Venture Micro-finance

Apr 2013

 

“You will get all you want in life, if you help enough other people get what they want. There has never been a statue erected to honor a critic.”

– Zig Ziglar

 

“It’s not about what it is, it’s about what it can become. Unless someone like you cares a whole awful lot, nothing is going to get better. It’s not.”

– Dr Seuss, The Lorax

 

Beginning of this year I made a statement I’ll probably end up regretting one day. That I would start making startups investments. The reason I said it was to try and prove a point. The point was that more capital has to flow into startups to create a self-sustaining ecosystem in Australia, it doesn’t really matter from where.

The goal was to spur those worth significantly more than me to start making startup investments. There are a lot of people donating their time and resources but few making the jump to add their capital. In meteorology, it takes a lot of precipitation from different places to form a cloud.

I figured I’d sound like a hypocrite if I were then not to put my own to backup what I was saying. The problem is I don’t really have that much capital. I’m currently a pre-liquid founder which means most of what I’m worth is tied to things I’ve done. I can’t really afford to make startup investments just yet. But am going to stick to my word and do it anyway.

So in some ways this is quite the statement. For someone without any money to be putting what money they have into something highly volatile to pursue an ideal seems just on the right side of crazy.

The downside is I might lose everything. Which may not be that huge of a downside since I’m in the unique position of being a) very young, b) have no real responsibility or dependents, and c) have the bulk of my net worth tied to the startup so won’t be left much worse off if this investing thing fails.

What would be lost is effectively under deployed capital. Money that would otherwise have been spent buying useless stuff. Besides, I kind of enjoy being broke. I think in some ways it is good for someone about to enter their 20’s not to have any money. It’s character building. If there is ever a point in your life you can get away with being broke, it’s now.

 

In deciding to be an investor, immediately you hit your first hurdle. Well, what kind of an investor? It’s not something you realise but there are actually many types of investors even in the niche field of startups.

Some are seed only. Some only do investments in syndicates. Some only do investments in already established and profitable companies. Some only invest in people. Some pick a sector they know about like health or education and only invest in those. Some don’t care so long as the referral comes from someone close in their network.

It’s pretty scattered. So in a lot of ways this essay is a thought experiment. To start to get a feel for how such a fund might operate. It’s first important to understand how venture investing works.

Venture investing follows a power law distribution with a binary outcome. An investment either wins or it doesn’t and returns are concentrated in a small number of highly performing companies. That reads as there are good investors and everybody else, but the median difference between everybody else is not significant.

So in the Darwinian game theory sense, just by starting you are as good as the median and inaction is as good as a failed investment. Which is good news because for a fund to work you only need one success. And you just need to not lose money long enough until you find it.

Being young is also beneficial. An investment typically matures over a 3-10 year lifespan. So the younger a person starts, the sooner that investment matures and a liquidity event may be reached. Since age directly factors into the life of an investment, you should all things being equal, start investing as young as possible.

 

Something I’m tired of is startup colloquialisms. Of “buzzwords” and “hustling.” Of people with an “innate entrepreneurial drive” who started businesses when they were 11. I’m tired of “serial entrepreneurs” who are on their 10th startup before they’re 40. I want to go back to when startups were about some smart people working on something they loved or a project in their spare time that eventually grew into a company. So I’d probably focus on those.

I think there is an entire dimension of startup few people see as worthwhile and frequently overlooked. Such as anything not on the internet in the world away from bits. The realm of small business structured for high growth. Subway, Coca-Cola, Walmart, Ikea etc were all based on a core innovation and were small and disruptive once too. People would probably disagree that these were startups but the costs involved to start new styles of transactional businesses have declined. The problem with this kind of company is it takes much longer to grow and is restricted by geography but when they do eventually become large, are much harder to displace.

An approach I’ve never seen before that I think would work really well is the ability to commit an amount of money as it’s needed by the startup. Like a bar tab. If you’ve ever been to a bar, you can start a tab, order drinks and pay for them later so the process of getting drinks is streamlined and removes friction. A lot of the time a company only needs a certain amount of money. If the money put into a company was as elastic as the companies need for it, it would align the incentives. The startup would only raise as much as needed so reducing dilution and the investor has capital that can be deployed elsewhere and the startup doesn’t waste money. To work there would likely need to be complete transparency and the money would have to be really fast moving. Like at the end of a phone call or email and be able to write cheques instantly.

Something I wish there was is a type of fund that invests in ideas before any work has been done on them. To compensate for the risk, the corresponding funding and stake would be small. I think a few thousand dollars would be enough. That’s usually enough to see something from idea to fulfilment. For a small stake, maybe 3%? If there was a small venture fund that did lots of tiny bets like that, I think they would emerge net ahead. This also starts to seem like an ad hoc description of micro-finance.

Back when I started Inksimple, like at the very beginning, I would have easily accepted a few thousand dollars for a few percent if it meant a lot of the silly mistakes could have been avoided early on. What are some of the silly mistakes? So many. I think I did everything wrong from giving equity to people who didn’t do anything to incorporating with the wrong documents to fumbling an acquisition to wasting too much time. Many times the business flatlined. If you can name a mistake, I probably made it.

But a few thousand dollars isn’t really enough to even get the right documents in order to process an incorporation or investment. So the investment would be more of a fixed equity based loan against future value created. And you could instead just write it all in a really founder-friendly contract. If the business works, then the contract comes into effect. If it doesn’t work, just end the contract when it tanks. Effectively bringing the legal cost of the investment to 0.

Could you imagine if you invested the first five thousand dollars in Facebook when they’d just had the idea? Or the first ten thousand dollars raised by Steve Jobs and Steve Wozniak when they’d first had the idea for Apple Computers?

Whatever the project is though, it would not be terribly difficult to repay a few thousand dollars. You could create an app over a startup weekend, build a small userbase and sell it for a roughly similar amount. So a bottom up approach seems feasible.

At the idea stage it would seem like a godsend. Someone will give you money to work on something you were going to work on anyway? That seems like the opportunity of a lifetime. The trick becomes finding which people were going to work on it anyway. Ironically, the kind of person who would start a company without funding is probably someone worth funding.

The success of a project at the idea phase is not a factor of the capital invested but of the composition of the startup. I’ve experienced first hand what you can do without any money. The difference is just explaining to someone what is capable with very little. Most people don’t believe that you can do much without money – and they’re wrong.

It also means the founders would have to be technical or at least know how to build something. No money could be spent on development because there isn’t enough money. The only way it could be feasible is to value the founders time at 0.

An investor once told me that anything is possible if you valued your time at 0. It didn’t seem like it then but this is one of the wisest things I’ve ever heard. Valuing your time at anything puts a lot of pressure on people to perform. It sets unrealistic self expectations. It’s like putting a yard stick which you constantly have to measure up to. When you value your time at 0 you’re free to do whatever you want.

The proposition of a startup is you are effectively buying time. You are trying to buy your freedom from the construct that is institutional finance. So when that time is valued at 0 it removes the economic incentive of it. So it doesn’t matter how much time is spent on something. That’s why a lot of successful startups start as hobbies, because the founder worked on them for free.

You’ll find the unhappiest people are those that put a price on their time, so they constantly feel like there isn’t enough time or that time is running out. The cause for this is ambition. There is a reason the most ambitious people always seem to be the most stressed out.

But startups are a different instance of ambition. Startup ambition tends to be different. I think of it like renegade ambition versus conventional ambition. Conventional ambition is to get top grades and go into a big safe corporate job with lots of benefits and status. Renegade ambition is to do what you love and become a rockstar.

 

Other limitations are in geography and capital. Having capital constraints forces you to be resourceful. People talk about “lean”, but few really practice it. I’ve always interpreted “lean” as optimizing within a set of limitations. By not starting with much you’ve set the limitations lower. Having a small amount of capital forces a project to be capital efficient.

A few thousand dollars is not a lot of runway. Certainly not enough to test some business hypothesis. Instead it’s more like a build it and see if people come scenario. To build something and hope it catches on. If it doesn’t catch on, turn it into something else. Keep iterating until people start using it. The project itself would have to be inherently useful since no money could be spent on sales or marketing.

How ambitious a project could you get? YCombinator when it first started funded people to the tune of 10 thousand dollars and got projects which were trying to change the world. If that is the upper limit then it would be curious what the lower limit might be.

But having such a small amount of money also precludes industries. What kind of industries can you start a company in for a few thousand dollars? Surprisingly a large number. In fact most startups, particularly in consumer internet, can be started with a few thousand dollars. Indeed most probably have.

It also means in most scenarios the project would have to make money. Even small amounts to become self-sustaining or to get a userbase significant enough to be accepted into an incubator program.

The type of person who can build a self-sustaining product of a few thousand dollars when extrapolated out is the kind of person who could probably build a large company if they had more money. That is probably a very resourceful person.

So it would also invest in people who seem like good founders. The entrepreneur is the essential ingredient while capital is the non-essential ingredient. Capital is the catalyst while the entrepreneur is the limiting reagent.

 

I really like that word – Founder. Probably because the word found is in it. That’s kind of what a founder does, they go out using trial and error and compounding incremental gains, discover their company in a market. It’s like discovering a rare element. All the circumstances have to be right for the company to be found.

Michelangelo once said that he could see a sculpture in clay before he began working on it. So the process of creating a sculpture was just to bring what he saw into reality, iterating to create the best image. That’s kind of the process of creating a startup.

Now who would be the type of person to accept a few thousand dollars, and why would they? It’s not going to be a someone who’s worked before with much experience and it isn’t someone with much in the way of savings. So it would probably be a student.

Good startups are born in dormitories. Not usually in business plans or big corporate. What young people are working on is usually a good indication of what’s coming next since they’re the ones who see how what currently exists can be improved when they try to learn it. So that’s where we’d start. What a person does in their 20’s plants the seeds for what they’d end up doing in their careers. Lots of undergrads are working on side projects that with a bit of tweaking might resemble functioning companies. The average student is more capable than most people give them credit for anyway.

The problem would be overcoming the flake hurdle. The hurdle that is inherent with any new project. Will the person behind the project see it through to completion? I don’t really know. Majority of the time I’ve met someone working on a startup, within a year they were doing something different. That compounding value is not present if the person doesn’t see it through to completion because it effectively resets the value creating process.

So a fund of this nature would likely back student projects, largely just to see if they would work. It would effectively play the role of Edwardo in The Social Network in universities. Like a friend who you can ask for advice and can provide the initial money to keep servers live. What it would also replace is a part time job. The part time job gets replaced with a part time startup.

Could you imagine a future where everyone studying in university, instead of having a part time job worked on a startup? The ripple effect would have quite profound results.

Even if it fails, which statistically it will. That person would probably have an inclination to do another bigger and better one so the ecosystem benefits. I feel like that goodwill would be beneficial but don’t know how to quantify it. In the same way when someone helps you, you feel grateful and would want to give back.

 

I think the other often overlooked parameter is time. If someone is working on something they love, it’s not something they would sell easily or flake out on. They will probably work on it for a long time and that time acts as a cushion if it doesn’t work initially. Like I think if someone were to dedicate 10 years of their life to a company from the onset, it would be very difficult for the company not to succeed. But how do you measure that?

It is effectively trying to measure commitment which is inherently volatile. You can’t just ask someone if they’re going to put 10 years into something or even know if they’re serious if they say they would. But if you could find someone who was serious, I think they would be a safe bet. Because it doesn’t matter what it is, there will be enough time to figure it out. And if a person was doing something they think they could be doing in 10 years, it’s probably really big. Because they wouldn’t work on something for that long if it wasn’t fulfilling or didn’t seem valuable.

 

So the very nature of a fund like this filters its ideal founder until it gets someone who fits the mould. But something interesting happens here. The mould is essentially me. So without meaning to, I’d be looking to invest in people who seem like me. Scrappy, inexperienced, young, technical, working on something they love for a long time.

 

Update:

Hummingbird Ventures

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