Investing with your gut

Just before heading out on stage at a tech conference, TechCrunch Founder Michael Arrington asked me, “You’ve invested in a lot of great startups, how do you pick your companies?” I responded, “I trust my gut” — he seemed unsatisfied and told me, “You’ve got to come up with something better than that.”

I’ve always admired the tech investors that construct a big overarching thesis to frame their investment philosophy. “Software is eating the world,” “the bottom up economy,” and “investing in thunder lizards,” to name a few.

This type of theme investing is a great strategy for funds, and certainly a worthwhile exercise, but it never really applied to me as an individual angel investor.

For me, the decision to invest in a startup comes after following a process that is heavily weighted towards EQ. This process starts with exploring the idea emotionally and then following the advice that my intuition (gut) sends back. Should it pass this hurdle, I then continue with traditional due diligence, using objective data to validate the entrepreneurs assumptions around the quantifiable aspects of the business.

So how does one explore an idea emotionally?

When evaluating a new product, I take the novel features (not every feature) and exhaustively play out how they might impact the emotions of the consumers that use them. After that, I take the same features and consider how they might evolve over time.

During this creative process, you’ll find that a collection of signals emerge from the exploration. These emotional signals are an accumulation of subconscious experiences that aren’t readily available to our active conscious minds, but rather surface as a level of excitement. If the starting intuition going into the process comes back amplified (e.g. a greater level of excitement), then it warrants proceeding to the objective evaluation of the business.

Let’s take my notes around Twitter (which lead to my investment in 2008). I was intrigued by a handful of novel features:

Tweeting — Quick public sharing.

Emotional reaction: Typing 140 characters is quicker and easier than starting a blog. The fear and time associated with writing a long post is nonexistent. Updates can be done through text, no computer needed (remember, this was before “apps”). This could be a huge draw for non-technical celebrities.

Following — A new contrarian concept that allowed users follow people they didn’t know. While this seems commonplace today, at the time it flipped the more popular bidirectional friendship model on its head.

Emotional reaction: Building a following base feels like a game or competition. Users will encourage their friends and fans to follow, bringing in additional users. This “game” of bringing in your friends and fans is free marketing for Twitter. Following forces public sharing as default, this gives fans a deeper connection with people they admire but do not know.

Syndication of content —

Emotional reaction: Users are beginning to use the nomenclature “RT” to indicate a “retweet” (this was common practice before the official retweet feature was developed), this ad hoc feature allows users to syndicate messages beyond their social graph, giving a user’s message increased visibility. The real-time nature of Twitter allows news stories to break faster than traditional media (even at the time, my startup, Digg).

In allowing myself to feel these features through the eyes of the users, I can get a sense of the excitement around them. In this case, the starting intuition came back amplified, increasing my excitement to make the investment.

This type of thinking can also be applied to larger industry trends.

My colleague and friend David Prager was one of the first owners of the Tesla Model-S. The second he received the car he graciously allowed all of his friends test drive it. What stuck with me most was not the car, but the sound it made. When he dropped me off he slammed on the acceleration peddle and was whisked up a large San Francisco hill, all I heard was the electric swish/hum of acceleration. For me, this was like so many sci-fi movies I had seen growing up — it sounded like the future.

A few days later I remember hearing a large city bus trying to climb the same hill. The diesel engine was rattling and struggling, almost as if it out of shape, fighting for it’s next breath.

It was clear to me that while consumer adoption would be slow, with technological advances in energy storage (only a matter of time) electric vehicles are the future of this industry.

These feelings led to me take a position in the company back when it was largely unfashionable.

It’s important to point out, I’ve used this framework more to help me steer clear of bad investments, than finding new ones. In evaluating my meetings over the last calendar year, I met with an average of 18 companies before I found one worthwhile of investment. That’s a lot of saying no.

For example, the currently incarnation of virtual reality gear doesn’t pass my test. Units are large, clunky, require insanely expensive computers, and setup is a mess. The experience, while fun, isn’t an order of magnitude better than traditional gaming.

So, as of right now, I’ve avoided Virtual Reality investments. At some point (years out) the right mixture of power, size, price, and reality technology will combine into a device that will likely see mass adoption. But as of right now, I’m a pass.

It’s important to note: I’m also a believer in objective data and using it to inform decisions, especially in later rounds of financing. But in the early stage, at the seed of an idea, the bet is largely based on the quality of the team and the emotional connection you feel with the product.

Many fellow investors believe the gut shouldn’t be trusted, and chalk up success using it to just dumb luck. Certainly creative intuition varies from person to person. There is no magic formula here. But I do believe we can think of gut intuition as a creative tool that can be called upon when evaluating ideas with very little data, such as startups that have yet to launch.