2018 YC Investor School Notes: Sam Altman
The Why and How of Angel Investing
To prepare for the class, Sam asked some of the best investors he knew why they invest. Some of the best gave similar answers, oftentimes using the same exact words.
First, what great investors like most about investing in startups is that it’s energizing. It allows investors to work with people that aren’t burned out on the world, have unlimited energy, and have new ideas. The beauty of inexperience enables people doing things for the first time to do things that others with more battle scars simply won’t try.
Second, startups enable investors to help shape the future. A key component of this is the ability to leverage one’s time by working on multiple things in parallel. While most of the time investments lose 1x, occasionally they’ll return 100x or 1000x. This, for the same reason slot machines are so satisfying, is incredibly addictive.
Third, startup investors get to be around some of the most talented people in the world. It’s especially gratifying to hear from a famous founder of a great company that something the investor did was a make or break difference in the founder’s career.
At the same time, it’s also incredibly humbling. Sam tracks his predictions for companies with confidence intervals using post it notes on the back of stock certificates. Startup investors will get used to being wrong a lot. But, the mental adjustment associated with getting used to this will be helpful in everything else in life. With deliberate practice, investors can learn a lot and get better quickly.
The number 1 mistake Sam made when starting to invest was caring too much about what other investors thought. It’s better to free oneself from this sooner rather than later. But, it’s a very common mistake for new startup investors. Many are swayed by when previously successful investors think.
The first question most investors ask YC startups is, “Who else is investing in the round?” Sam estimates that 80% of investors outsource 80% of their decision making to what others think about an investment opportunity. But, the problem is that almost everyone does this, thereby creating a schooling effect where a company gets hot for no discernible reason. Perhaps it fit a trend. Then almost everybody wants to invest in 1 company, because a few people decided they liked it.
The second biggest mistake Sam made when starting to invest was not understanding the power law. The power law means that a startup investor’s single best investment will be worth more in return than all of the rest of the startup investments put together. The second best will be better than three through infinity put together. This is a deeply true thing that most investors find. But, it’s so counterintuitive and it means almost everyone invests the wrong way.
The question that most investors think about when starting angel investing is, “Can I hit a bunch of singles?” In most other kinds of investing like stocks or bonds, that’s the right way to do it. Just compound singles for a long time.
But, angel investing is a business of home runs and investors want to look for things that can be potential home runs. This is the most important thing to learn and the thing that most investors get wrong.
Magnitude of Biggest Success & Failure Rate
So, it’s all about the magnitude of your biggest success not about failure rate. But, most investors talk about failure rates and some ask, “What is your failure rate?” or “What’s an acceptable failure rate?” These are the wrong questions and are the wrong way to think about angel investing. Investors can have 95% of investments fail, but if one of them returns a billion dollars, they’ll be totally happy. So, this is what you want to think about.
The first question that Sam tries to ask himself when meeting a startup is not, “Why is it going to fail?” or “What could go wrong?” The first questions are “How big could this be if it works?” and “Can I imagine this founder, this idea, this market supporting a massive, massive company?” Then, Sam thinks about all of the things that could go wrong. But, Sam found that if he thought about what could go wrong first, he filtered out the companies that could be giant.
The companies that could be giant are at the intersection of sounds like a bad idea but is a good idea. But, because that’s a very narrow intersection, and because they sound like a bad idea, the best investments are the ones that are easiest for investors to talk themselves out of, especially if the investor’s thought process begins with why they could go wrong.
First, consider why an active search for these founders and companies is so critical. Remember the power law. YC has funded about 1,600 companies. The top five YC companies represent about two thirds of the value that YC has created. The top company represents about one third of the value that YC has created. This is a very extreme and very counterintuitive thing. Also, many of these generation defining companies are started by people who are out of network, who aren’t too well known, who can’t get a bunch of press right away. So, investors have to search actively.
So, how do you find the companies that can be the handful of companies that get started every decade that are responsible for almost all of the returns?
The best way to do that is from other founders. This is part of what YC does. Founders refer other founders to YC and say that YC creates so much more value than it takes, go work with them. The idea of word of mouth as the way to find companies to invest in has been great.
For angel investors starting out, what some of the most successful angel investors do is just start helping founders for free. Angels may not get to invest in those companies, but referrals to others will come down the road. Much of this work is about people connecting you to other people that you don’t know. This is part of the value of an open network.
A lot of angel investors like to brag about how difficult it is to get a meeting with them or how founders have to have the right connections to be taken seriously. YC makes it really clear; anyone in the world can go to the YC website and click apply. YC tries to respond to emails and takes people seriously even when they do not have a personal brand, a reputation, or network. YC asks people in the network to connect it to the most promising people that they know that YC doesn’t.
Sam thinks the idea that YC is available and open was in the 2 or 3 most important secrets of YC. It was something that was really different and others hadn’t done it before. In fact, others bragged about the opposite. YC went in the other direction and strongly recommend it to others. Be open to that random email that comes in. Be open to the introduction of someone that, on paper, doesn’t seem like they’re someone you want to meet. 9 times out of 10, you waste your time. That other time makes it totally worth it.
One big shift in the last 10–15 years is that, now, there are more people that want to invest in good startups than there are good startups. So, founders are in the driver seat. Founders of good companies can choose among investors. The network of founders has gotten bigger and they share information. Accordingly, the asymmetry giving investors a lot of leverage is gone. Sam doesn’t think it will come back any time soon.
An investor’s reputation matters a lot. It is way more important to your future success as an investor that founders like you and say, “That investor did the right thing by me.” Than it is that you squeeze out a few drops of juice from a failing company. The number of investors that I have seen do incredible long term damage to their reputation by fighting over the carcass of a company that was never, because of the power law, going to matter to them anyway but, try to get out $10,000 or whatever from a dying company. If you’re playing the long game, that’s not worth it.
Reputation, especially reputation when a company is going badly, is super, super important. In 2018 Silicon Valley, Sam thinks that is the secret to winning deals.
YC tells founders to do reference checks on investors when choosing between them, just like investors do reference checks on founders. But, the founders would do this even if YC didn’t tell them to. Founders are increasingly using input from other founders that an investor has funded to make decisions about accepting investments. Sam thinks this will continue to be important.
In addition to reputation, investors can help their case by doing certain things before closing the deal such as, deciding quickly, being clear about reasoning, being responsive, being available. In short, all the things you want from a founder. Having a reputation for being good to work with goes a long way and is remembered for a long time.
Sam gets the questions like, “How do I get a good bargain?” or “How do I get better terms than everybody else?” all the time. YC recently has a company with about 10 investors joining a seed round. Each one asked for advisor shares, saying things like “Well, unlike all those other investors, I really do work super hard. I’m the only investor in a round that usually gets advisor shares, so you I to get them to participate.” Sam thinks a lot of people are looking for a good deal because valuations feel high. They have felt high to Sam for 7–8 years.
For Sam, the best investments have either been a ridiculous deal because no one else wanted to invest, or a deal that felt incredibly expensive. Oftentimes, when Sam was willing to overpay to invest in a company, the company did better. Especially when Sam felt he was getting screwed. For example, a huge up round 3 months after another round. Investors must watch out for situations where companies that work go fast and investors are anchored to some notion of what a fair deal is. In Sam’s experience, his best investments, with some exceptions, have been deals that felt the most expensive. For the exceptions, he understood something that no one else did and there was no competition whatsoever. He thinks value investing is not a winning strategy when it comes to being an angel investor most of the time.
Sam considers anything that he believes could be a 10 billion dollar company. Because it is such a tight criteria, there are no other rules. He considers any stage, any sector, and any business model. Others only consider one area at a certain stage. Perhaps they can came this work, but Sam has not figured out how to do that. Because the great companies in the number one spot on the power law are so rare, he suggests that investors only select for things that can be there, but be open minded otherwise.
Today, it’s easier to start a hard company than an easy company. In order to build a big company, a team has to convince people to join, pay attention, write articles, advise it, and care about it in general. It’s easier for a nuclear fusion company to do this than the 22,000th photo sharing application. People want to help with nuclear fusion. Look for situations where people want to help proactively for free.
Another filter is to consider is, “Is this a company that will be able to recruit hundred of really talented people who could otherwise start their own companies?” Sam thinks people don’t think about this enough.
YC has learned to mostly pick the founders. It’s difficult to hear a very early stage idea and know that the idea has what it takes to be a $10B company. It’s possible to say it doesn’t, but one cannot be sure that it does.
Sam thinks with practice it is possible that one can, with practice identify founders that have a chance at creating one of these companies. Paul Buchheit, in an offhand comment at a meeting 2–3 years ago, listed 4 traits that such founders have: obsession, focus, frugality, and love. Pay attention to these.
Intelligence is a really important and obvious trait that everyone screens for. YC ran an experiment and funded 20 teams of strong founders that didn’t have ideas, but were otherwise really good. They all failed. What YC learned is that the good founders are the people that have ideas all the time. So there is an intelligence component and a creativity component. Founders must have an ability to think independent thoughts…. some kind of intelligence that leads to seeing problems in different ways or thinking ideas that don’t yet exist, but should.
Communication skills, Sam thinks, are one of the most important founder qualifications that people don’t think about enough. So much of a founder’s job is about communication: hiring, fundraising, selling products, setting new directions for the company. Much of the founder’s job is being the company’s evangelist. Without these communication skills or the fast development of such skills, a founder is at a big disadvantage. With some famous exceptions, the founders of the most successful companies tend to be great communicators.
Execution speed, the need to relentlessly execute, is highly correlated with a founder’s success. YC tests this during weekly office hours. How much progress do the founders make? How quickly do they try a new idea? Do they say, “Hey, I came back and I tried that idea. This didn’t work but, this other thing did. In the process I had these three new ideas. I tried those.” A relentless cadence of execution is incredibly predictive of success. YC once joked about founders that are incredible on paper but never execute quickly and always have great reasons for not doing so. In any event, they never go on to be successful. Alternatively, there are people who get an amazing amount done. They have an unbelievable iteration speed, which means the speed with which they can generate a hypothesis, test it, and then implement it. That’s correlated with huge success.
Consider the founder’s rate of improvement. But, don’t make the mistake of comparing a founder at the seed round stage to Brian Chesky. This will always lead to disappointment and no investments. Look at founder growth rate like startup growth rate. While the two are different, it’s easy to underestimate exponential growth in either case. YC can often sense the founder growth rate over 10 weeks. Pay a lot of attention to a founder that is improving incredibly quickly over the couple of months you get to know her/him. It is possible to find people that are on a trajectory to develop into a Brian Chesky, which is super valuable. Sam has seen maybe 10 founders that he knew would develop into incredible leaders. That intuition has been right every time and means that he trusts this rate of improvement metric.
It is increasingly important to be aware of wrong motivations. Founding a startup is a very long term commitment that requires hard work over many years, over a decade if it works. A lot of people now start a startup thinking it is a way to get rich quickly. It is not. Also, as startups have become the new default career trajectory for ambitious people, there are a lot of people doing a startup as a resume item. Those people tend not to be able to endure the suffering of a startup. So, stay focused on mission driven founder.
Everytime YC thought a company was going to go really well but didn’t, the company or founder lacked a deep sense of mission. So, YC looks for mission as a primary motivation.
Other pitfalls include: (1) mediocre founders that stumbled on a nice business or had some metric growing well [Sam has never made money backing an okay founder with an otherwise good business], (2) investing after getting scared that others were investing in a company, (3) scenesters, people who just want to be around startups, go to startup parties and talk about being a founder [treat this as a red flag], and (4) low integrity people.
Accordingly, he thinks focusing on truly exceptional founders that make him think, “Wow, I want to go work for him or her,” is really important.
Growth Rate of Market
Some investors’ biggest misunderstanding, and Sam’s ~3rd misunderstanding, relates to the idea that a focus on growth rate applies not only the startup, but also the market itself. It is prima facie ridiculous for an investor to say, “What matters is not a startup’s current revenue but, it’s growth rate. But the only thing I care about is the size of the market today.” Some of today’s biggest companies operate in markets that didn’t exist 10 years ago. Consider FB and social networking, or Uber and ride sharing apps. Current market size is a bad metric that has become dogma among investors.
Investors should care about the size of the market in 10 years. First, if the market is already huge, big competitors will likely be going after it. Second, focusing on a big market means not getting to surf the wave of new technological change that pulls starts along and creates a ton of value in a short period of time. It is counter intuitive, but investors should prefer a small market growing super quickly to a very large market today.
Most investors chase the things that worked in the last set of companies (i.e. funding social networks after FB and funding ride sharing apps after Uber). It’s much harder to make these companies work the second time around.
Despite being more difficult than simply investing in the types of companies that worked last time, investors are far better off identifying the next rapidly growing market and investing there. By definition, this means not just following what everybody else says.
Real Trends vs. Fake Trends
Learn to form your own thoughts about what the next really big market is going to be. Sam likes to gauge whether a market is growing really quickly by thinking about whether something is a real trend or a fake trend. Many joke about angel investors moving like schools of fish that declare something a hot trend then never talk about it again 2 years later and saying, “Well, that just didn’t work.” While sometimes they are right, like mobile, they got most other things in the last 10 years wrong. Sam suggest skepticism are a first reaction to anyone talking about a big trend.
So, how does one identify a real trend? A real trend is one where, although not that many people are participating yet, the participants are using the platform a lot every day, and spontaneously tell their friends about how great it is.
Consider the iPhone. When it first came out, most of the mobile industry made fun of Apply because it only sold roughly a couple million in the first year. But, those that had an iPhone said things like, “It’s the greatest piece of technology I’ve ever had.” They used it many hours every day and it was life changing. While the number of people that had it were small, one could identify this as a real trend because the users weren’t just daily active users, but also hourly active users. This was the best free advertising Apple could have hoped for, because iPhone owners told everyone, “This is the future. You’ve got to buy it!”
Contrast this with VR. It was talked about as the next trend. And while it may be, today most people with VR headsets don’t even use them every week, let alone every day or hour. But it will be time to start investing heavily when a small number of people start putting their headset on for hours everyday and tell all their friends they have to buy one because it’s the greatest thing ever.
Figure out whether people are actually using the platform. Sam thinks this is a really important consideration when trying to think about the next technology wave. Most, but not all, of the biggest technology companies are created soon after one of these massive platform shifts. Sam likes Sequoia’s statement that, “You cannot create a technology wave. That is well beyond the capability of a small company to do. But, you can surf one, if you can find the wave.”
Good Ideas That Look Like Bad Ideas
As previously mentioned, look for good ideas that look like bad ideas. There is an articulable reason that this is going to be huge and most of the world is missing it. Unfortunately, Sam estimates that 90% of all angel capital in the startup ecosystem goes to bad ideas that look like good ideas. This is worth avoiding. Chasing what worked 2 years ago is a common way of making this mistake. Be skeptical if investing in such a situation.
Also, be skeptical in cases if there is a temptation to invest in a company where (1) hundreds of others are working on the same thing or (2) the founders work super hard to convince you is not going to be a long term commodity. Generally, the more founders try to sell why they’re super differentiated and why they have a long term competitive advantage the more skeptical you should be. Though, of course, genuine pricing power, moats, network effects or barriers to entry are desirable.
When looking for good ideas that seem bad, remember that the best companies all have great products. Sam thinks the current fashion in Silicon Valley has strayed too far from this and is too much about growth hacking, sales, marketing machines, and everything else. These do work for a while, maybe a pretty long while, via executing really well to grow a mediocre product. But, one cannot usually create a Facebook size company this way.
Oftentimes, however, companies won’t have a great product at the angel investment stage. But if the investor doesn’t think the company won’t get to a great product at some point, it’s fair to think that it won’t become a huge company most of the time.
Word of Mouth
Sam uses a simple framework when thinking about great products. Did a friend or someone he trusted, without any incentivization, spontaneously tell him about it? Did they say, “You’ve got to try this new thing. It’s amazing.” If a startup isn’t going to get there, Sam doesn’t think they’ll be at the number one spot of the power law of returns. Accordingly, he thinks this is a really important filter. Then, he considers, “Given that this company is growing by word of mouth, how big can it be in five years?” But, remember, human intuitions about exponential growth are terrible. So, stop trusting your intuition and just model it out with a decay rate and how much growth might slow.
Look for companies that get more powerful as they get bigger. Look for companies that get increasing pricing power as it gets better. Look for companies that have an easier time getting more users as it gets bigger. This is often fairly obvious, but not always. Accordingly, think about it deeply, and, after doing so, a narrative will emerge. Many get this wrong by getting caught up saying, “”Oh, this is so cool today. This company has discovered this wonderful thing.”
Sam also likes to think through the following question before making an investment: What do I understand that other people don’t? Without an answer to this question, he doesn’t feel like he has any competitive edge in that particular investment decision. This relates to the previous discussion about not basing a decision too much on the decisions of others. Sometimes, the thinking sounds like, “Everyone is bullish on this company. But, I’m more bullish, because I understand a specific thing about this market. Everyone thinks it’s good. I think it’s even better. So, I’ll pay this very high valuation.”
Almost all of the value in a startup is the revenue and earnings that it’s going to generate in 10+ years from now. So, if the investor can’t answer the issues raised by Sam’s framework, be pretty skeptical.
What can early stage investors do to add a lot of value to founders?
When founders are asked this question, they always say the number one thing they want help with is hiring. Help them find really good people. Help them interview. Help them close candidates. Help them with future fundraising.
It’s valuable to help with big strategic advice. Everyone wants to provide this and it is really valuable. But, in addition, what Sam did as an angel investor was try to be available all the time for tactical advice. This means being available at 11pm on a Friday night for a 2 minute phone call for some emergency.
What flaws are acceptable in a founder at a seed or series A stage?
If one thinks the founder is improving fast and it involves something changeable, a lot. But, don’t compromise on the things that don’t get better, like founder integrity. Sam buckets traits that he believes can change and traits that he believe can’t.
YC has had many very unsophisticated founders come through these doors. But they were smart, wanted to learn, were doing this for the right reason, and were super mission oriented. They have just progressed really fast. But, sometimes, a founder without domain specific knowledge may now know something like what a valuation is. This can kind of spook you. But that’s an acceptable flaw.
How do you judge for integrity with a founder that comes out of network?
YC has gotten this wrong a handful of time. But, YC has prevented mistakes hundreds of times, despite the 10 minute interview process, by simply giving a founder a chance to talk about an unethical thing they’ve done. Surprisingly often, they will tell you. Just listen to the decisions they’ve made so far in building the business, and expect more of the same types of decisions in the future. Just listen in the first few meetings. You’ll be surprised.
What are some results based observations about when to exercise pro rata and when not to?
Several venture firms have done very sophisticated studies of this. They’ve all come to the following conclusion: if the company is raising an up round led by a good VC (i.e. top quartile VC), you should always exercise pro rata. If investors do that across their whole portfolio, they’ll be happy. This could change if the world really changes but, in the world today, there’s very clear data on this.
What’s pro rata?
Often when you invest in a company, you will get a pro rata right, which is a right in future rounds to invest enough dollars in the new round to maintain the investor’s ownership level.
Will security tokens and ICO’s change financings?
Probably, but not in the way that most people think. Sam thinks we’ll find out that securities laws exist for a reason and that investors will want some level of that. He thinks there are some incredibly important ICO’s happening right now. But they are dwarfed by the number that are just in between incompetence and scams. However, he thinks that it’s possible there exists a much better mechanical way to track the investments compared to today’s methods.
What is an example of a good idea that seemed like a bad idea?
Reddit is an example that Sam remembers as part of his 2005 YC class. When he told his friends and talked about a site where you can find links, they said it was the dumbest thing they’ve ever heard, there are other things already like it on the internet, this one is just pictures of cats (or whatever it was at the time), and there’s no way to make money on the business. The Reddit example resonates with Sam, because he lost all his conviction when people he trusted said it was bad.
There’s another common version of this problem: an idea that seems good in the abstract, but everyone assumes the big companies will crush you. Dropbox is an example of this. YC funded them and when they were getting started, almost everyone said something like, “Oh, it’s a perfectly nice product but, Google, Microsoft, whatever, guaranteed to crush them soon.”
[Question inaudible. Related to the problem of defining and measuring new growing markets]
During Uber’s start, articles would regularly argue, “Uber is not worth X. The entire taxi market is only worth 10% of X.” It’s hard to navigate this as an investor, because one don’t have a sense for exactly how big the market is since it’s growing so quickly.
Look at shifts in consumer behavior that are creating new markets. If one thought of Uber as a replacement for booking limo services, that was one thing. If one started to realize that people had begun to use it as a replacement for taxis and then, public transit, and then, car ownership… one could project forward and say, “Wow, this market is actually going to be quite big, because all of this other consumer behavior is going to shift here.”
Would you fund a solo non-technical founder?
Sam wouldn’t say he never would. He’s done it before and thinks it can work. He likes it when that founder learns enough to build an MVP. He’s seen this most often go wrong with the founder’s ability to attract, evaluate, and retain technical talent. So, YC has a strong, strong preference for founding teams that have at least one technical founder and a strong preference for teams that have at least two co founders. Again, none of these are absolutes. Because of the power law, YC is always going to consider exceptions.
[Question inaudible. Related to founder traits]
Sam considers (1) a good amount of self awareness, (2) a good amount of willingness to take feedback, and (3) a drive and a desire to improve to be really important.
But, the founder needs to believe that she/he can succeed in spite of the flaws. So, that’s almost more important to Sam than someone who spends a lot of time categorizing everything the founder is bad at. If the founder is willing to listen and improve, Sam has usually found he can work with that founder.
[Question inaudible. Related to Sam’s investment filters]
A self indulgent way to do this, but one that works, is only fund founders that the investor wants to allocate a lot of time to. If this is lacking, if the founder is difficult to work with or doesn’t listen, or if you’re just not excited about the business, (a) that’s probably a red flag for their qualities as a founder and (b) the investor won’t contribute time and assistance and will not get this differentiated thing. So, Sam won’t fund a founder that he doesn’t want to spend a lot of time helping. That has always worked pretty well for him.
Geoff Ralston Comment
Sam mentioned that you want to look for founders who understand that startup success can take as long as a decade or more. It should be obvious that the same thing is true for the investors. Investing in startups is not a get rich quick scheme. It requires patience, passion, and interest that is, hopefully, reciprocated by the founder. Also, as someone that has done a lot of angel investing and compares results to Sam, listen carefully to what he says because he’s really, really good at it.