It's really hard to zig when the whole world seems to be zagging. One of my favorite quotes I learned in high school was:
"Nonconformity is the Highest Form of Social Attainment"
It was written as the yearbook quote of the smartest seniors as I was finishing my freshman year. It has always stood with me. I have had a low bullshit meter. I remember it even way back in kindergarden when my Saturday school teacher tried to tell me about Noah and Adam & Eve. Those stories didn't sound that plausible to me. Much to her chagrin, the other slogan I have always lived by is
When the masses start all running one way without questioning "why?"--and when it defies any logic I can figure out in my head--I call bullshit.
And so it happened that between 2000-2008 I was the biggest buzz kill at dinner parties. While many of my friends bragged about their 5 condos in Florida I kept talking about how the real estate market was in a bubble--their gains an illusion. I pointed to several Economist articles I had read that mapped historical prices of real estate for 400 years and how on average property values grow at no more 1.5% above inflation yet in many markets in the U.S. & Europe prices were rising at 10-25% per year.
"Yeah, but there is a shortage of supply. People always want to buy near the water and there is limited supply. The fundamentals are different now! You're stuck in the past."
The price of property has an inherent value tied to two factors: 1) the rental rate you could charge for your property and 2) annual salaries in a given geography. For reason number two people pay a higher price & rent in New York than they do in San Antonio, Texas. Yes, there are some factors that can affect property prices beyond these two factors (e.g. a high portion of vacation homes or a market changes in demographics such as age) but income (and the employment rate) has the highest correlation in most markets.
At dinner parties I was wrong for several years but I stuck to my guns. The numbers just didn't make sense to me. I kept pointing to the artificial gains in the Nasdaq in 1999 and said, "just because you bought in Feb '99 and sold in Sept '99 for a large gain doesn't meant the asset was correctly priced." My message to everybody at the time, "Sell!"
And so Buzzkill Suster continues.
The dinner parties now are filled with self-righteous angel investors bragging about how many deals they are in on. They have marked-up paper gains propped up by an over-excited venture capital market that has validated their investments. For now.
Logic tells me the following:
- It is hard to make money angel investing. I have called it a "mug's game" and I mostly try to avoid it. The best angels will do very well just at the best real estate investors did well in good times and bad. But the masses have now entered the market and everybody fancies themselves an "angel investor." It is the new calling card. It is the new cocktail party conversation. We list it on our bio's as bragging rights. We jockey to make sure the press release has our names on it. It is slowly becoming Florida Condos. And it's driving up prices beyond their inherent value.
- There are too many deals. For venture capitalists this isn't troubling. Too many angel deals just means more to watch and invest in for the ones that do succeed (if the VCs can get in at reasonable prices). But all of this increased company creation has to go somewhere. Arguement one says, "the world is different now. It costs less money to start companies so the world should have way more startups." I've heard the "world is different" argument in every bubble I've ever seen. It's true that it's cheaper to start companies now and cheaper to get distribution. Most of these companies will not get big enough and earn enough profits to pay big enough salaries for teams. People only put up with "ramen profitable" salaries for so long before they become disenchanted. Argument two says, "big companies can't innovate anymore so Google, Apple, Microsoft, etc. will continue to buy up this talent as a form of R&D." That is true--in a booming market like we're seeing now. Remember it was only 2008 where Microsoft and even Google were laying off employees.
- Many may simply hit the wall. If the "forever ramen profitable" or "startups as a source of M&A innovation" arguments don't hold then we're likely headed for one big brick wall. That would mean that the increased number of new business startups will lead to a "funding gap" of deals that can't get financed. We haven't hit that wall yet for three reasons: 1) not enough elapsed time, 2) the VC market is frenzied now, too and 3) we haven't seen a market downturn since the volume picked up.
- Great businesses take 7-10 years to build. People often talk about what makes a great investor. I always say, "if you're judging actual returns on a 3-year timeframe you're looking at mostly failure. This is the time it takes for a bankruptcy or asset sale to occur. Or a quick flip. Any of these scenarios aren't great outcomes for investors." The reality is that the "big winners" in business that drive extra-ordinary returns often take 7-10 years to materialize. Dan Munro linked to this excellent article in the WSJ in the comments with real data to prove the point. The problem is that this is longer than the average economic cycle, which means you need to be able to manage in good times and bad. Bad times often require more capital but ironically this is when capital is dried up. Bad times are when M&A halts to a trickle and this is when many businesses are rushing to get exits. If I judge the success of the "angel boom" by the last 18 months it is a resounding success--at least on paper. But I'll judge the angel class of 2009/2010 on a 7-10 year time horizon. We'll re-compare notes then.
- Investors are conformists by nature. I believe that huge financial, productivity and technical gains come from new innovation rather than derivative thinking. This requires novel thinking. Yet nearly any entrepreneur who has an idea that other people aren't doing will tell you that it's hard to get investors excited. Instead investors are looking for the next flash sale, private sale, game dynamic, social games that rely on mobile platforms with geo-fenced, location aware offers. That is conformity.
- People buy at the wrong times. Most of my MBA classes were a waste (since I had studied economics as an undergrad) but one totally changed my thinking. It was an investment management class. The professor showed that there is a big increase in volume of buyers as a market peaks and a big increase in selling as the market is falling. He said that data suggests people prefer to "buy high, sell low." And so it goes in tech investing. I saw VCs doing crazy things in 2007-08 when I first entered the VC market--crazy prices, limited due diligence, large funding rounds. I avoided much of this. in 2009 the market was completely constipated as investors focused on triage. I was very active in 2009 / early 2010. The market is over-heating again with people chasing deal. It's like "market amnesia." I must also say that all those angels who hid their checkbooks in 2008/09 are now back with a vengeance and paying higher & higher prices. Same with VCs. And now everybody is an angel. Even people who haven't had good exits, gained experience in their careers or have enough deep pockets to last a market downturn fancy themselves as angels.
- I'm skating where I think the puck is going. I'm not giving up on the market completely. I am avoiding "frenzied" deals for all of the reasons Roger Ehrenberg talks about in his excellent blog post. I'm trying to pick themes that I think will map to macro trends over the next 5-10 years. I'm spending a lot of time looking at video production & distribution because I believe this will form a larger basis of the future Internet and I believe that Hollywood & television will face large, disruptive forces. Plus, as I live in Los Angeles it is where some of the smartest talent thinking about this space resides. I'm looking at how the digital living room will change media consumption. I continue to be excited about the Mobile Web (as distinct from the Mobile App). I still love B2B application. I am really bullish on data-as-a-service. I will write about some of these topics soon.
Why should you care?
If you raise money from experienced sources--whether angel, micro-VC or VC--you will be better served in scenarios when the market corrects, where your large competitors launch hostile offerings or where things end up taking longer than you had expected in order to show progress. Mine is not an argument for VCs over angels--it is for sophistication over credulity. In boom times anybody's money will do. I've lived through two tech market corrections at close range. The first money to pack-up and head for the door is always the least knowledgeable / least committed to the long-term of our industry.
Note: If you're new to angel investing you may be interested to read my series on what I believe it takes to be successful--each of these links is an article: Access to the Best Deal Flow, Domain Knowledge, Relationships with VCs, Deep Pockets, Access to Buyers.
Reprinted from Both Sides of the Table
Mark Suster is a 2x entrepreneur who has gone to the Dark Side of VC. He joined GRP Partners in 2007 as a General Partner after selling his company to Salesforce.com. He focuses on early-stage technology companies. Follow him at twitter.com/msuster.