Ruling out rather than ruling in

One of the dangers of working alone is that when you start doing things oddly there’s noone to call you on it. It’s almost nine and a half years since I started angel investing as a full-time thing, plenty of time to develop strongly held beliefs that happen to be completely wrong. The only thing that keeps me grounded is reality: actual outcomes.

When results come in I re-examine my decision processes. What was it about this company that allowed me to get a good return on my investment? What should I have seen to prevent me from investing in this other company where I lost money? Actually doing this, versus sort-of doing it, is something I have to be conscious about; the alternative is letting my brain do the work behind the scenes, and human brains are so notoriously bad at this they just gave a Nobel Prize to one of the people who pointed it out.

I don’t believe in gut-level decisions. Having a bad feeling about something might reflect some sort of internalized rules, but there’s no real advantage to keeping them internalized, laziness aside. Getting them out in the open allows you to reason about them. This is especially important in venture where long cycle-times, high dimensionality, and sparse data inevitably lead to spurious correlation. You can’t build a venture investing process on data alone, you need to have a theory. The theory has to fit the data, of course, but it can’t just be inductive, there has to be a deductive element as well.

But even a theory that fits the data only gets you so far. In a previous post I said “There are two kinds of pitches. Those that are clearly bad ideas, and those where it’s not clear at all if it’s a good idea or a bad idea.” The reason this is true is that some ideas simply will not work and can be ruled out immediately: perpetual motion machines, selling dollar bills for ninety cents, etc. Ideas that might work, on the other hand, often have some intrinsic element of the unknowable about them. This argues for setting constraints to bound the space of venture-investable companies but also that the constraints can’t be so tight they’re a process for picking winners. Creating a process that picks winners is the same thing as creating a machine that predicts the future. I don’t believe that’s possible.

The beauty of constraints is that they rule things out, they don’t rule things in. They create a murky but bounded space of maybe that allows for ideas no process I know of, other than human creativity, could come up with.

A couple of months ago I wrote down my current understanding of my investing constraints in an effort to consciously improve my process. After writing them down I organized them into a handy-dandy table. It is below.

Market Product Team Deal
Feasibility Market size will be > $1 billion within 5 years. The product can be built and launched in stages. Team has experience building this type of product or company. Can afford to own ~1% after the Series B.
Desirability There are customers who would pay now. The business model can generate a large LTV. Team is ethical but wants to win. Possible to make 50x on Seed, 10x total.
Scalability Competitive intensity is and will be low. The product could be scaled to >$100 million in revenue. Founders can hire, raise, and sell. Know what will be needed to raise the next round.
Knowledge Have spoken to customers. Know landscape of possible competitors, substitutes. Know the founders well or know people who do. Know what similar initiatives are being funded.
My Role Can intro to partners, customers, thought leaders. Know potential customers who can alpha/beta-test. Team is coachable. Have appropriate protections.
Repeated Game Need to be in the market to understand it; market formation in early stages. Product draws on or feeds into related new markets. Can build a relationship with the founders. Investment and follow-ons big enough to make a difference, small enough not to bankrupt me.

This list has obvious flaws. For me the main one is that I can imagine scenarios where I’d bend some of these constraints. It’s a work in progress. It also reflects a very specific type of investing, one where founders have to spend years trying to build a market for their company to be viable. Given this assumption most of the other constraints seem to follow naturally. Changing this assumption–after all, most of the startups in the world enter pre-existing markets–changes the constraints entirely. You have to build your own.