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Here’s the biggest lesson I’ve learned from wealthy investors … it’s hidden in plain sight on this slide I put up in every presentation:
It’s right there at the bottom: stay away from predatory capital
That’s why I’m always looking to invest in a company that for one reason or another hasn’t allowed venture capital or private equity in the door.
This is the narrow window of opportunity between. . .
This SWEET SPOT is what every professional investor is looking for, and it’s something I see at least once a week.
In fact, my best deals are the ones where we kicked the venture capitalists out and took over to build a real company.
Why? Because the best growth-stage companies always have three problems I am outstanding at solving:
Since I always bring these things with me, I get invited into some sweet deals and companies.
Let’s talk a little bit more about what these deals look like and why the right people want to work with me (instead of investors you’re more familiar with, like Kleiner Perkins or a16z.)
Here’s the thing I learned from every single billionaire I worked for or studied under:
If you want to get a risk-free return, you can buy US Treasury bonds (which currently yield ~3.5%).
But if you’re chasing after 3X, 5X, 10X, or even the 25-50X+ returns, you have to be willing to absorb some financial risks. The secret is to understand which risks are acceptable and which are doomed to failure.
Here’s what I mean. Everyone knows that if you have access to the best deals at the best terms, you’ve got a huge advantage over everyone else in the market.
But even if you get lucky by finding the “next big thing” that is going up 10,000X. . .
The single biggest risk to you cashing in on this “life-changing” investment is every investor that comes in after you.
I know this sounds insane, but there is a very real possibility of you investing in a company at a $300 million valuation, the company selling for $1 billion, and you walking away with exactly $0.
In July 2018, Paddy Power Betfair (now known as Flutter) acquired FanDuel for $465M in cash. On the surface, this looked like a great win for the FanDuel founders and employees. However, because the two lead investors held strong liquidation preference rights, the FanDuel founders and most employees received nothing in this massive deal.
How does that happen? More often than not, it’s because the founders get seduced by Wall Street “Sharks.”
I see it all the time. A rising star of a company that looks something like this:
But in order to reach the next phase of growth, the company – sometimes for the first time ever – needs to raise “real” capital; usually between $5 – $20 million.
The problem is that most founders don’t have a Rolodex of rich friends who can back them, and they’re usually not very good at finding investors.
All of a sudden, this company starts taking meetings with prestigious firms you’ve read about.
Now, If you’re “in” this deal as an early investor, you think you’ve hit the jackpot. After all, if some celebrity venture investor wants in, it must mean you hopped on the money train, right?
In reality, it’s the opening scene of a horror film (spoiler: you don’t make it out alive).
Here’s why: “Sharks” are masters at gaining control of a business from the minority position.
Sure, they might pay a huge premium to own 20% of the company… but because of the way they structured the deal, they have 2 of 5 board seats, preferred shares, a liquidity preference, and drag-along rights.
Remember the Fan Duel example, where the founders got $0? It was stuffed full of “cheat codes.”
Fan Duel’s founders couldn’t stop the deal because they’d also granted the two lead investors drag-along rights. These drag-along rights forced the other shareholders to accept the decisions made by these two investors.
Typically, investors are just ONE VOTE away from legally taking over the company, selling it off for parts, and grabbing 100% of the profits. . . leaving early investors with nothing.
That’s why the founders and executives I work with are all beyond excited when I tell them they can:
While the total valuation of the business might not be “headline news” on Techcrunch when all is said and done. . .
The way the company was capitalized will often mean better economics for the founders, employees, and early investors.
Because here is the truth about professional investors (i.e “Sharks”):
They do not exist to fund innovation or support entrepreneurs.
They exist to make their investors – called Limited Partners (or LPs) – market-beating returns. . . and to otherwise enrich themselves.
This means they are highly incentivized to negotiate in their best interests only – even if that means crushing the founders, employees, customers, and other shareholders in the process.
That’s the reason why great companies would rather do business with me when less than $20 million of funding is needed.
In fact, my very best deals have typically been the ones where we kicked the Sharks out
and let regular investors in!
While most founders chase after “name-brand” institutional investors – like Sequoia, Tiger Global, and K1 – I purposely avoid them for one simple reason: the Venture Capital (VC) business model is very often the exact reason good deals go bad.
Here’s what I mean. Barely 5% of VC funds return more than the 3X expectation.
Source: Money Talks, Gil Ben-Artzy
In many funds, the actual investors, known as Limited Partners, take 100% of the risk for only 80% of the reward while the fund managers earn a guaranteed 2% + 20% of the reward for no risk.
Sign me up for that deal, right?
Not surprisingly, when you get a guaranteed salary to spend other people’s money on highly speculative plays, you tend to care less about overpaying for investments.
But remember, the VC investment model requires a small number of massive winners to overcome the high failure rate of startups.
To do this, they need to make 50 – 150 investments – at just the right time, and just the right price – to generate 1-3 blockbuster companies that produce substantially all the returns.
If you invest too early, while you mathematically have the chance for the highest possible upside, there is a ton of risk and it could take 7-10 years to see a return.
Invest too late, while most of the risk has been removed, and there’s not much upside left for you to take.
But as it turns out, there’s actually a risk/reward sweet spot – which I call the “Alpha Zone” – that provides the maximum return for the minimum risk (called the “risk-adjusted return”).
That’s why if you can get access to deals in the “Alpha Zone,” you’ve got a real chance at seeing a 3-10x return within a few years. And over the longer term, you might even have a shot at those “life-changing gains” you’ve heard so much about.
But here’s the problem. At any given moment, there are only a finite number of Alpha Zone investments that can take in a finite amount of money.
So what happens when you have billions and billions of dollars chasing after the same opportunities? It’s really easy to overpay.
There’s a common saying in real estate: “You make your money when you buy, not when you sell.” Said another way, it means the best way to make money is to buy something for less than you can sell it.
In fact, one of the easiest ways to make money is to have a buyer lined up BEFORE negotiating with the seller.
Now I know that “buy things for less than they’re worth” might sound like some straight-up fortune cookie investing advice. But too many people get themselves into deals where they overpay, have no margin of safety, and everything has to go perfectly in order to justify the price.
This is why I absolutely HATE getting anywhere near venture capital-style deals that ask you to believe in completely absurd valuations based on a large amount of hype and FOMO.
And when I HATE doing something. . . I don’t do it.