About 15. I mean, we just changed the valuation, and it's all in the residual valuation. So like, in some sense, the word, it's always nonsense, but it gives us a way to think about what are the assumptions that affect our DCF is margin. The key one we play with is this. The key one is this, where the value levers coming from, so that we can help understand who we believe. We believe we should make this investment. So we calculate that we model it out, not because we got the model, but because it helps subs. And this don't think you're gonna win by your options calculator. Okay, and so the thing to realize about venture is that it's sort of crazy. This comes from a paper that I wrote with Ramananda. It's in the Journal of Economic Perspectives, which is like a summary journal where you write about a field or something. So I actually wrote about entrepreneurship. We got this data from a big venture capital firm. I can't tell you which one they have to believe anonymous, but here's the idea as a very there's a big, a famous. What these buckets are is these are the dollar the black is the dollars invested into different bins. So this is the dollars invested in things that ultimately return less than one. This is one to three. These are three to five. And these are dollars invested things that ultimately return greater than 10 times. And then the blue bars are, how much money did they get back from this set of investments? Obviously, they spent most of their money into things that didn't do very well. This is a very successful and they got almost none of that money back. They spent very little of the money in the thing that did 10x but almost all the return over the history of the farmers companies, by the way, eight investments over about a 30 year period. You could throw the rest of it in the heat and they'd be fine. Okay, so, and then there's a bunch of stuff in the middle, but all of it doesn't matter very much. So that's the fast and first thing is, like, normally we think of a portfolio as kind of measuring regular finance. We think of a portfolio as knocking out the idiosyncratic risk that one goes up and this one goes down. So then we're back to here, up and down, back to here, up and down, back here. So then all we earn is a nice, steady, risk adjusted return. This is literally the opposite we're going to all the return is going to come from some random thing that blows up bigger than everything else. Second thing to realize is it's incredibly hard to figure out. So these are scores Okay, from partners. This firm also has every partner at the time that they did a deal to score the deal. Now they're doing it so they don't think it's a bad deal. But still, we're going to ask each person, hey, we're doing this deal. I know this is like a six or 10. You're like, oh, this is our best one. Okay? And then they correlated those we correlated those scores with ultimate output. And this plot is that graph. And as you can see, the correlation is zero. It's not just like kind of a zero, it's like zero. Okay, they basically have no idea which is their great investments, but continue to score. Some of them attend, and some of them are six, and some over and over and over again. I do love the fact that their whole scale 6010, is fine. Okay, so it's like, it's like, amazing that even among a top firm, very successful over an incredible period of time, which one of these is the greatest thing. Can't tell.
There were definitely arms of better works out. But of course, no ahead of time that that would be true statistically, right? No matter what we all randomly do darts, one of us would turn out to throw great darts right at the newspaper. So yes, it is true. I actually, I know one of the young people who was like, really good at it. There's actually more sense. So there's some of these done very well. But again, it's very a lot of small numbers, which is a few at the end of the day, we're just not going to have a lot of data points. You have tag air being big, you look like a genius. So it's very hard, by the way, there's another famous instrument from Paul BA is said so well that they actually sort of joke about the stupid, stupidity of things that they've done. One of my mentors, a guy, Phill the Hardyman, he for thought was pitched by FedEx seven times, seven different rounds. They came back and said, now you've got to believe now, nope, every single time. I mean, this firm passed on all of these, Airbnb, Google, eBay, so you just kind of start realizing they're very successful. They've done all of these, and they did Pinterest and LinkedIn, so they did good things. But even when these unbelievable firms tend to be the best firms in the world, the answer is, when they show up in your office, I think they probably this firm provably doesn't know either. You know when they're choosing to do so, if you take that as kind of the base, it's like, this is gonna be very
hard. Reminds me of a case we did about Jeff Bezos letter to his shareholders, because they keep on trying and failing and because it's his outlier, actually fully Yes,
same idea. And the question is, how are we going to lean into that once we have decided, once we firmly say to ourselves, if even the best in the world investing for decades cannot figure out which the best ones are not saying they can't figure out which the horrible ones are. It's clearly they've done well. So in some sense, the word they think they knew what not to invest in, right? Because, obviously, but not really, right. So it's not that they knew what not to invest in. They just knew something. But, like, incredibly upset we started this foundation that the best in the world couldn't do it. We couldn't do it. We're not going to be able to say which are our best and which are our worst. What are we going to do from that foundation that you said, Okay, how are we going to behave knowing that and you as an entrepreneur at the same thing? Because if you realize, if the experts in the world looking at all these businesses can't tell that these were good businesses, what are you hoping to find out about your idea? You really know it is genius, like no, if Airbnb didn't look genius, if Apple didn't look genius, Google didn't look genius, if Intel didn't look genius, basically all these things didn't look genius. Why is your idea it looks like genius? The answer is, it's not right, even if it is, even when it is the next great company that change our whole world, we're still not There really now
live in that world,
patterns in which on, for example, Stanford or Sloan,
yes or like, conditional on being funded MIT is the best 1.7 I think, on the scale by which you become a unicorn. So the most like 1.7% so the most likely group to become a unicorn, conditional on getting venture backed right, Berkeley, I think, is the overall most venture backed. It's a much larger school, so it's hard to compare these examples to apples. So we end so we know the top schools are harder to MIT, Stanford, Berkeley, it takes the plummet pretty quickly pass out into schools. It doesn't even make sense. You're telling me that the Harvard kids are just so much better than the Yale kids. Well, it doesn't make that much logical sense, right? That like Harvard? Yeah, wow. Entrepreneurial genius over here. But if you go to Yale no chair and yet you look at the data, the answer is it's wildly different. So Princeton in there is weirdly down. So like, there's a lot you do not understand about what makes Why is location seems so important? Why are they like so many more from San Francisco than anywhere else in the world, right? And then after that, it's like a few other places, Boston's won, but Boston, New York. And then you plummet, plummet. You go to other cities in the world. Really, no French people can come up with good ideas. Doesn't make any sense, okay? Even the only French people, okay? And so there's a lot of weirdness around the whole thing, we have not figured out search for patterns. What makes what gets it together? What makes it happen? And every venture capitalist in the world is essentially desperately seeking patterns. I even helped start a quantitative venture capital firm by desperately to use patterns to find it.
You know the strongest pattern we found
that good investors?
Yes, yes. You can't find very much at all at the earlier stages. There's nothing there. But when we start seeing people actually make investments now, if you have made an investment in this area before, and then IPO, the probability that this next investment IPOs is significantly, statistically stronger. This paper is published so but you could, you could back individuals. You can't even back firms. Sometimes Koya, don't be wrong. Sequoia is full of individuals that are quite good. But you can't just back Sequoia or a 60, or any firm. There are individuals, and statistically, you can back particular individuals. That's that's the strongest correlation we can find.
It's painful. 20
years later, it's still painful, okay, but it means, because we can't figure it out, we can't just wait for the person to walk into our office. We always joke about that person, but we're going to have to run a different way. Now, this is how most people view venture capital, because they do it like this. We're going to make an investment $12 million then there's a 10% chance to get $100 million first of all, is this a good idea, where MITC, we do that math, right? As a negative expected value investment, right? But literally, that's what people think. They're capitalists. It's a negative expected value investment of doing double projects. But that's mostly it. That is not correct, because that's not how we would do this investment. This is, this is the key idea. So what I'm going to do is, I'm going to take this same exact project and I'm just going to break it up into two parts. I'm going to say, Let's do $2 million first, and we'll get going. Okay. Along the way, we'll learn something, and then we'll get ten million now I want to be clear, I have not changed the ultimate probability. So I've changed this is the same exact deal, in a sense, because you still have a 10% chance. There's a 20% chance you go up, and a 50% chance you go up 20% to 50% right? So that 10% chance to get to $100 million to $100 million and all other paths are zero. We still have 10% chance on a minute. We still have 90% chance of zero, and we're still spending $12,000,000.50 bucks, right? Everybody with me, okay, but now what we can do is we can calculate the NPV, and we can calculate the NPV, by the way, I just made the discount rate zero here. Make our lives super simple, so, right? So the return required by investors is no percent, okay, so the expected value is incredibly easy, because we get here the end, we have a 50% chance of getting 100 million, a 50% chance of zero, right? So that's what, $50 million right? And we have to spend 10 million to see that outcome. So we spend 10 we have a $40 million valuation, right? So that's our expected value there. And then we just back up one more. We have 20% chance 40 million. That's with 8,000,080% chance of zero. And so we can back up once again. And then we have to spend too many to do it, so we have six. So the first thing here is that this is fascinating, because this is still the same project. I still have a 10% chance of getting the pros. You do these over and over again, 90% of the time we're going to zero. And yet, a minute ago, the whole project was negative, and now the project has a positive, selective value we should be doing.
Where did that come from? The option,
tools? The point is, right here, we have a choice. We didn't have to put in the 10 million last time. We just put in 12 million and saw the outcome. Now we have a choice as to whether that happened, and that and that choice makes all the difference in the world. What is the value in this simple example of the abandonment, figure out the value. Yes, why? When you didn't have the option to evaluate to abandon the whole thing before minus 2 million, and you have the optical bands, the whole thing is worth six, six minus negative two, you created $8 million in value just by inserting the advantage.
Why? Why does the value? What's the step up in value? I out this firm, imagine goes to 6 million
more certainty, and where would that certainly come from in real life? What is that? What is
the analogy? Exactly? Duration learning. We all can just boil it down to write something. This becomes the key. We need to break our firm into parts, because by breaking it into parts, we're going to create option value of abandonment. And where is that going to come from? It's going to come from this is going to affect how we invest and it's going to affect how we run. Because we naturally think of ourselves as saying, I want to keep my firm alive. We want to keep our firm alive.
Ah, and what? What firm would you not want to keep alive, one that was not going to pay out. You could either struggle for the next 10 years in a crappy, abysmal firm that eventually dies. You see that all the time, or you could abandon and want that next thing you're going to do with your life. And so even you as the entrepreneur, need to see the value of the abandonment. But moreover, you can see the value of the abandonment in the value it creates, and that's going to be the value that gets your business funded, and we can share so we can actually change that value by what we do make something more likely to be funded by venture capital, which would make it more likely to go out of business. So emotionally very hard, right? Emotionally very hard. Is there some part of us that would just rather fail next year than this year? Of course, honestly, when you say those words, you're like, actually, I don't know if that's gonna fail. I think I gotta fail sooner. Yes, but we're so against failure. We just sort of desperately try to push it off and push it off and push it off. And we don't do the things that would lead to value creation now that would lead us to defund it. That would lead us to decide how to or to do it, but when we did it, it would be a great idea.
The scenario knowledge
time spent working, the amount
of time that you put into your work at the beginning of the venture, overworking is probably more valuable so you can get that knowledge,
I would agree. So like killing yourself right at the beginning, we want to run as many experiments as possible, get as much information as possible, because it's not going to be perfect, right? Just because we try go to market strategy and it fails. I mean, our whole idea is bad, but you don't know what's bad. Marketing bad. If somebody thinks bad, it's like, what's so frustrating about it? You don't really know, in some sense, the more we could try five different marketing messages, then at least you'd be like, okay, none of that works. So it's like, exact combo of like, how much can we learn for as little money as possible creates this enormous amount, possibly just zero. That's the thing that's so funny about the state. It creates value today, before we found those experiments, the
plans do all means abandon the VCs,
because maybe the learning is fast. Is not a business that is completely possible. And so because growth, the VC is essentially about growth, right? Made money for growth. Growth is essentially cash. The faster I want to go, the more catch, the slower I want to go, the more likely I'm not the second catcher actually shrinking. Usually keeps off going. Well, our firms are usually so early that there's not like shrinking, shrinking, right? And often there's no going slower. You're it gets back to this notion of going slower just means you don't accomplish as much with the money, and then you die. There's not I waited to go as fast as that's impossible. But if you get up to actually having sales, and are actually choosing how fast to grow, to put more marketing, sales or deal with kinds of things you can choose to grow slower, stay more cash flow, break even. And in fact, that decision that's being made a lot today, it's like it's a neat cash flow break even. And let's kind of take money, spend it, and get back to cash flow break even. Take money, you know, spend too fast, but get back to cash flow. Break Even is kind of a new, except for crazy efforts, kind of the new mode of venture capital, but there are firms that never take outside capital. But Spanx is a wonderful example, right? The billionaire made an entire business. It did slow. I actually grew because she's literally had to order inventory, and so there's a whole bunch of years there of like slower growth. So she definitely shows right in some sense, could she have a millionaire faster?
This is the case where you could. And he
Well, I mean, just know, here in my in my simple example, there was a point I didn't really point out yet that's been useful. I said this was two years, and the reason I did not using discounted discovering zero. But yes, it's not instant, but it's very real. This running these experiments. So we should have a firm type may have talked about already, the Wi Fi assurance firm already it does it just it uses AI stuff to monitor your Wi Fi. Okay, so who cares if that's a good idea? The point is, if you think it's a good idea, we can sell it to anybody who doesn't need the right money. So then the question is, who should we sell it to? How do we go to market? So this firm, where we found it was just trying to sell that solution to everybody, they possibly and we said, stop that. We're going to give you a bunch of money. What we want you to do is run a whole series of experiments for a year. I want you to look at it first, but figure out what's our five best go to market strategies, hospitals, robotics. This is one we really thought of hospitals. Wi Fi is really important. Robotics firms, when they get into place, robots got to stay connected. And then one of those that they wanted to do was schools, K 12 schools. And of course, I was like the active we please have two schools. Okay, so we use schools and we do other areas. Actually, at the end of the experimentation, the data is really clear, school entrepreneur to this day. But anyway, the video just for weird reasons. It turns out somebody's Wi Fi in all of America's schools, and just one for staff who has to run around the entire county trying to keep the Wi Fi hit all schools. So when he finds out that we have private systems at school to tell somebody that's going on. So anyway, it turns out we could sell out really fast. We changed the whole business model, the whole web page. Went to we do schools, all this marketing target, our sales force, everything about we went to school conferences, and so we narrowed up the world dramatically so we could do the best thing that we could possibly do. And now, years later, we're in Tesla's Gigafactory partnership system. There is still a world where we're supposed to do robotics. And we just, we first destroyed the firm, right for a whole year. We made them screw up all their sales like it was basically like, oh, try marketing to these guys at this point, marketing for these guys. And we wasted all this money and all this time where sales at the end of the year were worse than they would have been, and it just been like, five thought we figured out and that that idea.
Okay,
so there's one other thing in here that I've done that like nobody's noticed yet. It's here. You'll see it as we go forward. Okay, who keeps the value created by this experiment in the in the world that I've set up and what we're about to go through? I'm just going to assume that the entrepreneur keeps it all. And right now you're thinking, but like just, I'm going to come back to couple times. I'm just going to assume the entrepreneur keeps it all. The reality is we have to have some negotiation, right? And it would be like all surplus is divided among the people, who would have to ask yourself, How competitive is the market for entrepreneurs for money, blah, blah, blah, we reach some agreement, but I don't want to be every time I show an example. I don't want to be changing the agreement level. So I'm just going to park the agreement level. As entrepreneur gets everything. I think VC gets only amount. They need to just do this kind of a weird assumption, but just going to pin us to that side. Okay, all right. So what we can do is that we can relook at this in the context more sort of a real world situation. If this is the world in the background, we can think of this now as actually implying a lot of stuff for our actual content what we're doing. So in this case, if this is our world after stage one of that first VC is best. What is the founder going to get? And what is the VC? The
founder should be 75 minutes, and that's 25% Why do you think that post money and post mortem graduation. So for investment, 2 million, but $2 $2 out of 8 million, exactly. So you see here what we have now, what we've actually we've got with these numbers, is we said the firms were 6 million that we call that the pre money, as a $6 million pre money. 8 million is called the post money, because if it was worth six, and we just gave it $2 million it's now worth eight, six plus the two, right. And so therefore the investor that went from six to eight put that money in owns 25% of the company right. And therefore the founder was 75% make sense? So by the way, even though, like, obviously, my example here is fairly precise, we're doing this, it's there in real life. You don't know all the numbers, but when we say firms were 6 million or 8 million or 10 million, and I'm buying 20% this is it. We're implying some statement about the probabilities and about the future rounds dilution that are going to happen that are going to make me willing to do this. This case, I'm just, just, how about round two, the new VC? Yes, the new VC is investing. Always the first person to go to. It's almost always the easiest to calculate. The new VC. New VC, hey, it's pretty easy. What's the free money? Yeah, 40 million. To free money. What's the post money? 50? So that 10 million is buying 20% what's happening to BC One and the founder?
Dilution? How badly
right you're trying to do? If
this person just took 20% they had to go down by 20% so they're each going to go down by 20% right? So 20% of that is 5% so they're going to drop by 5% right? And 20% 75 is 15% they're going to drop by 15 they're going to drop five. And this is literally exactly how you that good again, in real life, we don't know the little probabilities and the perfect outcome, but we're still doing the same thing. It is implying something about what we can do and what we can accomplish. Okay, so all the fact we're doing around the 40 million is telling you something about what you think the path is and the probability of those paths, all right? When we're done, we can also then calculate what our actual return would be if we pay off isn't successful, we get the 100 million now, so we get the 6020 right, and we can do the math up the first investor invested only 2 million right? About 20 million out, nice day, nice 10x return and a 58% IRR, the second investor, they invested much later. They only own 20% right? They also got 20 million out. They put in 10 so they only got 2x and only a 26% IRR, still pretty good investment. I What did VC one expect to get? What's their expected return on the day they invested too much?
Yes, and what did that? What does that back down to it in terms of dollars, I invested 2 million. What was I expecting to get back in the probabilistic statement, I was expecting to get back
20 I only got that one. It paid off, right? And we all know there's only 10% chance of that. So I'm in this world where there's only 10% chance. I got 29 expecting it eight.
I just told you the numbers.
I invested 2 million. What's the chance this thing pays up 10% we don't we don't know 10% that's only time to stay up. And when it pays off, 10% what do I get? 20 million because I only own 25% with firm right? And I know it's going to get futurely diluted. So I only own 25% today, but when time pays off, I also know I'm only going to know 20% by then by an important calculation we do not what do I own today? What am I going to actually exit then multiply that by the probability that we get there? What's the probability we get there? So I'm going to get $20 million 10% of the time, which is what I meant by winning an all a surplus to the entrepreneur, okay, there's no discount rate here. So what does the investor need to participate a zero return? They need to get their money back. Obviously, this is not correct. Obviously an actual discount rate return and B, we would negotiate and share some of the surplus so it wouldn't be 75% just some at some point later, somebody, people go back to these calculations. This is really weird. How do the investors it's literally, I'm just going to pin the investors again. We're about to do more examples, and I want them to be comparable apples to apples, so I'm always going to sort of
sell their shares.
It does happen more and more as the world has stayed private longer and longer. It's typically not done sort of right away. So the pre seed people never sell together, almost never sellership C people and the pre seed and seed are not really selling to the A that, I mean, like, what really happens is there's typically, if the firm really works. There's often these rounds. The people coming in at that moment are a little like, we don't care about the early idiots that did this thing. If you want to sell a piece of what you did at that point, the whole thing, we don't care. We're trying to get 500 million to work. So we'll take another secondary so the big unicorns, this happens in some later stages yesterday happens sometimes in other situations, and founders selling and early investor selling. But it's not, it's not crazy, comments,
question, relations,
in some sense, like often, VC two would not be, it would not be the same. It's definitely a new lead, but, but it could be, could be all the same person. So secora, for example, tends to invest fully in all of their rounds of WhatsApp. But often, if I had done these, this round, I would have least a part of this. It's, in some sense, changes nothing. I've pinned all these investors against the wall. Of they all make a zero expected value. So I make a zero expected value and a zero expected value than that, but it's a really important concept, because in reality, the right to invest more is something that I negotiate more strongly because I want to be able to put money into the next round. Because I assume it is not going to happen at the market efficient price. Where is it really going to happen? All over the place. And remember also that I have more information than the average person or term an entrepreneur for a while, so my information might be really negative, might be really positive, whatever it is, then what I get to see is a new firm come in and set a price. At that moment, I get to use all my information to decide, am I in or am I out? To what extent? So the tiger comes in and sets some incredibly high price. We say, You go with that. And when a really strong VC comes in and convinces the entrepreneur take a really low price, then we're dying to be like, Oh yes, I have the right to put it more and I'm putting in more money. So it's actually a really important part to say is, can I get more money to work into my winners? Because a lot of value can be created right there. And only put $500,000 in the early experiment once he was working, I put in $5 million and I paid very little to learn, and it bought me the right to put in five that is some sense, like where the real value is created. Careful. There's a lot of real world problems with this. Okay, there's two this follow on this idea is very important. In the idea of following on into your own rounds. There's a lot of real world problems. So first of all, any safe that you've ever done if you've invested. So don't get the right to invest. Angels almost never get the right to invest. So we have to go in on the side, negotiate a right to invest one two, even when I have the right to invest more, when do I get to use it? Okay? Now let's say Sequoia shows up and says this purpose, awesome, but we're going to give them a low valuation, because for Sequoia and they'll take super excited, right? I'm going to take my option to invest more. What does Sequoia
say? Why don't you go over the lake and we're going to take and then the entrepreneur terms looking
nice. And I think, Ah, I can either fight with the entrepreneur and Sequoia, or I can have my firm funded by Sequoia, because Sequoia says that we don't get all around that lake. So you have this right that is weirdly unenforceable. And in fact, the times that you get to exercise the rights are often the times that you don't want to be exercised. So you actually have to watch out with these rights, even if you have them, really think about what are we learning? I have a lot of ability to invest more in this stuff. So the ones that we love are ones where we've actually earned the right to invest more. What I mean by that, we often are very helpful. And after helping somebody, they often feel very hey, look, I really appreciate all you've done for me. So the next round shows up and Sequoia says they were cutting everybody out. They say, you cut everybody up. Done that. I promised a million dollars. Was just really helpful.
Please correct me if I want but doesn't pro rata rights. Give for the safe, give you the right to invest more. Yes.
So if you have pro rata rights, which some of them have, but it's rare, but, but note that pro rata is a strange statement in a safe, you don't know what you own, so they often come with zero, nothing. If they have rights, they're usually dollar amount, not pro rata. So you just like say, Oh, we've invested in many we have the right to invest another million because we don't own a percentage of the firm yet. We are safe. So there's no notion of more technical than some people. How about the valuation caps in the NSA? Where to or just set that trigger, yeah, so, so we would basically never invest in one that did not have a cap. Okay? Angels do all the time to us. It's like almost complete nonsense, because the whole thing I'm hoping to do here is learn a ton jack up the value of the firm, and I'm going to help you do that. And by having no cap, I'm going to capture exactly zero of that surplus. So that, to me, feels like incredibly dumb activity. By the way, I usually discourage any entrepreneur from doing it too. If I've invested in you in an uncapped note, and the next round comes around, do I really want to introduce you to lots of other VCs and really get your price up super high, because I'm going to get that super high price. What I like to, like, call my friend and, say, offer a 10 million valuation. I'm I'm on, I'm on the page with you. So like it, actually, it puts us on different teams. I hate being on different teams. Of my entrepreneurs, I essentially won't do it. I have something I essentially won't do it because I just want to be on your team soon as I've got a couple soon as I've got correct. Do you think that's the norm? And also to Angel side uncapped notes, right? Okay, and and lawyers are always pushing on the entrepreneur side notes. I don't know why. The only time that you may actually make sense is if we absolutely know we're about to raise around or we need a little bit of money while the round sort of completes. Then like an uncapped note, because we don't want to signal to the people who are coming in. We think we're worth 60 million, and they were about to offer us 80 million, oops, right? Or they're about to offer 100 I say we don't want to signal, and you can do it wrong. The other way, we put the cap 120 million, and they think, oh, and they think, Oh, these have jobs. Pick their firms, or the 100 20 million, I'm out. I don't want to spend a lot of time doing due diligence. We're going to find out. We can't reach agreement at 60 million, which is where I think you're supposed to be. So they're sort of dangerous in that one context. But when we're coming in the beginning early, the answer is, if I do a node has a cap price, we're not thinking they're going to do a round below that cap. We think you're only going to do rounds above that cap. So I would just set the cap at 6 million. 6 million free money cap. Sorry, I might be confused about the
initial expectation, as in, when the overall probability is 10 and the ownership at one is 25% equity could not be 2.5
Yeah. Except for that, I know that if we get there, what's going to happen? The only way we get to the 100 million, what's
the other space before then it's like it's
diluted down as probably the other mistake that most angels do. They buy a section affirm. They go, wow, I own two facilities firm. I'm going to be so rich you're going to get diluted down all throughout the whole ride. So you really have to focus on how many more rounds are they going to be, what prices are they going to be, and how much money we'll talk more about those class, but it's easier than you think. It's not, oh my god. There's too many things to know. But definitely want to take into account we're going to own far less by the end. And in some sense of the word, it doesn't matter if we're going to also gain we're also VC too. That's like a it's like almost a separate perspective, right? If this is a bad investment. I should just wait, unless you think the only way then I'm buying option. So there's a little bit of confusion there, but it's essentially just trying to figure out, what can I learn? So the most important thing here is I want to go back to is there's a lot of stuff about the game that's being played, but the most important concept is this affects how we run our firms. Okay, we just talked about this
affects how I run our firm.
So why does he immediately invest and get 7% right, and then they encourage their people to do but they don't. They used to say untapped. Say now they're more open to, like, a cap safe around so weirdly dangerous. Nobody the right one should invest in that. Investors all got pissed, so they're now more like, I think they want 20 million caps. You should have a cap, uncapped, weird thing even imagine like, such as the best case scenario, you start a company, you get all these people who are you going to convince the best friends? Uncapped note. And then the next impact is yourself a billion dollars. You know what you're returning to all your friends, first of all, second of all, you just screwed all these super important people in your life. I almost seem like really, almost no upside from the uncapped the only time we're doing these late stage rounds. Need a little more money or 300 because we don't want to signal too high. We don't, so then sort of not having a cap, and it's not that risky, because we don't, we're not going to go very long. We're going to go another couple of months. You're either going to get around I'm money risky, but in the sense that what we're not going to do with that money is suddenly blow our screw all the investors. We're just going to raise money like
dude value two years prior. So
that's the whole point. Is I invested before we learned all those things, so I need to invest it today's Oh, if I invested two years ago, it's fine. That's what I'm saying. There's this, there's a moment where firm needs more money. It's fairly common. Actually, we're like, raising the bees, but the bees take a little longer than it should. This is because the fee investors, particularly, they're a little shy, but also because if I draw it out, then you go bankrupt. So the bees always have this kind of weird incentive to like so they also fund them. We fund our companies to stay alive for a couple of months, and it's right in that moment. We don't want to ask and say and so we get money to discount for coming in that moment. This is risky. They don't get to be who's on money. But we don't want to tell them what price too low or too high. We just want them thinking they can do whatever deal they want to get.
So if you're saying that, one of the main reasons right by your early investors. So,
yeah, so one of the things you want to do right by them. Another thing is that we're on the same team, right? Because I don't want to
enter all my buddies again.
The more you're like, taking a little bit of uncapped you're just about to do around fine, but that's not what happens these days. You're going to do safes for like, a while, over and over and over again. And they all are people came at first, they took a lot more risk three years later. I really mean no more equity for that. You won't even feel good about it. You realize trusted. You get the same deal the investors. Okay, so what I'm going to start the important thing about this is how we invest, but also how we run our firm. So I want to think about the same idea with a more informative experiment, flip flop. So the numbers the same are still the same 10% chance of getting there, but the first experiment is only going to be, it's going to be a 50% chance of a 50% chance. Now this is a less informative experiment. This always takes everybody a minute, because it seems like we have a higher probability of getting the good signal, so it seems kind of better. But the reality here is is we're learning less when we do get a good signal, it's far more common. And we actually haven't learned that much. The gain from there forward is still, is now only a 20% chance of part on the left, you see what I mean. So this is a less informative thing, whatever it is we've done, and it will get us more likely to get funded in the next round, because it's a 50% chance of success in this less informative thing, it'll just get us funded at a lower valuation, okay? And this is a kind of thing that we might be able to actually choose to change this in our firm, right? So if we have this less informative, we can just do the math thing right all the way down through and we'll do the same thing, right? What is the founder going to get? Well, the expected value, when we do the math, is $3 million still need that early $2 million so now pre money three, post money, five, right? So me, as the investor, gets 40% so the founder gets only 60% now, because we've made the experiment less informative, the abandonment option is less valuable, and so we've created less value. So literally, there's less for you, the entrepreneur, or there's less for both of us to share. In this case, I'm giving it all to you, but like, there's less for us to share. So we have, actually, we've actually you have hurt yourself by making it more likely that you'll get funded next time. Okay, and then when we get to the next round, since the first experiment wasn't that informative, we're not as confident that the second one is going to work. So again, your valuation is lower. In this case, it's like we know all the numbers of the math is easy, and we can just literally do if you have only a 20% chance of 100 right, x has 20 million or 80% chance of zero, and then you have to subtract off the 10 million that you need to invest. So the second investor is then going to buy 50% which is going to dramatically knock us down again, 20% 30% so at the end of the day, VC one actually is the exact same thing. Why they're investing 2 million, they need an expected return of 0% there's a 10% chance of it paying off. So at the end of the day, they got to get $20 million but it all pays off. So in some sense, you know that we pinned them against that what happens is the investor, too makes a much bigger killing when it works this time, and the entrepreneur gets knocked down price because there's still so much uncertainty. When you raise more money, so you leave uncertainty around you, sort of it's more likely to get funded because there's like, hey, it might still work, but your valuation is lower, and you owe us a firm. That's the important concept, where, when we were talking the beginning side, no, you don't need to know the math around the value of the real option, although in this case, like these were easy to calculate, right? We know what the value of having this experiment is. It's five plus three and minus two versus plus six to minus two. So we know how much value we created with this abandoned option. We created 5 million. So we could go and calculate. But of course, the point the reason we wouldn't do that is because there's all these nonsense numbers of like, 50% chance of this. We don't really do. We do know how to run our firm and what? So this is the key. When we think about it, we say, Hey, what are you going to invest in? What if what you do is you kind of say, Oh, if
you give me money, what I'm going to do take these pretty prototypes
that I have here and I'm going to turn them into a reality. So you're telling me you're going to take your software backups and turn it into software okay? I'm excited that you know how to hire a software engineer. Are we going to learn a ton, returning it into a mock up, from a mock up to an actual little not a hire a software engineer.
Just not going to learn that much, right?
Whereas there are some things you could do, I'm going to run this teeny, tiny test. It's either going to show your cancer or gonna kill everybody's job. Like, what an amazing experiment, except for the dead. But, like, from what we learned point of view, like, wow, you tell me we can spend a million dollars and learn whether we we cure cancer or not, greatest experiment on earth. Like,
amazing experiment. So
like, you know, you said you can, literally, when you walk in my office, tell me what you're going to do with the money. What I'm listening for is, are we going to learn an enormous amount through that activity? Because, if not, what I say to you is, wow, this sounds really interesting. Rod, why don't you come back after you've done that? Why do I need to invest evaluations not going up, because you're not going to learn very much through that period. So like, I'm happy to give you money later. We're all good. What I want to be in is the one where, if it works, the valuation is going to be so I'm literally looking for your description of what you're going to do and how it's going to report. It's something that's going to reveal an enormous amount of information, to the point that we might all be going to get a beer later, because we just shut the fern down, right? I'm okay with that. If the experiment doesn't work out, I don't want this experiment. I want the experiment where,
oh, my god, beer. Sorry, it's
not working, let's do something. You see, it
absolutely anytime. What's fascinating about the world think about what I was a game as dangerous as the world versus the real world. What's fascinating I always find is that you don't need to think people can articulate this whole nonsense I just put up here in order to do it. Over and over again. We can see Behavior Economics at work in all these areas. There's no way people articulated back behind it. People get it in some intuitive sense. Some entrepreneurs are literally thinking of something right. My strongest repeat entrepreneurs, stupid idea. They are like, we figure out if this is going to work, I need a couple million dollars in success. We're going to run and then I'm at because I can make a lot of money in the next thing. I don't want to be doing a stupid thing, right? So there's a lot of entrepreneurs that like, feel it. They just know to like, have this description they're not saying. But in some sense, what we try to do when we think about teaching entrepreneurship these things that intuitively have worked for people, and I would codify them so we could say, Oh, I get it. I didn't necessarily intuitively think of that, but now I get it, because you can always say, I don't know which is the best way to land or who's the best customer. It's a question of how you are thinking about what tests you are going to run and what we're going to learn. So all I want to see is that we're going to learn a lot. And in some cases, you tell me about the hovercraft skateboard, the question is, can you make a hub that's like your currency statement, your cancer? And sometimes it's like, No, we just add us to know we can build the thing. Can we sell it? Is the question or what price? There's always different types of things. So it's always different. Every round is different, right? So in such as each time we're just going to do the same sort of thing, what are we going to do with the money? It's going to teach us more. Last time we talked about this Ltd, a lot of times it's moving toward those kind of numbers, different at different stages. Which was most important? How do we get as much information as possible with as little money as possible? And we can do real examples of life. Sometimes you start a sandwich shop on a busy city street, New York, and it worked. Where should you open your next restaurant? Where should you open your next restaurant? People? Naturally, another busy city street, New York. We just saw that work. Let's do it again. Otherwise, where should you open your third now again, the more than you're like, Hey, I'm an entrepreneur, so make sure that I stay in business. The answer is, of a busy city street New York. And when you have eight shops going, you know where they're all going to be, a busy city streets in New York. Okay. Now the thing about entrepreneur number two, he says, I don't want to mess around with just a few restaurants. I'm either going big or I'm going home. Okay, they open one in New York. They open a second to New York to make sure it's not fun. Where they open third, somewhere else you don't you get it immediately. The answer. So I want to open in the birds. I want to open the Boston, the West Coast season, maybe when they go Canada. My fifth one's in London. I'm trying to figure out, like, what, where? How far does this concept scale now? And I have eight restaurants, and they work in the suburbs and in LA and in London, and then, and I go to the venture capitalists with these people who fly back back, they're going to be like, whoo, this baby has wheels. And the first person is also going to go with eight restaurants at the exact same revenue, and they're all going to go pretty
good. It's not bad. You want to say, it's not a bad restaurant chain.
No idea how well that scales, but it was much riskier. Restaurant number three being in LA is way riskier than restaurant number three being another 20 plus restaurant number two. So we cranked up the chance that you're not going to make it at all. We trained the failure of an LA might work. And by the way, you might fail in LA only because now you're trying to manage a cross country restaurant. What a disaster that is. So in some sense, you might be like, oh, there's a jump too far. I want to do it in the prompts, because that's different than that. You gotta there's other things that push back. But like, you can immediately see in that example that like, wow. One way we have a lot more information. We gotta raise money. We'll get a higher valuation. But you also might put your stuff out of business.
Suggestions of how to think of a new startup, for example, maybe look at the biggest problems in the US, or problems they
what I've learned over
the years is that I don't know anything like, in some sense, like, that's what you when you really get into the data, as I started the class, when you get into the data that, like, the best people In the world have had, like seven big hits in their entire life. By the way this works, almost across the board. You go to, like, deep value investing, you think, oh, Warren Buffett, and it's a few investments almost. I mean, the founder, the guy before, Charlie Munger, sorry, Warren Buffett, who taught him almost all his returns come from a single investment. Like the answer is, you see it over and over and over. It's very hard to get away from this idea, and it's unbelievably hard to tell what's going to be a good investment. What seems not so hard. Something's going to be terrible, lots of terrible then there's just a ton of like, Oh, right. And there's very, almost non existently things where you're like, that is amazing. And it is amazing. I had one in my life where I was like, Holy shit, this is brilliant. And it just kept going. But even then, the problem is, I won't have enough shots on goal to get data around it. But even when you use data from the entire industry, it looks really like super hard to figure out. So that way, once you say I'm never gonna identify it in advance, the answer is, it's how I run the firm. It's all the way through. When do we lean in? When do we lean in? What's better we run. How are we changing and pivoting and looking? Oh, my God, that worked. Oh my god, is that working?
Well, you're going to have like, a super risky 5% chance of getting it right. There's not, like,
no, no. There's plenty of perfectly
solid businesses that are perfectly good, that aren't going to ever be huge, and they aren't going to ever be terrible or unlikely to terrible. I mean, running a business well is a married interest. You could run a sandwich. Well, fresh meat, fresh lettuce. Good workers, they smile at the workers. You have a little smiley face. When clients leave and your sandwiches are delicious, people will come back for sandwich. No, no, yeah, that's exactly it. It's not BC, I mean, when there's variations, no big alcohol, there's it's just very hard, everything can go to zero. And it turns out we can't tell. Turns out they all look stupid. They all look stupid. Google is dumb idea. Really. We have lots of great search engines already at the time that are dominating the world. A couple of kids with garage because their advisor would be went away for a year. Their advisor was bad because they had nothing to do. They were digging for bookies in the lab, okay? And like they was decided they couldn't surf the web search web well enough, because it was annoying to them, and they just happened to be database specialists. I know this is like my best friend was in the lab. Okay? They were just database they were like, Oh my God, this would work out better if we just classified it differently. I sucked the information off the web. We classified and we'll serve it
we'll serve it up to ourselves, okay, my friends, largest server in the world,
okay? But anyway, like it's like they all look dumb. The Google is that Google looks dumb. They all look dumb. Airbnb looks dumb, certain people's couches. Facebook, it's a dating app for kids in college. Really, it's gonna take up the whole world and be the, you know, the largest organizations ever. Really, you think you could call that maybe, I mean somebody invested in so maybe they did call it like the answer is, nobody who invested in that also did Intel and Airbnb and see to somebody that checks all those boxes mostly look deeper at what you'll find is yes, at an $8 billion valuation, they then got into that one, and I had a $42 billion valuation, and they brought some data bricks. I'm gonna invest in data bricks. So the question is, did you like were you there in the beginning? Did you actually spot Databricks before anything else? Snowflake, by the way, 10 years people making fun of it. Okay? Snowflakes was a terrible idea.
So in some sense, what you have to do is say, Okay, we have that humility to know two parts, one that we aren't going to know, and two, that that doesn't mean you can't start anything. It's just a question of like, and we aren't waiting. I'll sit around waiting for some like, that idea is as good as Google. I'm going to do it no, because Google wasn't as good as Google. Google was a shady idea. Okay, so, like, when you think of a drone idea, the answer is not, oh, my god, is that brilliant? Is what you're waiting for. The answer is, testing, experiment. How do you figure it out? In some sense, by doing this as many times as you can, iterating, testing. Going forward, you'll sell into something in the Sales Law, and then you have to figure out how well it's selling. If it's selling unbelievably well, maybe get venture capital if it's only selling, okay, don't get venture
capitalists are kind of hassles. Don't go getchas. Only get it if you need it, if you have this right metrics.
So basically, the grade value is a bit how much you can earn
for the next point. For
the is one of the core parameters. It's one of the core ideas that we're putting to work. We're not really going in there and saying, how do we learn a lot like we obviously want to make sure we're in places where, if it works, how big could it be? So that's why we say it's gotta be a billion dollar market. The last thing you want to do is learn that. Like, people really do want little bells on their shoes, but like, you can only sell that for a total of $30 million a year. Great. You learn all this, and you only get $30 million sad. So we're trying to figure out, like, if we got it right, would it be in a big so there's things like that, right. And then if we got it right, are these the entrepreneurs that could grow? Because you could scrub a perfectly good idea, right? So that's why there's a second statement. Like, okay, but if we got it right, would these people grow, or would they step out of the way? So like, one of my entrepreneurs, by the way, he's a third time entrepreneur, so it's lasted $700 million when you asked him in his five year old title work, he said, I'm the temporary CEO. We haven't given the founder title yet because we think we're going to go very rapidly. So we're going to almost immediately need people who are smarter than we are, and more knowledge about this particular area, so we hire in senior leadership over us. Good answer. You. I don't have to worry that you're not the person he was actually relatively young, but like, but he, but you weren't worried, because the business he was describing exactly what we were buying businesses. It was a serious kind of business, very rapidly, many of our businesses are not that serious, rapidly, right? We don't need great managerial organization skills. We just, you know, you get to work so people and you better know how to run a firm of 1700 people so, and he was the most firm. So we'll do it till here, but very quickly,
hiding after stage one. How does dilution work?
So the only thing that's like, what I haven't put in here this whole time is, normally, we would have the founder before I got involved at five years on 100% right before I get involved, I said, Hey, you're gonna need to hire employees. You need to make an option. And they would make an optional, typically 20% early on they make a function optional. So 1080, employees who don't exist yet. So future options to be given out employees on 20% and then, and then I come in and invest. So as we did these diluted numbers, you can think of this line as being founders and employees. The only other thing that would happen is, when these people showed up, they would redo this. They would say, hey, how many is your option pool? How many more people do you need to hire? I think you need to. So when we were actually doing the math about how much we're going to get diluted in the next round, we'd actually not only considered Eastern our best, we would consider that they're also going to insist on a bigger option too. So it's a little more forecast. It's all pretty consistent, so it's not crazy. So then you, as the employer, gets really down, which is why, every few years you got to do options.
The size of the option pool that VC requests is proportional to the information they would expect from getting from this experiment like you can think of a situation the option pool
is usually two things. It's kind of focused on, who did you say you need to hire? And if you said, oh, like, we need a big CFO, I'm gonna take, you know, 4% or something. So you need a biological or we need 20 engineers. Okay, it was a kind of said you needed in order to get to because what you're going to do is hire a bunch of people, three, whatever it is, and it gives to the next round. And I want that sort of all the fort, and then you got some leftover, maybe next person does the same thing. How many need? The second thing is, it's really kind of, there's a funny part of just negotiation on price. I'll pretend I gave you an X valuation, but I'll make your option a little bigger, and then I know that the next round we won't have to increase the option pool, so I won't get to the next round. So it's actually a way that we negotiate over price. Thank you. So I got to this already, but just like, this is like, it's potentially changeable, and you can actually be in charge of this. So there's questions that get funding. Should I increase the chance I get future funding or decrease it? First anybody would answer that, of course, increase it, not necessarily. I want to learn as much as I can. Should I run experience where the outlet tells us to go left or right? Or should I run them where it tells us to go forward or stop abandonment option, and then the other one is just telling us how to run our business along the way. So only one of those is going to get us to that true like crazy. So the rest of this presentation is long, way longer than we ever going to get through. It just runs through a series of examples and then a real world example, so you can look through it on your own. Kind of reinforce around ideas you
