Repeated vs single stage games

As an investor, do you let a startup implement an employee option pool that dilutes you in order to retain and attract talent?

Do you forgo exercising an anti-dilution clause in a down round in order to lower the dilution suffered by the team?

Do you forgo part of your liquidation preference at the time of exit so that employees receive more of the exit proceeds?

Do you help a company closing shop pay off its liabilities even though you have no obligation to do so?

Do you let a founder who has worked hard on a business with a low salary for several years perform a small secondary sale to meet their personal needs?

Do you invite other investors to an attractive deal that you have the funds to do on your own?

In a single stage game, the optimal strategy is to not do any of these as they make you strictly worse off.

In a repeated game, however, your long-term outcome depends on your ability to play future games. You miss all the outcomes from the future games in which you don’t play. And to play the game, you need to be invited to the game.

So the optimal strategy in a repeated game often produces actions that are quite different than the optimal strategy in a single stage game.

The corollary to this is that our actions reveal whether we want to play a repeated game or a single stage game.

Infinitesimally small lethal drones

I recently read that a $3M Patriot missile, which is normally used to shoot down enemy aircrafts and missiles, was used to shoot down a $200 quadcopter drone. You can read the full piece here.

This piece is important for two reasons.

First, it shows that there is a big difference between the cost of potentially inflicting harm using drones and the cost of preventing that harm.

I’m sure that the Patriot missile isn’t the cheapest solution to eliminate a small drone. However, the cost of taking out a drone is likely much greater than the cost of inflicting harm using one. Theoretically, you could launch as many low cost drones as necessary to exhaust all of the defensive resources of an organization before beginning to deliver lethal blows once these defensive resources are exhausted.

This leads to the second point.

Drone technology is improving such that drones are being equipped with the same capabilities at much smaller sizes. The smaller drones get, the more difficult they are for defense systems to detect. Imagine an infinitesimally small but lethal drone. Detecting and eliminating such a drone would be very expensive, if it can be done at all.

That, together with all its consequences, is where we’re likely headed.

Why we invest through syndicates

About half of our investments in the US are through syndicates where we pay an average of a 20% carry to the syndicate lead. This is in contrast to the other half which consist of direct investments where we don’t pay carry to a syndicate lead.

When I share this fact, many people question our approach. They want to know why we agree to pay 20% carry to a syndicate lead.

The reason is that, in markets with abundant VC capital like the US, success comes much more from having access than it does from having a unique analytical insight. There is more smart money chasing great startups than money that these great startups can put to good use. As a result, a lot of the money that wants to invest in a great startup isn’t able to get in.

This makes the VC asset class rather different than asset classes like public market stocks and bonds which are far less supply constrained.

To access a great startup, you first need to see it. You then need to get the startup’s founder to accept your investment.

In a recent talk with a friend who works at one of the leading VC’s investing in the Bay Area, he shared that his firm keeps a record of the Bay Area startups that get funded by top-tier VC’s and then calculates the number of companies in this list that the firm had the opportunity to see. Using this approach, the firm estimates that it sees 60% of the Bay Area startups that get funded by top-tier VC’s.

However, the firm doesn’t invest in each of these startups. Specifically, it doesn’t offer a term sheet to some startups and some startups to whom it does offer a term sheet accept alternative offers. From this set we exclude only the latter group because the firm doesn’t identify the former as great startups.

This means that the percentage of the great Bay Area startups that the firm invests in is less than 60%. I don’t know whether this figure is 10% or 50%. For the sake of argument, let’s take the midpoint of this range and say that it’s 30%. This means that even the leading VC funds in the Bay Area get the opportunity to invest in (see the deal and convince the entrepreneur to take the fund’s money) less than one third of the great startups in their geography.

The natural question is how you access the other two thirds of great startups, or more if you happen to not be one of the top 5 funds in the Bay Area.

Especially at their early stages, startups look to have multiple investors participating in a single round in order to have more brains and connections around the table. Investors also often prefer to invest together to lower their risk exposure to a company that has yet to achieve product-market fit, discover a scaleable growth engine, and demonstrate that it can achieve positive unit economics.

And when you have multiple investors investing in a company, chances are that one of them has an allocation that they can’t fill with their own capital. So they launch a syndicate.

In a very competitive market environment where even leading Bay Area VC funds get to invest in less than a third of the great startups in their geography, if we believe that a startup is a great startup, we’d rather have access to it by paying a 20% carry than not have access to it at all.

The founder

The founder is a movie based on the founding and scaling of McDonald’s by Ray Kroc and the McDonald brothers. It’s a story of ambition, persistence, creativity, luck, and ruthlessness.

If you’re looking to learn how McDonald’s came to be and to discover some of the characteristics that differentiate founders, I recommend watching the movie. I watched it last week and some of its themes remain in my mind.

Here’s the trailer.

TazeDirekt relaunching

My partner Hasan’s online grocery business TazeDirekt was purchased by Migros, one of Turkey’s leading grocery chains, following TazeDirekt’s closing in February of last year.

Migros recently announced that it will be relaunching TazeDirekt’s service next Tuesday, March 21st. If you’d like to be notified of the relaunch, you can sign up at this link. Or you can simply visit the TazeDirekt website to place your order on Tuesday. The initial relaunch will be serving Istanbul.

Up to its close, TazeDirekt had developed into a brand which offered its customers great products and consistent great service. In exchange, TazeDirekt’s customers loved the brand.

I hope that the Migros team successfully continues where Hasan and his team left off.

Profitability

Back in 2015 (I couldn’t find a more recent study with the same data), The Information released a study of the percentage of US tech IPO’s in a given year where the company going public was profitable at the time of the IPO. The graph shows that 11% of tech IPO’s in 2014 were from profitable companies. This is the lowest level in history, even lower than that in 2000 before the dotcom bubble burst.

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Since this percentage is unlikely to have grown much in 2015 and 2016, The Information uses this figure as a potential signal that we’re facing a bubble similar to 2000.

Looking at the data as a tech investor in Turkey, I think there’s a much more interesting takeaway. Specifically, the percentage of tech companies in the US which were profitable at the time of IPO has averaged around 50% since 1980, and around 30% since 1995.

This data shows that even US public market investors who invest in large and mature tech companies don’t look for profitable income statements. We already know that early stage investors don’t, but the fact that public market investors don’t either is a very strong statement. The reason is because what matters is not a company’s current profit level, but that it has a path to profitability.

For example, a tech company that can acquire customers much more cheaply than the gross margin that it produces from serving these customers during their lifetime may be spending a lot on customer acquisition to take advantage of this positive unit economics dynamic. The result is that although the company is unprofitable for the time being, it has a clear path to profitability in the future.

Investors in Turkey often dismiss tech companies because their income statements show that they’re not profitable. This is the case not only for large and mature companies but even early stage companies that are growing very fast. This can be short sighted. There’s a difference between companies that are unprofitable without a path to profitability and those that are only unprofitable for the time being because they’re investing heavily in their future.

US public market investors show that even large tech companies that are unprofitable can be very attractive investments when you examine the reasons behind their unprofitability. If this is the case, the same must be true to an even greater extent for smaller and faster growing tech companies.

Non-linear meaningful results

Time passes by linearly.

However meaningful results are achieved non-linearly. They come in the form of breakthroughs that occur after long periods of continuous effort with seemingly little results. It seems like nothing or very little is happening for an extended period of time. And then, all of a sudden, there’s a breakthrough.

From the outside, it looks like the breakthrough occurred overnight. It’s also more romantic to think of it that way.

But from the inside, you know that it’s the non-linear result of an extended period of continuous effort.

Investing time

When you invest money in a startup, you actually invest a lot more than that. You embark on a journey which will likely take at least 18 months and maybe longer than 10 years.

18 months is the shortest path to a successful exit that I’ve seen. It’s also how much runway most funding rounds offer in the event of failure.

And if you catch on to a big winner you’ll likely want to see it play out for as long as possible so this may mean a journey longer than 10 years.

So, in addition to money, you also invest your time in a startup. You spend time strategizing with the founders, helping the startup recruit, pitching the startup to other investors, solving founder problems, but also problems among investors and between founders and investors.

And while money is replaceable, time is not. If you invest in the wrong startup, you spend the precious moments of a finite resource on a business that gets less and less likely to succeed each day. The feeling of lost time hurts a lot more than the feeling of lost money.

As a result, when I’m evaluating whether to invest in a company, I’m not simply deciding whether to invest money in the company. I’m deciding whether it’s worth investing time in the company.

This forces me to hold potential investments to a higher standard. And more importantly, it makes me spend a finite resource in the way that I believe will create the greatest value.

Trends visualized

In a post from December 2015 I shared the reasons why trends are a lagging indicator of opportunity. Great startups and investment opportunities come from identifying the leading indicators of opportunity, so by the time trends have become trends they’re actually not that useful.

In a recent blog post, seed stage VC fund Founder Collective does a great job of visually demonstrating exactly this. Rather than call them trends, they call them themes. But the message is the same.

As Founder Collective shows in the charts below which depict interest over time as measured by Google search volume, the leading companies in areas like crowdfunding, virtual reality, the sharing economy, 3-D printers, and deep learning and machine learning were created well before those areas became trendy.

Investment domains

I received 3 business plans from companies operating in the internet of things (IoT) space over the last week. We haven’t invested in an IoT company so far and this is unlikely to change in the future. We simply don’t understand the domain well enough.

The domains we invest in are written on our website and made clear from our portfolio companies. They include marketplaces, e-commerce, mobile, classifieds, content, and SaaS startups. If an exceptional startup outside these areas comes along together with a strong reference vouching for the company, that’s likely the only way that we’ll take a look at it. And even then we’ll be looking for an investor with domain knowledge to lead the round.

I share this experience because it’s important for entrepreneurs to research investors before reaching out to them. Doing so will help you save the time which you spend reaching out to investors who aren’t relevant for your startup. You can then use this time to perform deeper research on those investors who are most likely to be interested in your company.

For example, Revo Capital invests in IoT startups and they clearly share this focus on their website. It’s better to spend your time researching the previous IoT investments that Revo has made, trying to understand why they made them, and using this information to structure your business plan when reaching out to Revo, than to contact us.

Since we’re also investors in Revo, I guided the 3 IoT startups that reached out to us to Revo’s website. But you can’t always count on investors to help you find the right investors for your startup. We happen to collaborate with Revo, but many other investors compete. Your best bet is to research and find the right investors yourself.