This is what separates really good entrepreneurs from the rest of the pack is they have that vision, they have that crystal ball that they can see, and more importantly, they have the ability to articulate it and convince not only co-founders and employees to join, but also investors and customers to to see that vision with them.
Hello and welcome. I'm Shane Parrish, and you're listening to the Knowledge Project, this podcast on our website, F-stop blog, help you sharpen your mind by mastering the best of what other people have already figured out. If you enjoy this podcast, we've created a premium version that brings you even more. You'll get ad free versions of the show, early access to episodes, transcripts and so much more. If you want to learn more now, head on over to F-stop Blogs podcast or check out the show notes for a link.
This week I'm talking with Venture Capital is Code covid of Mistral Venture Partners Codes. Path to becoming a VC wasn't a straight line. He was kicked out of university not once, but twice since he's investing at the seed stage before a product market fit has been established. Working to explore a set of questions for evaluating founders, the decision making process, common mistakes that companies make as they scale and information curation. It's time to listen and learn. The Knowledge Project is sponsored by Medlab for a decade, Medlab has helped some of the world's top companies and entrepreneurs build products that millions of people use every day.
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This episode is supported by a Team History, a podcast that tells the stories of teams who work together in new and unexpected ways to achieve remarkable things. Episode one of their new season is out today, and it tells the story of how Osako pitted two of their watchmaking factories against each other in an attempt to become the best watchmaker in the world. I really enjoyed the timeless lessons we can learn from their success. Search for team history anywhere you listen to podcast.
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So if you've got an app or website idea or you're just ready for a change of pace from your current agency, let the team at 80-20 show you how no code can accelerate your business. Check them out at 80-20 20. Think that's eight zero two zero Dotti and see. Good, I'm so happy to talk to you today. Shane, I'm your biggest fan. I don't know about that, but I appreciate it. Couldn't I know each other?
That's why I'm joking around a little bit here. You were kicked out of university not once, but twice. Can you?
What a great starting point. Not not my finest moment, actually. It's it's a love story. So we'll start off our our interview here with the love story. So it was a love story gone wrong. Third year university. My girlfriend of two years broke up with me. It was brutal, to say the least. And I spent an entire semester, fall semester sort of working it out. And that meant ditching classes and exams and and just generally doing poorly.
So at the end of that semester, of course, if you don't succeed well enough, they ask you to take some time off, which they did. And I couldn't contemplate that. So I sent a letter saying, hey, can I have another chance? I'm really sorry I screwed up, but I think I've got my head on straight. And they agreed and they said, OK, but you're on probation for the spring semester and hope you do better, like academic probation.
Academic probation. Right. So I went back for the spring semester. I did not do better. Turned out I didn't have things locked in and so they asked me to leave permanently. The good news is the story has a happy ending. I did take a year off and the following spring I sent a letter and said, you know, this real world stuff is really hard. With half a degree, I feel incomplete and can I please have another chance?
And so they agreed. I'm grateful for that to this day. And they the readmittance letter said, OK, you're on probation again. And by the way, this is your last last chance. So on the on the happy ending part, I graduated with honors. Top of my class was a sort of a turnaround story. I had had everything lined up and and it was a good ending. Where did you learn during that time?
Well, I think the biggest thing was that life is hard on your own and an academic degree and some schooling is a big help. And I just sort of got over the issue of that particular girl and renewed my commitment to success and and moving forward. I'm curious as to how you became a v.C.
What's the two second sort of short two minute 60 seconds of the two minute version from the end of university or three minute version until now? Sure. I graduated university in the late 90s. Ninety six, I think, and immediately went to IBM. So I did an engineering degree in undergrad and IBM was sort of the pinnacle of what I thought the world could be. And so I accepted a job and spent two years at IBM and really didn't like any of it, partly because I was very junior and there was a lot of very senior skilled engineers there.
So you ended up getting relegated to all the menial stuff. So on the heels of that, I moved from Toronto, Canada to Baltimore, Maryland. So I moved to the US to a startup called CNR, and that afforded me a lot more opportunity as a startup to be a designer and build real world things and have my hand in it in that process. Got an MBA and in my MBA class, I met my first VC. I'd never even heard of the asset class.
Didn't know anything about finance before that. When I heard what venture capital was about at the time, I fell in love immediately and decided that was it for me. And so within weeks I went back and happened to have a fortuitous meeting with the CEO of CNN and they ultimately hired me as an analyst in their new venture program. So I cut my teeth as an analyst. And then I moved to California, where I came up through the ranks, associate principal partner at multiple firms, and had a fairly successful start.
I finished at Motorola Ventures as running their West Coast program in California, which was great because the business card got me into deals that I wouldn't have normally gotten into with my good looks and charm. And so but Motorola canned the program effectively in during the 08 crash. And so I ended up leaving and going to a startup that I had funded and joined them as the CEO. And we grew that business for a couple of years and sold it successfully.
And then I took a sabbatical and sailed around the world for a year and then moved to Canada to start a venture program of my own.
So there's a couple of things I want to dive into. One, your undergrad was in physics or in engineering.
And so what were you doing, as you know, like what was the original job there? So I was an RF engineer, so radiofrequency designer, high frequency circuits, 10 gigabit optical links, sort of deep tech hard stuff.
OK, and then in silicon, like you went to become the CEO of a company.
How did that touch me with that experience? A little bit?
Yeah, it was interesting because I'm not a very good number two. You know, this is a personal thing, difficult for me. I question decisions constantly, whether they're minor or somebody else's. But even before university or while in university, I started five of my own companies, two of them venture backed. So no stranger to being an entrepreneur, I guess you'd say, and creating things from from scratch.
And so as a solo it. Was your eye color, the chief other officer, right, so I cleaned up after the CEO who was a genius in his own right, but really difficult to work with. So basically he would make promises left and right, and I would fulfill those promises as best I could. And it was a good thing we sold when we did. Otherwise it would have exploded.
Having that perspective, having worked in that role and also your perspective now, investing in teams of founders, how do you see that role?
It's critical, right? It's critical in a couple of ways. One is the operations person who fulfills on the CEO's vision and dreams and goal. But it's also the the right hand person to the CEO. So as the counterbalance of all that enthusiasm and and and drive, it's the levelheaded, sort of practical, pragmatic co-founder role. In my view.
A large part of your job now is evaluating founders. What what are the tools, the questions? You are the sort of things that you look at in order to do that.
Sure. You know, I think it's a bit cliche, but it all comes down to people. Right. So my job really is to meet with people and get to know them and decide who I want to work with. And so we've passed on good founders and we passed on not so good founders, but at the core of it, it's, you know, does this person have a vision on the future that doesn't exist today that we want to play a role in?
And it all starts with my first question with every interview is tell me about Inception. So why do you want to do this so badly that you're willing to break through walls and spend years in the cold as an unknown at the shot for the shot of being a successful entrepreneur? And the answer that you get back is really insightful, right? Is it is it a problem that they've experienced personally for a long time and just have to solve it? Or is it a job?
Is it are they want to partner who found some technology?
They want to exploit it or want to dive into that? I've never heard that before. Yeah.
I mean, I think entrepreneurism in general is a fairly new phenomenon, ironically. So it used to be an entrepreneur with someone who was between jobs, if you think about 20, 30 years ago, and now it's a bona fide vocation. They teach at a university. That didn't happen before. But I think the sort of the cachet and persona of an entrepreneur is the the Bill Gates, the Zuckerberg of the world, these these worldchanging amazing genius types.
Bezos, another good example. And so it's become a very cool thing to be is an entrepreneur. But there's a difference between being an entrepreneur and being born an entrepreneur and sort of having that DNA deep inside go into that. Like, what does that what's the difference?
Yeah, I think I think some entrepreneurs, just like it's like a bohemian group or society, that it's cool to be an entrepreneur and the underdog and and they you know, they feel oppressed by society and sort of fought against constantly versus the optimistic entrepreneur who sees the future a different way and, you know, eliminates all the barriers to getting there. Fundamentally different people have a friend who described being an entrepreneur as eating glass every day and then getting up the next day and wanting to do it all over again.
It's probably true.
I say it's the it's the hardest, most impossible job that you'll ever love. And it's the only opportunity that you can have as an individual in business to really create impact in the world. Otherwise, you're an employee, part of a big machine. And so it's the most exhilarating, you know, two miles an hour that you can ever go.
What are some of the other questions that you ask other than the story in the wall? I like to get to the really the character of the people that you're investing with to establish trust, to understand them. You bring them trust, which is critical. Right? So integrity, trust, rapport, all of those things are really integral to successful relationship. And at the core of all successes are talented people who are trustworthy, etc.. So rather than pick a personality or an entrepreneur from a series of interviews, what we do is we invest upside down.
So we invest a small amount at the precede stage and work very, very hard with our entrepreneurs to get to a series. And at the series, we invest significantly more than we did at the seed stage. And the reason I say that's upside down is that most firms will do one of two things. Two other things. One is they develop deep conviction and knowledge around a space and they pick the best founders to prosecute that space. And the other strategy at the seed seed, at the seed or series A?
Sure. And the other strategy is what we call spray and pray. So that is a high volume of deals, small check sizes, and then you hope for the the power law of venture economics to play their role. So our view is that it's nearly impossible to pick winners at the seed stage. There's a lot of memory, I guess you'd say, and hard won battles that that helped guide our decision. But at the end of the day, we are humble enough to know that it's impossible to pick unicorns consistently.
So instead, what we do is we curate a portfolio of 15 to 20 companies at. Seed stage invest a small amount of capital, but invest a large amount of time in the ensuing year for the opportunity to get to know that founder, to build rapport and figure out if if they're up for the task and then even more importantly, figure out if the market deems them worthy and their product worthy to exist at all. So put a little bit of money up front, see what happens, and then you get the optionality on the series.
That's the idea. That's right. So they ostensibly they invite us in because we don't necessarily have pro-rata rights, which means we don't have the right to invest significant amounts. So you also have to be a good partner and we have to earn it. That's exactly right. Now, the perverse part of that model is, of course, that we buy a very small chunk of a company at the seed stage as opposed to a regular VC who will buy 15, 20 percent of a company and have a more dominant influence.
Talk to me. You mentioned the power law of VC economics. Talk to me about that. What is that?
Yeah, I mean, if you look at the share, I'm going to I want to say failure, but I but I, I sort of hesitate to use that word. But the reality of venture is that at every subsequent financing, about half the deals fall off. And so to become a unicorn is a one in a thousand proposition. And so the power law basically says that you need to find that one unicorn in your portfolio of 20 or 30 bets of each fund in order to have the kinds of returns that our LPs, our limited partners are expecting.
And so those numbers are very hard to find. And unless you're a I'm going to call it a tier one firm who has a history of getting amazing deal flow from the best founders, it's really tough to to live on the power law and expect to get a unicorn in every fund. So we have a slightly different model. Ours is especially in a tier two market like Canada, if you will, as opposed to Silicon Valley. There's less unicorns born here.
So we are looking for the the the solid but mid hundreds of millions of dollars exit as opposed to the billion dollar unicorns. You need a higher batting average. We need a higher batting because the inbound is different and sort of like the deal flow is different or just the nature of the the economics is different. I think I think it's a combination of all of those things. I think the Canadian market is still nascent. It's early and young. I wouldn't take anything away from the quality of founders that we have here in the quality of ideas.
But the entire ecosystem is less mature and it's getting better day by day for sure. But you can't expect to for a number of systemic reasons. You can't expect to find a unicorn every year in Canada. What's in that ecosystem? What do you mean when you say ecosystem?
Well, the ecosystem of entrepreneurism, right. And innovation starts at the grassroots with a culture of risk taking. So that's a key piece. And that's followed by education, universities that are doing cutting edge research in things like artificial intelligence and distributed ledgers and so on. And then you have to have a robust ecosystem of incubators and accelerators and early stage venture firms and angel groups to support them, those students as they come up. And then, of course, you need the other layers of financing to continue funding the best companies all the way through.
A lot of people would argue that you can't identify these things in the beginning and it's just through sort of randomness that some of them work out to these these exits that generate the returns.
But you make a living sort of on the other side of that. Can you riff on that for a second?
Yeah, I think the numbers numbers sort of show that venture backed companies historically and statistically do better than non venture backed companies and not to sort of blow our own horn, but VCs have a lot of experience in pattern matching and they simply have a lot of exposure to things that company founders don't have every day. And so the idea of being a venture bankable company in the first place is a different kind of category of company. And having a good syndicate of VCs around the table who can give you insight into customer behavior, trends in the industry, talent that you can attract, etc.
and the credibility that goes along with being professionally funded gives an edge to those companies. So I can say refute, but I believe that venture backed companies tend to do better than none. I'm fascinated by these patterns. What are sort of the patterns that you see that are precursors to failure in startups? Like is there a way to change course? Is there you can see this in advance. Like talk to me about what you see is why did startups fail?
I mean, the number of reasons for failure probably far outweighs or far outnumbers the reasons for success for sure. But there are certain patterns, and it surprises me every day, actually, how very basic business fundamentals are lost on entrepreneurs as they're coming up. And I things that I simply take for granted, having done this for 20 years, are still news to founders. For example, building a pro forma financial model that takes into consideration what I'm going to spend and how what my expectations are for revenue in an honest, intellectually honest way, whether it's bottoms up or top down approach.
Being honest about where. Swimmers are going to come from how you're going to talk to them, et cetera, et cetera, is not something that is natural instinct for a lot of entrepreneurs. So having a clear roadmap inside a business is is fundamental. And to many companies start out with sort of grasping at straws and hoping for the best. And part of that naivete is important in building a company. But I think a solid structural plan is also critical.
Other failure areas come down to human dynamics. Right. So it's the the ego needs to be checked at the door problem where you have overzealous founders that don't communicate with their employees. They don't build a culture of success in winning. They don't communicate with their investing partners. And you can tell that pretty quickly, especially the early stages, because it's a fairly intimate group of small number of employees. Those are precursors to failure.
Almost every time there's some sort of like come to mind as you were talking, it was like, oh, those are what about like the idea of failure?
And then there's sort of like failures of the entrepreneur that might not be sort of like ego driven. That might be people driven. Right. Because often you start a company, I would presume, with friends or, you know, close people close to you. And then as you grow, you reach the ceiling of of capability of people, yourself included, like as you try to scale. Talk to me about some of the problems you see as companies try to scale and then getting rid of people like how do you decide when to move on from somebody who's got you to where you are?
There's there's a lot packed in that question. Let me see if I can tease it apart. You know, some common mistakes early on are expecting that you and your three co-founders, who you've split the company up four ways. Twenty five percent each will scale and it rarely does. Right. So more often than not, one of those co-founders finds something else to do and now they are benefiting because they have twenty five percent of the stock that's not invested.
So that's that's a simple mistake that we look for in capitalization tables before we invest. Following on that, there's the nepotism law, right? So rarely do husband wife teams work out for a number of reasons, but not least of which, in our view, anyway, you know, let's say the wife is the CEO and the husband is the CTO or the CFO. You know, their direct reports are rarely going to not going to go to the CEO and complain about the CFO.
So there's there's obvious dynamics there. Those are those are things that we have learned through hard knocks. And what happens there is you're getting insulated from information that, yeah, essentially.
And there's agency issue. Right. So what we're trying to do is minimize mistakes and thereby maximize opportunity. And so those common ones are minimized and they're observable right out of the gate.
So do you avoid them or do you sort of like is this one of the reasons that venture backed companies are more successful is because you bring these perspectives where you're like, OK, this won't work with this? It's a good question.
I think I think we're probably subject to our own biases in our most recent deal. Right. So to the extent that I've done 50 or 60 deals in my career, you know, there's been a lot of scar's, a lot of learning. It's probably only 10 or 15 percent of those have exited in a very positive way. And that's the reality of the economics. But the other call it, 80 percent who failed or did poorly presented learnings and lectures that that we've taken to heart.
Right. And so those are the the rubrics that you apply. Now, it's not to say that we would never invest in a husband and wife team or four co-founders who decided to split the company four ways. Those are signals to us to really challenge the entrepreneurs to to find out what what they're really in it for.
Do you think it's possible to have an even divide amongst co-founders like a 50/50 split or twenty five? Twenty five. Twenty five? I don't actually.
And so the reason is that at the earliest stages you have to sort of forward, look, the cap table. In other words, I'm going to raise a seed and I'm going to get twenty percent dilution. Typically the series is another 20 to 30 percent dilution and so on and so forth. And so the question is, at the end of the day, when you're at zero and you now own five or six percent of the company or let's say seven or eight, is that enough to keep you motivated and knocking your head against the wall?
Eighteen hours a day and busting through all of the barriers that are presented to you. And it's a question mark. Having said that, if you own 50 or 60 percent of the company, then you are all in. And so it's that simple, forward looking five year ahead view that we bring to the table. Right. And you do you sort of clean that up or do you avoid the situation?
It depends. It depends on how coachable the entrepreneurs are. And I don't say that with any sort of arrogance. But, you know, a good entrepreneur is a good listener as well. Right. They don't necessarily follow your advice because that's that's not necessarily a good thing. But they'll listen to ideas and perspectives and then they may right the ship. So I've been in situations where, you know, husband and wife team, they they decide, yeah, you're probably right.
And we're already feeling the strain at home. And so therefore, one of them is going to go off and she's going to continue to run the business as an example. But if they dig in their heels and say, you know, that's not going to be an issue, I guarantee it. I know this. We're different than everybody else, then we probably walk away. I'd love to hear you riff on the concept of ability because from one angle as.
Sort of the venture backor there's a credibility angle to it, but I would imagine a lot of what goes into being coachable actually transcends itself into the company as well and makes for a better founder or better operator.
Well, it does at its core ability is is sort of a willingness to be introspective and a willingness to respect feedback, whether it's from the market, from your employees, from your customers, from your investing partners. And so the entrepreneur who dismisses all of that and sort of their ego precedes their their rational ness. They end up failing in my experience. And so ability is critical. And you test that very quickly by challenging them in initial meetings. And so I don't agree with that.
That's the wrong approach. And just see how they react. And sometimes I'll be a little bit provocative just to test it. Is this proposed investment or both? And both. I mean, you certainly do your best to pre, but you once you invest money in a company of skin in the game, it's a different dynamic altogether.
So what are the differences you see in the response? You challenge this, the CEO, you're trying to put money into the company. They want to raise money. You've probably seen a spectrum of different response. Or should you talk to me about some of them? I have to say, and I was a bit tongue in cheek, but it's the entrepreneur's job to lie to me until I cut them a check and it's my job to pick the best liar.
And so, you know, integrity notwithstanding, which, of course, critical here.
But when you challenge an entrepreneur with a tough question and you challenge their assumptions, you know, they can react in a myriad different ways. Right. So they can obviously be really defensive, immediate media and say, no, you don't understand. This is the way it is. Well, that's a pretty strong signal. The ones I like are contemplative and they'll sit back and go, that's really interesting. Have you thought about it this way? And they'll they'll contemplate it and maybe they shift decisions or maybe they don't.
I prefer the ones that take it in consumate and then dictate their own path, not necessarily mine, because the fact is they're qualified to run their business. I'm not I'm qualified to advise and be a mentor, but I'm not qualified to run the business. Should the board do you think I always agree with the founder? Not necessarily. I mean, there's board dynamics. There's a whole nother subject. But, you know, I think it's it's a it's a variety of perspectives.
Board meetings in general are a venue for everybody to say what's on their mind and get educated and put it all on the table. And then hopefully the best decisions come out of that meeting. Not necessarily unanimous.
I'd love to hear like you're on the board of a lot of these companies. What's the difference between a bad board member, a good board member and an amazing board member? And I realize there's some flexibility to the role in terms of the company.
But what are the attributes of those different people bringing to the table at different levels?
I think well, maybe try and do is reframe the question to what is a you know, what is a board meeting for early stage companies? What kind of binded their you know, what we tell our entrepreneurs is that they're not really board meetings.
They're a moment for you to get out of the weeds and riff with a bunch of sympathetic, aligned partners on where to take the business and out of a sort of day to day tactical decision making mode into a strategic decision making mode so that that has implications on both parties. So from the entrepreneur's perspective, there's a spectrum of I hate I have to report to the board and I've got to spend three days crafting all these slides. And then I'm going to I'm going to go in and they're going to tear it apart to the other extreme is I'm using internal documents that I'm using to run my business.
And that's what I'm presenting to the board. And I have I've thought about it and I have three or four key strategic questions that I want to discuss with the board and get their perspective and then come away with a slight adjustment or realignment of the business. That's the entrepreneur's perspective. From a board members perspective, I think you have to show up with some humility and empathy for what the entrepreneur is going through. The other one hundred and sixty or one hundred eighty hours before you met them last or after you met them last.
And so I generally think of early stage board meetings as really brainstorm meetings, not board meetings. The board meeting, part of the formal formal part of the governance is five or ten minutes. Right. It's stock option allocation. It's a strategy around syndicate investors, follow ons and so on. But the vast majority of the meeting should be on the whiteboard talking about core strategic decisions for the company, which markets to go after next, who to hire, how quickly to spend the money.
What's our fundraising strategy? Deep, deep, important questions like that. And how does the role of the board change as the company scales?
Yeah, I think at some level later stage companies, it's a very different dynamic.
So I'm on a bunch of where I'm at least a couple of formal large one hundred million dollar plus company boards and it's a lot more formal. It's a little bit more nose in, fingers out, actually it's a lot more nose in, fingers out to use that use that cliche. What does that mean. Means that your you're observing and advising and reacting, but you're not managing, you're not necessarily creating dictums for the company to. Because the reality is that the company and their team are in the business, you know, two or three thousand hours a year as a board member, several dozen hours a year.
You're certainly not qualified. And if you are, you shouldn't be you should be in the company. Right. You're not qualified to run that business. And so it's a different dynamic at that point. I think board meetings then are a lot more about governance later stage conflicts of interest, public market facing type dynamics that are very different than an early stage company.
And how do you advise CEOs to pick board members at the early stage?
Yeah, I think of it as several tiers of advisors. Right. So as an investor, we generally get the right to be a board member or an observer in their board. And and that's really fundamentally so that we have information that we can report to our bosses, which are limited partners. So that's contractual. Right. So there's some board members that are filled by the investor base and then there's usually one or two independents that we we should as high as we can.
We get experts from those industries that have a pension for early stage companies and want to help out. We're all about finding the very best talent that's available. I have a friend who says the business plans aren't worth the paper they're printed on, but the process of creating the business plan is actually the value. And I'm wondering if there's something to the board meetings or to where the entrepreneur is, not necessarily the information that's being presented. It's the fact that they're focused and and diving in and collecting that information, trying to figure out what it means, anticipating questions from the board members as a means to better understand the business.
I mean, I couldn't have said it better myself. I'm in the board meeting is a time to reflect is the time to prepare for its accountability where we all know the Jim conundrum. You only go to the gym because your coach is there and you don't want to show up late and that forces you to workout and become a better you. So it's the same thing with board meetings. So it's it's the preparation process that is really where the value lies.
And in that that quiet contemplation that the CEO goes through, that's out of the weeds out of the day to day.
Walk me through your entire decision process from finding sort of possible companies to invest in all the way down to making the investment decision, writing the check. What are the gates that you have? What are the questions you're asking yourself? How are you evaluating not only the companies but yourself in order to commit capital? A bit more of a long winded answer. The process for us can take anywhere from, I'm going to say, two months to a year from actually multiple deals.
It's several years for whatever reason. We're tracking companies, but it starts with that initial meeting. So we'll be introduced to a company through a reputable source, one of our limited partners, another VXI, an accountant, a lawyer, etc.. We'll have that meeting and we'll decide whether we're interested at all right. Out of the gate. And so that comes from three things. Three core questions. Do we like the team? Do we like the technology?
And do we like the market? So we have a general rubric of what we invest in, which is enterprise software, and we're looking at the intersection of technology and enterprise functions. So does it meet that market segment? Is it big enough? Is it growing? Is it interesting? And we'll be able to assess that fairly quickly. The technology itself takes a little bit more digging and probing, but we can figure that out whether there's enough to go forward in that first meeting and then the team itself.
Again, it's a relationship building exercise. It's multiple meetings over multiple days and a rapport gets built up. Then if we agree that we want to move forward with the deal, we'll start doing diligence. So ideally, we're talking to customers, we're talking to personal references. We're getting to know the team even better, understanding the business model, challenging it, going through it, establishing all of those check marks. And then we'll have a conversation around valuation and structure and how much we're going to invest and what expectations are on both sides.
And if everybody agrees on that, then we have an agreement in principle. So we'll draft a term sheet. Entrepreneur will react to the term sheet. Some negotiation happens back and forth there. And and once that's done, we make sure that we have a full syndicate. We do definitive docs, which is the legal process. And just for for early stage, entrepreneurs are listening. You know, it's probably twenty or thirty thousand dollars on investor side and company side to prepare those docs.
And and then we have a closing. Checks are wired and ideally we have a 90 day, one hundred eighty day plan post investment whereby we set up the KPIs that we want to track and that we agree that the company with the company, that that's what they're shooting for. And then we move into the operational process. Are you cashing it entrepreneurs or anybody at this level or is it more you're just investing money into the company with a specific purpose in mind?
Definitely not cashing out entrepreneurs at the seed stage. Right. And I think it's probably wrong to assume that you're going to get a secondary seed stage every once in a while at a series or series B, typically a Series B, and I think it's prudent for an entrepreneur to take some cash off the table. Generally, good entrepreneurs aren't necessarily cashed out millionaires, and so the stress that it puts on them and their family can be alleviated a little bit.
By taking a secondary at the Series B, but we want full alignment early on because we know how hard it is, we need we need everybody rowing in the same direction. And how do you come up with a valuation? Like where does that come from? Often. I mean, from an outsider's perspective, it seems like some of the valuations I see tossed around in the newspaper headlines are just they seem outrageous based on the economics of the slightly arbitrary.
No, no, there's some rubric. So they're in SAS based businesses because they're very data driven SAS by itself or as a service. You know, there are there obvious statistics like the cost of acquisition of a customer, the CCAC, the lifetime value LTV. There's ratios there's different dynamics that you can pull from other companies that are successful and you can apply them to your company and then you can raise and lower. Generally, it's a price to sales multiple.
You can raise and lower your multiple based on the dynamics. Right. So if I have very high churn, you're going to get a lower multiple. If I have very high margin, let's say in the high 90s, you're going to get a higher multiple. But at its core, it's a function of a couple of other things that are somewhat different. One is the investor syndicate needs to own enough to make it worth their while. Right. So a lot of VCs will say I need to own 20 or 30 percent.
We won't get involved. Otherwise, angel investors may simply want to put dollars in and get reasonable ownership out. At the same time, the founding team needs to have enough equity to make it worth their while. And I think some VCs have it upside down where they say, well, we're going to own all this business, but then you've lost alignment of your founder. And if you lose your founding team, then you're in a lot of trouble.
Similarily employees, the option pool has to be sufficient and interesting enough to attract the right kind of talent. So we think about all of those dynamics when we come up with a term sheet and the valuation so that we're best prepared for the long term. And are you specifying what the money is used for? Look, at this point, I don't know. Right. Like have have companies proven the idea works at this point and now you're trying to turn the flywheel or it's like you're on the cusp of trying to prove it.
And then the series A would be more OK, now we're going to like just turn this flywheel more and more and more. We've got the model working right.
It's a great question. And it comes down in my mind to a business is a machine in a box. And what you're looking to do is put money in one side of the box and have more money come out the other side of the box in a very simplistic way. At the seed stage where we play, rarely do we know we have product market fit. So it's a lot of customer exploration, a lot of talking to customers, some early customer trials, some indications that the product does what it says it's going to do.
And we explore that with our companies. Now, there's an overarching thesis around what they're doing and the utility function, which is a function of the value that you're providing to the customer. So we think a lot about the value proposition. In other words, if I give you this product for one hundred thousand dollars, does it save you a million dollars? Rough economics 10x and therefore you're going to buy it. So we have that thesis and we have some early customer exploration and customers that we can talk to.
And that's the beginning of the relationship. So that's the seed stage going into the series. You have to have enough momentum and some early economic ratios, LTV to cash, for example, to prove that there's a market for your product. And so the series, the investors want to talk to a lot more customers and validate that this thing starts to scale the series. A investment is really around adding that scale, adding sales people, refining that box that I mentioned and understanding clearly the business economics, the unit economics of what you're selling, what your cost to acquire customer is.
And then at the Series B, it's all about scale. So we have a machine, we know it works. We pour gas in the tank is just going to go even faster. That prompted a whole bunch of things where you're answering that one. Is there a problem with technical founders or a default, I guess, to overinvest in technology and under invest in sales have made this mistake so many times.
You fall in love with technology, OK? Yeah. I mean, you fall in love with technology as a as a focus group of one, which is mistake number one. Right. So I'm a terrible focus group, for example, but I'm a technologist, so I love the gee whiz disruptive technology. The problem is that the world may not the world is a fickle place and it doesn't necessarily think the way I do. A stolid mistake the founders can make is relying on the better mousetrap to solve the day.
So the better approach is to do a lot more customer exploration and find out where the real pain is in the market and customize your product to suit that. And I can tell you that it's much easier as an engineer to build things with lots of bells and whistles and features than it is to go and talk to a customer because they're big and scary and they say no. And but the opposite is actually the best path. Go go talk to customers first and then solve their problem second.
I might be making this up, but I remember when Microsoft was under the antitrust sort of microscope and I think Bill Gates said something to the effect of the best technology doesn't win. And that has always stuck with me.
I don't even know if it was him that said it, but that line is sort of like stuck. With me as I watch technical founder sort of start companies and then struggle on the sales and marketing side or struggle to to sort of delegate that to somebody they trust.
Yeah, I mean, the problem is age old, you just the quintessential business school example is VHS versus Betamax. Right. One was better technology with smaller, denser, etc. and it still failed. They were executed. And so no question that marketing and sales trumped ideas and technology all day long.
So let's come back a little bit to sort of idea and execution. You need both together, right? A great idea with poor execution goes nowhere. Great execution on a bad idea might be, you know, a cash for you at the same level or something.
When you're evaluating the team, you're not just evaluating the founders or the sort of like that part of the business. You're evaluating the next level to the sea level in the business. And how do you think about that? Like, how do you evaluate those people where they're not the founders and they work in the business and they're probably not professionals, so they haven't scaled?
Yeah, I think the sort of bottoms up the the the balance of the team, the sea level team and the rest of the employees are evaluated on a matrix basis. Right. So your CFO, do they have the credentials and experience that that makes them suitable for that role? And that's the same for for engineering, et cetera. Do they have the right tools that we think are necessary to get the business past this stage? Because it's not always necessarily the the team that starts doesn't necessarily finish.
In fact, that's that's most appropriate. But it really comes down to the narrative of the CEO. It really does. Is their vision of the future that doesn't exist today that you want to buy into. Do you want to fall in love with and get excited about and then play a role in? And so it really does always come back to that to that vision.
How do you do that, though? Like how do you predict the future before it happens? Most of us anchored to the present.
If we're we're thinking about what the world is going to look like in five years, we sort of think about what it looks like today with this incremental progress. And what you're trying to do is often know the world that we know today is not going to be incremental. There's going to be a zero to one sort of flip, and we're trying to identify that flip in advance.
And this is what separates really good entrepreneurs from the rest of the pack, is they have that vision. They have that crystal ball that they can see. And more importantly, they have the ability to articulate it and convince not only co-founders and employees to join, but also investors and customers to to see that vision with them.
Talk to me about some of the mistakes that you've made. So what happens when you realize you've made a mistake? Do you just immediately write the company off and don't invest in it? Aleg don't invest any time in it anymore. Do you dive in and try to solve that? I know you're huge on problem solving and troubleshooting. Sure. Like, how do you handle that.
Yeah, there's there's a number of different models. I wouldn't necessarily say that ours is the best, but some VCs that I know I won't name names and believe in cutting bait early so they will invest in a company. And if it's not tracking, they simply walk away. Whether they sell their position or resign from the board and let the company fend for itself is their strategy. Our view is twofold. One is because we invest a small amount up front.
We have a structural sort of gate at the series before we invest a significant amount of capital. We have a much more clean decision, thorough diligence process, and that means that we can walk away from our early bets with minimal capital deployed and chalk it up to a learning experience. It's a lot easier to walk away from a couple hundred K than a ten million, and that's it. And so in our in our last fund, our cap was five hundred thousand dollars and it's a very small percentage of the overall fund, call it one or two percent for each deal.
And so you don't lose any sleep by walking away from those deals. And to be clear, we make those expectations super clear upfront with the founder. So we say, look, we're not writing a bridge note, we're not following on unless we meet these milestones that the market basically decides whether you exist or not. And they're comfortable with that. So that's the structural way that we do it. Having said that, there's always cases where a company is doing fairly well, not super gangbusters, but they're doing well enough to warrant a follow on investment.
And so now we're in it and that's really where the hard questions happen. So then it starts to go sideways or the market speeds up and goes past them, et cetera. Our view is that that we're partners with the entrepreneur through thick and thin. And so all the way to the end, we work very hard, even with the companies that aren't going to be gangbuster successes. And we think that the economics of that provide us with a 50 or 100 percent of a, um, payback.
And what I mean by that is, let's say you have a hundred million dollar fund and you have a company that you've put ten million dollars in. And if you walk away, maybe you get two or three million back, but if you help them, maybe you get a full 10 million back. So we think we can preserve probably half of the fund by putting in the extra time. Now, the trade off, of course, is that it is extra time and it is a lot of energy.
And so it's not for everybody. But our part of our ethos is that we enjoy working with entrepreneurs. We want to roll up our sleeves. We. Have a lot of experience and we want to bring that to bear, so the mistake at that level is sort of like self-explanatory. But what about the Serizawa when you commit money at serious a level and then you would like or you admit to yourself or the world's giving you feedback that you've got that wrong, how do you how do you get that feedback at that level?
Because now you have more capital committed. The sunk cost not only in financing, but time.
It's real. It's the nature of the game. I mean, if you're if you're afraid of failure, you shouldn't be a VC, that's for sure. This is probably the highest risk asset class in private equity that there is. And so by its very nature, half of your companies are going to fail. And if you're not comfortable with that, then it's probably not for you. And so the real question is, how do you deal with it when you start to see the ship going sideways?
Know and there's lots of tools for that for a VC. We can we can advise the company or coach them to sell the business early, try and recover some capital. We can make a change at the CEO level on occasion. Not my favorite thing to do because I think it rarely turns out well. But there are things we can do to right the ship. And if all else fails and the company goes under, that's that's the nature of the game.
You said you were conservative earlier and it's interesting that you just said if you can't accept failure, you know, you sort of shouldn't be in this business. Can you talk to me a little bit about that? Have you always been comfortable with failure or is this like you forced yourself through this process or.
I've always been comfortable with failure so long is that I face it with integrity and work hard to to do the best I can. And then I am comfortable with it. I think, you know, ironically, I my my personal portfolio is quite conservative. I have a lot of real estate investments and I do ETFs. You know, I don't trade. I invest in my funds, of course, which is investing in myself. But outside of venture capital, I'm quite risk averse, which is which is ironic.
We've had many conversations about sort of the CEOs and the response, how many active CEOs do you have and all three funds now at this point.
So we've invested in twenty nine companies in total in mistrial. And I want to think that there's about 20 left running. And so we've had a number of exits and failures, a couple of failures so far. And you're in contact with CEOs all the time. Talk to me about how you saw the transition between sort of February, March, April, the difference between CEOs who adopted right away and responded to that change and CEOs who sort of like denied what was happening and how the businesses sort of responded to those different cadences by the CEO, I guess.
Yeah, there's a question buried in there, which is what's the difference between a really good CEO and kind of a mediocre CEO and in my view, an experience and actually even some research to back this up that the most successful companies are highly correlated with timing? First of all. So are you in a bear market or bull market? That's the number one correlation between success and failure in business. Number two, correlating success factor is the market that you're in.
So if you're in health care, if you're in it, if you're in primary industries, each have their their cyclical time of success and failure. So, again, that kind of comes back to timing. But as a subindustry, the third most correlated indicator of success is the CEO. But ironically, it's only about 40 percent correlated. And so the question is, if you if you want to maximize that, because that's really the only thing that you can participate in actively is your CEO choices.
And so then the question is, what makes a really good CEO versus a less good CEO? And I'll start by describing a CEO like kind of a subpar CEO. That's the CEO who is terribly articulate, knowledgeable, experienced, credible, meets their numbers. Employees like them, investors like them, very, very compatible, very easy to get along with. Then you see yourself. Well, that sounds like a really good CEO. What what's the difference in that in an actual CEO is a an executive who sees change coming, you know, six, nine, 12 months ahead of everybody else and has the ability to change course in in the face of opposition from everybody else who is happy with the status quo.
And so that's a good rubric for thinking about covid in March. Right. So we went through this because we obviously have dozens of companies. We have dozens of experiences with different CEOs and how they dealt with the crisis. I'm happy to say that across the board, our companies are doing well, mostly because we we invest in enterprise software. And so, again, the utility of what they provide provides value. Having said that, there is a difference between the reaction of different CEOs in that time.
So, you know, the best CEOs I can think of have one specific in mind. We spoke in early March and he said, you know, I'm really worried about this covid thing. Have you heard about it? I'm thinking about going remote with my employees. I bought a bunch of PPY gear and they have protocols in place. And I was I was dumbfounded. Right? It was in my mind, it was a non-event at that point.
I remember you laughing at me first. And you were in you were in the. In the correct camp, absolutely, and within about two or three weeks before the well before the end of March, he was remote, that CEO. He was in a cabin full wi fi, directing things on a fully remote team. And his view was, I simply can't get sick and I don't want to get anybody else sick. And so that's the action he took was very strong, drastic, but decisive, drastic, decisive and correct in the end.
And there was it was a no regret move because worst case, you know, everybody comes back to the office. It's a non-event. But, you know, should the worst come to pass, which it did was the right decision. The opposite is a CEO who at the end of April said, do you think we should do something about this? Should we go remote? And, you know, that's a time lapse difference in the two years when you were talking about the difference between the ACTU and the BCA.
I'm thinking of this concept that Peter Kaufman gave me called advantageous diversions, which is you need it's not enough to diverge from what everybody else is doing. You have to be correct. And in order to be correct, you have to have a strong opinion and go against the grain and against sort of like the sand of what everybody else is telling you to do. And as a strong founder, you can do that. But you have to be correct. And if you're wrong, you're just one of those guys or girls who just, you know, didn't listen to what everybody else was doing.
And it's really easily explainable why you failed. And then there's Keynes, who basically said it's better to sort of succeed conventionally than fail unconventionally.
And there's a huge press or like pressure, I would imagine, on people to sort of not not want to put up with that scrutiny. Yeah, no, it's a really good point.
And one of the problems with the thesis is there's a survivor bias. Right? So the ones that did go against the grain and were successful can claim victory. Right. There's lots of people who you predicted 9/11 and they predicted the pandemic and they were right. But the ninety nine percent who say the sky is falling every day are wrong. So it's OK to be contrarian and thoughtful about being contrarian, but it doesn't necessarily always win the day.
I had a friend who unfortunately had to lay some people off during this and he shrunk his company from about one hundred to sixty. And I remember talking to him and I was like, he was so upset. And I was like, how did you decide? Like, how do you make these choices on, like, who to lay off and who to keep?
And is it functional? Is it level based? Is seniority based like how do you is that what you need to keep the lights on? And he said those are all really good ways to do it. But what I did was just ask myself who adapted to change? And then I kept the people that adapted to change and let go of the people who didn't adapt. So he's like who adapted to this new world and this new reality, the quickest they stayed and everybody else sort of unfortunately lost their jobs.
But now he's thriving. He's like, this is amazing. We're doing more with fewer people. He is a former admin. He's like leading a team of twelve people now.
And I remember you talking about that. And I think what's important there, though, is the fact that he realised that change was permanent and so the adaptation process around work from home was going to be permanent. And that recognition drove some of those decisions as opposed to if it's temporary, then I'm going to go back to the status quo. So that's a visionary CEO? Well, I think he might have. I'm speaking for him at this point, but it's sort of like I think he also thought, well, if we end up going back in three months, these people will be able to handle like going back because they can handle change.
And I think that's like an underrated thing that we have to look for in employees is like, how do you respond to change? And that comes back almost in a way to coach ability. Right. How adaptive are you to feedback? You're getting feedback that what you're doing may or may not be correct. You have to interpret that feedback and then you have to choose a path of action.
Well, I think it also speaks to a broader concept of diversity in general. Right. So people who have lived tougher lives tend to be a little bit more flexible. So that's why in general, foreigners are better entrepreneurs, in my opinion.
And I don't overstate it, but, you know, they're willing to leave their their country, their city, their place of growing up for new frontiers, maybe a new language, new culture. Certainly that alone is a is a strong indicator of their ability to adapt and and thrive in an unknown world.
That's a really interesting point, especially given the post pandemic world where small businesses are probably going to be what brings the economy back to full employment, if you will. And should that have an impact on immigration policies, do you think?
Well, I think it's certainly an opportunity. And I think there's a wave of diversity and inclusion that's happening that we will all benefit from. And it's irreversible at this point. So I think yeah, I think it bodes well for the future.
I want to switch gears a little bit and talk about sort of misvalued assets. What do you think is the most mis undervalued asset in the world right now, the most undervalued asset in the world?
Let me reframe the question to to what I think is interesting as an investment area. Our view is that we invest in technology, but not for technology, sake and technology that enables application of technology. So, for example, I know a lot of people talk about it. Being a sector is not a sector. Azmath is an algorithm that's enabled by very fast processors with new ways of thinking about how to analyze big sets of data and now smaller and smaller sets.
But in and of itself is not that useful. But I, combined with a subject matter as a collision, is really interesting. So we've invested, for example, in a company called Bluejay Legal that does A.I. Meet's case law. So what they do is they apply artificial intelligence on all the historical cases around a particular question that were litigated. And so they can predict with ninety five plus percent accuracy the way that a judge will rule on a particular question, given a certain set of not retrospectively, but in the future.
In the future. So basically the software will ask you ten questions that are salient that the A.I. figured out to ask. And if you answer yes or no, positive, negative, it will it will predict for you whether you will win or lose the case. And the the upshot of that is that the judiciary system can focus on cases that are 50 50, which really do need to be added to jurisprudence as opposed to the frivolous cases where you clearly shouldn't win or you clearly should.
So that's an application of A.I. in legal. I think areas that we're quite excited about are where you have this collision between disparate areas of technology and knowledge. So we have another company that uses behavioral psychologists and A.I. and debt relief as a as a conglomerate. And they provide an incredible solution. But it's really adding multiple disciplines of technology and understanding and bringing that to a product. Are you guys invested in cryptocurrency at all? What's your take on cryptocurrency?
We don't invest in crypto currencies, but we do invest in the underlying technology of cryptocurrency, which is distributed ledgers. So in my view, this is a a form of liquid trust that all parties can get behind. And if you think about business transactions at its most fundamental level, it's about trust. And as the world becomes a smaller place, trust is even more important. And so leveraging things like distributed ledgers, like block chains enables that to happen.
Can you have trust with anonymous payments?
Yeah, you can, because the I mean, with a ledger that is trustable inherently, then then both sides can can believe in in the math, so to speak.
I don't know much of a cryptocurrency is. It just strikes me as something where if you can move money around with anonymity, it's probably not a good thing.
I'm not saying it's not co-opted. And certainly crypto currencies is the first example of block gene technology in action. I'm not necessarily sure that that'll be that'll win the day. There are plenty of other applications of ledgers like supply chain, like identity that are much more applicable. And because you can't mess with the underlying data without being found out. Inherent in that is is a level of trust.
You work with so many amazing people on a day to day basis, you get to introduce to a lot of people. You get exposed to a lot of different ideas, a lot of different values. What do you take home from that and try to teach your kids? Like, how have you applied the lessons that you've learned working with people and being a VC at home with your family?
You know, honestly, the best part of this job is interacting with people smarter than me, you know? And if I had to sum it up, I'd say my my goal in life is to be the dumbest guy in the room and and that and I'm not so dumb, so I'll declare that.
But the point is, entrepreneurs and innovators and change agents are the most interesting people that you'll ever meet. And so it's a privilege to get to work with them and alongside them and back them. You know, I think one of the key lessons I've learned is that I try to pass on is failure is OK. Failure is actually a feedback mechanism to allow you to improve. So I spent a lot of time when I talk to people, I look for failure mechanisms that I can avoid.
And the lesson I give my kids is if you if you do less talking and more listening, you can find out what the other person knows and you already know what you know. And so now you've doubled down on your knowledge base and you haven't necessarily given anything up. And of course, conversation should be bidirectional. But the point is, learn from everybody around you and don't be afraid of failure because smarter people than you have failed a lot.
That's a really good lesson. I used to play this game with my kids and they sort of like stuck with it, which is like you're a detective and everybody knows something that you don't know. And your job is to figure out what they know that you don't know and then learn it. I love it.
I use that in networking. So I'll go into a room and I and I know there's somebody in that room that I have to meet and my job is to find them and find out something interesting about them. And I and I use it as a mission. It's great. I know you're a voracious consumer of audiobooks, podcast, different information sources.
Can you riff a little bit on. You curate the information sources that you're bringing into your brain and how you translate that into specific knowledge.
Yeah, my my sort of goal with reading and consuming information is twofold. One is for my my work. Right. So I listen to a lot of podcasts and books around start successes and failures, looking for clues on how companies can fail more than looking for success indicators. That just helps me in my day to day business. The other sort of half of the content that I consume is around at two fundamental questions. One is understanding what the meaning of life is and to put it in broad perspective.
So searching for what? What is happiness? What is truth? What is the point of it all? And by by reading fundamentally biographies up and down the line from, say, Marcus Aurelius to Putin to even even Trump's biographies written by third parties are interesting in that they give some inkling and some insight into what life is for them and why they're living it. But I will say, and I'm quick to say it, I'm a terrible consumer and a terrible retention.
We've talked about this in the past. So I listen high speed.
I listen. 3.X is like ridiculous. It is kind of in here. Truthfully, it's probably 2x on average. But for me, it's about it's a volume game and maybe it shouldn't be. But I'm a little bit 8D and so I don't like the middle sections of books. I'm only looking for four or five nuggets in a book. And the faster I can get to those, the sooner I can get done and get on to the next one.
I sort of feel like there's this ocean of knowledge out there and I've got to swim through as much as I possibly can. That's an interesting perspective. I think we sort of disagree on how we do information, which makes for interesting discussions. But I want to end sort of like on one of the things you just brought up, which is like how would you answer that question? What is happiness?
Yeah, I think my personal philosophy is there's there's three levels of happiness, and the first level is is somewhat simplified by saying it's physical, right? So it's the it's the five senses that we all have. So visual, auditory, etc.. And I think most people live with all due respect, I'd say most people live in the Five Senses world. So they they consume food because it tastes good. They they watch movies because it's stimulating. They listen to sound, you know, they enjoy good wine and trips and stuff like that, but they're all physical massages and so on.
I think the next level up is a little bit more interesting in that it's about learning. Right. So the endorphin rush you get when you learn something you didn't know and it clicks and it helps form you, I find that as a is a key piece of happiness. So you're constantly in pursuit of that.
I mean, ultimately, I think that philanthropy and giving and charity and teaching is the ultimate form. Right. So giving back what you've learned in life and making someone else's life richer and more poignant, meaningful is the ultimate happiness that you can get. And you have to look no further than than donating to a charity. It's an endorphin rush every time you do it, when you teach a young child to learn to read or something new, there's a huge endorphin rush.
And I think if you focus your energy on those give back areas, you're about as happy as you can be.
The best things in life are reserved for people who help other people succeed. I couldn't agree more. That's a great place to end this. Thank you so much, kid. Thank you for your time. Hey, one more thing before we say goodbye, the knowledge project is produced by the team at Farnam Street. I want to make this the best podcast you listen to, and I'd love to get your feedback. If you have comments, ideas for future shows or topics or just feedback in general, you can email me at Shein F-stop blog or follow me on Twitter.
A Chainey Parish.
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