Today marks the end of my one-hundred-fortieth week of working from home (mostly). Here are my takeaways from week one hundred forty:

• Investor perspective – Investors view the world and founders through different lenses. I participated in an event where a group of investors provided feedback on a few founders. It was interesting to see how each investor’s perspective informed their analysis of each founder and their market. Sometimes substance was overshadowed by other things; conversely, sometimes lack of substance was overshadowed. External validation also swayed some investors’ analysis of a founder, although I believe that wasn’t intentional.
• Home stretch – We’re in the final weeks of 2022. The year has gone by quickly. I want to make these last few weeks in the year count.

Week one hundred forty was a busy week. Looking forward to next week!

Some founders optimize for minimal dilution in the current round when they raise capital from venture capital firms. They do this by setting high valuations. For example, a company raising $1 million that wants only 5% dilution will have a $20 million post-money valuation. If they accepted 15% dilution on that same $1 million, they’d have a $6.66 million post-money valuation. The difference is large. In isolation, the 5% dilution at $20 million post-money makes the most sense to the founder.

If a founder considers the next financing round, things look different. Investors in the next round might be willing to value the company at or above the $20 million assigned in the first round only if there is a significant amount of traction. Otherwise, the founder could face many bad options (assuming they haven’t reached breakeven). They could run out of cash and close the business. They could raise at a valuation lower than $20 million. I won’t get into all the math, but depending on the terms of the first round, investors from the first round could receive additional ownership when the second round of financing is complete. Depending on how little leverage and runway the founder has, the dilution could be massive.

To avoid all this, founders raising capital should agree to reasonable valuations that won’t give investors in later rounds heartburn or force the dreaded down round.

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Today I caught up with an aspiring founder. He’s been working as an engineer for a growth-stage start-up for the last four years. He’s fully vested and thinking about starting his own company. I always like to understand people’s journey, so I asked about his—specifically, about choosing to get his master’s in computer engineering from Carnegie Mellon.

He told me he didn’t even know what Carnegie Mellon was and ended up at the school by chance. He joined the National Society of Black Engineers (NSBE) as an undergrad and attended their conference. During the conference, he got what he thought was a spam email about Carnegie Mellon and its master’s program. Having never heard of the school, he asked an advisor about it. He learned it was one of the top engineering schools in the country. He decided to stop by the Carnegie Mellon booth to learn more. Talking with the admissions staff, he learned that he perfectly matched the profile they were looking for and that the master’s program was a perfect match for what he was looking for. He was basically admitted on the spot. He accepted and excelled in that program . . . and the rest is history.

Matching is critical at the earliest stages of entrepreneurship and your career. The right conversation can literally change your life trajectory. You must be in the right networks for matching with the right people and resources to occur. This engineer was under-networked and didn’t know what he didn’t know. He didn’t even know that Carnegie Mellon existed, let alone that he should apply. Carnegie Mellon didn’t know he existed, so it couldn’t recruit him. The NSBE was the conduit that allowed him to be matched to Carnegie Mellon. The NSBE played the critical role of finding this engineer by meeting him in his existing network/community. It then connected him with people, companies, and schools in other networks he wasn’t aware of.

This engineer is smart and scrappy, and he has a chip on his shoulder. He’s what I call a high-potential, nonobvious founder (or he will be, when he starts his company). These are the kind of founders I like to bet on. Nothing was handed to them. They earned everything they have by climbing mountains. They’re a little different, so people can’t relate to them, but they’re going to win because they want to prove everyone wrong.

These nonobvious, talented people will drive the next wave of entrepreneurship. Sadly, the current seed-stage venture capital model isn’t set up to find and support these types of founders. I think there’s a massive opportunity to support more nonobvious founders outside the traditional venture capital network, and it’s an area I’d like to focus on.

I chatted with a founder about his plans for his company. His goal is generational wealth for his family. He’s aiming to sell the company in an all-cash deal. I thought the focus on an all-cash deal was interesting given his company’s trajectory. It’s growing quickly, and I believe it has the potential to be worth a billion or even ten billion dollars one day.

Compounding is a powerful force that many—including founders—don’t grasp. If you own equity for a long time in a company with a healthy growth rate, the value of the equity compounds over time and can end up being massive. If accumulating wealth is a priority, owning equity in a great, growing company is the way to accomplish it. The families that understand this concept have continued to own significant equity for decades in the company their patriarch or matriarch started. Their wealth has compounded over that time into massive fortunes. Think Walton family and Walmart. Jim, Alice, and Sam Walton are worth close to $200 billion because of their decades-long ownership in Walmart. Even some of the recent entrepreneurs who’ve accumulated immense wealth did so because of the compounding value of the equity they owned in their company. Think Bernard Arnault, Jeff Bezos, and Elon Musk.

Founders (and everyone for that matter) should be keenly aware of the power of compounding when they’re thinking about financial security.

Founders who decide to raise venture capital sometimes do things unwittingly that could cause a venture fund to opt out prematurely. The most common is setting the valuation before chatting with VCs. Founders decide the amount of capital they want to raise, pick a valuation, and put all that info in their pitch deck. This can be OK in raising from angels, friends, or family, but it’s not advisable when you’re seeking to raise a round of capital from venture funds.

Founders usually don’t have as good a grasp of valuations in venture markets as venture funds do. Funds usually see a constant flow of deals, which helps them keep a finger on the pulse of market valuation for companies at a particular stage. Founders are usually relying on conversations with other founders or data they find online. While helpful, these sources of information may not reflect current market conditions or may not give founders enough data points to really understand market conditions. A fund could be interested but decline to meet the company because the valuation is unrealistic.

Another variable founders should be aware of is a venture fund’s portfolio construction. I won’t get into the details of it, but when a fund is raised, the general partner(s) communicate to limited partners how many companies the fund will invest in, the average check size of each investment, and how much of each company the fund plans to own. These and other factors help create the hypothetical portfolio of companies the fund will own and the hypothetical portfolio return (i.e., how the fund will return a profit to limited partners). If a venture fund receives a pitch deck with a valuation that’s too far high, they’ll be more inclined to pass on the company. A high valuation can mean a lower share of ownership in a company, which can throw off the portfolio construction. If general partners deviate too much from the portfolio construction they communicated to limited partners, they have to explain why. These kinds of conversations can cause some limited partners to decline to invest in future funds. Of course, founders usually don’t know a fund’s portfolio construction, so they’re at an information disadvantage when they set a valuation.

So, what can founders do when they’re raising a round of venture capital? Simple: leave the valuation out of your deck. Include the amount of capital you’re raising and figure out the valuation as you chat with venture funds. These questions can help you figure out the right valuation and evaluate funds:

• Ask VCs what the current market valuation is for companies at your stage. If you talk to enough funds, you’ll have your finger on the pulse of the market.
• Ask VCs what their average initial check size is and if they have an ownership target. If a fund says they write $1 million initial checks and aim for 10% ownership, you know they’re likely in the $10 million post-valuation range.

Figuring out valuation for an early-stage company is part art, part science, and part negotiation. I hope this will help founders go into their fund raises better prepared.

Over the last year or so, I’ve shared with friends a hypothesis that leverage is causing extreme fluctuations in asset prices. I believe it was a material factor in the 2020–2021 runup and that it’s played a significant role in the declines in 2022. Leverage enables an investor to multiply the potential return on an investment. It can involve using borrowed money to amplify bets or other means to allow an investor to have exposure to an asset without fully owning it. Leverage amplifies movement in both directions, which can cause havoc in markets when things move to the downside.

History doesn’t always repeat itself; sometimes it rhymes. I started looking into the past to understand the present. Specifically, periods when interest rates were increased and financial markets experienced high volatility. I’m still early into this, but I’m looking into the mid 1990s now. It was a period of rate hikes and bond volatility that the Fed couldn’t explain at the time. Rate increases kicked off a sequence of events. We now know that volatility was caused by excessive leverage that most were unaware of at the time. Because the leverage wasn’t public knowledge, the volatility was hard to understand or explain. It’s early, and I still have more reading to do about other periods that fit my criteria, but what I’ve learned so far has been interesting.

I’m no economist, but my gut tells me we have more leverage in financial markets than we’re aware of. It may be amplifying market movements to the downside now.

Outsiders are people who aren’t working in an industry and (usually) don’t have relationships in that industry. They’re on the outside looking in, wondering what it’s like to be on the other side. They don’t understand how the industry works, but they work to fill their knowledge and relationship gaps. Successful outsiders can penetrate the industry through hustle and a bit of luck.

The experience of being an outsider who makes it inside an industry puts these people in a unique position. They’re different from insiders. They’re engaged enough to see and understand the mechanics of how the industry works, but they’re detached enough to question the status quo. They see things from outside and inside the industry simultaneously. This perspective can help them identify a gap that others have ignored and understand the potential in exploiting it. Further, they’re uniquely qualified to come up with the right plan to exploit the gap in a way insiders and those still outside the industry can’t.

I’m a fan of backing outsiders. They’re driven enough to hustle their way in. They’ve likely got a chip on their shoulder from wanting to prove others wrong. And they usually have strong conviction. All these are great founder traits.

While some think outsiders are “out of place,” I view them as scrappy people who can be catalysts for innovation.

Yesterday was Thanksgiving, a holiday I enjoy because I get to spend quality time with family and friends. We’re a few years removed from the beginning of the pandemic, and I’m more intentional about this holiday than I was pre-pandemic. This year I made a point of thinking about and sharing with others all the things I’m thankful for. The year hasn’t gone according to my plan or other people’s plans. At times it’s been frustrating and felt like a stream of bad news. But even with all of 2022’s curveballs, I was able to come up with a long list of people, memories, and things I’m extremely thankful for.

What are you thankful for?

Happy Thanksgiving!

I hope everyone had a safe and healthy holiday!

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I connected with an investor who shared how he evolved from a start-up founder to venture capital investor. He had an idea of what it meant to be a venture investor, but he learned that the reality is quite different. His first year was one of not knowing. He didn’t know what a good company looked like, so everything looked good to him. He didn’t know what his approach to finding great companies was, so he tried a bunch of stuff. The list of what he didn’t know is long. But the big takeaway from his first year was that he could learn by doing. There’s only so much that people can tell you about the craft; you have to get your hands dirty to learn and get better.

Having always been a practical learner, I agree with the learn-by-doing mantra. Action produces information. You learn from the information, improving your decision-making and actions. This was true for me as a founder, and it’s true for me as an investor. Some of my learning has been painful and expensive, but I’m comfortable with that. Instead of being unhappy about the money, time, or energy lost, I consider them the tuition I paid for knowledge.

If I want to learn how to do something, I now think about ways to do it so I can learn (and maybe pay some tuition too).