My Own Strategy: Fabrice Grinda on Angel Investing

They say that whenever two Angel Investors team up, there are at least three investment strategies in play.  Here at the AI News, we hope to entice a few well known angels to share their strategies.  The post below is by Fabrice Grinda.

I was reading The Checklist Manifesto by Atul Gawande which shows the efficacy of checklists in complex situations. It resonated with me, because Jose & I use a checklist as part of our angel investing strategy. The checklist does not lead to an invest / don’t invest answer, but it helps us make sure we cover all the bases and keeps us grounded. It’s especially useful when we encounter very eloquent founders or products we love, which tempt us to be less disciplined. 

I alluded to the checklist in my last angel investing blog post, And then there were a 100…, but here it is more explicitly:

• Is the product live?
• Are the unit economics attractive?
• Do we like the market?
• Do we like the team?
• Do we like the deal terms?
•  

The thinking behind the heuristics

You might argue that as early stage seed investors we should be willing to invest in pre-product companies. However, it’s so inexpensive and easy to launch a site these days, that if someone can’t get the site out of the door with $50-100k of love money, it speaks negatively of their ability to execute leanly and convince others to join them. It also makes us question their ability to raise money if they can’t even get love money from fools, friends and family. 

With regards to unit economics, we don’t expect the business to be large and successful. They would not need angel money otherwise. $10k / month in revenues are enough. We don’t expect the business to cover its fixed costs, but we want to make sure the business is profitable on a unit economic level. We typically invest in a company if the net contribution margin per customer over a 12 month period is 2x greater than the customer acquisition cost. We also want to see that the customer acquisition channel can scale. For instance we want to see that there is enough volume in the keywords the company buys such that it can increase its marketing budget from $1k / month to $30k / month without needing to increase the CPCs. There are counter examples of massive businesses that did not have business models or unit economics for a long time and figured it out later when they got to scale. Google, Facebook and Twitter notably come to mind, but it’s a much riskier approach.

Note that our requirement of unit economics does not mean we expect to see financial projections from startups. When a plan meets reality, reality wins every time! Startup financial projections are not worth the paper they are written on. However, if founders know how much money they are making per customer and know how much each customer costs them, they should have a good sense of where they can be in 12 months with a $500k – $1 million seed investment.

Attractive unit economics are not enough. It’s possible that the business has attractive economics in a small market and is more suited to being a lifestyle business than a venture funded business. We use our 9 business selection criteria to evaluate the market. 

What makes for a great team varies based on the category. As we focus on consumer facing businesses we come across many super smart product driven founders – which we love. It’s also not enough. In consumer facing businesses, it’s essential to have a viable customer acquisition strategy. Of late, we have been disappointed by the lack of business savvy of otherwise super smart, product centric founders. This is especially true of Y Combinator founders, who also have a tendency to be very arrogant. This is unbecoming given how early all their businesses are. In startups so much of the success comes from rapid iteration, entrepreneurs need to be accept that they don’t typically have the definite answer and that they will figure it out through execution.

With regards to terms, we are price sensitive. 99% of startups sell for less than $30 million, many for less than $10 million. Entrepreneurs think that raising money at a high valuation or with a high cap is a badge of honor, but raising money at a high valuation prices you out of exits and makes it harder to raise follow-on capital. There is so much frothiness in the seed market today that it’s not uncommon to see startups raising on convertible notes with $5-10 million caps. Given the Series A crunch and the difficulty of raising follow-on money, we are seeing startups with $5 million in revenues raising at $5-10 million pre. As a result if we deem the seed valuation too high, we just wait for the Series A. 

We also expect all the terms to be fair, not just the cap on the note. For instance if the company sells before the note converts we expect to get the greater of whatever our equity stake would had been if the note converted or a multiple on our investment, not just our money back. After all we are equity investors, not debt investors. We use notes only because they are cheaper and easier to setup. 

Why this approach works for us

I would actually not be using this strategy if I was running a $200 million venture fund based in Silicon Valley. As Peter Thiel points out in his venture class, venture returns follow a power law distribution (read Blake Masters Class 7 notes for more details). A VC portfolio makes money if the best company ends up being worth more than the whole fund. In this type of environment it makes sense to come up with convictions about companies that can be bring 10x returns and not worry too much about what the entry valuation is or whether they already have unit economics. Such a fund does not need to worry about minimizing losses from bad investments, it’s all about finding THE investment that will make the fund.

As I previously mentioned, with our heuristics we would not have invested in Facebook, Pinterest or Twitter. But it’s also important to note we did not have the opportunity to seed invest in them either. There are plenty of great companies coming out of New York, London, and around the world, but if you look at the Internet companies that created most of the value ($10+ billion exits), they are highly concentrated in Silicon Valley. I choose to live in New York for a combination of personal and professional reasons and Jose lives in London. As a result we don’t see the best Valley deals. If we wanted to be professional angels or venture capitalists, we would move to the Valley. We don’t intend to do that and thus leave the best companies to Y Combinator, Ron Conway, Jeff Clavier, Mike Maples, Founders Fund, Sequoia and the like.

Given we don’t expect to be able to invest in the next Facebook, Google or Linkedin, we came up with an approach that makes it probable for us to get 3-5x returns on most deals while minimizing our downside. That’s why of the 30 exits I had in my angel portfolio (which don’t include the companies I created or incubated), I made money on 17 and lost money on 13 – a 57% success rate. I made money on many of the exits that were below $10 million and even several below $5 million. I also managed to recoup part of my investment on most of the 13 companies that I lost money on. Overall for these 30 companies, I invested around $2 million and recouped around $10 million with a 62% IRR.

That’s not to say we don’t have stellar performers in our portfolio – I made 31x on one of my investments, but even that standout performance only accounted for 15% of my overall returns. Admittedly our approach is suited for the limited amount of capital we deploy and would not work if we had to invest significantly more capital. However, as we don’t want to be professional investors, it serves our purposes. It allows us to support many entrepreneurs, while keeping our fingers on the pulse of the market.

For many entrepreneurs, especially first time entrepreneurs, our approach works as it increases the probability that they make money on an exit. On top of that we don’t join boards or have reporting requirements. We decide rapidly whether to invest or not and give direct and honest feedback. We also bring expertise on how to maximize unit economics: long tail dynamic bidding on keywords, purchase funnel optimizations, liquidity building strategies in two-sided marketplaces, etc.

It’s probably worth pointing out that the heuristics and strategy are not set in stone. We adapt to changing market circumstances. I will publish a post in early 2014 detailing how we modified our strategy in 2013 because of the dual impact of seed stage frothiness and the Series A crunch. However, even when we change the approach we keep using a checklist to add rigor our thinking. This might reflect my Cartesian way of looking at the world or assuage the need of my inner economist / management consultant for frameworks and models, but it seems to work. 

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The post above appeared originally in Fabrice Grinda's blog, Musings of an Entrepreneur, under the title "Why We Play Moneyball Rather than Powerball."   He describes himself as an Internet entrepreneur, angel investor, student and lover of life, aspiring Renaissance man and co-founder of OLX, one of the largest free classifieds sites in the world. He currently lives in New York.

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The Next Silicon Valley is Probably Going to be….Silicon Valley, says CB Insights

“With the exception of New York, major venture hubs have shown little progress in dethroning Silicon Valley as the place for tech VC. Massachusetts and Texas are losing ground while everyone else is flat,” according to CB Insights, a New York based database firm. 

As the legendary Larry Bird once said to the other NBA players in the 3-point shot competition: you guys are all shooting for second place.  You know that, don’t you?

From CB Insights: “Silicon Valley has long dominated the spotlight for promoting and financing the growth of emerging tech companies. And so when you’re the 800 lb gorilla in an area, there will be others who aspire to knock you off of your perch. And so we see lots of breathless proclamations from other cities and regions that they are the “next Silicon Valley”. Chicago threw its hats in the ring during Groupon-mania but it is not the Silicon Valley as the data shows. And a quick Googling of the term “the next Silicon Valley” shows Seattle, Los Angeles, Bangalore, Tel Aviv and even the Brooklyn tech triangle (yes – really) have all thrown their hat into the ring thinking they could be contenders.

“But if we look at the data, we can answer if there has been any shift from Silicon Valley to other markets in reality or if this is all just talk. Specifically, we’re going to look at a few other venture hubs namely SoCal (LA & San Diego), Colorado, Massachusetts, New York, Texas and Washington.”

Has Silicon Valley seen a decline in tech sector deal activity over time? Not the case. Tech sector deal levels in H1 2013 topped those of H1 2012 by 10% and H1 2011 by nearly 21%, respectively. On a year-over-year basis, Silicon Valley tech deal activity has grown 19%.

And while Silicon Valley’s VC funding to tech companies saw a notable dip between Q3’12 and Q4’12, it has since picked up going back to historical levels. Year over year funding has actually increased 3% and dollars are trending upward over the past two quarters.

But with the exception of  New York, geographic markets from SoCal to Texas have had a difficult time in growing their share of venture-backed tech businesses. 

In the race for second place, CB Insights recognizes the following winners, placeholders, and losers.

Winner: New York

New York’s share of tech deals has grown steadily over the past three years and has stayed near 20% for each of the past three quarters. This has been spurred by a few things. Many of NY’s largest venture-backed exits have taken place since 2010 so it’s a region with some momentum. At the same time, a strong core of investors has emerged to back New York-based cos. For example, Spark Capital and Union Square Ventures, both top-tier firms, have co-invested in NY-based Kitchensurfing, Skillshare and Tumblr among others and continue to be active in the market.

Static: SoCal

While tech funding and deals in the region has grown 8% and 18% on a year-over-year basis, SoCal has little to show in terms of overall growth or decline by share of deals and dollars versus other geographic markets.

Static: Colorado

Colorado’s share of tech deal and dollars has remained very flat since Q2’10.

Static: Washington

Washington’s share of tech deals has hit over 5% in just four of the past 13 quarters, while funding share drifted above 5% just twice (with a high of 7%).

Loser: Massachusetts

While Mass. has taken the #2 spot in VC funding across all sectors in four of the past five quarters, its share of tech deals versus the given geographic markets has fallen over time and hit below 10% in each of the past two quarters. Funding share in Mass. is more mixed, but average and median deal share has trended at 9% since Q2’10. 

Paul Graham of Y Combinator recently called out Boston investors, writing about Dropbox. “Because the best investors are much smarter than the rest, and the best startup ideas look initially like bad ideas, it’s not uncommon for a startup to be rejected by all the VCs except the best ones. That’s what happened to Dropbox. Y Combinator started in Boston, and for the first 3 years we ran alternating batches in Boston and Silicon Valley. Because Boston investors were so few and so timid, we used to ship Boston batches out for a second Demo Day in Silicon Valley. Dropbox was part of a Boston batch, which means all those Boston investors got the first look at Dropbox, and none of them closed the deal. Yet another backup and syncing thing, they all thought. A couple weeks later, Dropbox raised a series A round from Sequoia.”

Loser: Texas

While deal share has slowly trended downward in Texas (only 4 more tech deals were completed in the state year over year, funding share has seen a steeper decline. Between Q4’11 and Q1’12, funding share fell 600 basis points and then another 400 basis points the following quarter. Since then, funding share to the Texas tech market has remained at or near historical lows.

Angel investors should recognize that the analysis above is based primarily on Venture Capital (not Angel) funding and that angel group results, as shown in the GUST reports, may differ significantly. But the current CB Insights report, available here, is based on substantial data as expressed in a fine series of graphs.

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Advice to Angels from Y Combinator’s Paul Graham

Y Combinator has now funded 564 startups including the current batch, which has 53. The total valuation of the 287 that have valuations (either by raising an equity round, getting acquired, or dying) is about $11.7 billion, and the 511 prior to the current batch have collectively raised about $1.7 billion.

As usual those numbers are dominated by a few big winners. The top 10 startups account for 8.6 of that 11.7 billion. But there is a peloton of younger startups behind them. There are about 40 more that have a shot at being really big.

One consequence of funding such a large number of startups is that we see trends early. And since fundraising is one of the main things we help startups with, we're in a good position to notice trends in investing.

I'm going to take a shot at describing where these trends are leading. Let's start with the most basic question: will the future be better or worse than the past? Will investors, in the aggregate, make more money or less?

I think more.

…………………..

The fact that startups need less money means founders will increasingly have the upper hand over investors. You still need just as much of their energy and imagination, but they don't need as much of your money. Because founders have the upper hand, they'll retain an increasingly large share of the stock in, and control of, their companies. Which means investors will get less stock and less control.

Does that mean investors will make less money? Not necessarily, because there will be more good startups.

…….
What about angels? I think there is a lot of opportunity there. It used to suck to be an angel investor. You couldn't get access to the best deals, unless you got lucky like Andy Bechtolsheim, and when you did invest in a startup, VCs might try to strip you of your stock when they arrived later. Now an angel can go to something like Demo Day or AngelList and have access to the same deals VCs do. And the days when VCs could wash angels out of the cap table are long gone.

I think one of the biggest unexploited opportunities in startup investing right now is angel-sized investments made quickly. Few investors understand the cost that raising money from them imposes on startups. When the company consists only of the founders, everything grinds to a halt during fundraising, which can easily take 6 weeks. The current high cost of fundraising means there is room for low-cost investors to undercut the rest. And in this context, low-cost means deciding quickly. If there were a reputable investor who invested $100k on good terms and promised to decide yes or no within 24 hours, they'd get access to almost all the best deals, because every good startup would approach them first. It would be up to them to pick, because every bad startup would approach them first too, but at least they'd see everything. Whereas if an investor is notorious for taking a long time to make up their mind or negotiating a lot about valuation, founders will save them for last. And in the case of the most promising startups, which tend to have an easy time raising money, last can easily become never.
………..
If you want to find new opportunities for investing, look for things founders complain about. Founders are your customers, and the things they complain about are unsatisfied demand. I've given two examples of things founders complain about most—investors who take too long to make up their minds, and excessive dilution in series A rounds—so those are good places to look now. But the more general recipe is: do something founders want.

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Paul Graham prepared the remarks above for last week’s 500 Startups’ PreMoney Conference.  I took the excerpts above from the written remarks on his website. Or you can watch a video interview with Ryan Lawler of Techcrunch here.

Paul Graham is a programmer, writer, and investor. In 1995, he and Robert Morris started Viaweb, the first software as a service company. Viaweb was acquired by Yahoo in 1998, where it became Yahoo Store. In 2001 he started publishing essays on paulgraham.com, which in 2011 got 17 million page views. In 2005 he and Jessica Livingston, Robert Morris, and Trevor Blackwell started Y Combinator, the first of a new type of startup incubator. Since 2005 Y Combinator has funded over 564 startups, including Dropbox, Airbnb, Stripe, and Reddit.

Paul is the author of On Lisp (Prentice Hall, 1993), ANSI Common Lisp (Prentice Hall, 1995), and Hackers & Painters (O'Reilly, 2004). He has an AB from Cornell and a PhD in Computer Science from Harvard, and studied painting at RISD and the Accademia di Belle Arti in Florence.

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