Welcome back to Inside the Mind of a NYC Angel Investor, a new series at AlleyWatch in which we speak with New York City-based Angel Investors. In the hot seat this time is Jason E. Klein, Founder & CEO of On Grid Ventures. Jason is the Chairman of Harvard Business School Alumni Angels of Greater New York, New York Region Partner for Yard Ventures, a member of New York Angels, and Managing Director of Empirical Media. Jason sat down with AlleyWatch to talk about the discipline needed to be a successful angel investor, his investment thesis focusing on“GeoDisruptive” businesses, and his belief that“failure is not a badge honor.”
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Inside the Mind of NYC Angel Investor: Jason Klein
Bart Clareman, AlleyWatch: Tell us about your journey into investing in startup ventures and how you came to found On Grid Ventures?
I spent most of my career in media, which from the early days morphed into technology. You had to have an entrepreneurial nature in the media industry to survive, given all the changes that have occurred.
When I left NNN five or so years ago I started thinking about what I wanted to do next, the pull of what was happening in the New York tech scene was pretty magnetic for me.
Concurrent with this growing tech scene was a growing angel investor community. The advent of an organized angel investing community allows people interested in the space to pursue angel investing much more seriously than I had ever imagined.
I had no idea how disciplined groups like New York Angels are about angel investing, until I started investigating it. There’s actually research studies that are done on angel investing. There’s certainly no clear route to success, but I focused on learning a more systematic and professional approach to angel and venture investing. There’s lots of places to look for data on best practices.
Where do you get the data that informs your strategy? What are your sources?
I look at the Kauffman study and some of its derivative studies and there’s good lessons learned. Angels that invest in areas they know get an additional 3x multiple on exit than angels who invest elsewhere. Angels who are active in the companies they invest in have also gotten an additional 3x multiple at exit. Angels who do a lot of due diligence, 20 hours is the mean, get a 6x lift in their exit multiples, on average.
Then when you actually look at angel returns, in general they’ve been pretty good. A lot of the recent studies show something in the ballpark of a 2.5x cash-on-cash return, IRRs that vary from 18-38% with a median of 22% [see for reference Robert Wiltbank, Wade Brooks, 2016, Tracking Angel Returns]. There have also been several studies showing that angel returns are better than VC returns on average.
Now, I always take some of that with a grain of salt, because you worry about bias in the angels who are reporting their numbers. But even if you discount it somewhat, the numbers suggest that yes, it’s high risk, but you can do this in a disciplined way as an allocation within a broader investment strategy
What percent of angels are applying that degree of discipline in your estimation?
It’s hard to say percentages; angels come of all sorts. Ironically, half of the angel and Seed capital invested in this country comes from the 10% of angel investors that are part of angel groups, which tend to take it more seriously, but even groups are not all alike.
I’m in two groups and they’re both different. New York Angels tends to be a group of very involved angel investors, and the key sign is that most of their meetings are during the business day, which implies a certain level of commitment.
Harvard Business School Alumni Angels is a much more varied group. That group is very inviting to people who want to be angel investors, or are new angel investors just starting out. But there are also a core of HBS Angels that pursue early stage investing very seriously.
The HBS group is very good for onboarding new angels. As a matter of fact, I teach New Angel Orientation for every new member of the group. Attendees tell me it’s very helpful for people who have not angel invested in the past. And we take any graduate of Harvard as members, not just the B-School.
Based on what you see at New Angel Orientation and your involvement with angel groups, what are the greatest learnings for new angels?
Certainly deal structure is one, if you’re not familiar with the basics of how angel deals tend to get structured. There’s a lot of relatively simple stuff you need to learn. We have people who come through new angel training for HBS Angels who have spent their careers doing enormous private equity deals, but you talk about convertible notes or a SAFE they’ve never seen an animal like that.
Another big thing is time management, particularly for HBS Angels. Many new angels have looked at corporate acquisitions, many have financing experience, they understand proper due diligence in doing a deal, but there is no freaking way you can do that level of evaluation in an angel deal. So a lot of it is, what do you focus on given limited time and how do you work your way through the process?
For people who have done corporate acquisitions, there’s a significant difference between the actual verifiable data that you’d get in that environment versus what you’d have access to with an early stage startup. How much does that data gap impact new angels?
I find that new angels who have been in business and have good, sound business judgment typically need time more than anything else. They need to look at a number of deals to develop their own sense. So much depends on picking the right entrepreneurs at this stage, so you have to make up your own mind about what your own indicators are for that and what makes for a successful entrepreneur.
A lot of what we talk about is how to think about risk and portfolio strategy. There’s a tendency to push too much capital out too quickly and not diversify. We encourage people to build up a portfolio of at least 10-20 angel investments.
A big part of that is allocating your capital prudently and being able to follow on when you want to follow on. When you have a company you’ve made one investment in, that’s tracking well and taking on additional capital, your initial bias should be to invest in the round, so you want to set aside some money for follow on investments.
Speaking of the indicators for picking entrepreneurs – what are the indicators for you?
There’s a number of things. I look for real domain expertise, someone who knows the industry they’re in. I don’t view dilatants too keenly. I look for someone who’s really committed, someone who is passionate about what they’re doing and the cause, and really wants to see it through.
I also really look for someone who has competitive awareness, which is often hard to find. It’s amazing how many entrepreneurs have no sense of what the competitive set is and don’t take it at all seriously.
I’m tired of seeing charts where you ask an entrepreneur about competitive sets and they come back with a very detailed chart with Xs and Os and it’s basically a product feature map, it’s not a competitive set. I interpret that as, you’ve had a summer intern look at your product versus someone else’s product and mark down a feature comparison. Meanwhile, the fact that one competitor might have raised $50M of capital last week doesn’t show up on that chart.
What difference exists between the investment opportunities you pursue through an angel group versus those you pursue via On Grid Ventures?
If something is outside of my core of what I call “GeoDisruptive” entrepreneurs, I’d be more likely to pursue it if it’s through one of the angel groups. If it’s an area I don’t know as well or haven’t studied as much, then it certainly makes sense to have the benefit of smart investors with domain experience taking a look at it.
With the data you mentioned earlier in mind – that you’re more likely to get a 4x return on investments in spaces you have domain expertise in – how do you get comfortable relying on other people to provide that expertise?
It’s a series of concentric circles. I won’t invest in anything that’s too far afield. There are a lot of areas I won’t look at at all, because I just don’t feel I can add any value. I need to have some kind of gut feel and some level of experience with a space to invest in it, plus areas where I can add value and bring something to the table. If you look at the deals I’ve done that are not Geo-related, they’re business I can relate to based on my own career experience, often from my time in McKinsey’s Consumer, Retail and Media practices.
Part of my philosophy comes from having spent a good part of my career in what I call special interest marketing. I spent many years looking at specialty information publishing, consumer magazines, all the way to complex professional database services. A common theme was that I always had people with terrific domain expertise at the head of those endeavors. You had passion and someone who’s a real enthusiast about the subject area. I look for that now in finding companies to back.
I also don’t believe that failure is a badge of honor.
Interesting – say more about why you don’t believe failure is a badge of honor.
I think successful people tend to have a pattern of success around them. It’s not that everything has to have been successful, but an entrepreneur who has done five startups and lost investors’ money five times, I don’t feel like being number six on that list. I’m pleased that person has gotten an education, and good for him or her, but what happened to the old line, “Failure is Not an Option?” Didn’t Apollo 11 Flight Director Gene Kranz write a book with that title?
Your LinkedIn notes you were the CEO of two businesses that went from losses to record profitability – you’re a turnaround specialist. What methods did you employ as an outsider coming in to turn those businesses around?
A good start is just coming in and trying to spend time understanding the situation and learning from people who know more about it than I do.
In both cases, I came in with a general mandate for change with a lot of different pieces that needed to get filled in. I came in with few preconceptions but really went to task, both internally to the organization and externally – trying to understand the environment and what the enterprise needed to do. In both cases I had a good team and had to make some changes, but I did have the benefit of a team of people and constituents I could reach out to.
For a startup CEO who recognizes the need to execute a turnaround at their own company, what advice would you give them to help right the ship?
It’s hard to generalize; every situation will be really different. Particularly these days, because there is this Series A crunch, it’s hard to raise a significant round of Series A capital, and a lot of startups face running out of cash too early in their lifecycle.
So what I try to coach entrepreneurs on is: here’s what I think a Series A investor will look for, so here’s what you ought to focus on. I always say strategy is about making choices, it’s about what you don’t do – as much as what you do do. You have limited time, there’s a lot of things you can’t do, so you really have to focus on getting the core elements of the business down with some real proof points around it.
You mentioned the Series A crunch and your “failure is not an option” credo –how you view bridge loans? Will you participate in them or do you view them as “bridges to nowhere”?
Every situation is different. The answer is yes and no depending on the circumstances. I have to have confidence the entrepreneur has a clear, focused, short-term action plan.
If they’re just running out of time and money and still haven’t proven the concept and still have a two-year plan out, I don’t plan to fund business payrolls on a month-to-month basis.
Tell us about your investment thesis around “GeoDisruptive” businesses. Define it for us.
It’s a business where precise digital location is necessary to be able to make the business operate. By definition, it’s a business that 5 or 10 or 15 years ago would have been impossible because the technology wasn’t there; OpenTable was an early example of it, certainly Uber and Lyft fit this, any of the on-demand services fit this, Waze fits this.
I look at industries, and in many industries, the geo-technology itself has the potential to be disruptive. It’s happened in some industries and it’s been waiting to happen in others. I try to find things where there’s massive potential for change and I’m able to get in early.
Cups is a good example of a company I invested in early. I call it “the Starbucks app for independent coffee shops.” I find it incredibly useful as a customer myself, if I’m standing on a street corner in New York City and feel like going to a nice place for a cup of coffee and I’m bored with Starbucks, the Cups app is a great directory of interesting places to go. It’s right in my hand and I have a prepaid plan so I can just walk into the coffee shop, don’t have to take cash out of my pocket and can get a cup of coffee at a discount. It’s incredibly convenient. And fun.
It’s often mobile-related. I think the indoor tech arena is waiting to happen. There’s been some fits and starts around Bluetooth low energy technology as well as some other ways to do indoor location. That’s yet to all shake out, but I think the potential for that is really tremendous.
When did you formulate the thesis and how far along into its evolution are we?
I formulated it about 4-5 years ago, and I’d guess Geo is only 20% along in at this point.
Describe the process of investment thesis formulation for someone who has never conceived of one. Do you set out to create a thesis as a purposeful act – “I am a venture investor, ergo I need an investment thesis” – or is it more organic than that – the natural result of deal flow and seeing the same themes repeatedly?
For me at least, a big part of my professional career has been about coming up with ideas and theses about how industries and businesses will evolve. In my corporate life I’ve made many acquisitions of line-extending companies, $10-100M, and in many cases we’d look at a market and say, “we want to buy companies of this sort for this reason,” and you embark on a long-term search for companies that fit that thesis and are good enough when you start evaluating them through the process.
In this case, the thesis for me is grounded in having spent almost nine years running a pretty significant company that sold large national advertisers on doing local targeted advertising. Because I ran that company through the evolution from doing expensive 4-color full page print ads to doing location and city-targeted digital ads, it got me thinking an awful lot about digital location and how that can help marketers.
One of my earliest introductions to media was doing radio in high school and college. I used to play Casey Kasem discs that came prepackaged with national ads. There you have a national advertiser reaching out to local markets. Through Casey Kasem you couldn’t target markets all that much, but if you’re going to pick spot TV or pick a local newspaper to run an ad in, you can.
But of course spot TV and newspaper ads are the low-tech ways to do this. Today you can get as specific as, here’s someone who’s standing in front of a Levi’s jeans rack, and you might be able to know the kinds of pants this person has bought in the last month or the stores they’ve shopped at, and you can give that person a notification or coupon to incentivize their behavior. You can get quite targeted and quite scientific. The technology needs to evolve a bit for that to be possible, but it’s not that far off.
How do you think about the privacy implications of that type of hyper-localized, hyper-personalized targeting?
Privacy is definitely an issue in this stuff. Companies that handle privacy well will be the winners.
Coming from the adtech and advertising side, I think properly targeted ads that respect bounds of privacy are a real plus for consumers. They can also be incredibly intrusive and incredibly annoying, so there’s got to be some control on that.
For example, health conditions are something that generally speaking are not tracked. People don’t want to be targeted based on sites they’ve seen based on health conditions, they find that particularly intrusive.
An entrepreneur friend from college described getting an MBA as a fear-based decision. The implication being, why get an MBA when you could just take the plunge and starting building something. Clearly the affiliation with Harvard Business School is meaningful to you (as it is to me as well) – what advice do you give to the person considering whether to get an MBA or take the plunge and start building a company?
There are way too many startups and too many bad ideas; too many people that don’t have real domain experience. I was just looking at some other numbers: by one source, the number of angels in Seed deals in the fourth quarter of last year was down almost 50% to ~870 nationally in the fourth quarter, down almost in half from six quarters ago. The investors are getting smarter and realizing that a good idea is hard to find.
Entrepreneurs come in all flavors. HBS is a pretty interesting case study. Historically, HBS has been the school that has spawned some of the most entrepreneurs of any business school, but historically those people have not been entrepreneurs in their first 10 years out of school. These are people who have done something entrepreneurial in later stages of their career, with Mike Bloomberg being one of the best examples of this.
When you’re in your 20s you really lack some of the skills, abilities and knowledge you need to start a successful company. Of course, there are many notable exceptions, but not everyone is going to be a Mark Zuckerberg. For those mortals out there, you might be better off getting some real experience, getting an MBA, and then working in an industry for 10 years so you really understand it and can build a thesis about what works for you – and then when you’re ready, go out and start the company when you see the opportunity is right.
I can’t say I’m an enthusiast about these so-called serial entrepreneurs who jump from idea to idea, who don’t really understand what they’re doing, but they’re so enthralled with the idea of success and the idea of being the next Mark Zuckerberg.
In a recent post on On Grid Ventures (by Anthony Gellert), it said that SAFE notes “are a nonstarter. So much so that the moment they are mentioned in a presentation, the whole room starts ranting at the entrepreneur and stops listening to the presentation.” Why all the hate for SAFE?
There’s a few issues with SAFE notes. A very simple one is that there’s something called the qualified small business stock tax exemption (QSBS), which was part of the 2015 tax bill. It basically said that if you make your investment in a C-Corp, in equity, and you hold it for five years and it’s a qualified small business, your gains are tax exempt up to $10M.
I’ve done a bit of exploration of investing in other countries, and we sorely lack the tax incentives that exist abroad, but this is the one significant tax incentive now in our tax code to support entrepreneurship and angel investing. However, it all hinges on making the initial investment in equity, so that’s a big factor.
Second, as I often tell other angels, your interests aren’t always aligned with the VC who comes in in the next round. Particularly when they come in and they have major investor rights, and you find yourself outside of that circle.
SAFEs are, I think, particularly egregious because the SAFEs were designed by incubators that have every incentive to see every one of their companies raise follow-on capital. The inventor of the SAFE owns 5% or more of the company’s common stock already, so they just want to see the company get funded. There’s no alignment of interest. If I’m an incubator and I have 5% of the company’s common equity, I can see why I’d want to raise the next round on a SAFE. It’s simple, it’s better for me, but it doesn’t protect the next set of investors.
What are the key protections an angel needs to have in place to ensure they don’t get pushed around in later rounds?
Often you just want some of the same protections the VCs get. It’s very good to have follow-on rights, because if the company takes off, the later investors may not want to have angels as part of the cap table, and those rights will be important to you if you want invest in the next round.
And then, information rights. I think good angels tend to lean into their companies, they want to be active, and they want to be helpful. Notes typically don’t have any information rights. That creates the scenario where the winds could change, the entrepreneur gets busy, and all of a sudden you don’t have any idea what’s going on with the company. Some entrepreneurs are quite good about sending a monthly email about what’s happening, while others go radio silent. I think having basic information rights is in both parties’ interests, and typically you don’t see that in notes.
On your blog you write about the importance of winning your category – but you also invest at the earliest stages of the company life cycle. What do you need to see from a founding team to believe they can win?
It goes back to my grounding from special interest information publishing. I like to invest in companies that can be number one or number two in their market. I don’t mind well-defined markets, and it doesn’t have to be a $10bn market. I want a company that’s going to be best in class, there’s a market or a niche that they can be a leader in.
To do that they need to have some credible insight about the marketplace, they can have some great technology, in some cases it can be through great execution and first mover advantage. You can see the background of the entrepreneur can play into it. There’s many ways a company can put a compelling story together that says they’ll be best in class.
I hate the argument that says, “it’s a big market, we just need a small piece.” That’s not for me. There are some markets they talk about that are winner take all, and others that aren’t. My default view is most markets are not winner take all, but there’s a strong correlation between success and market share.
I did start my career at Bain with the growth share matrix, being grounded in the value of market share and the links to profitability. I would hand draw charts on logarithmic paper, analyses of industry profits and market share and spent many hours racking up numbers. That may be a little dated but I think the underlying view is still right, which is that you really want a company that will be number one or two in its segment. I look for that.
If you’re a serial entrepreneur coming up with your five or six companies in a row, you’re probably not coming up with a plan that will position you as best in class. You probably have an interesting idea on different features. You probably have a feature grid and you think it’s a strategy.
Favorite book and why?
I tend to read mostly non-fiction. The book I’m reading now I think is pretty fascinating, it’s called Sapiens: A Brief History of Humankind. It looks at the evolution of mankind through the ages; I’ve recently become fascinated about genetics and how mankind evolves as a species. I’ve also read my share of Bruce Springsteen books and now reading Born to Run.
A VC or angel investor you admire and why?
Alan Patricof, who has been a phenomenal investor initially in private equity and then for the past decade or so in venture. He built a great firm with a team behind him. I hope we can all be as vibrant and engaged in our 80s as he is.
Spaces you’re watching closely in 2017?
Geo-information, big data, and artificial intelligence. There’s still more and more information that’s becoming digitized that is local in nature from disparate sources. You’ve got APIs that exist that hadn’t existed before. You’ve got raw data being created in ways that have not been possible previously, and then the advancements in AI and learning algorithms to ingest that and make sense of it have been tremendous.
In 10 years, how will the world we be different from a how-we-live-our-lives perspective?
If you look back, as much as people can be tech enthusiasts, most people overestimate the speed with which new technology will take over.
I think what you will see is greater growth in the area I’ve been looking at, geo-disruptive businesses where the technology of precise digital location is settling down and the advances haven’t been absorbed yet. There will be some really interesting businesses that will get developed based on known technology, as opposed to self-driving cars where there still needs to be additional basic tech developed.