On this special segment of The Full Ratchet,
the following investors are featured:
Each investor describes their investment thesis and
how they evaluate startups for investment.
Mahendra: Well, my thesis is pretty sort of straightforward with a lot of other good ventured masterpieces. Start with the management team; #Brad who I sort of describe him as my friend and mentor talks about two things: “Are we passionate about these people?” and “Are these people passionate about that business?” The equation of passion starts to play out and “Do I like these people both that emotional level, at intellectual level?” One of the VCs that I interviewed for the venture capital book said, “I look at entrepreneurs in a very simple way. After I’ve checked all the boxes, I close my eyes and ask this question; “If I had to leave my kids with this entrepreneur for a day or two, Do I trust this person and off that I can drop my kids off at that place” and I thought that was just a wonderful way to say, “Yeah, that’s exactly how we should look at these relationships because it’s a family.” That’s one rule that I apply to you don’t want to say things like this in the first meeting with them because you spook them out but behind the conversation I’m trying to say is that, ” Hey, can I take this person home for dinner? Can I leave my daughter with this person for a few days of some emergency comes up?” And that’s sort of the trust factor that comes. Obviously, the intellectual side you want to make sure they’re solving that i problem. Obviously you want to make sure the market is ready. That’s sort of the first filter that you apply and then the market readiness is all is this unknown right. All of us feel like the market is ready but sometime it is not, you know? IoT. for example is this… a lot of buzz going on in IoT But nobody knows what that means and there are few companies out there but is it a market ripe enough for good investments? We don’t know. You know, we see other things happening in the marketplace like for example: You probably read about all of these space technologies that are now 2:03- 2:05 (unclear). Very soon, entrepreneurs are now sort of running in this direction of solving problems where satellites can be floated in the space. Interplanetary travel is becoming at least from a discussion standpoint it is becoming more and more of a prominent but we don’t know the markets are ready and so that’s the hardest part in our business, is to know whether the market update is going to be good and that’s where some of our judgments start to come into play and that’s where I still struggle with you know. I believe I have an idea of how to pick good entrepreneur and make sure the market dynamics are well understood but still the reality is nobody knows how the market dynamics are going to play out.
Nick: Right. Yeah. We had #John Huston on the show and he was talking about #Webvan and timing was just wrong and now we have #Instacart.
Mahendra: Exactly! A great example. I think but here there is a wonderful lesson in this example of #Sequoia. Sequoia was an investor in 3:01 (unclear) band to the best of my knowledge and the loss boatload of money, right?
Mahendra: Well, then I think is several maybe five, six hundred million dollars very quickly and then what ends up happening as investors, we have this institutional memory where we’ve been scarred and we’re like, “We’re never going to touch this whole category ever again” but I get a lot out there to Sequoia saying, “Oh, you know the whole economics of this business have changed to a point where if we invest in Instacart, card #Amazon might acquired it, #Uber might acquired it or if it becomes big enough, it could become a public company.” So I think there’s a good lesson to be learned here that even though your prior fears may have occurred. They may have occurred for some reason, so don’t just walk away from the whole category.
Nick: So on today’s special segment, we have #Christine Tsai of #500 Startups. Christine, can you talk about your thesis and also how you evaluate early stage startups for investment and if there are any unique aspects of your approach?
Christine: Yeah, so my thesis is largely kind of how 500 thesis is of course but you know generally we… I think our approach is very different from traditional VC and our thesis is that a lot of the VCs make very concentrated bets and they think they can pick winners. We don’t quite think that. We think if maybe your #Sequoia or #Excel or like that the top six, you can but you know ninety nine percent of VCs it’s not you know, picking winners is very tough and you know, even think about some of our companies that have turned out to be really successful, you know it’s not like we saw that they were going to be billion dollar companies early on. Our thesis is that you can… If you’re only making, you know ten picks a year, let’s say for example, you have to… I guess, better be very lucky that you’re going to pick the right companies but most the time you probably you know, for most in venture capital you’re really counting on you know those couple winners to make big returns.
Christine: So are the our thesis is that you need you know, a big portfolio to increase your chances of getting kind of those successes and for us, we are investing early stage so usually seed and post-seed is where we invest and we think that certainly puts us at an advantage in terms of, you know say these companies down the line go on to you know, becomes huge companies were getting in pretty early. So at least multiples of interest and multiple it works in our favor and I think for us you know, we’re also investing small amounts into a lot of these companies so we already have this assumption that you know the majority is companies won’t result in a good return for us. Like you know, whether they fail or they get kind of quired for nothing or even if it’s only a two or three ‘x’ return, that’s not necessarily going to move the needle on the fund but that’s why we invest in a large portfolio because we actually think that’s less risky than the current V.C. model and I think that actually speaks to the fact that VC as an industry hasn’t performed that well, you know the last several years but that’s kind of our thesis and in terms of like what we companies for, we have a strong preference for companies that have a revenue model. So… Like a very clear revenue model so whether it’s very transactional or people are actually paying for the service; Commerce is a great example. We aren’t big fans of companies that are just consume or only and then. Monetization and you think, “Oh, we’ll figure it out later or it’s something that’s not where the margins are very thin”, we have invested in some of those companies but largely it’s not something that we really believe in and you know, obviously investing largely in software or Internet companies. We’ve done some hardware but not a ton but we also like to look at companies from the perspective of ‘how are they going to grow?’ and ‘what’s the distribution strategy like?’ That’s actually one of the ways that we like to differentiate ourselves that we really understand growth and come in term I think is growth hacking. You know, old school term is marketing but just generally like how do you grow the business and how do you… Not just grow but also retain customers.
So I think that kind of sums up our thesis on, “How we evaluate?” but in terms of maybe like, “How is this different from other investors evaluate?” but in terms of maybe like, “How is this different from other investors?” Certainly it’s the large portfolio theory is not necessarily a new one. I think first round invests in this way maybe they don’t invest in a thousand companies. They invest in like a couple hundred but we have more you know certainly gotten a lot of influence from investors like #First Round or you know, certainly #Y.C. and etc and we’ve kind of put it on steroids I guess.
Nick: On today’s special segment, we have Eric Gasser. Eric, can you talk about your thesis and/or how you evaluate early state startups for investment?
Eric: So I use the Dave Berkus kind of formula. Which is a shameless plug for TCA again. But it’s management, industry, and product. And I kind of put those on a scale. Currently, the more recent halo report from ACA shows the median deal done is right around three million dollars the more recent report. And so I kind of used that as a gauge to say “Look, if you’ve got average management, average product in an average market size, then you’re valued at three million dollars-ish, and we’ll go from there” and it floats. So if you got above average management, but everything else is average, then maybe you’ll be worth a little bit more.
So that’s one kind of thing that I focus on. The next element is how do you compare to everything else I saw that month? Because the deal flow is just tremendous, especially when you’re in the TCA world, the sphere. So my sphere of inputs results in between forty-five and fifty-five deals a month. That’s a lot for anyone to process! So how do you compare to everything else I’ve seen that month? And unless you have a gun to my head, I’m not writing a check anyways, so I can take my time and I work on kind of a forty-five day/sixty day window, meaning if I see something, I track it for a while, and if I decide I’m going to invest, I act fairly quickly. And I also try to loop in as many people as possible.
To give you an idea, if there’s something I’m tracking that’s within TCA, and I’m like “Okay, this is an Orange County deal. I really like what they’re doing…” I drive to Orange County, I meet with the guys that are leading the deal. I then come back to San Diego. I then get anybody that I think may be interested in this deal in San Diego on the phone or an email or whatever, and say “Look, this is what I’m doing. What do you guys think? You guys should come with me.” And I’ve quickly raises between two hundred and half a million dollars from doing that.
I also have some rules, and I’ll share those with you. I don’t do husband and wife deals. I don’t do deals where revenues are more than ninety percent outside the country. One of the currently rules I put in place is I don’t do two-sided marketplaces. I’m seeing this huge influx in two-sided market places and, man, there’s only so many things I can be in. how many market places do I need? Market place for pens and socks, I mean, that’s probably gonna be the next one.
Nick: It’s at least twice as hard. So it can be huge opportunities, but it’s a challenge.
Eric: And some argue with me. They’ll say “Two-sided marketplace is the most defensive company you can build,” and I said “Yeah, but getting to defensibility requires more capital than a company selling a widget.” And I’d rather invest in a hardware company, anyone making a piece of a widget, than a two-sided market place at this point.
And then every year, I kind of evolve those rules. If I see trends, then I add another rule. And it keeps me focused, right. It keeps me—if you’re two-sided marketplace, husband and wife, and all your sales are in another country, the odds of me investing are very, very low.
Nick: Gotta be able to filter that deal flow somehow, right.
Eric: Yeah! Yeah, and it’s actually hard sometimes. I had a great story. I met with a—this is when I first moved to San Diego, a TCA member said “Hey, I got this really hot deal, you should come with me to meet with them.” So we go to this place, we’re outside of a Starbucks. It’s probably eighty degrees, maybe eighty-five, there’s a little umbrella bent, like broken hanging off the side, totally not Starbucks style, right. It just wasn’t perfect. And then this couple came. They didn’t introduce themselves as couples, they introduced themselves as Joe and Susan, let’s say. The guy I was with, the TCA member, was like “These guys are really giving something creative” and they kind of went through their spiel and I’m like “Yeah, this all looks good,” and then I saw a glimpse, an exchange of eye contact, that I was like “Something’s fishy…”
I said “How are you guys associated?” Well, husband and wife. I was totally out of line, and I said “Oh, you know what, it’s unfortunate, but that’s one of my rules. I don’t invest in husband and wife.” and I’m pretty direct. Like I’ll tell you real quick if I’m not interested. And the woman said “We’re out of here!” and she slammed her laptop, she put it in her bag, and she looked at her husband and said “We’re leaving now!” He puts his head down, they both get up and walk away! This is exactly why you don’t invest in husband and wife. Because when s— hit’s the fan, they pack up! It’s was amazing!
Because I get so engaged, I want to be more connected with the founder community. I want to be more engaged. And what it does is it allows us to make better educated decisions when we spend more time with people. Some people say “Well, your due diligence process”—Eric Gasser’s due diligence process—“is too long.” If you think hanging out and having tacos on the beach, taking you do dinner a couple nights, and meeting in a random park to let our kids play together—if you think that is too much work… I need to get to know who you are, and get to know how you think, before I write a check.
But then, when I write a check, I’m on your side! You’ve got a huge fan that’s screaming from that rooftops, and I don’t think I’ve had anybody tell me to my face “Hey, Eric, your wacky tacos on the beach” or “I don’t want to take that appointment,” but at the same time, it hasn’t led me wrong yet. And if you can put up with that, then I’m the perfect investor for you.
Nick: Yeah, I’ve certainly probably been too direct and too upfront with some of my entrepreneurs on why I’m not investing, but I’ve never gotten a big “Screw you!” quite like that.
Eric: One of the elements that’s really fun is that, when I first made the commitment to call every applicant, it’s a big commitment. I thought “Eh, it’ll take a day.” it doesn’t take a day. It takes three whole days out of my month to call everyone back. Then what it does, after we make our selection, takes me another two days to call them back and tell them that they’re not coming back. Because I want to get the feedback from those people, just like any entrepreneur would want feedback from customers or people that didn’t buy their product, I want feedback from the founder community. “Tell me how you feel, what’s your next steps, what should I do next?” that’s what makes the difference.
Historically, people are afraid of that conflict. And I turn it around and I go “We made a decision, we’re not moving forward. And these are the reasons why.” If there’s anything I can do to align you with a different type of investor, based on those three that I referred to earlier, I’m happy to do it. If it’s the lifestyle play, I tell them they’re gonna be tremendously wealthy, good luck for them, and keep killing it, and I wouldn’t raise any money.
And then a lot of times, they get pissed, hang up, they’ll yell at you, whatever—but you know what? It’s a learning curve. I may be the only one that tells them that, but other people are speaking with their wallets and not writing checks.
Nick: I can’t believe these entrepreneurs are yelling at you and hanging up!
Eric: That’s why I was saying—historically, we haven’t had this much outreach. I talked to a gentleman—I’m gonna use gentleman loosely—on Friday. And it was Friday at around four o’clock, and he just started yelling at me. He was like “You have no idea what you’re doing!” and I said “Are you done?” and he said “Yeah, I’m done.” And I said “Well, let me explain where you’re coming from and where I’m coming from,” and you can clearly sense the frustration in their own.
It’s almost like they’re desperate, and usually it’s like a mix-match of expectations. Their expectations are off. They assume that we just write checks. And in the past, what we would do with their applications—I’m referring to say three years ago—they used to get a really nice letter from us about all the things that they can do, services that are available for entrepreneurs, which is great. The problem with that is it just went in the deleted box. They just deleted it. They didn’t read it. “Oh, I got denied. Okay, delete.”
When they get a call from me, and I say “Hey, look, I’m the one who screens all the applications. I led the committee that made the decisions that were made. I’d like to talk to you about your startup,” they get more information out of that conversation than I do. They have a better understanding of the process. And, hopefully, the majority of them have a deeper respect for what we’re trying to accomplish.
For some reason, most of these entrepreneurs, this isn’t their first gig, right. They’re onto the next gig and they’re trying to do something different. And so they go to the next one and they’re like “—-, I hit a home run! Okay, I’m galling Eric Gasser!” The guy I turned down a year ago is calling me back saying “Hey, I’ve got this new thing, this new widget, what do you think?” I don’t think we had that level of engagement three plus years ago.
Nick: Love a good tenacious, strong-willed entrepreneur, but I just question, what are they saying to their customers when their customers are saying “Well…I don’t really like this aspect…” Is it “No, you’re not buy this, and you’re gonna like it!”?
Eric: I don’t know. You learn a lot. This is a direct correlation to how early in the lifecycle in the startup we like to engage startups. And if it’s me speaking on behalf of Tech Coast Angels or me speaking on behalf of Seed San Diego, they’re both powerful engines that work here in San Diego to move the ecosystem forward. And I could be wrong, but Seed San Diego needs entities like San Diego Venture Group and needs entities like EvoNexus and Connect and others. Without all of us, we’ll fail. You can’t just have an incubator sitting in the corner of the city thinking that you’re gonna bring startups to your town. That’s just not gonna work.
And so that element and the moving parts and the structure that’s been built in San Diego, I’m lucky enough to plug in right in the middle of it. The swell was building before I got here. What San Diego’s doing right now is phenomenal.