August 16, 2018 John Tough 0Comment

Listen to Mike Maples on the Origin Podcast here

It was one of the better venture-related podcasts in the past few months. Here are my notes:

Risk-Return: Get paid for your risk

  • The reality is that every profession has a top 10%
  • Managers are too reliant on anecdotal wisdom as opposed to first principal or theoretical basis
  • Get paid for the risk you take in two ways
    • Invest before the Series A firms (series +1 firms)
    • Getting ownership at a lower price basis
    • Get pricing power by not competing with big firms at pre-product market fit: get a real chance at ownership here
  • All investing, fundamentally, is how you get paid for the risk you take

Understanding Competitive Advantage: Playing Offense

  • After getting in early, where else is your money competitively advantage?
    • Pro-rata rights
      • If you are Benchmark or Sequoia, you get to see Floodgate and Founders, Baseline and First Round deals. They have more optionality on what deals to do.
      • It’s their specialty to do Series A and Series B deals
    • So, follow-on should primarily be exercising your pro-rata rights and for the most part in Seed deals
      • Index the top tier Series A firms;  and most (seed) funds overestimate their follow-on investing skill and spread too thinly. More often than not should overindex to these deals.
      • And many firms are not applying the same rigor to follow-on investments. When you see (seed) firms doing Seed extensions and Seed 2’s the firms are incorrectly assuming their money is still competitively advantaged.
      • On as theoretical basis what is it that you know that the market doesn’t know? Why is your wisdom greater than the wisdom of the crowd? The exceptions are:
        • Company crushed numbers and is inflecting. In that case the preemptive strategy works and you add-on before going to market
    • Always play offense with your money and when it is competively advantaged
      • Invest before others care (seed)
      • Pro-rata rights that the rest of the world doesn’t have but only I have
      • I know something on the tip of my tongue that the rest of the world doesn’t know yet (the pre-emptive strategy)
        • Hoping for the best is not an example and this is where most firms that do Seed Extensions or Seed-2’s overcommit to resere
Fund Operations Reserve strategy
    • Angle 1: ”Do you have high enough conviction to go super pro-rata? If not then its a no-commit”
    • Angles 2: Follow-on investing is more like index investing, versus picking investing. “Picking” is an infinite range of companies/ options. But follow-on investing is you investing from a fixed pool of companies. So in this case, is my wisdom greater than my wisdom of the crowds? And index investing assumes no unless you know something you are sure you know. “The problem most investors in follow-on scenarios believe they know something that are not so: intangibles of Founders, board insights, etc. But I give the market a ton of credit for figuring out the best performers.”
      • With lack of quality upstream interest, be careful to think you know something the market doesn’t know.
      • Be sure you explicitly know something differentiated.
  • “Your fund size is your strategy”
    • Successful start-up outcomes are a rare event: 10 companies out of 1,500 seed deals create 90% of the returns. Power law distribution
    • Fund portfolios within the Funds themselves also follow a Power Law distribution (more power law oriented with Seed as opposed to Series B/C)
      • So to aim for a 3x Fund and you assume a power law distribution, then the top deal is 1.5x your Fund, your second deal is 0.75x and your third deal is 0.375x, etc. All totaling to 3x.
      • And when the best company has to return 1.5x the Fundf by itself, you do the math: $100M Fund means the best deal returns $150M. And if your average ownership stake is 7% then one company has to be worth $2BN.
      • When your billion dollar exits dont return big for you, you have a problem.
Forecasting as a Strength (Book mentioned: superforecasters)
  • Amateurs can outpredict professionals in forecasting if:
    • Continuous forecasting
    • Intellectually diverse team
    • Process everyone believes in
    • Write down what they believe the truth is to the best of their knowledge at the time; AND revisit and ask the tough questions: what is surprising us and what has changed and what is the new truth with the new facts
    • GOAL: Don’t get too attached to being right individually. More about getting to the right answer for now, cumulatively.
  • As venture investors, they forecast for:
    • Pace of investing (deals, dollars)
    • Average deal size
    • Average price
    • Ownership
    • Expected reserves
  • The more uncertain a future is the more valuable the forecasting process becomes
Buffet and the Strike Zone of Competence
The art and science of hitting (baseball) is to know your “circle of competence” and where you hit best. (If a ball comes within a certain region of the plate for Ted Williams then he hits 0.450 –  And then in another part of the plate, if he took a swing he would bat 0.130) So the art and science of hitting is knowing your circle of competence, and then having the rigor to only swing at balls in that circle of competence.
In investing, there are no called strikes. So in theory you have the opportunity to invest only when a deal is inside of your circle of competence. In order to do that you have to know your circle- and that takes a few Funds.
One observation is to go back in time and ask: what are the best [seed] deals done and if so are we at a Fund size and strategy that matches that adjusting for new truth that we believe?]
Takes a while to get better at follow-on support. Everyone starts overly-optimistic. Need to adjust and temper expectations.
Seed: More of a people flow business than a deal flow business