VC10X - VENTURE CAPITAL PODCAST
Venture Capitalists (VCs) & Angel Investors share their investing thesis, screening process, value-add, exits, and more. Hosted by Prashant Choubey (@ChoubeySahab)
David S. Rose is an Inc. 500 CEO, serial entrepreneur, super angel investor, best selling author and keynote speaker who has founded or funded over 100 pioneering companies. He has been described by Forbes as "New York's Archangel", by BusinessWeek as a "world conquering entrepreneur", by Crain's New York Business as "the father of angel investing in New York", and by Red Herring magazine as "patriarch of Silicon Alley". He is the New York Times best selling author of both Angel Investing: The Gust Guide to Making Money & Having Fun Investing in Startups and The Startup Checklist: 25 Steps to a Scalable, High-Growth Business.
So I am actually a fifth generation entrepreneur and quite possibly back farther beyond that, but we don't have the genealogy to prove it but we can prove at least five generations. When I became an angel investor, it turns out that I'm a third generation angel investor. One of my relatives was the angel investor behind the first supermarket. My great uncle David Rose, who was born in the 19th century, was the angel investor behind everything from the portable kidney dialysis unit to vascular stapling, hyperbaric operating chambers.
I come by it genetically and naturally. And knowing that I was an entrepreneur at heart from childhood, I started my first company when I was about 10 and then started companies in high school and college during the .com boom and .com bust. And then finally, after the.com crash, I went to the dark side, became an angel investor and started investing in early stage companies. Then got back into the entrepreneurial space and continued angel investing and then became a VC, helped start a VC fund. So it's all sort of additive.
I am today an entrepreneur, an angel investor, VC, and I've written a couple of books about how to be all of those. So it's an ongoing, open-ended story
Angel investing V/s investing in VC funds
Those are two very different things. The question is, what is your goal? So the, the subtitle of my book angel investing is “A Gust guide to making money and having fun investing in startups”. So those are two different things. If the only thing you're interested in doing is making money. And you just want to put some of your assets to work in the class of early stage high growth startups, then absolutely positively, try and become a limited partner in a venture capital fund.
There are thousands of venture funds around the world. Some of them are generalists. Some are later stage some somewhere earlier stage, some specialized in geographies or particular marketplaces. And in those you, again, you have to be an accredited investor, but you can put your money into the fund in unlimited partnership. And then you sit back and the fund does all the work, the VCs, the venture capitalists, who are the general partners of the fund take that pool, the money that they've raised from people like you and institutions like university endowment funds, or pension funds or insurance companies, Corp groups that have a lot of cash sitting on their hands and have to invest it for a return. They'll typically put most of their investments into safe returns, and they'll take a little bit 5% or 10% and put it into riskier things like venture capital to see if they could, you know, go to the level of their returns.
So VCs take that fund and a VC fund of money that they've brought in from their limited partners can be anywhere from 10 or 20 million for a very small fund to 2 billion or more for one of the very larger ones like Sequoia. So when you put your money into a fund, the full-time fund managers, the GPs spend all their time looking for companies investing that money, helping the companies and so on. So forth, totally hands off for you. You just sit back and you get the profits, if any, which hopefully there are gonna be.
That's the easy way to do it. If you're just trying to make money from the early stage arena, being an angel investor, however, it takes a lot of work. It's very personal. You're making the decisions yourself, you're investing out of your own pocket. Typically your pocket is not as big, a $2 billion venture fund. So the typical angel investment per company is on the Eastern west coast of the US is about $25,000 per angel per investment. In middle America it's gonna be 10,000, $15,000 a bit less than that.
Those numbers are generally true around the world as well. So if you look for, venture funds in India or, Europe, middle east you'll find roughly similar numbers. So when you're putting your money in directly to this company, you're putting it in and it's going in, it's not coming out.
You don't have the flexibility. You don't actually have the flexibility of the venture fund either of getting your money out. If you just decide, you wanna move on you, can't in both cases, angel or venture money. It's in and it stays locked in until there's an exit.
The difference, however, is that with an angel investment, you have to make the decision yourself. Nobody's gonna tell you what to do, nobody gonna manage your money for you. When you put your money into a venture fund, you are paying the GPs to manage your money. They get paid 2% of the total amount, every year to cover their salaries and they get paid 20% of the profits that they make for you from your investment. In the case of an angel group, you pay typically flat dues of a few hundred or a few thousand dollars a year.
But there are no carried interest. There are no fees. You actually get all the money that you're gonna make from it, but you do all the work and for somebody with no experience or little experience in the startup world and understanding the economics and valuations, and the trajectory of these companies, it can be very scary to do a deal by yourself and make an angel investment by yourself. And that's why angel groups can be so important. There are a really good way to put your toe into the water by investing alongside other angels. Who've been there before you done that, and understand the marketing. I've made a, probably 120 angel investments.
So I have an intuitive feel for valuations, not always right. Can't always pick perfect companies, but I have a pretty good feel for different business models that I've seen different competition in different industries, valuations deal terms, structures, how that all works.
That just comes with experience and reading my book. My book is given out by most of the angel groups in the world as their sort of instruction manual for their members on how to be an angel investor, but that's a good place to start. And then joining a group will get you deal flow, and the ability to work with other investors investing in a similar scale and similar types of companies. And that can be a great way to get started. And then some people find if they really dive into it. They really double down and, have made, 5 or 10 investments through a group. At that point, they've probably developed their own reputation, their own brand, their own network of founders who can refer deals to them. And they can then say, Hey, you know what, I'm gonna go off my own. And I know enough now to do my own deals or like me, they can do that and stay in the group because the group just provides a camaraderie and more deal flow and more interesting people to help make things happen.
What to look for in companies while investing?
So different investors invest in different stages, different types of companies, different industries. I am an early stage investor, which means I am typically the first or one of the very first checks into a company, after the founder has put in their own money. And after their friends and family, if they've done a, what's called a hustle round from people they know.
So I'm typically in the, the first outside round when investors angel investors look at a company to invest in, they're looking for several things. First of all, is this the type of company that makes sense for an angel investment? Not all companies are angel investment. As a matter of fact, most companies are not probably only 5%, 10% of companies of all the companies that get started are appropriate for angel investing. And that's because starting a company is very risky and most companies that get started fail within the first five years, three years.
Therefore if you're investing money and buying a piece of a company and it fails, you lose all your money. And so if you, if you, for example, invest in a public stock, it might, it might go up, it might go down, but it's likely to be there. You invest in a startup company, the odds are better than not that the company will evaporate and lose all your money, which means that the one or two companies that actually manage to survive and grow and become big, have to grow so big and so fast to make up for all the money you've lost in all the other companies, which means it's a very interesting risk reward analysis. And that means that not every company is, or even most companies can be angel investing, for example, a local yoga studio or a hotdog stand or a hardware store, or most of the main street businesses that you see. They can be great businesses for somebody. They can be profitable, they can throw up an income for the owner and their family. They're perfectly fine, but they're not the kind of businesses that can be so big, so fast that they can make a profit for the owner and the angel investor.
Typically the kinds of businesses that we invest in are ones that we believe have the potential to throw off 30 times our money to return 30X of our investment within six years. If you think about it, that's a lot of money. And that means to, for our investment to be worth 30X, the whole company has to be worth 30X, right? I buy a small piece of the company. And so if my piece is worth 30X and I'm buying a whole piece of a larger company, the company has to be worth 30X, the original valuation.
So to put things in perspective, if I invest say a million dollars, and I get 10% of a company, that means we, the founder, and I agreed when I invested that the founder's company, when he brought it to me was worth 9 million. I put in $1 million and that doesn't go to the founder. It goes into the company's bank account. So now the company is worth the 9 million. We agreed it was worth plus the million in the bank account. So that's 10 million and I now own one 10th of it, right? So if I put in a million dollars for a 10th ownership of the company for me to get back 30 X on my 1 million, that means the company has to be worth within six years, 30X 10 million, which is 300 million. Most companies are not like that.
So number one is the company investible. Number two, if it is the kind of company that's the angel ABC investible is if the right stage for me. So investing in a company, a later stage series B company, which might now be worth $200 million, 300 million, that could be a great investment if you're putting in, you know, hundreds of thousands of, of dollars or millions of dollars or tens of millions of dollars as a venture fund, but as an angel investor, if you're putting in $10,000 in a company that's worth, you know, 200 million in the series B around, you have such a tiny, tiny, tiny part that it's unlikely, the company's gonna be end up worth 30 times that, you know, 200 million, a 6 billion valuation, it happens, but it's very, very, very rare.
What is Traction?
The easiest way to think about traction is something that is outside of your control. So what is traction? Traction is not trademarking your brand name, traction is not writing code. It's not hiring a team. It's not paying for Google AdWords. It's not developing a product. It's not doing any of this stuff because that's all within your control that you can do.
Traction comes when somebody who is not you does something to prove that what you've done has value. And of course, the best kind of traction is for sales. When somebody is buying your product and paying money for it, and hopefully profitable sales where the money they're paying is more than it cost you to develop. It that's the best proof of, of real traction. And so therefore investors typically like to see traction and mentor funds typically like to see traction, um, angel groups typically invest earlier. Um, historically angels were the first people after your friends and family who would take a real flyer on, on your, your venture. They still wouldn't invest only at the idea stage because they're looking to invest in companies, remember angels see typically 44 deals for everyone in which they invest. And so that means that's a 2.5 percent hit rate.
And so if you are looking at 40 companies lined up in a row, which one are you gonna invest in? The one that has actually shown that they've got customers who are buying their product and have a reasonable rational way, or somebody who has got a crazy idea to take over the world, right?
In reality, most serious angels, having lost a lot of money on crazy ideas to take over the world will invest in the company that has actually shown traction.
How to track your investments?
There are various tools you can use. As I mentioned, I founded a company called Gust and Gust is the global infrastructure platform for entrepreneurial finance. So on the one hand, Gust is used by a majority of the angel investor networks in the world to manage their, applications, their deal flow of collaboration, internal assessments.
On the other hand for companies, it's used by over a million and a half companies to create a profile, like a deal room that they can then share with angel groups, accelerators, investors, VCs, and the like. And so the platform as a tools platform works for both sides. Then of course, when they come together, the company's putting all of its data into Gust profile and the investors can look at all their, their companies.
And you can get a quick overview to see where things are that being said, the biggest challenge for early stage investors is that companies and founders are notoriously not good at all about reporting because most companies run into trouble. Every company runs in trouble. Most companies ultimately fail. Nobody likes to discuss failure. Nobody likes to go back to their investor and say, oh, you know, things aren't really going as I promised it. And so therefore what you typically see is it's like pulling teeth. I was once talking with a CFO of First Round Capital about 15 years ago, First Round Capital, which I'm limited partner is one of the leading seed stage venture fund.
So I said, I'm having trouble getting reports. How often do you get reports from your companies? And he said before, or after we prompt them, I said, um, okay. Before.He said, about 20%. How about after? He said, oh, about 35%. What!? The number one venture fund in the world is only getting reports from 35% of your companies when you funded them and you have all the rights. OK. Maybe my record isn't so bad. So the, the biggest single challenge is with communications. And, and I have that on both sides, right? As a founder, again, I don't wanna tell my investor bad news and when I have good news, I've often got other things going on.
So investor relations is a problematic area. There is no good answer to it. VC funds when they invest in, you are typically very good. If they have a whole team that will call you up and yell at you to try and get your reports on time. But following up and asking and expecting to see quarterly or annual reports is very, very important. And then you just try and track things and at any given point, an angel wants to try and be helpful, but an angel is not running the company. An angel is not on the board of directors. I mean, if you are on the board of directors, that's a separate thing and you have board responsibility, but as an individual investor, it's typically a very passive relationship. And you generally want to be helpful.
Perspective on the current state of the market
So I've been around for multiple cycles during the .com crash. It was almost only the dot coms, the tech companies that were, affected. And so therefore you'd had companies valuations for early stage investment deals in the early 1990s, started out in the very low single digit millions, 2 million, 3 million, 4 million, 5 million, by the end of the .com boom, late nineties. They were at crazy numbers, hundreds of millions of dollars, you know, because there was no rational. We were all in this euphoric bubble. And then when the .com crash came, they all got knocked down by 90%, 95%, 98%.
That was a very searing lesson for people who hadn't been through a cycle before when the global financial crisis came along in 2008, your thereabouts, having been scarred the first time, all of the investors angels VC startup companies began to quickly say, oh, we see a problem coming.
And so they immediately began to hunker down, stop spending, tighten up their teams, their cash, and drop their unrealistic valuation expectations. And most of the dot coms made it through the global financial crisis. After that you began to have this period of growth unmitigated growth. And for the last 10 to 15 years, you had an explosion and bubble valuations. You were now getting closeto where we were during the .com boom.
During the beginning of this year, the end of the, of the pandemic. And so the pandemic, everybody stopped in the pandemic until we figured out what was going on. But once we realized, how that was all working out, a whole new crop of companies did pretty well and it helped accelerate various things. The boom continued and it continued up to the beginning of this year when everybody said, okay, things got a little high.
And then a few things happened, the stock market, which was tied to the tech world and stuff like that crashed. Then a few months later, the whole crypto world had some very bad things happening. And a lot of that stuff and Bitcoin, I know a lot of other token companies went down and then the whole market began to go down as well.
Now you had a sort of triple threat and all of a sudden people said, okay, maybe this gravy train we've been on for the last 10 or 15 years is now ending. And so all of a sudden everybody has gotten very tight.
I would say in the last three to six months, valuations have cut and cut in half maybe. People are being very tight with their checkbooks. So that being said in entrepreneurship, innovation does not stop in down periods.
Companies are gonna be created. They're gonna get funding and companies that are smart enough to get created now and realize that this is a tough time to get funded. So they have to be necessities and mother of invention.
They have to be bootstrapping, they have to be tight and lean with their money. Those will be strong companies that when the money comes back in, in one year, two years, three years, five years, they'll be then strong hearty companies. So this is a great time to startup a company. Not a great time to get cash coming outta your ears and just dropping onto your head, but there is cash out there, but it's gonna come at, prices and valuations that are appropriate, not what they were a few years ago.
David's website- http://www.davidsrose.com/
Resources page- https://davidsrose.zealous.space
Follow David on Clubhouse- https://www.clubhouse.com/@davidsrose
Follow David on Linkedin- https://www.linkedin.com/in/davidsrose/
Follow David on Twitter- https://twitter.com/davidsrose
Follow David on Quora- https://www.quora.com/profile/David-S-Rose/answers/Startups
Hosted by Prashant Choubey- https://twitter.com/ChoubeySahab