Intuition is nothing more and nothing less than recognition.Thinking, Fast and Slow | Daniel Kahneman
Before discussing a methodology, i.e., a logical investment decision-making framework, I would first address the elephant in the room: emotions. Whether you admit or not, emotions are always involved in decision-making. When contemplating a prospective investment, greed and fear are the first things that loom in my mind. One of the sentiments that I associate with seed investments is Fear of Missing Out (FOMO). There are two components in FOMO: 1) the idea that there must be something better out there and 2) the sentiment of exclusion or scarcity. Some accelerators advise startups to capitalize on investor’s FOMO and manufacture pressure and competition to allure such investors.
FOMO concerns to sleep if you stick to your competitive advantages and if you trust your brains and guts when saying ‘no.’. Similarly to some VCs, as part of my regular practice, I keep track of my anti-portfolio. I am sure that due to the law of large numbers, at some point, I will regret learning that one of the ‘pass’ opportunities has become a unicorn. Still, I accept it as part of the rules of the game.
What can you do?. Typically two things: preparation and trusting your guts. The practice consists of some form of due diligence, knowing the market (particularly who are the competitors and their strategy), interviewing the founders, etc. The second thing I do is to trust my guts, i.e., my instincts. I share Malcolm Gladwell’s view in Blink, that in most cases, spontaneous decisions are often as good as—or even better than—carefully planned and considered ones. Unconscious pattern recognition should allow me to spot cases to be passed or considered for further research, i.e., startups that seem to have some anomaly. To enable some reflection and to avoid any compulsive buying behavior, I usually impose a 24-hour wait rule before making any investment decision. Then I tend to act swiftly.
Part of the FOMO problem in seed investment arises from the fact that in general, there is no cooling-off period. Once the check has been sent and the documents are signed, usually, there is no turning back.
Investment decision framework
After a cooling period, I then apply my investment criteria and the following framework for deciding whether to invest or pass:
- Product/Market fit – Who are the customers? Competitors?
- Secret sauce
- Will this investment ‘return the fund’?
- Estimate value at exit
- Time to exit
- Path to exit: How many rounds? How much funding? How dilutive?
- Free Cash Flow / Leverage / Liquidity (path to exit)
- Pre-Money Valuation vs. benchmarks
- Margin of Safety
Some additional tests that I would love to implement, but haven’t done so far are the following: