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Afford Anything | Get Smarter With Money
The Hidden Math Behind Every Venture Capital Fund, with former Wharton Prof. David Bell
01:01:05
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- [00:00]
A
Today's guest owns a copy of the original Uber pitch deck. He wasn't an investor in it. Someone gave it to him a few years ago. But in that deck, the founders sketched out several scenarios for what might happen to the company. At the time, Uber was largely just an idea, and in their worst case scenario, they said we might just become another cab company in San Francisco. Nobody at the time imagined a hundred billion dollar company. And given that, the only consistent lesson that we can take from history is that the future always ends up being surprising. How do we evaluate opportunities in your career, in your investments? How do you evaluate opportunities given that you don't know what you don't know? That's what we're discussing today with former Wharton professor and venture capitalist David Bell. Welcome to the Afford Anything podcast, the show that knows you can afford anything, not everything. This show covers five financial psychology, increasing your income, investing, real estate, and entrepreneurship acronym Double I Fire. I'm your host, Paula Pant. I trained in economic reporting at Columbia. And today we welcome David Bell back to the show. He was our guest on the previous episode, episode 732. So if you haven't caught that one yet, go check it out. But that episode really focused on that letter E Entrepreneurship. Today we're switching letters and we're focusing on the letter I Investing. Specifically, we're diving into a corner of the investing world that to most of us is a black box. And that is the world, the opaque world of venture capital. We know from audience surveys that a significant portion of this audience has a net worth that's north of a million, even outside of your homes. And that means that many of you qualify as accredited investors. And that means, per the SEC's criteria, you can jump into one of the riskiest asset classes out there where without actually knowing what you're doing. And the dangers of that are probably self evident. Here's the part that's less obvious. Venture capital is a world in which if someone's managing $100 million, they're collecting 2 million a year in fees, mostly regardless of performance. Which means the incentive structure is a little bit bananas. And that makes this the ultimate case study in fees and incentives. I asked David to explain one of the most opaque corners of investing. Now, in case you didn't catch last episode, David has a PhD from Stanford. He's a former Wharton professor. He co founded and runs a VC firm called Idea Farm Ventures. And he has seen this world both from the classroom as well as inside the machine. He also speaks in a manner that's practical, grounded, no fluff, high signal to noise ratio. His density of ideas per minute is quite high. So in this episode, you're going to learn how a venture fund actually works. You're going to learn where the money comes from, how the people running it get paid. You'll learn how to evaluate a fund manager, and you'll learn why a founder and a funder can sit on the same side of the table, but have totally different incentives. Bottom line is this. Your future ideas are downstream of the conversations that you're exposed to. And to that end, David is a voice worth having in your ear. So please welcome David Bell back to the show.
- [03:20]
B
You've made the transition from academia to being a VC and the world of academia. Most of us have a good sense of what that is. Most of us have no direct experience with the VC world.
- [03:34]
C
Right.
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B
And that world seems a little opaque.
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C
Yeah.
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B
So first, for the average person who's listening, how does one go about becoming a vc? I'll leave it.
- [03:46]
C
Great question. Okay, so I'll sort of answer it in three tiers. That might be helpful to the audience. So I agree it's pretty opaque. I mean, some of these things now are going into sort of the pop culture. So for example, I had the good fortune about a month ago to go to a free event at nyu and it was Malcolm Gladwell, who's just an amazing.
- [04:06]
B
Oh, with Bill Gurley.
- [04:07]
C
With Bill Gurley. Oh, were you there?
- [04:09]
B
No, I interviewed Bill Gurley two days prior to that.
- [04:12]
C
Okay. So what I was gonna suggest to the audience is the sort of movies and things like that about Uber. And it gives you a little bit of a sense that the venture capitalist is the person often who's giving the entrepreneur money. And there's different points at which money can be taken. So it's sort of seed stage or early stage investment is when the idea itself is very nascent, very fragile. It could be huge. It could be nothing to that point about Bill Gurley. I actually have the original Uber pitch deck. I was not an investor by any. Somebody gave it to me years ago. And I think if I remember, they painted different scenarios of where Uber could go. Scenario number three, like the worst case scenario would be like, it's going to be like another cab company in San Francisco. I don't think it was anybody at the time. Thought it would be whatever it is, a multi tens of billion, $100billion company. So the venture capitalist is someone who injects capital when it's kind of risky. If it's early stages, maybe even before the product's created. And then there's other kinds of venture capitalists, where the business is already up and running, maybe making a lot of money, and the company's thinking about listing the. Sorry, the founder is thinking about trying to list the company on the stock exchange or selling it to somebody else. And they just need a bit of extra money maybe to get their product wider distribution, go to an international market. By then it's less risky. So there's various levels of risk. The most risky is like the very early stage. Paul has got this idea, she seems bright. Shall I give her money or not? So that's what the venture capitalist does, is they inject money at different points. The way they work, where does their money come from? Might be one question the audience has. So sometimes if they're very wealthy, and perhaps Bill is in this category, he could just take it out of his own bank account. But more typically, that money that the venture capitalist is managing has come from other investors. And they're called, in the typical nomenclature, they're called limited partners or LPs. So they're often people that have to be qualified because it's so risky. The government doesn't want somebody who's working and has a family to put all their money into a venture capital fund. That would be a very risky thing to do. So the investors are supposed to be accredited, meaning that they have a certain income level and so on and so forth. And then the people managing the fund are called the GP or the general partner. So let's give a real example. To be a venture capitalist, you have to believe and make other people believe that you have some kind of edge in whatever it is. So let's imagine you and I decide to become venture capitalists. And we think we have a very unique edge in investing in certain kinds of consumer products. Maybe because you started a consumer product brand in a prior life, maybe I taught people how to do it. Somehow we think we've got an edge in finding the next touchland. We have this belief. So what we're going to do is we're going to put together a presentation that articulates our point of view of how we think we can make money for our investors. And then we run around New York, we run around the world, or we go to people who we think might be willing to give us money, become limited partners. And we're also going to decide on how much money we're going to raise. So to make the math easy, imagine you and I decide we want to raise $10 million. And we think this Joe guy over here, he's done very well. He might be willing to give us half a million dollars. So we'll go in front of him, we'll pitch him, and so on and so forth. So you kind of go through the process of trying to convince people to give you money. This is a nuance. But if Joe commits $500,000 out of the 10, he doesn't write us a check tomorrow. But we do something called capital calls, meaning when we decide to invest in Touchland, we ask him to send us a check for 50k or whatever his pro rata piece of the total investment is. Now, if we've got $10 million worth of commitments, this is the math that the audience, if they burn this in. This covers 99% of cases. Most venture capital companies run by a rule that's called 2 and 22 numbers 2 and 20. So what does this mean? The 2 is a percentage, 2%. This refers to the management fee. So every year on $10 million, 2% of that I think, is 200K. So you and I would collect from our investors in totality $200,000 from which we would pay ourselves a salary, maybe pay an intern, pay our legal bills, rent a space like that's our kind of management fee. That sort of keeps us afloat. And then the 20, that refers to the profit sharing. 20% for us, 80% for the investors. So let's say we made $10 million on an investment. We put in one, we got back 11 of that 10 million in profit that came in. You and I as the general partner, get to keep 20% of that 2 million. And then the 8 million, we distribute it to our investors, Joe and the others, in a pro rata of whatever they invested in us. So that's how every venture capital company more or less operates. There'll be a certain number that they are managing that's called the AUM assets under management. So imagine you're managing a billion dollars, then every year you're getting 20 million. But probably by that point you might have a huge team and offices in different places and so on. If you sort of step back and say, well, let me think about the incentives. So if you and I have $10 million that we're managing and we're making $200,000 every year in fees, usually for a 10 year period. Most funds are supposed to begin and end within a 10 year period. Wouldn't it be nice if we were actually managing $100 million? Then we get $2 million every year in fees. So the incentive oftentimes for the venture capitalist is after they've done the first fund, number one, and one or two things in that fund look like they're tracking, like you probably haven't got any money back within three years, but some of them might have gone up on paper. Then we can prepare our PowerPoint presentation number two, and we can run around the world again, or New York or wherever we think our targets are, and we can try and raise $100 million. So now by year four, we might have two funds running in parallel. One that's going from year one to 10, another one that's going from year three to 13. And so now we're collecting even more fees.
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B
Is the capital call is part of the capital call, the fees? How does that work?
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C
Yeah. So usually there's a percentage of the capital call as the fee, and a percentage of the capital call is actually going into investment. So in totality, say, for example, Joe committed $500,000 to this fund vehicle, he would know going in that roughly a fraction of that was going to be his contribution towards the fees and some other fraction of that was going to be going towards actually being invested in companies. And I don't know what. I mean, I should know this. AI will know this. Where the genesis of the 2 and 20, who cooked up that? That was the number. Now it is the case that someone who's shown that they're just an unbelievable investor, since we're in New York, this might be someone like Steve Cohen, who owns the Mets. If you invest in his fund, he might charge you 3% because he's so good, and he might take 30% of the profits, but because his track record's so good, you'd say, well, okay, I'm an investor, I'm going to get less, I'm going to get my fraction of 70%. But because this guy's so good, I'd rather have less of what he can create. But 2 and 20 is the norm.
- [11:43]
B
Yeah. It strikes me that if that 2% has to cover your salaries, your legal fees, your office, your assistant, that the fund can't be too small because then it would be so under capitalized, the management fee would be insufficient to just cover.
- [11:59]
C
Yeah. So I mean, there's a concept of a single GP fund, a single general partner. So maybe if just you or I were just getting started, we might say, I'll just do the whole thing myself. And 200k, that's enough money for one person to manage all of that. And I think also the fee shouldn't be so high that the manager's not motivated to go out and find investments. But yeah, that's how most of the venture capital. There are other structures as well. But if you were to say, hey, what's the average VC fund look like? Most of them will have that 2
- [12:34]
B
and 20 structure going back to the fee being part of the capital call. Does that mean that if they don't find a touchland, they don't find a company to invest in, that no fees have been collected and therefore the management fee isn't there?
- [12:49]
C
Well, the management fee typically gets collected regardless because you have these ongoing things, right? To pay your team, to pay your rent. So the management fees covering effectively not just the managing of the doing the investment and the paperwork, but the other things you need to run a team.
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B
So like it gets paid up front and then later there's a capital call for the rest of the investment.
- [13:10]
C
It sort of comes in at a regular cadence so that the manager in our case is only to employees. So it's pretty easy. But if we had a bigger fund and we had real employees, like, we'd need to have enough money called in and in the bank just so we could make payroll every week. But we're never calling more than 2% of the total amount of the capital, but on an annual basis. So again, you've got to say, well, if the fund lives for 10 years, 2% times 10 years, like 20% of all the money has gone into sort of keeping the engine running and the lights on and stuff like that. And so as someone who might invest in a venture capital fund, you might quibble that said, gee, that guy Joe over there on $100 million fund, he's going to make $20 million over 10 years regardless. But it's not quite that simple because there might be various clauses of performance that he has to meet. And this is a reason why to be an investor or a limited partner in a venture capital fund, you have to sign paperwork saying that you're accredited because you have to be that you have to be willing to lose everything that you're putting in.
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B
Right? But the barrier to be an accredited investor is so low, it's not super high.
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C
I think it's a few hundred K of income.
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B
Yeah, a few hundred K of income or like a net worth of few million dollars. Yeah, a few million. I mean, pretty much any. And this is something that's always struck me about the qualifications to become an accredited investor. Essentially it means if you are A successful dermatologist.
- [14:44]
C
Yes.
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B
You might not know anything about investing, but you're a great dermatologist. And so you've met the net worth requirement. Heck, it could even mean that maybe you are a middle school teacher, but you are in your, you're 55 years old and you have spent the last 30 years very carefully managing a portfolio of Vanguard index funds. And you've done so in such a way that you now have met the net worth requirements. And so in both cases, maybe you're a, you're a professional who is highly paid and so you've met the income requirement. Maybe you are a boglehead investor, index fund investor, you've met the net worth requirement.
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C
Yeah.
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B
Either way, it doesn't necessarily signal that you know how to either evaluate a startup.
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C
Right.
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B
Or specifically, what an LP would need to do is evaluate not just the startup, but evaluate the chooser of that startup.
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C
Yes, GP 100%, exactly. I couldn't agree, couldn't agree more. I mean, it's a very risky asset class, as you say. Actually thinking about people that I meet because I'm an investor in some funds myself, and this is exactly the profile you describe. And when I go to the annual meeting, I sometimes meet people who are very successful dentists. I'm thinking of an orthodontist friend and so on. And I guess what these individuals have decided to do maybe for two reasons. I'd like to be part of this sort of VC startup. And bear in mind too, not every venture capitalist is investing necessarily in early stage startups. They might be investing larger amounts of money in things that have much less risk, that are already up and running. And in that case, the calculus for the investor is, gee, if I could write a check of $50 million and I could triple that in three years, that would be really good, as opposed to writing a check of $2 million right on day one and hoping I can turn that into 200. Those are very different kinds of fund managers typically. But yeah, absolutely. What you're doing as a potential investor, maybe you're doing it because you want to just be part of this ecosystem. You're probably also doing it because you know something about that general partner who will have actually had to pitch you directly before you write a check. You might know some other people who are LPs, but yeah, it's a real trust game. You're trusting that this general partner that you're sending some of your money and there's typically a minimum. I mean, you might not even be able to invest In a fundamental, unless you commit at least $250,000, you're not writing that check up front, but you're committing $250,000. So it's a non trivial amount of money. But the way the system's supposed to work is you as the lp have to be willing to say, you know what, I'm totally fine if that goes to zero, which people might be signing on to without really thinking through that. Yeah, it could really go to zero. I mean if you're in a good fund, probably won't. And most funds, they'll show you what their performance has been up to date. And this is why when you're a first time fund, you have to have sort of a chicken and egg, you have to have some secret sauce or track record for people to actually trust you enough in the beginning. But yeah, it is a risky asset class and I think now you can participate probably in smaller amounts through Angellist and things like that. You may still need to be accredited. It's a risky business, right? Oh, but I should say still very important business. And this is if you watch, you listen to someone, incredible investor like Bill Gurley or you watch some of these shows, I mean the venture capital system is still like a really important system and it's a really dynamic and vibrant part of the US economy. And coming from New Zealand and same thing in Australia, access to venture capital, there's much, much less available. And so the good and the bad is sometimes a founder have to be much more scrappy to build something on their own with limited resources. But the downside is often they don't have the powder that could really accelerate them because the venture capital ecosystem is not as well developed. So I think the one good thing about the US is it's a pretty fluid, dynamic place. Which is not to say things won't go bust all the time as they will.
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B
Yeah, right. Speaking of which, are there specific geographic clusters where New York of course obviously comes to mind. But outside of that, are there particular geographic clusters where either VC funds or startups tend to emerge?
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C
Yeah, 100%. So the classic would just be sort of Silicon Valley. Right. So technology oriented investors, technology oriented founders, and usually there's a whole ecosystem around that. So if you think about, of course there's all the major companies there from Google, Meta Alphabet or whatever, but you got Stanford University, Berkeley. So there's a whole sort of brain trust, if you will, of founders and also you'll have people who may have started companies in other parts of the world. They want to be in Silicon Valley. If you think about maybe Medtech and pharma and stuff like that, sort of as a whole northeast corridor around Boston and other places that sort of deal with that, there's a little bit of that in Philadelphia, New York, I guess there's been a lot of great consumer companies have come out of New York. If you go north and you go into Toronto, around the Waterloo area and the University there, that's where there was BlackBerry. So once sort of things get rolling in a certain location, that tends to often be an attraction of similar types to that. So for sure there are real geographies of both types of companies and types of investors.
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B
And to what extent do you see Texas and Florida playing a role? There seems to be a lot of.
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C
So Austin's certainly become a place where a lot of prominent venture capitalists have moved. I mean, I know people. Everyone's now talking about taxes and stuff like that. I think, yeah, certainly some funds down there in consumer and tech space are in Austin, Florida, I think is the same kind of calculus. Both people who could be very wealthy personal investors like moving there for a variety of reasons. Plus an ecosystem kind of bubbling up. And sometimes it's even the civic infrastructure is trying to lean in. So from what I understand, Miami, for example, really was doing a big push into kind of fintech crypto. Like we're the place for sort of innovation and financial products. So I remember I went down there to some crypto conference, something I don't know too much about, with a friend years ago. So you also sometimes get civic leaders wanting to promote their community around a particular kind of venture ecosystem.
- [21:46]
A
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- [25:23]
B
Siemen mobile.com. If a person listening to this is assuming that they have sufficient assets. Right, Assuming they're, they want to diversify out of more than just passively held index funds, there are a few options available. You mentioned angel list.
- [25:49]
C
Yep.
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B
There's some of the more creative methods of investing. You mentioned AngelList 10 years ago, what's it not real estate syndications, but the, the thing that became super popular about 10 years ago where you could online, you could all pile into like a shopping center in Des Moines. Real estate crowdfunding. Yeah, real estate crowdfunding that really became trendy about 10 years ago. You could buy shares of private companies on a secondary market.
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C
Absolutely, yeah.
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B
And then of course there's the possibility, if you have sufficient assets of becoming an lp. Like how would a person who's interested in some type of investing sort through and compare risk profile pros, cons. I mean, how would you even begin to frame that?
- [26:40]
C
There's pretty decent public information out there about the industry and then there's things that you can dig into for particular funds to ask about performance and so on. And certainly before you ever wrote a check or made any commitment, you would want to have an in person or a face to face discussion with the general partner. You'd want to see the track record, not just the things ideally that they'd invested in that had sort of gone really well, but also the bets that they'd made that had gone bust and what their kind of rationale was. So it needs to be. We talked about marketing in marketing speak, right. This is a very high involvement decision. I mean it's maybe not quite as high as buying a house or something like that, but it's a very important decision. So I think also to the extent that you know somebody who's already an lp, that can potentially be helpful as well. But you're looking for signals that this GP is really going to manage the money efficiently. You might also be looking for exposure to certain kinds of companies. So there's a fund that I'm an lp, have been in all of their funds that I think is just exceptionally well managed. And it's nothing to do with what we do at IdeaFarm. It's mainly software and service businesses and things like that. And I just know the team works unbelievably hard. They're incredibly high quality, they get into really good deals that other people don't get. They've got a bit of magic that's allowed them to be very successful and to perform it, probably the top 5% or even more. So it's something that you really need to diligence before you go in. I wouldn't be charmed by a gp. And it's again, it's like the old. I mean, I'm not that old. I never saw this. But it's the Groucho Marx thing, right? You don't want to be part of a club that will let you into it. You know what I mean? So if the GP will accept your money off the bat, that's not necessarily a good sign. Right. And of course, since we're here in York, I mean, there's been unbelievable scandals around the venture industry not that long ago. Right. You think about someone like Bernie Madoff, who was just the guru, who, doing whatever he did, who had these incredible returns for whatever, 20 years. And I don't think if, remember from the documentary that the guy even made one investment. He was just printing out fake reports and sort of carrying this mystique. So, yeah, you really need to dig under the hood. Who are these people? Who are the other LPs, what have they invested in? What are the big winners that they've had? How do they source all the deals and so on? Yeah. Yes. I guess it's not a flyaway decision unless you literally say, gee, I'd like to be part of this and I can lose that 250k, it doesn't matter. Well, then it's a different consideration.
- [29:22]
B
Yeah, but I can imagine if somebody's listening to this, they have a net worth of, let's say, 5 million, 250,000. That's 5%. And sometimes you want to take 5% of your total portfolio and invest it a little bit more aggressively. Or alternatively.
- [29:40]
C
So here's one thing that you can do. Here's another bit of jargon. You may have got into it with Bill, but when you're a limited partner in a fund and you're committing to having your capital called into that fund, the 250k, the fund manager, she or he is investing different bets in different companies. Sometimes what will happen if there's one company that's a real breakout company that's just absolutely flying off the charts, and the GP managers, let's say she's already put 2 million into it. That's all she could really do, but sees the thing is just going through the roof. But because she needs to have a whole portfolio, she can't dump the whole rest of the fund into the thing that's taking off the other piece of jargon here is something called an SPV special purpose vehicle where she might go out to all of the LPs and say, hey, this thing is going off like a rocket. I'm going to try and very quickly bring together like another 5 million bucks. And I'm just going to put the 5 million not into a whole bunch of bets, but it's all going to go into this one thing. When you get that kind of opportunity, that's also something that you can do. Instead of committing your 250k to the entire portfolio that's yet to be chosen, you could dip your toe in the water by putting something into an spv which in theory should be one of the best performing companies because the fund manager is sort of doubling down on it. Does that make sense?
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A
Yeah, it's a concentrated bet.
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C
Yeah. So as a buddy of mine, actually I'll give him a shout out. He's a great guy. I'm dating myself, but what a great guy. It's a guy called Evan Lowenstein. Evan and Jaron, they were twins and they had this great song, well, others, but the hit was I'm Crazy for this girl. She rolls the window down. If you've heard it, you might recognize this from the orts or whatever. And so he does many things as a musician, entrepreneur, all kinds of stuff. But he's been very successful investing in various SPVs and technology companies and so on where he's just gone into the spv. Obviously it's more risky, it's only one company. But the fact that an SPV is even being raised to begin with tells you that the GP has very strong conviction. So again for the audience, I made a huge mistake with a fund that I. Fantastic gps. They were doing an SPV in Alibaba and I was like too stupid to throw all of my retirement money into that spv which if I had done would have been a huge return. I already had some exposure because I was part of the fund and the fund had put money into Alibaba. But had I thrown a huge chunk of money at the spv that would have been a huge return.
- [32:14]
B
Right?
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D
Yeah.
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B
You always remember the opportunities that you miss. There does come a bit of loss aversion where it's like, oh man, I remember passing on an opportunity and that's
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C
part of the game as an investor for sure. And you might see this, some people even have it on their websites, but they'll be the so called the anti portfolio. So you might go to the website of a fund that the anti Portfolio that they miss is, oh, my God, we knew Jeff Bezos, but we didn't invest in Amazon kind of story.
- [32:44]
B
Right? Right. Here are the things we missed. Here are the things we passed on. As a small business owner, one of the hardest things, one of the hardest skill sets that I still have not fully learned is hiring. Hiring is probably one of the most difficult things to do. And as we talk about VC funds, it strikes me that in a way, if somebody is an LP or an aspiring LP or they're considering becoming an lp, they are, in a sense, making a quote, unquote hiring decision.
- [33:16]
C
Absolutely.
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B
About that gp, that fund manager, how does a person, if you think of it in terms of the quote, unquote hiring skill set, how does a person evaluate a good one from a bad one?
- [33:29]
C
Oh, man. So there's all the surface things like the credential. Oh, gosh, this woman went to mit. That's very fancy. So there's the credential and the label. But I think if you could accomplish this, maybe it's not easy to figure it out, but if you were able to have a conversation with a company that that GP had invested in and you could learn a bit about whether they were helpful or not, that would be a very, very good signal. So you look at the portfolio that the GPS had and they had a huge win by investing in Company X. If you were able to somehow get access to the founder of Company X and say, hey, did this person really help? Were they a good investor? Did they add value? Did they bring in other capital? Did they help us hire? That, I think is a very, very good signal. If you could ask the recipients of the GP's money whether the GP was actually good or not. I think in these kind of things, you're always trying to look for signals, and I'm sort of thinking, allow. What would those signals be? That would certainly be one if you could get access to it. And not to be too esoteric, but there's the guy who got the Nobel Prize for the economic theory of signaling. Michael Spencey became a dean of Stanford Business School, and he wrote this sort of. It was actually quite humorous white paper back in the 70s when he said, paul is trying to hire someone. She's got two people where the resumes are equally good. Always reference letters are always good as well. Right. You never give an employee a reference letter, says, I'm a total idiot. So the problem you have is you have asymmetric information, meaning that you don't know whether this potential employee is good or not they know, right. You're trying to choose between hiring, between me and Joe. We both look amazing on paper. So the theory of the signaling says, is there a candidate who does something that's so painful that a lazy person wouldn't do it? And that's what separates them from the pack. In technical terms, it's called a separating equilibrium. And sort of the joke here is like, if Joe was a guy and he went and he burned a whole bunch of money getting a fancy education and working his self to death and graduated top of his class, that's a credible signal that he's good. Because that cost him a lot of time and effort to accomplish it. It's like the reverse problem where Hyundai offers you a 10 year warranty on their car. They're not going to be able to do that if their cars are piece of crap. The whole thing's going to unwind. So you're trying to find something that only someone who's truly like the good person could actually deliver against. You know what I mean? I know it's a little bit esoteric, but this guy, he got the Nobel Prize for basically saying, and here's the cynical part of it is that if you went to a fancy place and worked like a dog, even if you learn nothing, the signal's still valuable because he had to put in so much effort to actually accomplish it. Does that make sense?
- [36:21]
B
Yeah, yeah, yeah, that absolutely makes sense.
- [36:24]
C
Yeah. I kind of wish I'd come up with an idea that's like a Nobel Prize winning idea, but it's quite deep in a way. Right. I think you're looking for these signals all the time and companies are sending you signals all the time. Right. I have no idea what's going on on the inside of my Mac, but I trust that little apple logo and that's a signal to me that it's a good product.
- [36:46]
B
Right.
- [36:53]
A
I'm wearing Quince right now. You know, every time I record one of these, I say the same thing because it's always true. So earlier today, I'll tell you exactly what I was wearing.
- [37:01]
B
I did an interview.
- [37:02]
A
I spoke to ron Johnson. Watch YouTube for that interview. You'll see I was wearing a Quint camisole and quince pants, like a professional looking pair of pants. Then I came home and I changed into jeans from Quint's. Why do I wear them so much? Because they make elevated essentials. They use premium materials. We're talking washable silk, organic cotton, European linen. The denim which I'm wearing right now is super soft and comfortable. And everything at quince is priced 50 to 80% less than similar brands. So they work directly with ethical factories and they cut out the middleman. So you are paying for exceptional quality, you're not paying for brand markup. So it hits that trifecta right? It's a great price point, it's super high quality and it's ethical. And it's not just apparel. They also make elevated essentials for your home. So from bedding, bath, kitchen essentials, furniture make your summer wardrobe feel easier. Go to quince.com Paula for free shipping on your order and three six 65 day returns now available in Canada too. That's Q-U-I-N-C-E.com Paula for free shipping and 365 day returns. Quince.com Paula
- [38:17]
E
this episode is brought to you by Google Chrome. You think you know a browser, but Gemini and Chrome? That's new. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50 page restoration block. Or finally break down that long article you've had open for weeks. Gemini and Chrome is here for it, ready to make anything online make sense. There's no place like Chrome. Check responses, set up required compatibility and availability varies. 18
- [38:43]
D
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- [39:19]
B
Let's take the example of someone who went to a fancy place and worked like a dog. There are going to be certain areas in which they have tremendous talent. They're very good at X and Y. But there are also going to be specific areas, as is true with all people, where they fall short. Some people are great visionaries, but they're poor on operations. Some people are great at operations, but they over complicate things and over design for edge cases. So you have, I guess with any person and with any basket of skills or talents. There's a variety of both pros and cons, and that's just inherently true of all humans. Yeah, and a good team is comprised of people who counterbalance each other's strengths and weaknesses from the outside. How do you evaluate that team Cohesion,
- [40:16]
C
that's a tough one. And again, I certainly don't want to. I mean, in the context of just explaining the theory of signaling, the credentialing could be important because it represents something else, but certainly by no means does. University credentialing doesn't really mean, I think, very much at all. Maybe it's like 2% of the variance. And this would be a fun one for your listeners because I'm sure many of the products they might have actually used. So I'll give a shout out to. The most successful entrepreneur from New Zealand is a guy called Nick Mowbray, who, with his siblings started a company called Zuru that makes all kinds of toys for kids. And now he's a consumer company called Zuru Edge that in the last six or seven years has built 27 consumer brands like Millimoon Diapers, Rascal and Friends Monday Hair Care, by far the most successful consumer builder in the CPG space, probably in the entire world. I think Nick, when he was 18, was probably building a toy company, not going to MIT. So, yeah, there's many things. So to wind it back, I think somebody who other people look up to or want to work hard for or aspire to be part of that team, if you get a signal of that as part of their personality, can be important. And again, I think what you said is having the mix. And one thing I enjoy about my partnership with Jem at the Fun is like, he and I are quite different in a lot of ways. We have similar thoughts about things, but I'm probably overly optimistic, a bit too laissez faire. He's a guy that just really gets stuff done. He's always more pessimistic, which is good because especially as a gp, you don't want to be writing checks to just everybody who comes through the door. So when you get into the team situation, you are looking for these, I think, complementary skills, but there has to be some underlying core of similarity and agreement. I think that's absolutely critical. So whatever that underlying core is like, that has to be solid, because if you have deep philosophical differences about what the heck you're doing and why, that's probably unresolvable. But if you have different viewpoints, that coming together is a really good collective whole, that's very positive, right?
- [42:29]
B
If a person is thinking about potentially becoming an lp, but they're weighing that against buying shares of a private company on the secondary market, where there you've got something that's a bit more established, right, you're weighing that so you're weighing it against that option. You're weighing it against some crowdfunding options. You're weighing it against investing in syndications.
- [42:50]
C
Yeah.
- [42:51]
B
Other than risk profile of later stage, a little bit safer, early stage a little bit riskier.
- [42:57]
C
Yeah.
- [42:58]
B
What are some other ways to understand the risk profile differentiations?
- [43:02]
C
That's such a good one. Boy, I wish I had some better divining right into it because yeah, I think the first thing is certainly stage, like somebody who's got to further along probably is more likely to get to the end. But that also has to be tempered by like a really important question which is at the end of the day, like who the heck is going to buy this thing and for what price? I'll give you a really interesting example. So I was at a consumer conference maybe a year or so ago and there was one founder and she was talking about a beauty brand that she had built. And she said Once I had $100 million in revenue, I had like a dozen people knocking on my door, maybe from l' Oreal to Church and Dwight to whomever. And there was another guy on the other side of the room and he said I was building sort of a mattress type company with a tech angle to it. And I literally had one person that I could sell to and we had one go around that fell through and luckily two or three years later it came back and it got done. So I think with all of these things, right, like money on paper is just that until it's money in the bank. It's been in the news a lot lately. Right. It's a bit of an unfortunate story about allbirds. How it was $1.4 billion I think at the peak of the IPO and then dropped to 39, 40 million. And now I think I saw it's being rethought of as an AI company or something. Right. So you might have said on the secondary market back in whatever 2018 like to buy, that could be a good thing because it was really taking off. But if you'd bought that and held it too long, you'd really be in deep trouble. So why are the investors or the founder like putting those shares up? Maybe if it's a founder, you might say, well, she just got married. Having a family needs to buy a home, that makes total sense. So it kind of depends on the motivation for why those things ended up there. Maybe it's an investor with a different risk profile wanted to unload a few. But I guess just being in this venture world for so long as optimistic as I am, I always see these things as really, really risky. And I think if it is an SPV and something that's taking off, that's probably less risky, because that GP's probably had a lot of experience. Maybe it's not even their first fund. So they're really backing this thing for whatever reason. So that can be a little bit de risked. If it's a secondary where the founder, she's just wanting to. And I can't really say it, but one that I'm thinking of, boy, some people came into a secondary transaction with large checks and tripled their money in 18 months. That definitely happens too, because in this case, a founder was just wanting to give some money back to the parents. So if the reason for liquidity is more of a personal reason, and you can kind of see that the endpoint is only three or so years away, then that can be a really, really good thing. And this is typically, though, more for more institutional type investors. So even as a small person, if you come in and you put in 250, okay, well, 750 is not bad, two years out. But number one, you may not have access to that opportunity because the person who's doing the secondary might just want to deal with two or three investors. But, yeah, so there are signals. So we're talking about signals. So a founder who's doing really, really well, who has a personal motivation to offload a little bit of equity, that could be a real opportunity.
- [46:26]
B
What do you make of the idea that the founder or entrepreneur, that their incentives get changed the moment that they begin to take in outside funding? Because. Let me just cue this up a little bit. I'm a small business owner that has up until now, chosen to be completely bootstrapped.
- [46:46]
C
Great.
- [46:47]
B
And the reason for that is largely because I want total autonomy over all of my decision making. And I do not. A, I just don't have any desire to have an exit.
- [47:01]
C
Right.
- [47:02]
B
I'd like to be doing this until I'm 100.
- [47:03]
C
Right.
- [47:04]
B
But B, I certainly don't.
- [47:06]
C
If I can last beyond 100, we can come back. I might have to be quite a bit beyond 100 to make it when you're 100, but that's fine.
- [47:15]
B
But then B is I don't want to have financial ties with partners who would be pushing for growth that is maybe a little too big for our britches. Growth that might be unwise because it wouldn't be paced out in a way in which we could do it well. Nor would I want to have Financial ties with funders who are just pushing for an exit. Even in cases in which an exit might not be the right thing to do.
- [47:47]
C
Man, this is all the right stuff. Yeah, 100%. I always say to people sometimes, and you're like, obviously very judicious about this, but with many founders, they think the first problem they have is money. I need to go out and raise money. That's actually the last thing. Like, the proper order I always counsel people is, so what is the strategy and what are you trying to get done? Then? Who do you need beyond yourself to help you do that? And having figured out those two things first, like, what's the minimal amount of capital that you need to achieve the first two things? But oftentimes you'll see if I need to raise $5 million to, yeah, okay, but why five and not four? So you're thinking this is the right thinking is it's like, what's the strategy? What am I trying to do? Who do I need to do? And then do I need money at all? So that's the first piece. The second piece, you're absolutely right. When you're bringing in capital, you're bringing in someone else into your ecosystem who may have a totally different objective function to you. And going back to our early conversation about funds, if I'm a typical fund person, by giving you money, I want you to be marking up that valuation as quickly as possible. So I can now put you in my presentation to my LPs to show how good I am, or to put you into a presentation to raise even more money for a future fund. So my motivation is for you to, on paper and in actuality, give me returns that are as high as possible as quickly as possible. And that might actually be to the detriment of your business. So again, without naming names, you could probably think of particularly consumer businesses that probably never should have been aspiring to be bigger than about a billion. Like, that's kind of the cap, right? Like, you're not going to have a direct to consumer sock business that's going to be worth $50 billion, right? You might have a platform business like Uber that might be worth north of 100. Like, that makes sense. So first of all, consumer businesses should never raise too much money because there's a hard cap on how big that they can get. But if you were to take money with someone who had those two motivations, like, grow as quickly as possible, give me a markup as quickly as possible, and maybe money back, you might start making decisions that don't make any sense. Like burning through a whole bunch of money on Meta, for example, hiring people that you don't really need to hire, making products that are outside of your core product. Like you think, oh, maybe I should start making a movie now you burn a bunch of money hiring like Leonardo DiCaprio or something, you know what I mean? So that is the thing. So again, it's like was having a conversation with a friend who was in town from New Zealand and he's building what I think is an unbelievable business in the pet food business. And his consideration is I built it all myself with my own money. Cause he already had a big exit previously and his partners and his only reason to take money from an investor would be will that money and the expertise of the investor help me to grow more quickly than I would otherwise grow by just continuing to fund it myself. And that's really the key consideration that that investor who's giving you the money, if they're wanting you to grow in your valuation to be juiced, well, they should have some clear path that they should be pitching to you of exactly how that's going to be accomplished as opposed to giving you the check and hoping that you figure it out.
- [50:58]
B
Right. In that case, would that relationship naturally have to end in an exit?
- [51:04]
C
I think, yeah. Good question, Paula. I think honestly most investors at some point need an exit because most people that you would take capital from if they were venture capitalists, they need to also return the capital to their LPs and it becomes a little bit of a problem for them. If most funds have this kind of 10 year, you can extend a bit, but called 10 year, the rough thing. So if they've got to year 13 and they haven't got any money back, that's creating a bit of a problem for them with their own investors. So whereas if you took money from an individual or an entity that just was playing the long game and maybe you're giving them some sort of dividend or something like that, then it's a different story. But yeah, there's a great book that a founder posted on LinkedIn. I was just talking to her the other day and I think it's called something like Founder Unfriendly. Like it's friendly, but the word. I forget who the author is, but you'll be able to find it from AI and I've not read it, but she posted it and she's a great founder, so there must be something to it. And I think it's getting to this root of the problem, which is the investor and the entrepreneur may have different time horizons, different objectives, different views on. So the more alignment you can get before the money goes into your bank, the better.
- [52:19]
B
For me, that idea developed after I read a book called Lost in Founder.
- [52:24]
C
Oh, yeah, what a great title. I haven't read it, but I was like, man, I'm working on this other book right now. I was like, I gotta come up with a good title. Yeah. Lost and Founder.
- [52:33]
B
Lost and Founder.
- [52:34]
C
Yeah. I would buy that book even if I never read it, just to have it on my shelf.
- [52:39]
B
Yeah. It's written by Rand Fishkin, who is the founder of SEOmoz, which later became moz.com?
- [52:46]
C
not to. Well, again, coffee kicking it. Here's another great title, a book I have actually read. Read Andy Dunn, he wrote a book called Burn Rate and it's in the same thing. Right. Everyone knows what a burn rate is, but it was also about getting burnt out as a founder and sort of mental health issues. But yeah, Lost and Founder, Burn Rate, there's a few where the titles just run off the money.
- [53:08]
B
Right?
- [53:08]
C
Yeah.
- [53:10]
B
But yeah, in that book, Rand Fishkin talks at length about the different incentives that a founder has versus the founder versus the funder.
- [53:21]
C
Yeah, yeah. And I think that's why you've talked a lot about different asset classes. Right. And if you think about just buying some stock in Apple, the good thing about that is first you could get some advice from someone who tells you whether they're good. You could read up about whether you think Apple's on the right trajectory. But also, if you didn't like it, you can sell your shares tomorrow.
- [53:40]
B
Right.
- [53:40]
C
So liquidity becomes important too. And if you invest in a venture capital fund, depending on the manager, it might take you a little while for some of that money to be recuperated again, depending on what their philosophy is.
- [53:55]
B
Right. Are there any questions I haven't asked? Anything else that you'd like to cover?
- [54:01]
C
I guess we were having a chat earlier with Joe too, just about AI and stuff like that. I don't have a strong viewpoint on that, except to say I think it sort of behooves everybody to try and learn a little bit about how it impacts them personally impacts their opportunity set, and also would help if they want to be an entrepreneur or business person, how it helps in that regard. And if you go back to 20 years ago, whenever the Internet was first kicking off, I remember I was at an academic conference and I was there with a fellow. He was my academic granddad. So my advisor's advisor, very nice fellow. His name is John Little, and he's a professor at mit, actually, very renowned as an institute professor, and has a law named after him, Little's Law. And I remember saying to John, we're at this conference, every frigging paper was something to do with the Internet, like this, like late 90s, 2000. And I said to him, I said, john, why is every track of this conference is all something about the Internet? He says, is this going to be a big deal? And he looked at me, he's like, dave, do you think the automobile was a big deal? Just to say, yeah. And that turned out to be pretty transformative, right? But I think people are saying with AI, like the transformative index, or whatever you want to call it, is going to be exponentially bigger. I mean, that kind of remains to be seen, but I think just staying abreast of what it is, how it works, how it can help me, I think is really, really important.
- [55:25]
B
Right? Well, if you think about, I mean, the Internet was for millennials, the differentiation of the millennial generation is that we are the last generation that will ever remember what life was like before the Internet, right? And that is the key defining attribute of the entire millennial generation, right? And what they're saying is that Gen Alpha now, the key defining attribute is that that is the last generation that will ever remember what life was like before AI.
- [55:59]
C
Oh, this is. Yeah. What a great observation. Yeah, 100%. It's funny, I'm sitting here as a Gen Xer, thinking we're like the forgotten lot. What did we forget? I remember, it's funny, I was talking to somebody yesterday. Oh, actually, it was on another pot. It was so fun. We were talking about, now milk vendoring is back. I guess in Jersey or Philly or whatever, you can get milk delivered by the milkman. And this was a thing when I was a kid in New Zealand, my job, I had to walk to the end of the driveway, leave out the milk bottles, and you put like 10 cents in each bottle, like an honor system. And I remember I got, like, in deep, deep trouble with my parents because my buddy across the road and I were like six years old. We decided it'd be a good idea to run around the neighborhood somehow at night, parents, we snuck out and, like, steal all the milk money up end all the bottles, and then go and buy candy the next day. So, like, I'm old enough to remember, like, milk delivery and bottles. And, you know, what you said is interesting. I wonder what kind of things will come Back too. So I remember roughly 2000, I was in San Francisco and at a buddy's house, we wanted to watch a movie and have a couple of beers. It was a Sunday night and there was a company called Cosmo back in the day, which you could go online and some dude on a bike would show up with his whatever, Titanic and a six pack of beer. And then I forget how you return the dvd, but anyway, you could. And the thing went bust. It was overcapitalized by VCs. But you think about, well, yeah, now there's Doordash and all these other companies that are worth multiple billion dollars. And so sometimes I try and think about what was kind of before its time. So we talked about pop up Pantry shipping, these pre cooked meals. I mean, I think if I might be pronounced Tavola or whatever it is, like they've kind of done that several years later and they're killing it. Like they're doing several hundred million dollars a year in revenue. So sometimes you're just a little bit too soon.
- [57:56]
B
Yeah, too early.
- [57:57]
C
Too early. And then the idea kind of comes back. But yeah, that's interesting. They will be the last generation not to know what it's like to grow with AI. Wow. Yeah.
- [58:08]
B
Yeah. Well, thank you again for spending the time with us.
- [58:14]
C
Thank you. Paul.
- [58:15]
B
Find you if they'd like to learn more?
- [58:16]
C
Oh, sure. They can just find me on LinkedIn. Probably the easiest place. David Bell. B E L L. I have a personal website, davidbell co. Those are probably the best two places. Yeah.
- [58:29]
A
Excellent.
- [58:29]
C
Awesome.
- [58:30]
B
Well, thank you.
- [58:31]
C
My pleasure. Thanks, Paula.
- [58:35]
B
Thank you.
- [58:35]
A
David, what are three key takeaways that we got from this conversation? Key takeaway number one. When you invest in a fund, you're not betting on the startup, you're betting on the person picking the startups. Almost anyone with a solid income or a solid net worth can become an accredited investor. You are qualified to write a check, but that says nothing about whether you can tell a great fund manager from a con artist. David's whole message here is to slow down, dig under the hood and get suspicious when someone makes it a little too easy to hand over your money.
- [59:21]
C
I wouldn't be charmed by a gp. It's the Groucho Marx thing, right? You don't want to be part of a club that will let you into it. You know what I mean? So if the GP will accept your money off the bat, that's not necessarily a good sign. Right. And of course, since we're here in York, I mean, there's Been unbelievable scandals around the venture industry not that long ago, right? You think about someone like Bernie Madoff, who was just the guru, who, doing whatever he did, who had these incredible returns for whatever, 20 years. And I don't think if, remember from the documentary that the guy even made one investment. He was just printing out fake reports and sort of carrying this mystique that
- [60:02]
A
is key takeaway number one. Key takeaway number. Money on paper isn't the same thing as money in the bank. What matters is who actually buys the thing and for how much. Because a valuation can look incredible right up until the moment that you try to sell. And that's when reality sometimes punches you in the face. David describes two founders in the same room, and they had the exact same paper success, but completely opposite outcomes. One built a company that a dozen buyers wanted, and the other built a company that had a single possible buyer. And that person nearly lost the whole deal when it almost fell apart. So before you chase a hot private deal, ask who's waiting on the other side when it's time to sell?
- [61:01]
C
I was at a consumer conference maybe a year or so ago, and there was one founder and she was talking about a beauty brand that she had built. And she said, Once I had $100 million in revenue, I had like a dozen people knocking on my door, maybe from l' Oreal to Church and Dwight to whomever. And there was another guy on the other side of the room, and he said, I was building sort of a mattress type company with a tech angle to it. And I literally had one person that I could sell to. And we had one go around that fell through. And luckily, two or three years later, it came back and it got done.
- [61:33]
A
By the way, this concept about money on paper, I talk about this frequently in the context of real estate as well, because people get really caught up in their home value. And the reality is your home value only matters at three points. When you buy, when you sell, when you refinance. Those are the only times, the only three distinct point in time, times when the valuation actually matters. Other than that, it's purely theoretical. So we can take that lesson from residential real estate and apply it to the very opaque world of venture capital. It's the same concept. Don't get too caught up by what's on paper, because until it becomes reality, it's all just fancy imagination. That is the second key takeaway. Finally, key takeaway number three. Money is the last problem to solve, not the first. So most founders think that step one is raising money. David flips this order completely. Step one is figure out the strategy, figure out who you need beside you, figure out what you're doing, and then ask whether or not you need outside money at all. Hopefully, ideally you don't, but this is a sharp check for anyone who's tempted to throw cash at a problem before they've done the actual thinking.
- [63:03]
C
With many founders, they think the first problem they have is money. I need to go out and raise money. That's actually the last thing. Like the proper order I always counsel people is so what is the strategy and what are you trying to get done? Then who do you need beyond yourself to help you do that? And having figured out those two things first, like what's the minimal amount of capital that you need to achieve the first two things?
- [63:26]
A
Those are three key takeaways from this conversation with former Wharton professor and co founder of Idea Farm Ventures, David Bell. Thank you so much for being part of this community. If you enjoyed today's episode, there's one thing, one and only one thing that I really want you to do to the milkman, assuming milk delivery has come back to your neighborhood. Send it to the guy on the bike who's delivering a DVD of Titanic and a six pack of beer. Send it to Steve Cohen if you happen to run into him at a Mets game. Send it to that successful dermatologist who's never evaluated a startup. Send it to your orthodontist, especially if he's an lp. Send it to the intern who's getting paid out of the 2% management fee. Send it to the founder who raised 5 million even though they only needed 4. Send it to the Bogleheads. You know. Send it to that 55 year old middle school teacher with a Vanguard Index Fund portfolio. Send it to anyone charging 2 and 20. Send it to the founder of a DTC sock business. Send it to everyone who passed on the Alibaba SPV and still thinks about it. Send it to the Gen Xers who feel forgotten. And then send it to the last Gen Alpha kid who will remember life before AI. Send it to all of those people and more. Because that is the single most important way that you spread the message that you can afford anything. But not everything. Thank you in advance for sharing this episode far and wide. And wide and far. Thank you for being an afforder. This is the Afford Anything podcast. My name is Paula Pant and I'll meet you in the next episode.