E219: How Emerging Managers Can Beat Multi-Stage Firms

0:00Ben Horowitz famously coined this term, earned secrets, which is the secrets that you earn through doing something for many years. Specifically, it's usually in a space. It's solving some kind of problem. How important is it for the companies that you invest in to have an earned secret that others would not know? It's everything. And that earned secret, almost by definition, couldn't come from exclusively prior experience, pedigree, or signal. If it's truly novel, the prior pedigree and experience juxtapare advantage will come from the melding of an unknown opportunity with incredible talent and expertise.

0:34That collision generates all the return from our perspective. I always look for this paradoxical mismatch between market size and awareness of market. You're one of the top Fortune 10 chief security officers, and you're one of 10 people on the planet that understand the pain point of these large organizations. And yet that market could be$100 billion or a trillion dollars, but it's only known to these 10 people.

0:58Mike, I've been excited to chat. Welcome to the How I Invest podcast. Thank you for having me. I'm a huge fan and it's a real honor to be here. So you work alongside potential portfolio investments for 30 days. You quote unquote grind with them. What exactly are you trying to ascertain in those 30 days? what we're trying to get at is we're trying to get at the heart of the founder. At Preseed, in my view, the only durable asset is the founder. The product to change, the go-to-market will change, the cap table will change. And trying to understand the founder, the carbon-based life form that you are putting money into for the next decade plus is something I want to understand.

1:46And that is what we're trying to figure out. and figure out in a respectful, collaborative way that even if we don't invest, and by the way, historically so far, we only invest one and two of those investments that we do that 30-day process with. Even if we don't invest, hopefully you got a piece of advice that's useful to make the company grow. What I would say is the number one thing we have found is success is, I've called it action-based self-awareness. And to know and see that in real time gives us asymmetric edge on understanding that founder who has that and those who don't, because those are the things that are most important.

2:25Of course, in the first two meetings, we diligence everything that I think a lot of my peers do. We'll look at the go-to-market, the product, the TAM, et cetera. We want to know more. We want to know about the human and not just what they say, because they think a lot of founders are fantastic pitchers. And they say, and I'm human. I can get moved by a good story. We're trying to build an unbiased framework to watch the chef cook in this kitchen and taste the food in this restaurant, not relying on their past pedigree of the future of the past restaurants they were in or what culinary graduate school they came from.

3:04We're really interested and obsessed with what that founder is doing in this one and helping and being helpful along the way and proving it with our own hands and feet. said another way you've identified two factors that are predictive of startup success which is the founder being able to execute quickly and the founder being able to respond to feedback from the market internally or advisors very quickly and one is not sufficient if you take the execution to extreme somebody that executes lightning fast but never internalizes the feedback that doesn't work if you take somebody that internalizes the feedback but sits around doesn't do anything that doesn't work.

3:45Both of these are necessary and predictive of a successful founder. To build on those two things, it's also having self-awareness about what you are going to be good at and the limits of your own abilities, time, and interest. Because at the end of it, and this gets to a very important part of allocating, which is they're going to have to build a team, right? The majority of that capital is going to be focused on getting other people, right? One of the jokes we say in my firm is that venture is actually pretty easy. We give money to people. So those people hire more people to make us more money.

4:19If you don't understand where you and others begin and how to orchestrate that, you're probably not going to make a great hire or be a good person to work with on it. And therefore, probably a bad capital risk. So being able to see that in situ, understanding the founder's self-awareness as a human, I think has a huge impact on team, hiring, culture. These are a lot of the assets that are off spreadsheet that I think are really going to be predictive of survivorship and returns, et cetera, so on and so forth that drive DPI, IRR, and all the things that LPs want out of an emerging fund. At the pre-seed, obviously you want a unicorn founder that's 100 out of 100 in every single imaginable trait.

5:06But if you had to stack rank those two or three traits that are predictive of a startup founder, what are those? I'll go back to what I said. It's action-oriented self-awareness. And that is the thrust of it. Some people have action based on driving more top of funnel. Some people have action based on just driving more PLG and product. I actually am relatively agnostic in what they pick. Because at the end of the day, you mentioned this rubric of taking the feedback. If I've done my job right, the feedback doesn't come from me or any of my operating advisors who helped me. The feedback will come from the questions we've asked together and what the market is telling them.

5:49And then will you do it and learn more by doing versus talking? What's really cool about setting up a structure like that is founders solve it so many different ways. And it is one of the best parts about my job. The title of my last newsletter was founders. I love you the purplest. And it's not about being good or bad, or you have to be, you know, the, the, the, the bar is 7.0 and you're 6.9. You're out. And I know you're trying to get to this, this idea is like, what is the predictive success? The best answer I can give is action oriented self-awareness and what's really cool. And I've discovered so far, both in the first eight investments out of the fund.

6:27And then I tested this myself with my own money and fund zero of 25 angel investments is that rubric has so many cool different ways that founders have solved for. And also too, I've missed as well, like where I've mistaken talk for action. I've mistaken confidence for signal when I'm really looking for self-awareness and I got bluster. So what I would say is this is a work in progress and I am both equally confident and just like my founders who are confident in their MVP, I'm constantly iterating on that thought to make it better and better and more refined. One of the things I'm really trying to do is define terms so that people know exactly what they mean and they could replicate our guest success.

7:14So you mentioned coachability. There's extreme versions of this. You could be completely unmovable, uncoachable, which you could also reframe as highly principled or first principles based. Or you could be the other extreme, which is too coachable, where every day you get another conversation, you change your, you pivot your strategy. Tell me exactly what level and type of coachability you're looking for in the founders that you believe will lead to these billion,$10 billion outcomes. In terms of billion dollar outcomes, like those things happen in the first two meetings, right? That is the work that is done by pre-seed venture to date.

7:51We'll look at the TAM, we'll look at the go-to-market, the unit economics. I believe those are necessary and sufficient, but not sufficient conditions to generate those outcomes. And a lot of people can look at that in terms of what's the right TAM, what's the right LTV to CAC ratio. The X factor is understanding the human. Understanding the human in the box that is going to be making these decisions and understanding how their psychology, how their frameworks work, so that they, as their unit economics get disproven, as their TAM may shrink or grow, are they going to have action-oriented self-awareness to capitalize on that more rapidly than anyone else that's competing with them in the space?

8:33That's the part that we're really interested in. Butchability. I think it's a fascinating concept. It's one of the most misunderstood concepts in startup investing and venture investing, especially at the early stage. The way that I look at it, I have a couple of different frameworks. I don't have the perfect one framework. One is on average, if I'm looking for somebody that could build the next unicorn or decadent unicorn at the pre-seed stage, I want somebody that's mostly uncoachable, call it or eight or nine on uncoachable and has some room for coachability. Another thing that I look for is are they coachable on the things where I have higher believability or they have lower believability?

9:06That's when I expect that founder to be coachable and something that they don't know. But if I'm coming in and I'm teaching a crypto founder about anything about the crypto space, that's kind of obvious, and they haven't integrated that into their strategy, that tells me that they haven't done the due diligence, they haven't done the hard work, they haven't done the 10 ,000 hours to find these insights. And I find that as a big red flag, find that as a very weak part of their strategy. I'm trying to really understand for myself and for the audience, what does it mean to be 10 out of 10 in terms of somebody has the perfect level of coachability?

9:41What does that mean? Look, if I'm going to lecture one of my founders on the future of AI, or if I'm going to lecture Ben on distributed energy, we are not deep science or deep tech investors. we would have those discussions. Well, we are sluggers. So the coachability we're talking about is in the go-to-market. And at the pre-seed level, you can be incredibly seasoned salesperson, marketing person, and having a repertoire of skill sets. However, when you apply it in a new pre-seed startup, those battle lines are unknown. So our coachability is really focused on the go-to-market motion and to put some bounds on this.

10:24I don't want to debate somebody about, you know, like, look, have you really considered all the gas charges on your crypto? Or like, have you really considered regulatory compliance frameworks on your wealth management? We are not doing that. You know, that is not what the coachability we're talking about is how they think about go-to-market, how they work with the distribution aspect. That is the crux of 90 to 95 % of what we do. And inherently at the pre-seed level, regardless of how much experience you have, if you're entering a new space that has a billion-dollar or decacorn outcome, that interaction has to be unknowable.

11:00Because if it were knowable and someone already put a framework together, Salesforce would already be in. Oracle would already be in. Meta would already be in. Someone would already scaled it. So we're looking for how you encounter novel go-to-market motions. And that coachability and watching those atoms collide at that pre-seed level and what you do with the energy that hits those sparks in the hands of someone who's incredibly skilled and crafted and has tenure and coachability, that's the founder we're looking for. Ben Horowitz famously coined this term, earn secrets, which is the secrets that you earn through doing something for many years.

11:42Specifically, it's usually in a space. It's solving some kind of problem. How important is it for the companies that you invest in to have an earned secret that others would not know? It's everything. It's everything. And that earned secret, almost by definition, couldn't come from exclusively prior experience, pedigree or signal. If it's truly novel, the prior pedigree and experience juxtaposed against a new unknowing frontier create these interesting collisions. And that intersection, I think, is how we interpret the earned secret. Or other parlance you hear, what's the one thing that no one else knows?

12:27What's your unfair advantage? That unfair advantage will come from the melding of an unknown opportunity with incredible talent and expertise. And that collision generates all the risk and all the return from our perspective. And watching and having a system and a process to ascertain that, that's the magic. That's the magic you can't, at least yet, I don't know how to put that on a spreadsheet. I don't know how to do a regression analysis on that or an AI-enabled sourcing to find, And oh, yep, that's the one. That's the one that will figure it out. And I think that's where you can find undiscovered founders and therefore outside returns.

13:13I always look for this paradoxical mismatch between market size and awareness of market. The best way I found to explain this is you're one of the top Fortune 10 chief security officers and you're one of 10 people on the planet that understand the pain point of these large organizations. And yet that market could be$100 billion or a trillion dollars, but it's only known to these 10 people. I find that to be extremely powerful because you have this huge market and almost by definition, it's not competitive because there's few people on the planet that have that earned secret. And I love this paradoxical mismatch between market size and awareness of the market.

13:51Build on that. I mean, this is like, since we were revoking books, this is the zero to one, like Peter deal, like world's smallest monopoly, unfair advantage aspect of it. And I think a lot of it comes from people who have novel insights about weird juxtapositions of different problems that may have been old and intractable. To tell the story of one of our portfolio companies, MoneyStack, they do financial counseling for people with mental health problems. And it's one of these, oh yeah, it just makes sense. Every mental health problem, and they're starting with problem gambling, it actually turns into a financial problem, right?

14:26And as someone who spent a lot of money from my time at Bank of America, we worked so hard and tried to acquire customers in what we call moments of truth. Loss of a loved one, death in the family. If I could be the financial person of record in that moment, my LTV tech is out the roof. The problem with those traditional strategies are you're ambulance chasing. It's ingenuine. It's inauthentic. It's weird. Don't talk to me. But if you can hold the hand and actually add value at people's lowest moments after they've said, okay, I've stopped doing Daily Fantasy and DraftKings, et cetera. I now need to rebuild credit.

15:02I now need to tell my wife of how to budget restitution payments. If you can actually hold them through the most moments, you can be the advisor for life. And everything that we know about the unit economics and wealth are going to be there. So to me, that's an example of what I think of this earned secret, which, by the way, it's hiding in plain sight, that everyone has a mental health problem at some point in time and everyone has money problems, but no one's really put these together. I love that idea of earned secret, but that's how I conceptualize that in terms of where I look at the world and interpret what you're thinking about.

15:42one of the most valuable ideas in the startup ecosystem that i think applies to everywhere is how to create non-zero-sum platforms and if you were just to focus on value creation if you were just to do a razor i want to invest in any company that creates a trillion dollars in customer values let's forget about the business model let's just assume that we didn't even know the business model, you would be spitting out 100x funds over and over. And I think where people get stuck is they focus a lot on value extraction. And people should focus very much on how do we build? How do we help those people in need?

16:21How do we scale this on a platform level? And really, how do you build something extremely big? Then how do we take every last dollar from the customer from day one. I think that's one of the biggest differences between the Deca Unicorn founders I find and the average or median or however you define the average, even venture-backed founder. A hundred percent agree. It's one of the reasons we have an impact thesis at our firm. So we invest in the sectors of education, climate, healthcare, and economic mobility. These, I mean, that is coachable superheroes is the name. Coachability is how we deploy capital.

17:00The superhero parts talk about sector. And in addition to all the psychological benefits the founder has about being impact, our view is exactly that, that if you find the answer to energy, that by nature is a big human problem, that we don't have to worry about value extraction. That's a big deal from a value creation standpoint. If we solve mental health and the intersection of mental health and financial problems, that is a big deal that doesn't need extraction. One of my LPs is famous, this guy Trevor Sumner, he said, hey, if you're going to pick a problem, might as well pick a big one and start a company.

17:38And what you said resonates so hard. It definitely shapes a lot of what we do from an impact perspective. And we think, hey, man, if you can solve energy brownouts across the globe and have a limitless way to figure that out, I think there's going to be enough money for everyone around. We have a big blue-collar thesis in terms of future of work is economic mobility. If you can solve for what happens from AI and the loss and degradation of entry-level test-taking white-collar knowledge workers, which are going to be disintermediated as they look to trade craft and other parts of it, you can solve that problem.

18:20I don't have to worry about extracting every last dollar or pound out. we're going to solve a big problem, make the world a better place along the way, and we're going to make a lot of money. One of the things that I really have changed my mind on over the years has been this reluctance about startups changing the world. I thought it was this superficial meme that people say to make lots of money. But then when you look at it from first principles, it's a necessary component. If you want to have a$10,$100 billion outcome, which the mega, the multistage funds today have to invest in, the world will not allow you to extract$100 billion in value unless you are significantly creating likely trillions of dollars in economic value.

19:04So that changing the world, the scale of what you're doing has to be on that level of changing the world, not because it's a nonprofit, but because it's a necessary condition for those kinds of exits. I 100 % agree. And that is one of the cool things that we get to see in 30 days. People put it on the slide deck and people can see that being pitched, but it's different to see in action. It's different to see when you sit in the seat and watch how the company operates to see if that ethos isn't just at the founder level, but it extends to everything that they do, that they are solving the world's biggest problems.

19:43Since you asked about Vanguard, we started at this. Like if you ever go, and it's been a while, I haven't been working there for 10 years, but like when I was there, like they lived these principles about shareholder value. Like when I would take a recruit out, the recruit in our cafeteria would get an unlimited lunch voucher. Me as the hiring manager, I get a$5 lunch voucher. It is a temple. They live their values about making shareholder value creation at the center of everything they do at the smallest iota. And that's something that you, you know, to get back to what you're saying, like, founders say that they want to solve the biggest problems in the world.

20:20Don't tell me, show me. I want to see it from the inside. I want to see it after most VCs turn the lights out and start their formal due diligence of looking at your corporation documents, your bank statements. I want to see how you treat your employees about it. I want to see how you talk to your customers about it. I want to see how, when your customer says no, how you use that grandiose mission to compel them otherwise. I think those are the really coolest things that I think are both incredibly valuable from understanding the underwriting basis, but then also understanding how far this company can go and how far the willing, you know, everyone says in investing, I want missionaries, you know, not mercenaries, I think is what you're getting to.

21:01I want the same thing too. And I want to see it. I want to see actual evidence of it. So I'm just not wooed by a very nice presentation. And said another way, No offense to nonprofits, but I've come to the realization that startups are the most leverageable way to change the world from zero to one and sometimes even zero to 100. I have not found that to be the case in nonprofits. I see nonprofits as a way for a startup who has exited to now change the world from 100 to maybe 500, but that's zero to 100. I just have not seen that with my own eyes. And I've had plenty, plenty examples to give. I still participate in a lot of nonprofits I donate to, and I've served on some really great nonprofit boards.

21:45I definitely appreciate their role in the ecosystem. But I guess I would say I vote with my feet and we're an impact fund and I think startups can change the world. And I became a solo GP because I share the same ethos. It is the absolute best way to make a dent in the universe. And I got everything in. I'm all in on that, both personally, professionally, financially, philosophically, all the lees on that same idea. This is the best way to change the world and make a dent in the universe. So support for today's episode comes from Square. It's all in one way for business owners to take payments, book appointments, man staff, and keep everything running in one place.

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23:28Run your business smarter with Square. Get started still. You mentioned solo GPs. You have an entire community of solo GPs. You yourself are a solo GP. Why should startups take money from a solo GP? Because we have conviction and can move fast. And I think that those are the ones with the most interesting things to say. We're the freest ones in the industry to do things. We're the most unencumbered and able to move. I would also say, that's what I would say. I also would say solo GPs have to do the things that most founders are doing. We have the most operational empathy. Everyone is talking about founders hyperscaling with AI.

24:06You know who else has to do that? Solo GPs. Because we have to use AI. So when you talk about cultural fit at the pre-seed level, hustlers and grinders, and you're going to find I think solo GPs are both industrious and diverse out of necessity, not out of some sort of false luxury. I think there's a misconception that solo GPs will not help to lead other capital and they're mitigated by their networks. And in my short time, I have found the exact opposite. I think that the emerging manager and solo GP community in specific, we always joke there's like an informal union, solo GP local 144. And that ethos goes back to my podcast, Alone Together.

24:51and that was the name of my podcast where we just talk about other solo GPs we know each other in the industry. So this idea of signal and network and solo GPs are lone wolves. I don't know, I hear a lot of this lore, both from founders as well as sometimes LPs. I am here to tell you that underground and undercurrent exist and that culture is rich, vibrant, and I have at least one data point where I've led in my short career, we can make good by founders and deploy very quickly. So I think this idea of being distributed is, it's an asset, not a liability.

25:30There's a lot of innovation happening at the pre-seed in the startups themselves. There's a concept called seed strapping, where you raise a little money and then you become profitable. There's the advent of AI, which you mentioned, which is lowering costs and also allowing companies to scale their revenue quicker because one salesperson could do just so much more. How does solo GPs fit into this world of the AI startup? Seed strapping, hyperscaling, all the buzzwords. I think solo GPs, particularly pre-seed, early stage solo GPs, to some degree, we don't care. We don't care whether you skip an A, et cetera.