Nivi: There are so many sources of dealflow out there, from friends and incubators to AngelList, FundersClub and Republic. Why is it so important to get into the deals you want to get in to? What happens if you don’t?
The majority of returns come from a few deals
Naval: One out of 100 or 1000 companies account for the majority of the returns every year.
If you look at just about any successful angel investor’s portfolio, the majority of returns come from one deal. And when you take out the top deal, the majority of the remaining returns come from the second-largest deal. It’s extremely nonlinear.
If you removed the top two or three deals out of just about any fund’s portfolio, you would probably have a negative performing fund, instead of a 4x to 10x fund.
Getting cut out of deals is a sign you won’t do well
It’s all about adverse selection. When you get cut out of a deal, that’s an indication that the deal may be a winner. Instead of a one-in-100 chance of becoming big, the chances are probably one-in-five or better.
This is a common scenario: You meet a company that’s raising capital, and while you’re taking to time decide, a top-branded investor rolls in and writes a big check; next thing you know, everybody piles in because there’s tons of signal; and now the entrepreneur says, “Sorry, the round’s closed,” or, “I only have $10,000 left for you.” This is when your brand makes a difference.
I started AngelList partially because I was cut out of some very big deals early on that, to this day, I have qualms over. These would have been career-defining deals that would have made me a lot money. But my brand simply wasn’t strong enough.
Even though you want to be non-consensus right, there comes a point when consensus has value: when the Sequoias of the world show up; when the statistics become more baked; when the founders are well known; when there’s more information on the table. Also, when Sequoia invests, it can create a self-fulfilling prophecy by removing some future financing risk and allowing the company to stand out when it’s recruiting or going for PR.
Nivi: Dealflow and access are the most important things to work on as an investor. Your judgment doesn’t have to be that great, because the returns follow a power law. And you can always get capital if you have good dealflow and access.
It’s okay to pass on investments—you just don’t want them to pass on you. You don’t want to hear, “I will come to you if I don’t get money from Sequoia.”
Paying two-and-twenty to a good angel investor is a steal
Naval: This is why it’s often better to back an angel investor and pay their management fee and carry, rather than going out on your own. In angel investing, it’s a steal.
The old two-and-twenty model was put in place by KKR, a private equity firm managing billions of dollars. Today, an angel who’s managing a just a few million dollars will charge you the same two-and-twenty, even though their labor as a proportion of the invested capital is far higher.Go to YC and ask them to invest your money for two-and-twenty at the same time they put in their own money, and they’ll laugh you out of the room.