As you probably can imagine, I get asked this question a lot. So let me take you behind-the-scenes on how I evaluate which companies to fund.
Venture capitalist usually set up limited partnership funds and file a Reg D form with the SEC. Typically, they raise capital from limited partners.
But here’s two major problem facing a new VC fund. Until you have a track record, you have no track record. Without a track record, why would any limited partner want to invest in you. In addition, with a limited track record, you’re asking limited partners to park their money with you for 10-years while investing in high risk startups.
The challenge is that only 10% of the VC funds end up getting 90% of the limited partner funding. Why is that? Because for a limited partner like an endowment to park money for 10-years, they want to earn internal rates of return between 70% and 90%. So they prefer to invest in the top 10% of VCs.
So what happens to the other 90% of VC funds that are not in the top 10% of returns? Well, they die. In fact, the average VC fund only gets a return of 18% to 20% IRR. It’s called “One fund (for 10-years) and done.”
I look for companies with the potential for 100x returns. If I invest a $1 million, I’d like your business to have the potential to get back $100 million in 5-7 years. A single “hit” with a 100x return can set-up a VC fund for life. For example, Accel Partners made over 1,000x funding Facebook’s seed round. Just one investment caltipulted Accel into the top 10% of VCs for life.
I’ve been pitched by over 1,000 companies this year. Only 3 companies seem to have the potential to fit my investing criteria.
What do other VCs look for? The VCs that are likely to be “one and done” tend to settle for 10x on a series A for companies with proven traction and 20x on a seed round. But VC general partners will likely not last beyond 10-years if they don’t hit a 100x company in their portfolio.
I’ve been pitched by some super promising companies but the problem was that the founders wanted something like 20% equity for $20 million. For a company with no revenue! Without getting into the details of pre-money versus post-money (which I’ll discuss in a future post), we’re in the vacinity of a $100 million valuation. To get a potential 100x return, the valuation would have to jump to $10 billion.
Even if successful, how many companies reach a $10 billion market capitalization?
So now that I’ve discussed the math problem for VCs, you’ll understand why VCs look at the market size as their #1 investment criteria. It’s not a secret that successful VC investments are 70% market and moat, 20% founders, and 10% product. However, the types of companies that realize 100x returns are likely to be in markets whose future size is presently unknowable. As a result, I believe that metrics like TAM (total addressable market) can be deceptive. In my opinion, VCs are simply taking wildly imaginative guesses when it comes to market size. Peter Thiel articulates another complicated factor in guessing. Thiel says, “Build a monopoly in a small market and expand into adjacent markets.” So a company may start in a small market but end up in a bigger total market.
Thiel also calls out the elephant in the room. What does every VC seek but will never admit in public? Hint… it starts with “mono” and ends with “poly.” 🤫 The greatest tragedy for a VC is to guess the right market but fund the wrong company. Silicon Valley is a winner-take-all world. Sustainable differentiation (aka “Economic Moats” as termed by Warren Buffet) is absolutely required to become the winner-take-all. Interestingly, Warren Buffett doesn’t like to use the evil “M” word either.
Finally, I’ve been around the tech scene in Seattle for sixteen years but now “snow bird” (well without the snow) between Las Vegas and San Francisco. I’ve often wondered why the Bay Area companies have dominated the 100x exits. Unlike most Bay Area VCs that only invest within a 20-mile radius from their Palo Alto office, I travel around the US and talk to companies everywhere.
So I’ve been able to compare the difference between founders from a variety of states. My observation is that the Bay Area has one thing that other areas don’t have… technical product managers who have experience in “100x Exit” companies.
Don’t get me wrong. I’ve met with experienced technical product managers (who do for example 5-Day Design Sprints) in other states but they just don’t have experience in companies that have had a “100x Exit.”
I am writing this post from Bar Harbor and Acadia National Park in Maine. If you’re looking to understand the blockchain, you’ll first need to know the difference between Proof-of-Work and Proof-of-Stake consensus rules.
Proof-of-Work (POW) was created by Satoshi Nakamoto as the consensus algorithm for the Bitcoin blockchain network. On the Bitcoin blockchain, miners authenticate transactions onto blocks on a “first-come, first-solve” basis. Essentially, larger miners with the fastest supercomputing servers “win” the Bitcoin reward by solving the transaction puzzle first.
Proof-of-Work (PoW) consensus rules allow decentralization and security at the same time, but at the cost of expensive server capacity and energy. As a result, the larger miners with faster supercomputing capacity tend to dominate the smaller miners… inadvertently reducing some of the decentralization value of the node networks. In a nutshell, PoW works for simple transactions like cryptocurrency but is too energy inefficient for more complex touring tasks needed to run apps.
The genius of Satoshi’s blockchain innovation was to make it prohibitively cost-inefficient to hack the Bitcoin network. In other words, hackers would have to inefficiently pay for the supercomputing costs of mining 51%+ of the block verifications if they wished to change the consensus rules. A proposition that makes no financial sense. Read my blog last month to understand details of how the blockchain works.
Ethereum founder Vitalik Buterin, however, plays “devil’s advocate” and claims that the risk to the Bitcoin blockchain security would be malicious attacks by governments or attention-seeking hackers.
“What about attackers who have a really large, extra protocol incentive, or just want to watch the world burn? Could be a government. Or hackers that want to have some fun. The critique here says we’re assuming we have these participants motivated by economic incentives. What if there are people who just want to break the thing regardless?” Buterin said.
Buterin is moving Ethereum 2.0 from a Proof-of-Work to a Proof-of-Stake (PoS) consensus model that will gradually be implemented over the next five years. He claims increased security, performance and scalability for an Ethereum built on the PoS consensus model.
The Proof-of-Stake (PoS) replaces “miners” (who create new blocks) with “validators.” Staking is when validators voluntarily put their own ether (the currency used to pay validators on the Ethereum network) into an “escrow like deposit” lock up utilizing smart contracts. So instead of a PoW “first-come, first-solve” reward system… the PoS grants transaction validations based on how much ether the validators lock up.
Buterin plays “devil’s advocate” on his own PoS system by explaining the possibility of Evil Smiley Face Guys who purposefully adds new blocks with incorrect transactions. So the new Casper PoS system including a “challenge period” where anyone on the blockchain can challenge the validator’s validations. If the challenger finds an error, the challenger will receive a portion of the lock up deposit that was due back to the validator.
“The challenger can submit a transaction that points to [the block in question]. That calculation runs on the blockchain. The blockchain’s like, ‘wait the actual answer is 256 and this guy submitted 250 so this guy’s wrong.’ The original guy’s deposit is destroyed and part is given to the challenger,” Buterin said.
Proof-of-Stake consensus systems can work as long as the platform is widely in use. On the Bitcoin network, new coins are issued in exchange for successful authenticating transactions onto the blockchain. Because only a finite number of Bitcoins will be issued, the limited supply encourages the value of Bitcoin to keep going up.
Because new ether coins do not have a limited supply, the value of ether has no underlying basis and fluctuates wildly based on market whims. If a better blockchain system came along causing everyone to jump on the bandwagon, the value of ether could theoretically collapse. Furthermore, because validators need to own ether to participate in validating transactions into blocks, a collapse in the value of ether will likely create a “panic” scenario where validators leave in flocks.
Perhaps, this is worse case thinking… but I’m just playing the devil’s advocate. Nevertheless, the likelihood of an ether collapse has a higher probability than a government or attention-seeking hacker attempting majority control over the Bitcoin Proof-of-Work system. In addition, a government or attention-seeking hacker could also manipulate the markets to create an ether collapse.
I’m writing this blog post from Wall Street (NYC) and it’s a good time to talk about market cycles.
Around 2002 six years prior to the Great Crash Of 2008, I read an article by Prof. Fred Foldvary who wrote in 1997: “the next major bust, 18 years after the 1990 downturn, will be around 2008, if there is no major interruption such as a global war.”
Foldvary’s prediction was based on a book that he wrote analyzing real estate crashes since 1800. The economics professor concluded that real estate crashes about every 18-years (give or take 3-4 year variations) with the exception of world wars (no real estate crash in the 40s) and currency collapses (there were two crashes in the 70s due to Bretton Woods).
The insight that the real estate market would crash in 2008 was invaluable… although I was not fully prepared for how the crash would effect my loan and realtor commissions as well as the negative effects on my construction company.
DISCLOSURE: Nothing on this blog is meant as investing advice… just mere educational pontification on my part. Oh ya… and all the photos on this blog are taken by my iPhone.
Unfortunately (or maybe fortunately for those that pay attention), the Fed does not seem to pay attention to the Austrian Economic School Of Thought. They should adjust for Credit Expansion and Credit Contraction Cycles and not just the consumer price index.
The Fed should pay attention to the rate of growth in nominal final sales to U.S. purchasers and look for deviations. The last three deviations from normal trends on nominal final sales measure of aggregate demand were the October 1987 stock market crash, the Asian Financial / Russian Rubble crisis (and collapse of Long-Term Capital Management) in 1998, and Fed’s liquidity injection to fight a fictitious deflationary collapse in 2002.
What the Fed did in those three deviations can be described as being irrationally exuberant over false indicators. The Fed over reacts to an economic crisis and over inflates liquidity into the markets that cause irrational exuberance in the real estate markets.
That the Fed uncannily does this in a consistent 18-year pattern is remarkable.
But I use these trends to my advantage. I look at investing like a NFL Football game. The first 4-5 years are Quarter 1 and would include the period 2009 to 2013. During this time, banks have collapsed and mortgages are not available. So goes my rule of thumb, “Buy real estate when no one can get a loan, and sell when everyone can get a loan.” I only acquire real estate in Quarter 1 and always sell in Quarter 4. For me, real estate is not a long term investment.
Other indicators are when purchase prices fall below replacement cost (the value that an insurance claim will repay) and when cash-on-cash returns over 24%.
SIDE NOTE— despite common belief to the contrary (and as a former top realtor this is almost sacrilege to say), your personal home is not an investment. You may have heard Robert Kiyosaki say this and it’s true. However, I still recommend you buy your dream home in a luxury area because of the prosperity identity that it provides. Read my last blog post for a discussion about the reptilian brain and limbic system.
In Quarter 2 (2014 to 2018) and Quarter 3 (2019 to 2023), it’s possible to make good money but also very risky to flip and land develop. From my experience, the risk comes from paying high interest rates IF utilizing hard money lending combined with delays from government interference, environmental issues, and permits. If you have the cash to avoid leverage with high interest rates, this could be a decent strategy. In Quarter 2 and Quarter 3, I prefer to be the hard money lender and invest in tech via my venture capital fund. Historically, keep in mind that we experience 1-2 stock market crashes in Quarter 2 or Quarter 3.
Finally, I’d be careful to invest in Quarter 4 (2023 to 2027). Indicators of Quarter 4 are zero-down subprime lending, mortgage fraud, and overbuilding by developers. Quarter 4 is the time to sit on the sidelines and wait. If you have long positions in companies, hedge your bets by simultaneously shorting these industries. You’ll need the help of a seasoned securities attorney to make sure that you’re 100% compliant with our laws.
Today… according to my perspective, we are in Quarter 3.
So many Americans want to lose weight. On New Years Day, we make a resolution to diet and exercise… through willpower. Yet after three months, we fail. Why does this same pattern keep occurring every year?
I’m writing this blog post from Niagara Falls. The sheer power of the water is breath-taking. It reminds me of why binge diets don’t work. Trying to willpower our way to fitness is like swimming upstream against the current of our nonconscious mind (Niagara Falls).
The human brain consists of three functions (well sorta). Modern neuroscience like the Global Workspace Theory has shown that the triune concept of reptilian, limbic and neocortex are not actually locations in the brain. In other words, all conscious and unconscious activities occur like an on/off switch in both corticol and sub-corticol areas.
The neocortex functions of your brain is where language, meaning, willpower and thinking occur. The limbic functions of your brain processes motions, learning and memory. The reptilian functions of your brain processes reflexes, muscle control, balance, breathing, heart beating, sex, feeding/digestion, and most importantly habits.
The reptilian function nonconscious of your brain is highly suggestible. It is like Aladdin’s Lamp. It always says, “Your wish is my command.” The Buddha suggested that our habits determine our destiny. Habits occur in the nonconscious functions of your brain. The only way to succeed as an entrepreneur is to learn how to reprogram the nonconscious functions and how to master your daily habits towards attracting the energy of money. In our Niagara Falls metaphor, your habits are like the powerful water fall.
In an upcoming blog post, I’ll explain the “goal habit” method that I’ve used to reprogram the nonconscious functions of my brain for financial success.
As a side note, the nonconscious functions explains why celebrity endorsements work so well. Our brain associates the “safe and familiar” celebrity with the new brand.
An entrepreneur also must self-master the limbic functions of your brain which determines our behavior from either pain or pleasure. In the limbic function of your brain, emotions are now understood as a cognitive activity and the amygdala is seen as what executes these cognitive emotions.
Entrepreneurs who have suffered from PTSD may have a harder time being present and getting unstuck from the past. Psychologists refer to this as self-state stories and the wrong stories could undermine your companies success. PTSD and negative self-state stories occur in the limbic function of the brain. Could PTSD and negative self-state stories be another reason why your company is doomed to fail?
A solution to PTSD and negative self-state stories is the habit of quieting your mind throughout daily meditation.
“I think therefore I am” is patently false. Neuroscience is now finding primitive neocortexes in reptiles and birds. Some neuroscientists like Joseph Ledoux speculate that emotions are a higher form of evolution than neocortex consciousness. So it’s slightly more accurate to say, “I feel therefore I am.” But that’s also slightly false. In understanding the reptilian functions of the brain and nonconscious self-identity, the correct statement states, “I have spindle neurons therefore I am.”
Will power, thinking and planning occur in the neocortex function of the brain. However, will power, thinking and planning alone cannot create success if it’s swimming upstream against the powerful water flows of the reptilian functions (habits) and limbic functions (negative self-state stories).
Success is something that requires the character of a successful person and wealth consciousness. A successful company always has a founder who has the BEING-NESS of a successful founder. Without successful BEING-NESS, a founder cannot WILL their company to success.
When picking founders to invest in, I am intuitively assessing their daily habits, how they handle their emotions, and the nature of their self-state stories. I am skeptical that determination alone is enough for a founder to succeed. A founder will not succeed if they are trying to binge diet or swim upstream.