Investment Thesis: The Basics

Per my recent post introducing the topic, this is the first installment in a series in which I plan to put in writing the themes and heuristics behind my early stage investing activity. For this first post, my goal is just to categorize and ‘bucket’ the major themes. In subsequent posts, I’ll pick up each of these and examine them in more detail.

First, the basics:

Companies rarely succeed or fail on the strength of their ideas alone; the quality of the team and their ability to communicate and work together has at least an equal role in a firm’s ultimate success or failure. These two factors interoperate to create (or fail to create) economic returns for the founders and investors. But even in a positive return scenario the price paid for performance can compare unfavorably to competing and less risky investment alternatives.

So, to feel good about writing a check to a founding team, I have to get my head around their ideas and the people behind them, *and* we have to agree on a price that balances the first two factors against the daunting risks faced by any new company.

So far, so ordinary. What (I hope) makes this interesting is the set of beliefs and assumptions I put into each of these buckets, which are unique to me and reflect my idiosyncratic bundle of experiences and observations as an employee, founder, investor, and business partner. In shorthand form (with details to be added in later posts), here’s a rough cut at how I think about each bucket:

Ideas: Charlie Munger has two great quotes that apply directly to building a sound intellectual foundation for any investment thesis:

• “Stick to a narrowly-defined circle of competence”, and
• “It is better to remember the obvious than to master the esoteric”

I’ve spent the last 15+ years working at the intersection of consumers and ‘interactive’ technologies (including pre-Internet stints in audiotext and in-flight entertainment systems). I started out helping existing brands connect with their customers electronically, but for the last 10 years or so have focused almost exclusively on creating new consumer applications and brands online.

Drilling down, most of the online applications I’ve helped to build fall into two major categories: branded retailing (e.g., Patagonia.com, Nordstrom.com), and social media platforms (e.g., Judy’s Book). In the process, I’ve learned a ton about supporting disciplines like search engine optimization, search engine marketing, online advertising, lead generation, viral marketing and game dynamics (to name just a few).

So, despite being in the ‘technology’ business for most of my adult life, my “circle of competence” isn’t in technology per se, but in using technology to connect individual consumers with stuff (whether it’s merchandise, digital content, service providers or – most important of all – other people) in a fun and emotionally satisfying way.

From an investment perspective, the ideas that I connect with and understand the best tend to stay pretty close to this problem set. And even when the “esoteric” comes into play (think Semantic Web, microformats, data portability or any one of a dozen other exciting ideas that might be applied to solve these kinds of problems), I tend to evaluate it through the lens of the “obvious”: i.e., how does it make life better for a definable group of people who would be willing to pay for the benefits delivered?

Team: The more time I spend with entrepreneurs (and would-be entrepreneurs), the more I appreciate the maxim that “ideas are like a**holes – everyone’s got one.” Value is created by people who can turn ideas into products, products into companies, and companies into businesses. This is hard enough to accomplish as an individual contributor within a going concern, but the kind of people who can do this from scratch (and not just jump on board a rolling train) are rare indeed.

In evaluating the people behind an idea there are too many variables to itemize in this introductory post, but the things I care most about (and are an immediate no-go if absent) include my top three:

• Integrity – I wrote a long post on this subject a while back, but the core idea bears repeating: there are lots of ways to make money, and most of them are legal, but far too many achieve their returns by deliberately exploiting human weakness. I’m happy to limit my investment options (and possibly even my returns) by avoiding this kind of entrepreneur, not least because if they’re OK screwing someone else there’s every chance they’ll do the same to same to me the first chance they get.
• Passion – It’s sad that this idea has become a business cliche because it’s far more rare in real life than common usage would suggest. The kind of passion I’m talking about isn’t to be confused with money-hunger or raw competitiveness (not that those attributes are necessarily bad). Instead, it’s an almost religious conviction that the insight they’re building on is so real and powerful and fundamentally right for the customer they have in mind that they’re not going to sleep until they’ve gotten it right. As long as it doesn’t cross over into delusion (a real risk) this is powerful stuff, and is almost a requirement for the difficult first phases of a company’s life (yes, exceptions exist).
• Emotional Intelligence – At the earliest stages of a company’s growth, almost nothing is certain. Passion and conviction are only effective when paired with the ability to listen, hear and adapt to all the subtle cues – from customers, team members, sales prospects, business partners, etc. – that, taken together, hint at the correct course for the business. In my experience, this is the least common attribute among prospective founders, and therefore the most valuable. As the noted military strategist, Helmuth von Moltke famously asserted, “no battle plan survives contact with the enemy”, and founders whose passionate conviction in their ideas prevent them from adapting to conditions on the ground are unlikely to succeed.

Price: “Fair” pricing for early-stage investments is a dissertation-worthy topic which I’m neither suited nor qualified to tackle. My lens, at least for this post, is limited to the qualitative and personal considerations that govern my thinking and check-writing.

The primary constraint on my pricing appetite is capacity. At this point, I’m investing only my own money. I often co-invest with others (more on this in a later post), but I’m not spreading my risk or leveraging my bets with other people’s money, so my capacity is finite, limited to the share of my liquid net worth I (and my wife) are prepared to allocate to these kinds of bets. Because this number is small relative to competing pools of investor dollars (e.g., institutional VCs), I only look at deals where a relatively small amount of money (i.e., from tens to hundreds of thousands of dollars) can command a ‘meaningful’ share of ownership in the new enterprise, where ‘meaningful’ is counted in whole or double-digit percentage points.

But wait, you’re thinking, there are plenty of deals out there where that amount of money can get you a stake in a really exciting new business, even if your ownership claim is measured in fractions of a point, where the ultimate financial return to you could be much, much greater. And while that’s absolutely true, it misses the main reason why I make early stage bets: I love spending time with founders, thinking about their markets and business problems and looking for ways to help them succeed. If I just wanted to write checks and wait for distributions my price parameters would be completely different, but I wouldn’t have any fun doing it, and having fun is important to me.

In my next post on this subject I’ll pick one of these three topics and drill into the specific heuristics I apply when evaluating an early stage investment. If this topic is interesting to you, stay tuned.