not a lot of money in venture capital. Far less than in hedge funds or real estate or mutual funds or any of the other financial vehicles out there. I think we’ve done a lot with a little, but it’s hard to do some of the really ambitious stuff with the little that we have.

Nick:   Yep. So, Jerry, the second item in your system is about the flock and building business 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?

Jerry:   I think if you go back to the idea that entrepreneurs will go to Sequoia because Sequoia will help them succeed and that you can’t compete with Sequoia because you don’t have the reputation for helping companies succeed the way that Sequoia does, right. I mean, you just can’t. There’s just no way you can compete. I’m gonna say that’s ninety-nine point nine percent of the people who can’t, including myself… The way that you can compete is by picking a very, very specific sector and becoming an expert on it. So it’s actually not hard to become one of the top twenty most knowledgeable people in an emerging technology sector if you do the work. It’s very hard to become a top expert in ten of them, but becoming an expert in one of them? I think anybody can do that if they do the work. So for several years, my sector was ad-tech and I invested in it, I wrote in it, I started a company in it, I knew the people in it, I spent a lot of time with them, I knew the customers, I knew the technology. I knew a lot about it. I don’t know if I was one of the top twenty experts, but I could write for the industry trade magazines and have my stuff published so, in that sector, I have a reputation for being one of the investors to go to. And there were a few investors that were like “Well if you want to do ad-tech, go to one of these few investors” and I was one of them. So I got to see a lot of companies, I got to meet a lot of founders, I got to talk about a lot of new ideas, and it’s sort of self-reinforcing. So you start seeing a lot of companies in the sector and there’s no body in the sector that knows the sector better than the entrepreneur. They’d done a huge amount of work on something extremely specific and when they pitch you, they educate you in it. So you can understand what they’re pitching.

Nick:   Should be the case.

Jerry:   Yeah, and as an investor you should make sure you’re learning from your pitcher. So it’s—after doing that for a year or two, you know the sector as well as anybody. And in some sense, you have an overarching view of the sector that’s better than even the entrepreneurs who know their specific product and service very, very well but may not know what everyone else in the sector is doing. And once you know that, it’s easy once an entrepreneur comes and talks to you and they say “Nobody else is doing this.” Say, “Alright, the reason nobody else is doing this is because, A, it won’t work, or, b, there’s actually twenty other companies doing it, they just haven’t gone public yet, or, c, there are twenty companies that tried to do it and they all failed because XYZ.” You can evaluate pitches much more easily. If you know the customers, you know what their large pains are right now. The pain changes quickly, because companies come in to address the pain and the pain moves somewhere else. So you need to be on top of that in real time. And C, you know what pricing is, you know what companies you’re getting has pricing you can actually make rational pricing decisions. And then D, it’s like you know…my company’s supposed to be “We need to hire a head of sales.” Oh, alright, well have you talked to these five people? Because they’re all heads of sales at competitors and they have the skillset you’re looking for. I’ve met some of them, and I can reach out to the other ones because they read my stuff in the trade magazines. You can actually add value because you actually know something about your sector.

And I think it’s hard for a lot of investors to stick to that discipline of investing in what you know because I think a lot of investors think they can pick. They can look at a company in any sector and say “Hey, that’s a good idea!” And in some sense it’s actually easier to look at companies that aren’t your own and think they’re good ideas because you don’t really know the complexities of the technical feasibility. People come to me with health care ideas and I’m like “Wow! That’s awesome! You should definitely solve that problem, it seems like a big problem. I know it’s a problem for people I’ve known. Solving that problem will be amazing!” But it would be silly for me to invest, because I don’t know why that problem hasn’t been solved yet. There’s a reason it hasn’t been solved yet, but what is the reason? And if the only source of my information is the pitch, well, it’s hard to know—the people who are pitching really believe in their solution, so they’re pitching you what they believe, and it’s hard to know if it’s entirely accurate or not.

I think investing in what you know, it is the one way that you can compete with Sequoia. For several years when there weren’t that many ad-tech investors, I would have larger venture firms, when they were looking at an ad-tech firm call up and have me look at it and the quid pro quo would be that I would get to invest alongside them. And that was ideal. It’s an awesome strategy if you can do it.

Nick:   Yeah. When we’re making decisions here on what to invest and I put together an investment thesis that we review as a small team, and ultimately when I’m looking at things too far afield for my core, I found that I can’t answer the questions of the thesis appropriately. Cause I just don’t know the industry dynamics well enough, but… Anyway, so Jerry, the third element you talk about it about publicizing your focus. So why is it important and what are some examples that you’ve done in the past?

Jerry:   When I left my start-up, because my co-founders and I consider ourselves horrible managers–we really hired people we didn’t have to manage. So you have somebody come in to interview and you ask them “Alright, what are you gonna need back from me as your manager?” and they say “Well maybe we can meet once a week and you can tell me how I’ve been doing and tell me what I need to do in the next week” and we’d be like “Ugh, no, we can’t hire them.” And then you have other people come in and you say “What do you need from me as a manager?” and they’d say “Well, you’re gonna tell me what I need done over the next year and I’ll come back if I don’t have enough resources.” We were very entrepreneurial and we loved those people and that might not be a great management philosophy, but it was a great way to meet a lot of people who were very entrepreneurial. My first company that I invested in and knew was one of our first employees at my company and he called me up and said “Hey I’ve got this idea. They just released the iPhone app SDK and I’ve got this idea for an ad network for the iPhone” and I said “That’s a great idea.” He said “You raised a bunch of money for the company we had worked, can you help me figure out how to raise some money for it?” I said, “Yeah, A, I’ll put in some money because I know you really well and I love the idea and I’ll introduce you to a couple of the firms” and those firms that ended up leading the investment were First Round Capital and Union Square Ventures, and when he put out the press release, he was kind enough to include me in the press release and after that, I got a ton of deal flow. They read the article and were like “Oh, he’s investing!”

The problem with most—finding angel investors or early stage investors is actually knowing who invests. Most angel investors, you wouldn’t even—I have this problem when syndicating stuff and I want to bring in angels, like “Wait… So who’s investing right now?” Because people have invested in the past but maybe it’s just in companies started by friends or that they were investing and now they’re not investing. They come and go and it’s very difficult to keep track. I have a list of hundreds of people that I flip through and I email them and half the time they’ll say “Oh, I’m not investing this year, I’m doing something else, I started a company” or whatever and then people start investing and I don’t even know about it. So it’s difficult for me, even though I’m doing this full time, to actually keep my network up to date in syndicating investments. I imagine for entrepreneurs, it’s ten times harder.

Nick:   And sector focus as well, right?

Jerry:   Oh, yeah, totally! So I think letting people know that you’re investing in specific sector is…you know… It puts you in the top ten percent of potential investors for people because they know you’re there. And that does the entrepreneurs a favor because otherwise, it’s hard to know. Even on AngelList, because AngelList has—I don’t know how many people are in there now as angels, but I think it’s more than ten thousand. Andi think most of those ten thousand people aren’t actually investing. They made have made an angel investment or they may want to make an angel investment, but they’re not actively investing. Most of them are probably not great prospects for an entrepreneur. And it’s almost impossible to tell the difference unless you go through them one by one and look at all their investments and see when they made the investment and see if they’re an investor or an advisor or mentor or something else. It’s difficult to figure out those people. So let people know you’re investing. You’ll get deals.

Nick:   So Jerry, 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 for you?

Jerry:   So I think venture capitalists right now are taking less risk than they have in the past, so they’re investing in companies that are further along. But by the time they’re further along, it’s become more obvious they’re gonna be successful, it’s really hard for a smaller investor to get in. There’s either gonna be a much higher price or there’s gonna be a lot of competition for the deal. So I think, in general, you have to invest a bit earlier before the venture capitalists are investing. I also think that—this goes back to the emerging markets point—if the company is obvious to everybody else, and this is really…so even the early stage investors, if most of the people think it’s obvious this companies going to succeed, it probably won’t. It’s obvious you’re going to have a lot of competitors also going into the same sector. If it doesn’t require a lot of capital, which earlier investors prefer, then you’re gonna have a lot of people starting a company because it doesn’t—there’s not any real barrier to entry. You want to go after stuff that’s just not obvious yet.

Think of any great company right now, so like ten or twenty or thirty years after the fact when they were founded, and think about them back when they were founded and whether or not it was obvious at that time that they were going to be successful. Even Facebook—in some sense, Facebook was obviously going to be successful, and yet it wasn’t at the time. Myspace was there, why would people want to use this thing that was limited only to college students? It really didn’t do much. You had to use your real name… There are a whole bunch of reasons that people at that time would have looked at it and said “This is stupid” right.

Nick:   Doesn’t make sense until its success, right.

Jerry:   Right. It’s sort of the inverse of the idea that you can’t pick. The inverse of the “can’t pick” is the things that you do pick are not going to be obvious that they’re going to be successful. I think that’s two sides of the same coin. Things that are obviously gonna be successful, maybe they’ll be successful in the sense that they’ll sell their product to customers, but they’ll probably also have dozens of competitors and no real defendable position that would preclude other people—other companies coming in competing with them. And you see this all the time when you look around. I look at—I’m not gonna name company names—but some of the sectors that confuse me are things like the home delivery services that keep popping up, the doing services as a marketplace kind of thing. These things where it’s very easy to get into that niche and so there’s going to be scores of competitors so the niche, even if the niche itself is big, can’t be that big for you. And there’s no reason to think that there’ll be one winner, as with most businesses in the world. There’s not one company serving them. The only businesses that have a single winner are ones that have some sort of defendable position. Either intellectual property or network of facts or some sort of insuperable learning advantage. And that’s just not most companies. There’s not one dry cleaner in the entire country that services all dry cleaning.

If you think about the wider world, that’s the case with almost every business except for a few. I do think you need a few things that other people pass by because they just don’t know if they’re gonna be successful or not. I think you also need to do things that other people are confused by and this is kind of the flipside to being an expert in a certain sector. If you’re an expert in a certain sector, you know things other people don’t. So other people will look at the deal and be like “I don’t get it.” It’s like “Well, I do.  I know the customers, I know their pain. You don’t know it because it’s maybe a little obscure.” I mean, with ad-tech, most people don’t know people who buy media for a living. And they don’t know that people have this problem, and in fact the problems that programmatic ad-tech are solving have been around for twenty or thirty years, being talked about for twenty or thirty years, but all of a sudden we have the technology that can solve them. Anybody in the media buying sector would say “Alright, if this technology really can solve these problems, then there’s really a market.” People who weren’t in the sector would say things like “…I don’t get it. What’s wrong with the way it’s being done now?” Not why it’d be a problem but if it is really a big problem now.

So I think that’s the flipside to being an expert, is know the things that other people don’t. That gives you a strategic advantage when you’re investing.

Nick:   So I like to wrap up interviews by asking for tips for angel investors, inventor investors, and at the end of your piece, you provide some portfolio management tips, related to the gambler’s ruin. Can you walk through some of these tips?

Jerry:   Yeah, the gambler’s ruin… Imagine, let’s flip a coin. If it’s heads, I’ll pay you two dollars, if it’s tails, you pay be one dollar. So now this is an awesome bet. You always take that bet. But even if you take that bet, say you have a hundred dollars in your pocket, let’s day you’ve got a hundred dollars on one coin flip, there’s a fifty percent chance that you’ll lose all of your money and you’re done. You can no longer gamble because you have no money. Whereas if you divided it up into smaller sectors—like so if you—I’m gonna put ten dollars on each bet, then the odds are that you won’t lose all of your money. In fact, you’ll make an infinite amount of money if you continue playing. So you don’t want to be in the position where even though your expected value is positive, you have an awfully good chance that you won’t be able to play anymore because you’ve run out of money. That’s the gambler’s ruin.

So you want to make sure that your bet size is not your entire bankroll. You want to divide it up into enough that you can keep playing and not go broke. So I think a lot of angels will say “I have a couple of hundred thousand dollars to invest” and they’ll put it into four companies, and this is not a coin flip. If you have a one in three or one in four chance of making money on any given investment, making only four investments is an awfully good way to lose all of your money most of the time and never get to the point where you get that one unlikely occurrence when you make ten or twenty times your money that pays for everything else. So you need to make your bet size small enough that you can have enough bets where your probability of getting that outlier that pays for everything else.

The other thing is you—so you keep a standard bet size. You should have an amount you invest in a start-up which is the same for every start up you invest in. This is if you’re not leading the deal. If you lead, then you have to kind of adjust your bet size based on how much money the company actually needs. But if you’re following someone else, if you’re an angel, you should have a standard bet size. And this prevents you from doing the kind of irrational thing where you’re like “Wow, I’m really psyched about this company, I’m gonna invest three times as much” verses “Oh I’m not psyched about this company so I’m just gonna invest one times.” If you’re not psyched about the company, then you should invest. And also it’s that feeling that “I’m feeling lucky on this one” that’s entirely irrational. Don’t listen to that little voice. You’re making good bets. Do it as a business person, not because you feel good about it, and make standard bet sizes.

Also—this is one I actually argue at other venture investors all the time about this one, early stage investors—I think that one of the prime things that you can do to make more money is to invest in the series A after you’ve invested in a seed. So when you first invest in a company, you’ve done your due diligence, you know the founders, you know the technology, you know the market. That’s great. But you don’t really know everything. Because your interaction with the founders before you invest is going to be very different from your interactions with the founders after you invest. This is a very common venture capital thing where you show up to the first board meeting and hear what’s really going on, and then you have to readjust your expectations. Sort of—it’s almost an inside joke among venture investors. The fear of the first board meeting.

Nick:   Yeah, the list of unknowns is decreasing over time.

Jerry:   Right, that’s when you hear like the “Okay… That customer that was in contract…well it’s not in contract anymore because it’s not gonna be a customer.” That kind of stuff. The engagement rate that’s been going up for the last six months has just plateaued and you heard the problems. So I think the day after—if you’ve been invested in a company from the seed until the A for a year and you’ve been involved enough with the company, actually doing—you know, helping them out, helping them grow, doing whatever it is you can do to help, you hear all the good news and the bad news. You’ll be in a much better position to evaluate whether or not it’s a good investment at the Series A than the people coming in from the outside to lead the series F. So you can make a really good decision at that time, like “Is this a good price or is it a bad price?” And if it’s a good price, then you should put more money in, as much as they’ll let you. Because that’s a good bet. You know this company better than anybody, you should know whether the price is a good price or not.

I think that’s where I’ve made most of my money, actually, is the series A. So I’m a seed investor but I’ve made most of my money in the series A because I’ll but a lot more money to work in the Series A than I have in the seed round. And that money is a lower return, obviously, because it’s a higher evaluation, but it’s also a much lower risk. So that’s, you know, I think that’s a—everybody should try to do that. Try to get, A, the right in the seed contract that you can invest in the A and, B, figure out if you should invest in the A, then C, invest in the A if it makes sense. That’s my primary tip here. I think that’s how you end up making enough money to make this worthwhile. The downside to that is that if you want to invest in a certain number of companies in the portfolio, then you hope that the series A you’re gonna invest three or four times what you invested in the seed around for the companies that are worth it. So, on average maybe two X into the series A as you did in the seed round. It means that your seed round amount has to be a third of what you hope to invest in that company. So you need to reserve money for the follow-on rounds to do that. Which means that, depending on how much money you’re putting to work, it limits the number of companies you can invest in.

And then, you know, the next thing is that you should invest in enough companies that you actually have a portfolio and not a couple of bets. So this is the gambler’s ruin. So I think that as an angel investor, or an early stage investor, you should be in at least thirty companies so that you don’t face this gambler’s ruin. Which means that the amount of money you need to invest is, divide that by thirty companies, and then divide that by three to get your seed round check size, which is dividing your total amount to invest by ninety. And most seed stage companies really don’t want a bunch of five or ten thousand dollar checks, because it makes it hard for them to manage their company when they’ve got a hundred ten thousand dollar checks on their cap table. So your check size has to be reasonable enough, which means to have to have a rather large pool of money to invest as an angel investor if you want to do it professionally as opposed to doing it because you want to help the founders. Sort of hard news for some angel investors is if you want to be writing twenty-five thousand dollar checks into seed stage companies, well you probably need a couple million dollars set aside to invest in those companies over the course of five years. Which is a lot of money for a lot of people.

Nick:   Yep… Certainly on the show I’ve been an advocate of reserving capital, getting that pro-rata right, kind of executing the right, and I know I’ve had some guests on that say they do early stage angel investing and they don’t ever ask for a pro-rata and they don’t do follow-ons. Hopefully we get more people on that can explain why they choose not to do that.

Jerry:   This is one of my pet peeves. So I always for pro-rata, and then I always ask for information rights as a seed stage investor, because if you don’t have any information rights, the pro-rata’s not worth anything. People are like “Oh, you want to invest or not?” well… “How’re you doing?” “Well I can’t tell you that.” It’s silly, right.

And I’ve actually walked away from a couple of investments. There was one company, it was an ad-tech company years ago, where the lead investor, was a big boss in VC, said “We don’t want any other investors” so “yeah, you want this guy who knows ad-tech, fine, but he’s not getting pro-rata, he’s not getting information rights. He gets what he gets, he doesn’t get upset.” And I said “Alright, never mind. Good luck, I’m not going to invest because it doesn’t fit my model.” And they came back after the investment closed and said “We really want you involved. We’ll give you advisor’s shares.” I think like half a percent or whatever, which is how much my money would have bought in the company. So they came back and said “We want to give you advisor’s shares” for the same amount that I would have paid for. It’s just crazy that they would forego my being involved because they didn’t want to give me pro-rata, and the pro-rata would obviously be a tiny amount of the A, like half a percent of the A, wouldn’t even squeeze anybody else out, but the reason—I don’t understand why other angel investors don’t ask for this. It’s really self-defeating. I think it’s they just don’t understand that they need it, or don’t understand the value of it. But it’s, you know, I tell everybody I can “You need to have this. You should have it.” And frankly, it’s not a big deal to get it. Your money is as green as anyone else’s in series A. So the entrepreneurs that say they don’t want to give it to you, it’s irrational for them not to give it to you.

Nick:   So, transitioning here before we close out, Jerry, what are you currently most focus on?

Jerry:   I think we’re at a transition point where a lot of the technologies that have been the driving force behind start-ups for the past five to eight years are petering out. We’re kind of reaching the part of the S-curve where it’s not as steep anymore. So I am looking for people who are doing something really interesting technologically. So the beginning of the S-curve. I’m looking at some of the maker movement stuff. I’m looking at robotics, I’m looking at neuromorphic chips and deep learning. I’m really looking for people who are doing something interesting technologically even if the market hasn’t been curved out yet.

Nick:   Awesome. If we could cover any topic in venture investing, what topic do you think should be addressed and who would you like to hear speak on it?

Jerry:   Oh… That’s not fair. [Both laugh]

Nick:   Everyone loves this question.

Jerry:   Right! I would actually love to hear one of the guys from O’Reilly talking about the biomaker movement. The people who are doing some really interesting things with biology… That stuff is like Science Fiction. But I think  that as Moore’s law starts to peter out as it has been since 2004, you’re gonna see people  doing some really interesting stuff that’s just different than what we’ve been seeing for the past forty years. I think that there’s a good chance that something’s gonna come out of that sector.

Nick:   So Jerry, what’s the best way for listeners to connect with you?

Jerry:   Uh, neuvc.com. N-E-U-V-C dot com. And it you can figure out how to work it, that means you’re technical, which I like, and you can send me an email from there or you can follow me on Twitter, GANeumann. G-A-N-E-U-M-A-N-N. And I often respond, not to blatant pitches, but to conversation on Twitter.

Nick:   I must say, I do love the website. It comes up as almost like a DOS prompt with a command. So it’s a fun one to check out. I will have all of Jerry’s contact info in the show notes. Jerry, I find your articles to be fun, engaging and very valuable from a learning standpoint. So thanks for your contributions through the blog, and thanks so much for doing the interview today.

Jerry:   Thank you, Nick. I enjoyed it.