Messed-up Cap Tables

Even the most well-intentioned founders often end up with a bad cap table. It wreaks havoc on everything from future fundraising to internal team dynamics.

I feel strongly about this topic & have been at its negative receiving end several times. Therefore, consciously dropping some harsh truth bombs in this post.

During my recent India trip, I was introduced to this amazing founding team building in the edtech space. Yes, I know! Byju’s and all. What can I say – I am a true contrarian.

This is a truly gritty team that’s been grinding in the space for several years (starting from their undergrad days at IIT) with minimal capital and seems to have now hit on a game-changing opportunity. They have signed a highly lucrative commercial contract, something that even massively funded companies in their space have been unable to crack.

This team is arguably the perfect example of the founder persona I believe in the most. In fact, these are the kinds of backstories I wait for. Intelligent founders with authentic passion for a large TAM, unique customer insights earned via frugal execution and strong leading signals of perseverance.

As I went through my investing checklist, this deal checked all boxes EXCEPT one. The one whose real importance I have learned only by burning my hands many times. In fact, this item is so important that I ultimately had to pass on investing in this startup because of it.

The deal-breaking reason is a messed-up cap table! Here’s the situation – with product-market-fit still being some distance away even after multiple iterations, the founders have already diluted 30%+ to 3 angel syndicates, even before an institutional round has been raised.

To add further pain, even the current round is being done at a relatively low valuation, mainly because of insufficient traction in the business as well as young founders lacking leverage in fundraising discussions. This round will make founder dilution even worse!

Based on my past experience with other portfolio companies, these highly diluted cap tables lead to 2 types of issues:

1/ External – follow-on VCs hate to see these type of cap tables. While they are themselves looking for 20-40% ownership in an institutional round, VCs also want to ensure founders have enough skin-in-the-game (equity ownership) to be incentivized to build the company for next 7-10 years. In addition to this, a 10-20% ESOP pool is also typically required to attract & retain talent.

Structuring an optimal cap table that balances the ownerships of founders, investors & employees requires having enough “space” in the cap table to begin with. Having a pre-PMF cap table where angels own 30-40% of the company leaves no room for this.

In fact, cap tables are such a big issue that I have seen financing rounds of my portfolio companies get nipped in the bud, even though the business itself was on a strong path.

It’s important to add another nuance here. In teams with multiple co-founders (3+), follow-on investors also care about the individual ownership of each founder. Especially, the ones considered “mission-critical” for the business (eg. the market-facing “CEO”, the one who has built the technology & is managing it “CTO”). Therefore, having large founding teams can add additional structuring risk to the cap table.

2/ Internal – messed-up cap tables don’t piss of just VCs. I have first-hand seen them creating internal issues amongst the founders, around misaligned incentives. A few real-world examples from my experience:

1 of the 3 founders is pulling much more weight compared to the other 2. As they start getting increasingly diluted in situations like above, resentment starts to surface regarding ownership % of specific individuals not accurately reflecting the value they are creating/ not creating. A zero-sum mindset sets in, where the % of the pie starts mattering more than the size of it.
Because angels own a significant portion of the business as a block (often larger than each of the individual founders), they feel they can dictate how the business should be run operationally & start meddling in execution, creating unnecessary overhead for the founders.
Because earlier rounds have been done at low valuations, both founders & existing angels go into a dilution-insensitive mindset. It manifests in many adverse ways including internal bridge rounds being done at relatively high dilutions, taking low prices for small external rounds etc.
1 of the 2 co-founders starts losing interest in the business (happens especially when fundraising has been hard). While this founder is checked-out & is just going through the motions, the person still doesn’t want to let go of any of his equity. This causes resentment in the other founder, who continues to believe in the business & wants to build it over the long term.

The excessive dilution scenario of the edtech startup is just one type of messed-up cap table I have seen in my investing career. Some other real examples include:

Unbalanced ownership between founders – Eg. 2 so-called “co-founders”, one owns 80%, other owns 20%.
The other extreme of unbalanced ownership, where an equal co-founder isn’t creating equal value. Eg. a close friend of the founders being given equal ownership, even though the person has no specific skillset or value-add to offer for the business.
Non-operating co-founders with material ownership – Eg. someone who helped get the company off the ground, perhaps incubated it in some way, but has no operating role in the company. Yet, continues to hold founder-level equity.
Too many non-institutional/ unsophisticated actors on the cap table – Eg. multiple angel networks, AngelList syndicates, individual angels & advisors crowding on the cap table.

I often get push back from founders that they can solve these cap table issues relatively easily. Some statements I hear:

“[FOUNDER] We can find an investor to buy out all the angel networks on our cap table.”
“[FOUNDER] I am already talking to XYZ to relinquish his balance equity”.
“[FOUNDER] Having that non-operating founder on the cap table is not a big deal. He is willing to sell in the next round.”
“[ANGEL NETWORK] If the company gets a term sheet from a VC, we will claw back some equity to the founders.”
[FOUNDER] It doesn’t matter if angels own 40% of the company. Ultimately, the founders are running it.”

Time for some harsh truth bombs here:

Most VCs filter out startups with messed-up cap tables at the initial stage itself. Forget getting a term sheet, you are unlikely to even enter diligence.

Secondary deals are really hard to pull off, unless the fundraising market is red hot and/ or the business is hitting it out of the park.

Once any person or entity has equity in the company, it’s extremely hard to get them to give up even a small portion of it.

History is riddled with countless examples of large public & private companies where a person or entity with even a small % ownership will assert selfish authority during tough times & at key decision points.

To summarize, founders & early-stage investors need to be aware of cap table risks & their downstream impact on the company’s future. During any financing round, while it’s understandable that everyone’s top priority is survival & getting the cash to be able to live & fight another day, it’s also important to be strategic & think through the long-term consequences of the dilution being undertaken, as well as both the type & quantity of new actors entering the cap table.

Closing out with something I frequently tell founders on this topic – “Every time you are considering a new dilution on the cap table, think of it like getting a tattoo on the face. You have to live with its consequences every day going forward.”

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Macro-Optimism, Micro-Skepticism: A Framework for AI Investing

This Generative AI wave is both a tremendous opportunity over the long term and a ticking bomb in the short term.

Sharing a framework to navigate & eventually thrive in this hype cycle as a tech investor.

As the Generative AI fire rages on with full force, I have been thinking through the best approach for me as an operator-angel to navigate the current environment.

What makes this AI wave particularly challenging for venture investors is that it’s full of contradictions depending on what time horizon you choose to view it from.

In the short term…	But over the long term…
The space is clearly in the early stages of the hype cycle.	It’s perhaps the most defining technology shift of our lifetime, likely to drive a socio-economic change like the agrarian ➡ industrial age transition.
Though AI is “consensus” in Silicon Valley, the agreeing crowd has a track record of being right quite often.	The only way to generate outlier returns is to be “non-consensus-and-right”.
Early entrants are likely to attract significant venture capital, potentially generating quick mark-ups for early investors.	Like previous platform shifts (eg. Web and Mobile), early entrants are unlikely to be the eventual winners (there were at least 8 major search engines before Google came along).
Pre-product stage startups commanding rich valuations is perhaps justified, given investor-demand & the hockey stick growth potential of the space.	The best way to generate above-average returns is investing in the best companies at reasonable valuations.

Clearly, there is a time horizon tension at play here. As an investor, one doesn’t want to miss out (or appear to have missed out) on the earliest stages of the greatest platform shift in our lifetimes. At the same time, as the recent Web3 wave taught us, maintaining discipline during hype cycles is key to ultimately realizing cash-on-cash returns.

To manage this tension & navigate this wave in a risk-adjusted manner, I have been using a framework I like to call “Macro-Optimism, Micro-Skepticism”. This approach involves always keeping two opposing emotions in your mind while evaluating opportunities:

Macro-Optimism – a strong belief that AI is going to be a super-powerful force of positive change in our lifetimes. Having this belief should translate to an immense yearning to learn as much as possible while the tech is still embryonic. It should also translate to keeping an open mind about its possibilities & having the imagination to think about “if it works in this way, what could this idea become?”.

It should lead to a low-ego & eyes-wide-open mindset while meeting founders working on the frontiers of AI. It should also lead to having the awareness to not underestimate any person or idea, no matter how divergent it sounds within your current lens.

Micro-Skepticism – realizing that in the initial stages of a hype cycle:

(1) most ideas will turn out to be invalid, as how a major platform shift shapes the future is, to quote Brad Gerstner of Altimeter Capital, “unknown & unknowable”. And;

(2) the space will initially attract a lot of low-quality actors, including scammy founders, tourist investors & others with a get-rich-quick mindset.

Realizing this should translate to looking at each new investment opportunity with default-skepticism – keeping the bar high, asking hard, intellectually honest questions & calling BS when you see it. This approach requires running a rigorous conviction building process, keeping FOMO at Bay & staying true to your investing value system.

Of course, parallel processing these opposing ideas is easier said than done. As I wrote in my recent post “Investing Landmines”, we are susceptible to many biases that get further exaggerated during hype cycles. Some ways to get better at managing them include:

1/ Leveraging complementary peers or team members that can keep you honest & call out your blind spots.

2/ Using some sort of light-weight system to ensure you are asking all critical questions & spotting typical pitfalls. As an example, learning from the likes of Atul Gawande & Mohnish Pabrai, I have found simple checklists to be helpful.

3/ Consciously sleeping on a deal before pulling the trigger, giving the ‘think-slow’ part of your mind enough time to digest facts.

Ultimately, am excited at the opportunity this AI wave is providing for investors with a growth-mindset to test & fine tune their systems. While I have no doubt that all of us in the tech ecosystem will benefit from this platform shift one way or another, I also hope some of us emerge wiser from it.

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Investing Landmines

Successful investing, be it in stocks or venture capital, requires avoiding behavioral landmines at every step of the way.

Here are the major ones that every investor should have top-of-mind.

Successful investing outcomes, be it in public or private markets, are typically the result of the following sequence of events:

#1 Real world research and/ or experience germinates a non-consensus view.

#2 A conviction-building process for this view helps in getting to a probabilistic distribution of future outcomes.

#3 Courage helps in putting real money behind the view.

#4 If all goes well, the non-consensus view starts turning out to be right (non-consensus ➡ non-consensus-and-right).

#5 After a certain hold-out period, the market provides a liquidity opportunity that is attractive-enough for the investor to cash out.

Investors have to fight specific pitfalls at each step of this sequence:

For #1, it’s the herd mindset that evolution has deeply wired into our psychology. We seek comfort in others validating our views, which is the exact opposite of what contrarian thinking entails.

A by-product of herd mindset is FOMO, which has quickly become the dominant driving emotion of modern urban life.

For #2, it’s hasty bias-to-action. Individuals have a tendency to overcommit & get positively biased very quickly, often even before adequate investigation. Every investing action releases dopamine, which makes individuals feel powerful & good about themselves. Therefore, even sophisticated individuals are quite trigger-happy & demonstrate a tendency to “just do it”.

Running a solid investing process calls for a scientific approach that starts with default skepticism, generating a hypothesis & then putting in the work to approve/ disapprove it with intellectual honesty. PS: check out more about bias from consistency & commitment tendency in this amazing write-up by Charlie Munger on Farnam Street.

For #3, it’s fear. Fear of losing money, of losing face, of future distress. Am sure we all have seen many examples around us of folks who did a decent job at #1 and #2, but never pushed chips on the table. That friend who spotted Google at the earliest stages. Or who had heard of Bitcoin from credible sources before everyone else. Or who was seeing East Bay become the new South Bay or Gurgaon become the new Delhi.

Am also confident that as children, each of us saw our parents hold a non-consensus view for those times & not act on it, which in hindsight, would have led to asymmetric gains.

For #4, it’s lack of patience. Markets typically take time to appreciate & subsequently reward non-consensus views. This period can range from a couple of years to sometimes more than a decade. Holding out with a view that doesn’t match the crowd for long periods of time is extremely hard psychologically for even the most experienced investors.

Humans by nature seek thrill & quick rewards. While a lucky few are born with the delayed gratification gene (like this Nevada’s Pension Fund Manager), for others like us, we have to train ourselves to get better at it.

For #5, it’s greed. Once the market slowly starts appreciating your non-consensus view, given its pendulum nature, it then starts gradually moving towards the other extreme. At a certain point in time, it will soon provide windows where very attractive, & sometimes egregious, returns can be booked. Case in point: after the Nvidia stock stayed flat for several years, the recent AI-fueled stock run-up is finally providing an opportunity for insiders to cash-out.

But then, greed starts kicking in. Maybe hold-out longer for even better returns? This is where the discipline of taking chips off the table & booking profits becomes really important. However, this is really hard to do when investors have faced a long lean period & are now starting to see things finally go up. As legendary fund manager Mohnish Pabrai often says – the art of when to sell is the most difficult.

To summarize, the key to successful investing is recognizing and working towards actively avoiding the above landmines at every step of the way, most of which are behavioral.

Reputations & underdogs in VC

In venture investing, there are obvious stars in the portfolio that generate returns. But what about the ones that are struggling?

I believe that spending time with the underdogs offers the opportunity to learn & build reputations. Here’s why.

During a recent brainstorming session with one of my VC friends, the topic of bandwidth allocation between high-performing “stars” and struggling “underdog” portfolio companies came up. In the flow of the conversation, I ended up saying this:

Star portfolio companies will likely generate returns, while the struggling underdogs offer the opportunity to learn & build reputations.

There is an inherent dichotomy in managing a venture portfolio – the best-performing companies require little investor bandwidth & yet, have high probability of success while the ones struggling demand an inordinate amount of effort & yet, have low odds of success. Brad Gerstner of Altimeter said this in a different way during a recent fireside chat with Mubadala:

If this founder relies on us to succeed, then we chose the wrong founder. Our job is to increase the probability of success, not create the success.
Brad Gerstner, Altimeter Capital

Given this dynamic, it’s natural that purely from an opportunity cost optimization perspective, venture investors will be drawn to divert bandwidth away from struggling companies & towards forward-looking activities like triaging & protecting likely winners or sourcing new deals.

However, as an operator-investor focused on the pre-seed & seed spectrum of financing, I tend to view this tradeoff differently. Personally, I believe in spending time with struggling portfolio companies & supporting their founders as they guide the ship through choppy waters. Not for emotional or moral reasons, but because it makes execution sense in really early stages of venture investing:

1/ Because it’s unclear who will eventually win: till Series A, which is typically an acknowledgement that the company has reached product-market-fit, both “high performing” & “struggling” are loosely defined, temporal phases of company building. Companies will move in & out of these buckets during the up-and-down journey towards PMF. Only by spending enough operating time can an investor develop independent judgement on each company’s potential, quality of execution & what all stakeholders should be doing to tip the scales & increase the probability of achieving PMF.

I call this “building conviction” – something that Paul Graham clearly did for Airbnb by closely observing how the founders were building & iterating on the ground. This is what gave him the conviction to bat for the team in front of top VCs even when a majority of them were just not seeing it.

The alpha of OG venture investors like Paul Graham is their ability to see the kernel of a “top” company within a “presently struggling” one. This happens only by spending the time to closely track the founder’s execution approach & mindset. Reproducing some of the email exchanges between PG & Fred Wilson of USV, to highlight this (Source: Paul Graham’s post from March 2011)

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2/ Because you learn what is not working: venture investing is a feedback loop business. It’s an infinite game where the goal is to keep improving daily by learning what works & doesn’t as the world evolves & incorporating the lessons back into your systems.

In my experience, spending time with companies in troubled waters helps absorb lessons not available anywhere in the physical or digital world. Be it co-founder conflicts, screwed up cap tables, botched hiring or excess spending, these human experiences are worth their weight in gold, and reflecting them both in front of other portfolio founders as well as in your own investment process going forward, is key to tilting the playing field a few degrees in your favor. Cumulatively, this can add up to a huge competitive advantage over a long period of time.

3/ Because fighting till the last breath is a DNA: while what Brad says above is true, especially for growth stage companies which is where Altimeter operates, even the best founders pre-PMF need a lot of support & coverage for their gaps & blind spots. The best venture investors strive to create delta on the “increase the probability of success” part of the job, which is why while capital is a commodity, individuals GPs that move the needle during a company’s long lifecycle are rare & so in-demand.

I remember listening to Doug Leone of Sequoia at an event a few months back where he mentioned believing in fighting alongside the founder till the last day of the company (also reflects his tough New York Italian upbringing!).

My organic investing style is cut from a similar cloth, wherein I focus on bringing a company-building DNA to every cap table I have been a part of. Though, it hasn’t been without some self-doubts, as there is no immediate fruit to show for all the labor this approach demands.

Case in point being an erstwhile portfolio company in queue management software. I was literally the first check into the company as an angel way back in 2015, and also helped syndicate that first round. About 2 years in, the company was out of cash, all employees had to be let go, 2 co-founders jumped off the ship, and the remaining 2 founders were trying to engineer a pivot from a consumer app to an enterprise use case.

On paper, this would look like a dead duck to any sane person barring 3 people – the 2 remaining founders and me! We kept pushing on, literally on fumes. I remember having many late-night operating sessions with the founders every week for almost an year, in parallel to my day job at Alibaba & also being an expecting first-time father. In fact, I remember my better half asking me more than once – “why are you burning yourself up over a small angel check? Is this worth the opportunity cost of your time as a Director at Alibaba?”.

As I now reflect on these questions, I feel it’s all about the DNA of doing whatever it takes alongside founders. Long story short, the company pivoted successfully, crossing $1Mn ARR at high profitability. The business started throwing up so much cash that investors got multiples of their investments back via dividends, with founders also receiving significant cash-payouts, and deservingly so, for their grit & sacrifice. It didn’t become a unicorn or a household name but left everyone net-positive.

This experience left me with many operating learnings & a lifelong friendship with the founders, whose next company I have promised to back again. Even till today, I use the mental model from this investment while looking for both positive & negative leading signals in any new team I meet. I have no doubt this experience is helping me sow the seeds of future success.

After more than a decade of experience both as an institutional & individual investor, I have only now come around to accept my nature of not giving-up on people & companies that are struggling. It’s part of who I am and perhaps, my alpha as an investor.

I don’t know if this is the smart way to do venture investing or not, but I would like to leave you with this idea – fighting for the underdog companies will at the minimum, help you learn some valuable lessons & build your reputation as an investor that in turn, will create future value in more ways than you can imagine.

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Three unicorns & a VC

In my 1st year as a VC, I was fortunate enough to source 3 of the best enterprise startups built out of India over the last decade.

Reflecting on what these companies looked like before they became massive successes and the lessons that taught me about the best way to approach venture investing.

In my first year as a VC Associate in 2011, I started supporting a GP who was native to Chennai, already had some portfolio companies there and was informally leading coverage for the region. Naturally, I started visiting the city regularly and was perhaps one of the few VCs at the time who was spending significant bandwidth in the ecosystem there. And mind you, this is way before the city became the SaaS powerhouse it is today. I spent the most time in events around IIT Chennai, especially in the Rural Technology & Business Incubator (RTBI) there. This is the time when Zoho wasn’t a household name yet, and a few interesting startups like Stayzilla and Ticketnew had just started to emerge.

Candidly, I used to feel a little foolish every time I boarded the flight to Chennai. Was I just wasting my time by not covering Bangalore & Delhi? Which venture-backable company could I realistically hope to find in an IIT’s incubator, that too one which had the word “rural” in it? While my colleagues were neck deep in sourcing hot eCommerce deals from Tier 1 hubs, was I missing the boat by spending time with boring enterprise software & niche consumer Internet companies started by these humble, grinding-type founder personas?

What I didn’t know at the time was that meeting founders in an under-covered but growing hub like Chennai was actually a competitive advantage, a potential “edge” that was there to be leveraged. It led to me meeting two of the best enterprise software founders from the last decade, at a time when both companies were fledgling – Girish Mathrubootham of Freshworks and Umesh Sachdev of Uniphore. My guess is I was also one of the first VCs to ever meet them.

I met Girish during a really nondescript startup event in Chennai. He wasn’t even pitching there, and the organizer randomly introduced us after the event. I still remember Freshdesk had 25 beta customers at the time. I took the deal back to the senior team; we had one call with him but didn’t end up investing for a variety of reasons. Talk about missing the deal-of-the-century!

While meeting Girish was more serendipity, I give myself more credit for spotting Umesh. I was the only godforsaken VC who had built a deep relationship with the RTBI team at IIT Chennai. As part of one of my visits, the lead there introduced me to Umesh & Ravi. They were building Uniphore out of the lab there, with the active support & guidance of Prof. Ashok Jhunjhunwala. I don’t remember the exact traction they had at the time, but it was really early. They were building voice technology keeping rural/ vernacular use cases for India hinterland in mind, which was nicely aligned with RTBI’s mission.

While I didn’t get to interact much with Girish, Umesh and I spent a bunch of time together. I brought him in 2 times to meet the Fund’s senior team, once just before I was about to leave VC and move to the Bay Area. Fortunately, Uniphore didn’t become an anti-portfolio like Freshworks. One year after I had left the Fund in early 2014, it ended up investing in Uniphore. Cut to Feb’22, Uniphore raised a $400Mn growth round at a $2.5Bn valuation, becoming a trail-blazing Indian startup story of grit & perseverance.

As I write this, another similar story comes to mind. Again, in my first year of VC, I had a chance to meet Baskar Subramanian, co-founder of Amagi. This was the most non-intuitive play ever. At the time, Amagi’s flagship offering was a platform to insert regional, localized ads in popular TV programming. For example, say during a national TV soap telecast on Sun TV, viewers in Chennai & Coimbatore would see different vernacular ads of local brands from their specific locations.

If one went by the classic VC playbook of pattern matching, Amagi wouldn’t make it beyond the first meeting (perhaps why most funds passed on it at the time). The company’s existing market didn’t seem like it would support a venture outcome. On top of it, Baskar came across as the polar opposite of a typical VC-backed founder archetype. He was a bit nerdy, a bit fidgety, a bit unpolished around the edges but really smart & always with a big smile.

As expected, while the Fund passed on investing, two things stood out to me even then:

Amagi had signs of early product-market-fit in the use case it was going after.
Baskar and team were gritty, grounds-up entrepreneurs with a humble vibe, strong belief in their overall market thesis & the energy to play the long game.

Candidly though, I was still in my 1st year of learning the craft of venture investing & even though I caught these signals from 1st principles, I didn’t have the experience & chops to convert these signals into conviction & fight for the deal internally.

Cut to Nov’22, Amagi raised a $100Mn Series F from General Atlantic at a $1.4Bn valuation, with the company hitting $100Mn ARR! From its origins of inserting local TV ads in the Southern states of India, it has now become a global software platform for cloud broadcast & targeted advertising.

These and many other stories that I have experienced over a decade of early-stage investing, have taught me a valuable lesson – given the inherent randomness in outcomes, a terrible way to do venture investing is to be dogmatic. While frameworks, heuristics & pattern-matching do help evaluate deals more efficiently, you can’t become a slave to them.

Outlier venture outcomes typically come from unintuitive & unpredictable places. If one studies the history of the biggest wins in both public & private markets, they mostly emerge from “non-consensus-and-right” situations. Spotting these, by definition, requires an independent & radically open mind.

When Tim Ferris asked legendary VC Bill Gurley of Benchmark about why he thinks he missed investing in Google, Bill had a tremendously self-reflective response:

Essentially, Bill is saying that at the time, Google was the exact opposite of a classic VC template deal. And that’s exactly what should have pushed him to evaluate it more deeply as a non-consensus bet. In the words of my friend Nakul Mandan of Audacious Ventures – “the pedigreed, buttoned-down, big logo’d, all-bases-covered teams often end up generating a 1.5-2x return while the maverick, underdog, underestimated, headstrong, quirky founder ends up creating the 100x bagger”.

Marc Andreessen has a great expression around the optimal mindset for venture investing (also applies to starting a company) – “Strong opinions, loosely held“. I like to call it having a radically open mind while evaluating any opportunity. In my head, this approach includes:

1/ Turning over every rock to find deals.

2/ Not discounting any vertical/ space upfront, irrespective of general ecosystem biases.

3/ Not underestimating any founder, irrespective of age, pedigree, or track record.

4/ Trying to probe further when the gut feeling is positive but misaligned with VC thumb rules.

5/ Listening to co-investor feedback but making up your mind independently.

6/ Trying to imagine “What if everything goes right?”.

7/ Finally, getting super-excited when a company seems non-consensus.

This is the behavioral North Star I am chasing & where, I believe, the real Alpha in venture investing lies.

Doing more with less

As an angel, one of the strongest leading signals I look for in a startup is progress per unit of capital – how much forward movement has the team achieved & the resources it has consumed for it.

My thoughts on why a capital-efficient mindset is so important for early-stage tech founders.

Having seen 1000s of deals across a decade of investing my own as well as institutional money, I rarely cringe while evaluating a new company. As an investor, I have often seen the same goods-and-bads in other deals several times before. As an ex-founder, I have walked the path & made the same unforced errors so almost every time, I can empathize & almost pre-empt why a founder is doing things a certain way.

However, there is one specific thing that is guaranteed to make me cringe – a founder attempting to raise an amount that is totally out-of-sync with where the business is. In many cases, this is accompanied by other precursors:

No intent to bootstrap from idea to “some” traction.
Wasteful handling of the last round.
Coding & building product for months at a stretch without putting anything meaningful in front of customers.

Personally, one of the strongest leading signals I look for in a startup is progress per unit of capital – how much forward movement has the team achieved & the resources it has consumed for it, especially when evaluated relative to other comparable startups.

I remember an interesting learning from my time at IDG Ventures (now Chiratae). Sudhir Sethi, the Managing Partner & the lead investor who had backed Myntra (Zappos of India at that time; was eventually acquired by Flipkart for ~$300Mn in 2014), often cited how when he went to meet Mukesh Bansal (the founder) for the first time at the Myntra office, he observed they were working out of a dingy space in a classic Indian neighborhood market with the ground floor occupied by a fruit & vegetable vendor. Sudhir used this as one of the positive signals for the team’s ability to execute in a cut-throat eCommerce vertical like fashion.

Fast forward a few years, and I got a similar insight yet again in the retail context. While working with Alibaba, I saw how frugal the Group was in terms of saving every dollar of operating cost. eCommerce works on wafer-thin margins, especially in highly competitive & price-conscious markets like Asia. And one could see this by comparing the bare minimum facilities & perks we got at the US HQ in San Mateo vs even well-funded growth startups, which were offering everything from catered meals to draft beer stations at that time.

Why is a capital-efficient mindset so important for early-stage tech founders? It’s because they are playing a game where the odds are hugely stacked against them. Where 9 out of 10 new startups fail on average. Where the starting point and end point of companies are vastly different, with each year choked with iterations, a major pivot every few years, and team members jumping on & off the ship.

Setting yourself up to have even a remote chance of winning such a game requires many shots at the goal, many course corrections, and many resets. At the same time, capital is scarce at the pre-PMF stages even for the best teams. Capitalism is brutally efficient, throttling money when relative risk is high, & opening the faucet once success is highly certain (typically post-PMF).

Building even a decently sized company can take anywhere from 6-8 years, & up to 15+ years. In such a long period, both the overall economy as well as your specific market will go through several cycles. The key is surviving long enough, even with limited capital, to be able to walk this arduous path.

This is what the best founders bring to the table – using investor capital like their own, each dollar wisely deployed towards only what’s truly necessary for the stage, raising each round with specific milestones in mind, and realizing that ownership is everything, with each bps of dilution being the costliest trade shareholders can make. To me, this mindset & building approach is perhaps the biggest signal of perseverance in a team.

Come to think of it, in the non-tech world where starting a business isn’t called “doing a startup”, entrepreneurs typically use their savings to get going, & once there is enough business confidence & profitable revenue flowing-in, grow using either internal accruals or debt. Initial bootstrapping creates skin-in-the-game, profitable revenue creates high confidence that customers want what you are making, & debt creates financial discipline around managing cash flows while preserving the founder’s ownership to compensate for all the risk they have taken.

This model has been used by everyone from Sam Walton to Richard Branson, & continues to survive in all parts of the SMB economy. While the venture capital model definitely works for building tech companies, which are asset-light, highly scalable & operate in winner-takes-all dynamics, I believe the founders who are in it for the long run build with a similar philosophy – planning for the next basecamp & raising conservatively, maintaining discipline around cash & giving high importance to ownership.

On a related note, I wanted to share something I recently wrote on Twitter regarding a fundraising pitfall specifically for serial founders:

Often see serial founders who have seen success before (scale and/ or exit), raise large rounds at high valuations at the idea stage!

From what I have seen, even the most successful founders have operated in phases where a lack of capital could have potentially killed their startup. That’s probably why on the 2nd attempt, they try and take that risk out of the equation at the beginning itself.

Oddly enough though, having a capital-rich Plan B to fall back on reduces the scrappy iterativeness, discipline & underdog mindset that startups usually need to succeed. And which probably contributed to their success the 1st time too.

In asymmetric bets like startups, to reference The Dark Knight Rises, “the way to climb out of the pit is without a rope”.

Hopefully, as this cycle resets, all of us founders & investors will go back to the drawing board & start appreciating Benjamin Franklin’s age-old virtue of frugality as a key to success in business & life.

Conviction vs Randomness in Venture Investing

Recently came across a fascinating Twitter thread from June 2020 by Dave McClure, ex-founder of 500Startups, where he talks about how “investing with conviction” is a myth. This tweet captures his sentiments well:

I agree with several arguments in this thread:

1/ Picking winners in early-stage investing is really hard. Power laws govern the best venture portfolios, driving down the hitting %. Per Horsley Bridge data, even for a top VC firm like Sequoia, ~4.5% of portfolio companies generate 2/3rd of aggregate returns.

2/ Intelligent venture investing, by its very nature, involves making both Type 1 and Type 2 errors. Therefore, even high-conviction deals are likely to exhibit unexpected outcomes, both positive & negative.

3/ There is a lot of hindsight bias in the way investor narratives are created around companies that turned out to be successful – “Look, I had high conviction on this deal & it turned out exactly as I expected. Ergo, I can predict the future”.

So in games like this where outcomes are random & often uncorrelated with the level of effort that goes in, does it make sense to discard the input process?

Based on more than a decade of venture experience, I tend to view it differently. I believe it’s still important to have a rigorous process of building conviction and to keep improving it bit by bit with each experience. Even though eventual outcomes might still be random, this approach helps tilt the playing field a little in your favor every time. Over a long enough time horizon, as one keeps taking more shots at the goal & with continuously improving odds, the hope is that a home run arrives sooner than later.

Particularly at the earliest stages (angel/ pre-seed/ seed), especially with the advent of small check investments ($1-5k via syndicates/ SPVs) attracting a new generation of 1st-time investors, it’s easy to assume that outcomes are randomized & therefore, fall into the trap of doing spray-and-pray that isn’t backed by an intelligent investment process.

It’s important for new angels to first deeply study the asset class & build their personal investment process – areas of expertise, focus sectors, stages, target founder persona, deal flow engine, unique value-add to get into best deals etc. Post which, the odds of success are significantly better.

While being a champion of a “conviction-building” investment process, I also agree with the 3 takeaways that Dave closes the thread with, regarding having enough shots on goal:

Even with the most intelligent investment process, venture investors need to acknowledge their limited picking ability & therefore, keep taking enough intelligent shots at the goal for the odds to work in their favor. Semil Shah of Haystack wrote a great post titled “Shots on Goal” on this idea a while back.

Equally important as portfolio diversification via numbers, is making asymmetric investments – ensuring that the few winning bets have huge outcomes so that even with a high loss ratio, the returns math still works at the portfolio level. The smartest thing a venture investor can do is to befriend the power law, and work towards being on the right side of it!

To summarize, acknowledging the randomness of venture outcomes doesn’t need to be at odds with running a rigorous & continuously-evolving investing process. In fact, such a system should be intelligently designed to account for this randomness, combined with other considerations like power laws, compounding, economic cyclicality etc. Even a few points of “edge” that is systematically created with each experience, can slowly accumulate into a sizable alpha over the long term.

The futility of Plan B

Growing up in India, where inherent chaos makes sure most things don’t go according to plan, I got organically trained to always have a Plan B. The classic fallback option – the bylane you take when the main road is clogged because a minister is scheduled to pass through, the backup college seat you block in case you ranked low in the entrance exam for your top preference, or the autorickshaw you hail when the car refuses to start.

Look, I get it! Now that I am a father to 2 boys, I see the instinct parents have to ensure their children are tangibly & emotionally “safe” in all situations. So, I can appreciate why my middle-class upbringing was designed this way. To top it up, my technical education & early analytical jobs further pushed me into the world of scenario analysis & fail-safes.

Down the road, as I entered the risky world of startups, I naturally brought this instinct with me. While building, operating & investing in high-risk-high-reward endeavors, my animal brain would always push me to have a Plan B in my backpocket:

If this startup doesn’t work, I can always go back to Company X.
What if this investment fails? Let me spread my resources & take a smaller bet.
If I don’t like living in Country Y, I can always go back to India.

A few years into taking these asymmetric bets (presumably backed by Plan Bs), I expectedly started encountering failures, both big & small, one after another. They ranged everything from major projects going South & unforeseen external risks coming to the party to unexpected company restructurings & gross misjudgment of certain people’s skills & intent.

During a recent introspection of these adverse experiences, something interesting jumped out – every time I attempted to call on a Plan B for a specific situation, more often than not, it wasn’t really there. In some cases, the “backup” companies had changed their strategy & weren’t a fit anymore. In others, I had grown in a different direction & going to a fall-back option would be a negative step. Many times, people I was relying on to help materialize a certain Plan B had either fallen out of touch, were themselves dealing with adversity, or had changed their context & therefore, relevance.

So this was my lightbulb moment that inspired this post – in high-risk-high-reward situations, Plan Bs are….fictitious. The very nature of extremely risky situations is that they take you in unpredictable directions, change your context in unimaginable ways & leave you with baggage that’s hard to foresee. And all this happens in parallel to a rapidly-changing external environment that in most cases, becomes increasingly incongruent with your endeavor (most asymmetric projects are by definition, contrarian in relation to established rules of the game that the majority operates by).

This complex system renders even the most thought-through Plan Bs useless. Given asymmetric bets are driven by power laws (a few will drive a majority of the total outcome) & compounding (need a long enough timeline for ideas to mature, which is when outcomes start growing exponentially), positioning yourself to be on the right side of these rules requires going all-in for a significant period of time.

While having a Plan B provides the initial psychological space to initiate a risk, in my experience, it unfortunately also creates a mental mechanism to cop out of it, & even worse, often doesn’t provide the safe landing space it initially promised.

Going forward, my aim is to ditch the “Plan B” mindset in all asymmetric bets. A fall-back instinct comes from a place of fear, and while controlled fear can be a useful tool to drive alertness & urgency, it becomes adverse when acting as a roadblock to going all-in & persevering on a thoughtfully-chosen path.

It’s important to add here that while ditching the Plan B outlook, I will still proactively focus on avoiding the Risk of Ruin at an overall life level. Asymmetric bets require multiple shots at the goal & therefore, safeguarding the ability to keep playing is paramount.

On a related note, a mental heuristic I have recently started using while making asymmetric decisions I am 50-50 on – “which option is the fear side of my brain asking me to choose?”. In most cases, I then lean towards the other option!

I have found the following quote by Swami Vivekananda to be hugely inspiring in driving this mental transformation:

Take up one idea. Make that one idea your life – think of it, dream of it, live on that idea. Let the brain, muscles, nerves, every part of your body, be full of that idea, and just leave every other idea alone. This is the way to success.
Swami Vivekananda

As you consider this approach, I want to leave you with this outstanding scene from Christopher Nolan’s ‘The Dark Knight Rises’. As a frustrated Bruce Wayne is trying to catch his breath after yet another failed attempt at climbing out of the pit (he was using a rope each time), an old & wise prisoner gives him the mantra for successfully making the climb:

You do not fear death. You think this makes you strong. It makes you weak.

How can you move faster than possible, fight longer than possible, without the most powerful impulse of experience – the fear of death!

Make the climb…as the child did. Without a rope!
The Dark Knight Rises (2012)

Munger Musings – Notes from DJCO Shareholders Meeting 2023

As a long-time student of Charlie Munger, I eagerly wait for his musings at the Daily Journal Shareholders Meeting every year. This time was no different! Here are some of my notes capturing Charlie’s wisdom at the DJCO 2023 meeting:

Importance of under-served markets in software

Both Munger & Buffet are big believers in moats. Having witnessed the natural creative destruction of even the best companies like Kodak & Xerox, they understand the power of competition & what it can do to long term returns of investors.

Munger spoke about how the software business of DJCO, which offers a solution to automate legal courts, is operating in a large yet unaddressed market that incumbent software companies hate. It’s an unsexy business that has long sales cycles & as Munger himself said – “it will be a long grind”.

However, these same reasons also limit competition in the space. Munger believes that this combination of a large, underserved TAM + low competition is likely to drive superior long-term returns, as long as DJCO shareholders are prepared to ride through the grind & hold over the long term.

In my view, this idea also has some interesting insights for venture investors in the enterprise software/ SaaS space. Too often, investors start chasing the hot market of the year without realizing that a space that is obviously popular will end up attracting disproportionate competition & investor $$. And as history shows us, too much competition in a market drives down returns for everyone.

Therefore, there is some merit in looking at startups going after unsexy or under-served verticals. These non-obvious nooks & crannies often hold the most potential for contrarian-and-right bets.

2. Holding is tax-efficient

Munger spoke about how he hates to sell his holdings as California would straight-up take 40% away in taxes. As he went on a brief rant about how California is driving businesses away with its tax policies, the underlying insight stayed with me – how holding securities over the long term is a brilliant strategy for tax efficiency. A simple rule that anyone from Berkshire & DJCO to common folks like you and me can follow in our lives.

As the likes of Robinhood have leveraged the excess liquidity environment over the last several years to create a generation of young day traders, many of them don’t realize how tax-inefficient frequent trading is.

3. #1 bias is denial

When asked what the #1 behavioral bias is, Munger said “denial”. And it’s so true. Often times, when the present reality is too brutal to bear, our brain tricks us into living in a delusion. While this stems from an evolutionary survival mechanism our brains have developed, taking major decisions under this denial state can cause havoc in our lives.

Proactively trying to see & live in one’s reality at any point in time is the best way to behave rationally. If one thinks of all of grandma’s wisdom handed down to us in popular sayings (eg. “live within your means”), they all urge us to recognize & live within our own realities.

4. Betting big when the right opportunity knocks

I loved this sentence from Munger – “What % of your networth should you put in a stock if it’s an absolute cinch? The answer is 100%”.

While I am positive that Charlie wouldn’t like this to be construed as a stance against diversification, which is important for almost all portfolios in varying degrees, the spirit of this sentence is this – a few times in your life, you will come across a no-brainer opportunity with massive asymmetric upside. It will happen very infrequently, but when it knocks on your door & you are convinced about it, go all in & bet really big. Over a lifetime, these bets will drive the majority of your returns, financial or otherwise.

If there is one thing that separates the likes of Buffet & Munger from other investors, it’s the mindset of betting really big when the odds are extraordinarily in your favor. During the meeting, Munger mentioned how Ben Graham made 50% of his money from just 1 stock – GEICO. Also, he illustrated the importance of power laws by sharing how Berkshire’s initial $270Mn investment in BYD (made in 2008) is now worth $8Bn!

PS: I have previously riffed on this idea in my post ‘Only need to get a few right‘.

5. On using leverage

Munger admitted to having used leverage to buy Alibaba stock in the DJCO portfolio. When asked why he violated his own rule (his famous quote being “there are only 3 ways a smart person can go broke – liquor, ladies & leverage”), Munger responded with another fascinating quote:

The young man knows the rules. The old man knows the exceptions.
Charlie Munger

The insight behind this is something I say a lot – context is everything! Rules & checklists are great for driving overall discipline & avoiding foolish behavior but as Munger demonstrates, it’s not wise to become a prisoner of your own rules. With experience, one should learn to spot exceptions & when the context is favorable, be bold enough to break the rules.

6. On long-term economic trends

While both Munger & Buffet generally hate to predict macro trends, Charlie mentioned a few interesting observations:

-Inflation is here to stay over the long run, given most democratic govts. globally have shown an ever-increasing inclination to print money.

-Most govts. across the world are going to be increasingly anti-business, with tax rates steadily going up.

-If one looks at economic history, the best way to grow GDP per capita is to have property in private hands & make exchange easy so economic transactions happen (the essence of capitalism).

If these trends are even directionally true, it makes sense to hold assets that can fight inflation (eg. stocks), as well as invest in a tax-efficient way, over the long term. Developing an investor mindset that can operate in a high-inflation environment will be important.

7. The playbook for success in life – Rationality + Patience + Deferred Gratification

When asked the thing that’s helped him the most in life, Munger said – rationality! Loved this line from him:

If you are constantly not crazy, you have a huge advantage over 90% of people.
Charlie Munger

To significantly improve the odds in your favor, Munger prescribes combining 3 things:

-Rationality (which is often, just doing the obvious)

-Patience (take advantage of compounding)

-Deferred gratification (live within means, save & invest)

Like most things Munger says, the above ideas are simple & profound, yet hard to consistently follow for most people as their biases come in the way.

Building…one at a time

I recently tweeted a really interesting insight I heard from Mike Maples, Jr of Floodgate at a recent Draper University closed-door event:

This is so true, and a common mistake that founders & product leaders make while building new products. Looking back on my own startup, while I rigorously tried to execute Paul Graham’s “Do things that don’t scale” philosophy, I still created unreasonable expectations in my own head around user growth for each MVP iteration. This was probably due to the baggage I was carrying from my previous experience of working at large companies like Alibaba, where numbers were talked about in Millions & sometimes, Billions.

When the absolute user numbers weren’t met, my morale as a founder would get hit with each iteration. In hindsight, hitting numbers shouldn’t have been the goal at all. The ideal 0-to-1 mindset is like that of a scientist, with curiosity being the core driving emotion, backed by an iterative product development approach. The target outcome of this approach should be to gather insights that help refine the hypothesis.

Similar to how scientists drive their research process one experiment at a time, I have realized that building any new product or service from grounds-up requires moving one “unit” at a time. It’s up to you to decide what that unit should be – acquisition, activation, frequency of use, revenue or even just getting qualitative feedback!

In a scientific process, more than just the number of experiments run, what’s important is taking the learning from each experiment & applying it to the next one so it becomes better than the first.

Similarly, a good approach to building anything new is to delight one person at a time. This automatically focuses the building process & anchors it on an actual customer, thus making it easier to ship something that solves a monetizable problem for someone in the real world. Trust me, this is a non-trivial hurdle that many startup teams are unable to cross.

The 0-to-1 stage can be highly fuzzy but breaking it down into one unit at a time helps give more clarity to the team around the exact short-term goals.

The most profitable way for a product to grow is via word-of-mouth. The above approach naturally optimizes for it. And once the testimonials & organic growth start kicking in, traction compounds with minimal incremental effort.

Of course, the key to executing this building approach well is patience. Again, think of a scientist. A larger research budget or more headcount can’t necessarily speed up a breakthrough. Similarly, building one unit at a time requires a small team committed to iterating over a long enough timeline for customer compounding to kick in. A lean & capital-efficient operating model is a requirement of this approach as a long runway significantly improves the odds of success.

Learning from my mistakes as a founder, as I have now started working towards regularly putting useful startup & investing content out there, I am consciously following the approach of publishing & learning one unit of content at a time – blog post, Twitter thread, LinkedIn post etc.

Same for my angel investing, wherein I am trying to help each founder, co-investor & startup employee I meet, one week at a time, with whatever resources I have – network, expertise, capital etc.

This approach is helping me to first put the core enablers of my venture investing craft in place that then, hopefully, self-compound. Therefore, I feel much better this time about hitting my long-term goals.

PS: on a similar note, I really like this post by a16z on how creators only need 100 true fans to build a business. Whether this number is 100 or 1,000 is less important. The real insight is that even a small number of dedicated fans are needle-moving.

Also, in case you are interested in other similar startup insights shared by Mike Maples at the DraperU event I referred to earlier, check out my Twitter thread on it.