Mike Maples: Three Frameworks to Evaluate Startups and Founders | E1242

To me, in all investing, there's two: one is you got to get paid for the risk you take, and the other is always play offense with your money. You have to play the game that's on the field, but you don't have to play the way everybody else plays. Ultimately, if you're not finding inefficiencies in the game, you ought to be asking yourself, what am I doing? What am I in this for?

Well, I think that you can, as long as you're way less than 100 million. So I think that you can do investments of less than 100K, and we've talked about this before, right? I mean, I imagine now with your major fund, Harry, you know, you probably don't let angels come in for much more than 100K, right? Like, no way, not a chance. Like, if you say, hey, I'm doing 750K funds, or 750K rounds, and I'm an angel, and Harry, let's go do deals together, you might say, hey, that's great, good for you, I'll see you out there. But are you going to do that person any favors? Probably not, no. But because with the 500K that someone needs from a smaller fund, I get five amazing angels in for 100K each.

Probably 100%. And so if you say, hey, I'm doing 100K checks, I think that can work, but that's a fund size of probably $10 million, right? That's not 100.

It's a long story, but basically, to me, your fund size is your strategy. And I guess I'm kind of famous for saying that for a long time. I don't know if I've ever really expressed why that is. So here's why: the power law is real, and so people don't realize that Pareto is not just 80/20, it's a curve, it's a continuous curve. So 80% comes from 20%, but it's also true that 4% yields 64% because 80% squared is 64% and 20% squared is 4%. And so when you have a fund, let's just use ballpark figures, let's say you have 25 investments in a fund, your best investment is going to have to return 64% of all returns, that one deal. So if you want a 5x fund, you know that one investment by itself needs to return, you know, 64% of five times the fund in profit. And so that's why your fund size is your strategy. Your fund size is basically, it's kind of like if you're a pole vaulter, it's the height of the bar that you set that you promise to jump over. And if you don't jump over that height, you have a bad fund.

I never really did. You know, it's weird, we were better at 150 million than we were at 75, but that was really, I don't think that was really due to fund size. So like, if you trace our history, our first couple of funds were just awesome, and we just tapped into the zeitgeist and hit the market at the exact right time. You know, I was making a video this morning for Josh Kopelman's 20th anniversary, and I just marvel at the fact we used to hang out at Il Fornaio and just marvel at the fact that nobody realized what a great business opportunity this was. We're like, are we just stupid? Are we just, you know, having delusions? Because nobody seems to think this is a good idea, and this just seems like one of the opportunities of the century, just right here. And every time I would see something, I'd show it to Josh, and every time he saw something, he showed it to me, because neither of us had any money. And so like, we were just seeing all these things. Well, fast forward a few years, I'm on 22 boards, and I just didn't have the sharpness of mind. You know, when your phone's blowing up all the time, and if you're on 22 boards, it's blowing up all the time, there's always something totally screwed up. You're not as awake to the possibility of what Pinterest could be when you get pitched by Pinterest, right? And so, you know, our next two funds at about 75 weren't as good, and I remember at the time having some angst about it. So we flew out to Yale because the Yale endowment is one of our LPs, went to Dave Swensen and said, hey, look, I'm going to have regrets if I don't tell you here's mistakes I think we're making and what we're going to do about it. And part of it was sort of getting our fund size to an amount where we thought that we could really execute our model well. But we made some changes. You know, we changed the way we did follow-on investing. We had a dedicated partner, Iris Choi, do follow-ons, and she's accountable for follow-on returns, which more seed funds should do. I don't understand that, if I'm totally honest, because the point of the follow-on... so we don't do follow-on at all. If you look at the data, bluntly, we grossly overestimate our ability to pick our winners. But the point is you have asymmetric information and you should be able to pick better because you know the company better. So why would you lose that asymmetric information? Pro rata rights are a right. And so the high order bit to me in all investing, there's two, right? One is you got to get paid for the risk you take, and the other is always play offense with your money. And if you're a seed fund, in theory, your first checks, you're playing offense with your money. If you're not, you've got no business, you're just not in business, right? But there's the occasional situation where, you know, you own shares in a great company, Applied Intuition, Figma, Twitter, Octa, one of these, and sometimes you just kind of know, right? And yes, the prices get bid up, but great firms are coming in, you have a choice to decide whether you want to exercise that right. And keep in mind, it's a right that you have that nobody else has. And so to me, that would be an example of playing offense with your money. The hard thing is when the rounds are priced as they're priced and your fund sizes are still small, exercising that right can be several million dollars.

So what I came to believe was that the first question you got to answer is, do I want to do follow-ons at all? You know, you can have it be zero, that's one option, but you're giving something up when you do that. You're giving up a right that's worth something. So then the other way to look at it would be to say, I think it's probably higher than zero, and so then the question is just how much higher. And so we settled on 70% upfront, 30% in reserves, and Iris is accountable for that 30%. And I can't strong-arm her into trying to, you know, protect some investment that's not working. She's like, look, Maples, you know, you guys are holding me accountable for returns on this basket of money, but do you not think there's so much context that's lost? So like, you know, you could look at the numbers, you could look at the data, but actually I know the founder better than anyone. I know the speed of contract progression. I know all of these nuances which aren't in the data that Iris doesn't know.

But here's the thing, right? Most seed funds would say, hey, I know more about this company than the market knows. That's why I'm going to give this company money even though it can't raise. And in those cases, I used to say, you know, I think you know things that aren't so, right? So what I would... I give the market writ large a lot of credit for knowing what a good Series A deal is. You're talking about firms like Benchmark and Sequoia and General Catalyst and a16z. And if none of them want to invest in a given company in our portfolio, I'm like, okay, who's more likely to be right about the progress of that company? Having said that, if they decide they really do want to invest aggressively, that's a pretty strong signal too, because they're picking not just from the companies we invested in, but from every seed investor. And so they're judging that to be among the very best outcomes of all seed investments. And in those cases, I think you got to at least look at, do I want to exercise my pro rata right? You can't just blindly follow Sequoia and Benchmark and folks like that, but if they're saying, hey, I think this is one of the best projects in the private landscape right now, having the right to invest in that is worth something.

No, but that's closer to right than not. You know, like if I look at Fund One, what was our top performer? It was Demandforce. Who followed me in Demandforce? Gurry at Benchmark. What was the second best performer? Twitch. Who followed us in Twitch? Ethan Basser. Okay, let's talk Fund Two. What was number one in Fund Two? It was Lyft. Who followed us? Navin at Mayfield, Founders Fund, a16z. Okay, what was the second biggest winner? Octa. Who followed? You know, we did that with a16z, then Sequoia came in, Greylock at Sequoia. And so one way to think about it is your follow-on dollars might be best thought of as a subset of where the best firms follow, because we've had the best firms follow and the companies not do well. Varghese, Sequoia aggressively followed and it didn't do well. So one way I think about follow-on investing is for a seed fund, it's closer to index investing than people think. And if you say, okay, I'm going to index off of the very best funds, as you kind of point out, more often than not, if that's all you did, you'd have massively better follow-on returns than most firms. If the LPs knew, like if they tracked what's the return on follow-on checks versus first checks, there'd be pitchforks and like revolts in the street. It's so bad.

Ish. Here's the way I would phrase it. Our business is hard in seed, but not complicated. 5% of our checks need to be 100x cash on cash on the first check, and about 10 to 15% need to be 20x cash on cash on the first check. You achieve that, you're a 10x fund. And so the loss ratio is about the same between a 3x fund and a 10x plus fund. What matters is the magnitude of your big winners. But it kind of goes back to this Pareto idea. If your best company returns, say, 64% of your fund, the follow-on check in that company is going to probably be a 20-bagger. The hard thing with this assumption is that it presumes that you know outcome scenario planning, and you never know how big your winners can be. You never know, but you can say we have a way to hold ourselves accountable. And Iris, we're measured on what we call picking skill, which is what fraction of our first checks become 20-baggers or 100-baggers. Iris is measured on what fraction of follow-on dollars go in the best companies, and that's completely objective, right? You can just say here's a stack ranking of the companies by their current value, and what percentage of our dollars are in those top companies. And so that made a big difference in our returns.

I'm not sure that sounds fancier than what we do.

No, I say, for this to make 100x on the first check, what would have to be true? So the way I think of scenario planning on a first check is I say, okay, given that it's 85% likely it's not in the top 15%, you know, if I say every investment is going to be in the top 15%, it's just simply not true, right? It's not grounded in reality. The better discussion to have is to say, look, given that it's 85% likely to not be the top 15%, how big does it need to be if it is in the top 15%? And is there a world where that could happen? What does that world look like? And so, and this is why, you know, there's all these, I believe, false debates about valuation. Everybody says, well, if the company's awesome, you can pay any price. And I'm like, that's true to the extent that you can make 100x on the first check. And so I'm like, you know, that to me, that's the high order bit. If we're going to invest one to two million bucks, can we make 100x on the first check? And if we're doing it at 40 post, like we did Applied Intuition, okay, they just raised at 6 billion.

Yeah, or more. And so if we're doing that, it needs to be a 5 billion business. So we forecast that. But this is why price matters, right? So, you know, it's a lot easier, our entry price is 25 now. In the case where that's your entry price, that's what the exit needs to be. And there's no escaping that. And people say, well, that was then, this was now. I'm like, no, I've studied venture returns for the last 50 years, and the physics of what a good fund looks like has not changed.

I don't think so. I just think that a lot of people have forgotten what the right goal is. And so I sit there and I say, look, I need to make 100x on my first check. There has to be a way I can do that if everything goes my way, and I'm not going to get that by acting like an efficient market operator, right? So to the extent that seed investing is an efficient market, it's not going to be a good business. And so you got to find inefficiencies for it to be a good business. And then people say, well, what if I can't find inefficiencies? I'm like, okay, then you shouldn't be a seed investor, because the idea is not to invest as an active investor in efficient markets, right? Like if you're an active investor, you have to find inefficiencies in the market, or you got no business investing.

Neither of us are an inefficient market. Well, I think that the mistake that people make is to think of startups as a quote-unquote market. Now, I would grant you that more of the companies are fully priced today than they were when Josh and I got started, but to me, that's just part of the fun of it. That's part of the spirit of the game is to see what other people aren't seeing, or at least to try to do that, or maybe occasionally to get into something that not everybody can get into. But to me, that's the fun of it. It's like solving a puzzle or a riddle. And, you know, there's so many startups, there will always be 30 or so every year that are great.

I'm more likely to do that, yeah.

I'm unlikely to do that. I need to think that it could move the needle on the fund. And so I, you know, probably about as low as I would go is half a million bucks.

That's a great question. You know, I can't think of a single time. It's been our biggest mistake. I look now, we could have done ElevenLabs, which is a $3 billion company, probably the best company coming out of Europe now. Could have done it at 25. Would it have been a 100-bagger? Uh, no, 150.

Yeah, yeah, yeah, and we could have done a 250K check.

Yeah, but you know, so I look at it like that's why you have partners. They're like children, you just blame them. Yeah, but you know, like our business, I like to say, you know, our business is hard but not complicated. 100-baggers on the first check 5% of the time. And, you know, in order to do that, you have to pick opportunities that can be big enough if they work, but you also have to care somewhat about the price.

If I think it could make 100x on the first check, if it was Kasser Unice, I would. But I'm like, okay, so like this will happen sometimes. Some of our younger folks will come to me and say, hey, look, here's a round that's done at 10 at 40 post, and we did Applied Intuition at 10 at 40 post. And I say, okay, is the founder Kasser Unice? Because I think Kasser is one of the best founders I've ever worked with. And so they're like, well, I don't know if he's Kasser good. And I'm like, okay, it's not worth 40 post. And so, you know, 40 post was like a real stretch for us. And we're like, this company's going to have to be worth north of five billion dollars at least for that bet to have been justified. Because here's the other thing, Harry, is let's say that I thought, okay, I can't make 100x, but I can make 20, and he's that good. There's an opportunity cost, right? My fund, I only get 40 shots on goal. And if I take one shot that I don't believe has any chance of being 100x, now I have 39 shots on goal, and I have one fewer way to make 100x. And so I just have to, like, if I'm going to raise $150 million, I need to know what game I'm playing, and I need to be honest about it and play that game with integrity, or else, you know, different fund size.

Oh yeah, yeah, but I think we've gotten better and smarter too. So, you know, I think it's gotten more competitive. I think that there's a few things that give you a real advantage today that didn't matter as much then. I think today having a temperament advantage makes a big difference.

So like in 2021, we're seeing all these projects and they're, you know, they're raising money at 30 and 35 and 40, and Ann and I are just looking at each other like, we don't have to do that. And, you know, poor some of the young associates and principals are like, we haven't done any deals this year. I'm like, that's okay, you know, we haven't found any that meet our conditions. And I think that Ann and I have done this long enough to be like, okay, we don't have anything we need to prove to each other, and we don't need to, you know, have points on the board this quarter, this month, this year. You know, Silicon Valley will make more, and we'll just, we'll be there. And so I spent a lot of time as Dana thinking about what's our circle of competence, what are the situations where we've made money historically, and what are the situations where we think we're well set up to make money in the future. And we need to see projects that meet those conditions.

Well, if the field's not your conditions, you just have to be more discerning. So, you know, Buffett said it well once: investing is like a game where there's no called strikes. And so you just let pitch over pitch go by, and everybody says, swing, you bum, everybody else is swinging, and you just say, no, I don't have to swing. I don't see my pitch. I'm just going to wait until a meatball comes over the plate and just swing at it with all my might. And if one doesn't come, well, I'll wait, some will someday. And this is a great way to think about pacing, because in 2009, everybody was in the fetal position, and Ann and I were seeing deal after deal where we're like, this totally meets our criteria, this is awesome, and funded Lyft at five and a half million post money.

She wrote 750.

She made like, I don't know, 250x maybe on that investment. So that was good. But we were in an environment where people were afraid to invest, people thought the world was going to come to an end. But because we were like, okay, this is the type of project that we think is attractive, when we see one of those, we don't care what the market's doing, we're going to say yes to those. Similarly, in 2021, I only made one investment the whole year, this company, Hadrien.

Well, I just didn't find any companies that met my criteria. And so one thing that's interesting about having a circle of competence, and I actually learned this from Buffett Munger, is if you know what your circle of competence is, if everything's systematically overpriced, you do fewer deals because fewer deals meet your conditions. If everything's systematically underpriced, you do more deals, but that's the situation you want to be in.

You have to play the game that's on the field, but you don't have to play the way everybody else plays, right? And ultimately, if you're not finding inefficiencies in the game, you ought to be asking yourself, what am I doing? What am I in this for? That's what we're paid to do. We're paid to find opportunities that are going to make money. Nobody's interested in indexing the broader overpriced seed market, right? Like that's not a good business. And so you got to find attractive opportunities for us. A lot of that in the AI arena has been some of these enterprise, you know, so Applied Intuition was one, a more recent one was, you know, Cicero, which is another one that's doing really well. But we had a very specific set of conditions for what kinds of AI investments we would do and not do.

No. Well, Applied was expensive. It was 40 post.

No, actually, the reverse is true, but I don't know if that would still be the case.

Only. Well, Applied was hot. Kasser would have raised money from anybody he pitched with that idea. He was that good, and his idea was that good. He was that well prepared. So he pitched two firms, got term sheets from both, decided to work with Mark. Mark joined the board. And I kind of said, okay, probably the Series B round is a little bit de-risked here, and so I should probably put in as much as I can get in on the round. And so that's what we did. And then immediately, as soon as our check cleared, Iris was trying to buy more.

I've done that, yeah. Tell us about that. And then the other thing I've done is I've been in a situation where the founder wanted me to do something with them, and I said, I'd like to work with you too, but the price is too high. And this is one of the things about convertible notes is I could say to that person, look, you know, you can issue a convertible note any price you want. You can, you know, if you're raising at 20, you can sell me half of them at 20 and half of them at five. And they might say, well, other people may not like that very much. I'm like, I understand that, but like, you can decide, right? But I'm not going to pay that price that everybody else is paying. And so, you know, you learn quickly whether they value your involvement in a differential way or not. And, you know, if they don't, it doesn't hurt my feelings. I'm not going to pay the price, but it doesn't hurt my feelings on the commons and prefs.

I really like Nick, but I think that's [bleep]. I would, if it made a difference meaningfully in my ownership early, I'd do it.

It's not so much that. It would be maybe I can say to the founder, hey, look, this is a way for us to have some type of a joint gain. I know you need to get the price you want to get, and there are reasons that you want to get that, but maybe we can get some type of a blended price if I buy preferred plus common, and then I own more. I'm taking more risk, but if I believe in the company, I've never made money or lost money based on common or preferred ever in the ones that worked. And so I will... you do uncapped notes? Only in very rare cases have there been any. Would have done one for Applied because like right after the Series A, we wanted to own more. And so there are times when doing an uncapped note works to your favor. If you say, I have so much conviction that I'll pay a discount to whatever the next price is, I don't care, because, you know, otherwise why is the founder going to give you any kind of preferential treatment when the round comes together? You got, if you believe in the company, you got to position yourself for the next round.

I've never done that, no. I was tempted to at times, but I never did.

Yeah, so I think that there's a couple of things. And by the way, this is something we haven't really talked about yet that is good for seed. So let's imagine it's 2015, and Lyft stock at the time was in the private markets was about 25 bucks a share. It was worth more than it is today by a meaningful amount. At the beginning of the year, we said, you know, we need to sell some of this because we're behind a billion and a half dollar preference stack. We're in this thing at a half million post my evaluation. We're competing against Travis Kalanick, who's a freaking maniac who I respect a lot, but I'm like, you know, he's not a fun guy to compete with. And this thing is going to impact our fund, right? We are way in the money on this thing. And so Ann had a Post-it note on her monitor that said IQ test, and we put it on in January that year. And the IQ test was, I need to find a way to sell some of our Lyft stock this year. So she ended up selling a fair chunk of it. I don't think half of our stake, but a fair amount in 2015.

Yeah, so, but it was, you know, it was really good, like the highest it ever got.

Oh yeah, so we were like, okay, we need to sell enough to return all of Fund Two. So she did. And so one thing that I think a lot of seed funds don't get is there's two ways to make money. One is on entry pricing inefficiency, but the other is to arbitrage exit price inefficiency. And so like with Lyft, a16z was in Lyft, they couldn't have done that because the problem is, A, it would have sent a signal, and B, selling a couple hundred million bucks or whatever, it doesn't matter to a16z. It doesn't affect their fund enough. And so one of the things that seed funds can do is they can start to say, hey, is the market about to value this thing as if it executes perfectly for all the next five years? Because the capital markets are such that there's so much money that a lot of these companies, no matter how exciting they are, are going to get fully valued as if they're perfect for a very long time.

So that's the thing, right? Like this is the other thing I found is that when the times you should be selling into some of those rounds, everybody wants a share of the company. So like what I learned was that it's actually a win-win for the founder because you say to the founder, you can't just do it on the fly, you can't be transactional, but if you say to the founder, hey, look, let's be realistic here, you're better off in the fullness of time if certain players are in your cap table and not a seed fund, you know, Fidelity or, you know, folks like that. So what do you say we get strategic about it? How about we put ourselves in a position where we can get somebody like that in when you raise your next round if it clears a certain threshold? And what usually ends up happening is at first they're like, I don't know, but what ends up happening in reality is by the time the round comes together, the founder's coming to you saying, dude, you got to do me a solid. You said you were going to sell. I need you to sell more because everybody becomes pigs. Everybody wants in. Nobody pays attention. So ironically, the times that it's easiest to sell in these really hot rounds is probably the time you should think seriously about it when you're a seed fund and you don't want to. I call it, Iris came up with a term for it, actually. We call it an initial liquidity event. So it's an event that has the same impact on fund economics as an IPO. So it can't be just, you know, 10 million here, 15 million there. It's got to be something where it has the same impact on your fund as if the company went public.

They will say the same. I'm not. Yeah, and you know that you never make a trade that you don't somewhat regret. I mean, unless you just sell at the top, right? But like...

But you know, Lyft traded up to like 75, and you know, when it went public and the lockup, I mean, we got out at like 75, and so we would have done even better, but it was still the right decision. It was still the right risk-adjusted decision, right? Like because once your fund's in the carry and you're in the money, and it's like you've still got that upside. And so that's the... so first of all, does your psychology change when you're in the money? I think it does a little bit. But I think that the other thing is it's like you get into these situations where the variance in the potential outcomes is so great. So I agree with Brian Singerman in one sense, which is some of these things can ride a lot farther and higher than you think. I agree with that. The issue though is that sometimes both can be true, right? You can be in a situation where you're a hundred times in the money in five years, and no matter how good the company is, it's just valued to absolute perfection, right? And so in those cases, I look at it like even if the Brian Singerman outcome happens and it doubles again or even quadruples again, just have enough stock so that you know you're going to benefit from that upside too. But I just think that when you're... 100-baggers are pretty rare, right? I keep track of them. I have a list I can show you on my laptop, right? 100-baggers of the last 20 years.

There's about, there's a little over a hundred that are exited, and there's a little over 100 non-exited that I track. Most of them I don't track because I don't think they're real.

I've only got like three or four. Okay, so yeah, so Twitter would have been... Twitter was a little over 300x. And gets all the credit for Lyft, that was like about 205x. What else? Applied is probably encroaching on 100x in the first check. Twitch got close, but not quite there. It got to 94x. And there's a few others that I think have a shot.

Yeah, but here's the key. You got to do it in a way where you're not just being selfish about it. You want to do it in a way that... in fact, we did sell some Applied, but we did it in a way where it was in full cooperation with Kasser, right? I was like, I'm not going to do this behind your back, or I'm not going to do this against your good wishes. And so is there a way we can make this a win for you? That's the discussion we need to be having. But you can't have that discussion the day the round closes, right? You got to be like, hey, here's how I'm seeing things. Am I making sense? You know, Kasser is a grown-up, right? He's like, hey, I get it. I understand you got a business to run. So do I. 100%. The best founders generally do understand, like they do, especially if you don't surprise them and you're just not greedy and transactional about it.

And if you say to them, if you say to the founder, hey, look, can we agree that all things being equal, this would be a good investor to have in your cap table after the next round? And this is a good way for you to get them without getting crazy massive dilution. What do you say we try to engineer those circumstances?

Hopefully not much. You know, I think that sometimes, you know, the place where I would also agree with Brian Singerman would be sometimes you get in the money and you lose sight of the fact that you can get a lot more in the money.

Yeah, you know, I think that kind of goes back to the first principles, right? You can make money on the buy and you can make money on the sell. And what most people don't understand is that the seed funds are actually better positioned to make money on the sale than anybody, better positioned than the multi-stage by a wide margin. And that requires, though, for the seed manager to be much more sophisticated than most are being. Most are just like, should I sell? Should I not sell? You, what you want to do is have an opinion, right? And you want it to be grounded in the facts. Why do I collect information on the 100-baggers? Because I'm like a train spotter. I'm like, you know, in Britain, right? You have those train spotters.

I think it's case by case. I think you should say to yourself, okay, there was a time when we were sober and we kind of said if the following things happen, we might be sellers, and that's happening now.

Most of my mistakes have been in our early funds. We followed on in too many rounds in the companies that weren't going to make the difference.

decision. Our biggest failures are so not related to that. Our biggest failures have been failures of imagination. You know, it's like when I passed on Airbnb, or, you know, what's another one we passed on? We would have done really well, Datadog.