Last week we talked about the power of constraint. Constraint gives the non-traditional startup investor the ability to compete on equal footing with the very best absolute returns investors in the world, at least in terms of dealflow and diligence. But without a basic understanding of the mechanics of modern startup investing, it’s hard to put our newfound advantages to work.
What Not to Do
The idea that anyone can get up off the couch and start successfully investing in startups is ludicrous. But it’s equally ludicrous to assume that funding young companies should be the sole domain of a tiny group of individuals who, by and large, have an awful track record. The point of knowing the [B]asics is to have the “minimum equipment” you’ll need to leverage your [A]lignment and [C]onstraint without disqualifying yourself out of the gate.
Traditionally, these basics would be acquired as an associate at a VC firm, or from the other side of the river — as a founder raising money. As a non-traditional investor, you’ve presumably skipped over these years of formative experience. You can treat the rest of this letter as Cliff Notes. But worry not, startup investment is one case where “fake it until you make it” is actually a viable strategy — one of the many privileges afforded to those willing to deploy capital in good faith.
One of the early ways investors get started is through local city-based or MBA network-based “angel groups.” There are a few of these, such as the HBS angels and Sand Hill angels, who have a track record of investing in winning startups. By and large, however, they are social gatherings where non-professional investors, whose livelihoods have nothing to do with the success of their portfolios, trade war stories and pretend to have a legitimate interest in deploying their modest capital.
My advice would be to skip this preliminary stage and jump to the part of the story where you build your network and reputation inside of your industry, as we discussed last week. The marginal benefit you might gain by hanging with a local angel group in terms of “learning the ropes” of deal structure or diligence is easily replicated by reading professional investors’ blogs. You’ll also avoid dangerous groupthink and the drain of being surrounded by people more interested in being seen as startup investors than actually putting any concerted effort behind it.
I’d also urge you not to start playing with live ammo until you’ve served as a formal advisor, with or without equity comp, for three organizations which fit your investment criteria. If you are investing along with our constraint guidelines (you are, right?) you should have sufficient industry standing to be desirable as an advisor. We could (and should) spend a whole letter discussing the relative merits of paying advisors with equity — or being a startup advisor as a path to equity payoff. Nevertheless, it’s an established practice which will enable you to see the guts of some businesses which fit your investment profile. This will hone your sense of red and green flags, and soothe your burning desire to cut checks so you don’t end up Tim Ferrissing your whole fund I (sorry for verbing you Tim).
4 To-Dos for your First Year
Compressing years of startup investing experience into a listicle is probably just what the internet was invented for, but that doesn’t make it a good idea. Instead, here are a few quick guidelines — the bare necessities to prevent immediate disqualification in your rookie year:
1. Triage using red flags, not green flags. Your self-talk while analyzing investments matters. As you look through your list of prospects, you could say “This founder looks plucky and I like the technology,” which will have you considering a large chunk of the list. If you focus on red flags for your initial triage, you’ll avoid more losses (a key characteristic of successful VCs) and knock more of your list down. For example: try categorically ignoring startups who ask for NDAs to share decks (a rookie move). Space isn’t a perfect match for your expertise? Chuck it. Deck is 30 slides of pure eye exam? Ignore. Sure, you might be missing a good-but-unpolished opportunity. But 80/20, you’re passing on an inexperienced entrepreneur.
2. Ignore terms. Professional investors are much more concerned with the opportunity to go 1000x than they are minor quibbles with the term sheet. This is a controversial viewpoint, because many entrepreneurs have been rejected by VCs who claim the deal doesn’t work for them due to the terms. But whether it’s a debt-vs-equity issue, valuation, or anything else in the offer letter, the quoted rationale is an excuse 90% of the time. They just didn’t like the deal, full stop. Unless there is something truly egregious, like a usury most-favored-nations clause or a highly nonstandard loan assigned to a founder, you should be focused on the fundamentals. You’re never going to win because the terms were good, and you’re rarely going to lose because they were bad.
3. Eschew traditional analysis. Trying to apply valuation techniques from your later stage experience to startup investment is an exercise in futility. Early stage companies often have no revenue to speak of, and even fewer have EBITDA — or should at that level of maturity. Try looking for a no-nonsense proof of concept. Do they have product-market fit? Can you imagine how it might be extrapolated? How about the team, what does their track record look like? Does the opportunity fit your mental model of successful patterns in the space? All of these admittedly qualitative heuristics will be more useful than any attempt at extrapolating value from financial indices, or god forbid trying to run a DCF.
4. Optimize for reputation. Your goal should not be returns or getting into “hot deals” straight out of the gate. Tweak your mindset, and your success metrics. A year into your experiment, put a mark in the win column if you’ve gained a reputation as an honest, helpful and serious investor. Throw another mark in there if that reputation has resulted in a higher volume of desirable dealflow, and a better signal-to-noise ratio.
So you’ve got the [B]asics in hand, and you’re investing in your [C]onstrained playground, where you hold a winning tactical position at the top of the hill. Next week, we’ll talk about how to press your advantage using [A]lignment, the secret arrow in the quiver of every successful non-traditional investor in the world.