Black Swan Seed Rounds

http://blog.samaltman.com/black-swan-seed-rounds

by BIackSwan • 12 years ago

198 98 12 years ago

blog.samaltman.com

cwal375• 12 years ago

I don't think black swan is an appropriate title. This investing is more like when a small group of people split a large powerball jackpot; statistically unlikely, but not really fitting the definition of a black swan (at least as proposed by Taleb).

His rules:

1. The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology.

2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities).

3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs.

http://en.wikipedia.org/wiki/Black_swan_theory

On a related note, Antifragile is a fun read. Taleb is extremely sure of himself, and extremely passionate. His books and ideas (culminating in Antifragile) can be pretty seductive in the moment.

graeme3• 12 years ago

I think there's a difference from a Powerball jackpot. There, the upper limit is defined. Whereas there's no upper limits on Sam's investments.

They're perhaps not black swans in the sense that Sam is aware they may increase in value, but other than that they seem to match the criteria in a way that Powerball doesn't. Taleb has spoken specifically about how black swans are not lottery tickets because of this calculability.

cwal375• 12 years ago

The limit doesn't matter so much as striking it in the first place. Realistically, all of the mentioned investments are within the realm of reasonable thought. The presumption of a black swan is that it is completely outside the ability for one to rationally assess a system then predict it with decent success. 5/40 would be a phenomenally high success rate.

Lottery is totally not black swan, which is exactly what I was trying to say. Despite having prior knowledge of the company's situation (unlike a completely random lottery), it seems to me that these investments are closer to the lottery than black swan.

You don't place bets on a specific black swan, but you could place a different, outside bet on a disrupting event (kind of the idea of antifragile, benefiting from disorder). I think under Taleb's comments in Antifragile, living life as an artist as opposed to someone who is inherently reliant on the stability of say, an office job, is placing that bet every day.

JoshTriplett2• 12 years ago

I think there's a difference from a Powerball jackpot. There, the upper limit is defined. Whereas there's no upper limits on Sam's investments.

Statistically, you can still define a finite expectation value for an unbounded probability distribution, just as you can compute a finite value for an infinite sum.

prostoalex3• 12 years ago

Whereas there's no upper limits on Sam's investments.

There's no public company with a valuation above $1 trillion, so there's an implied upper limit in practical terms.

lifeisstillgood2• 12 years ago

I like this. My favourite rubric in this area is "there are no Black Swans only Xmas Turkeys." I think that is similar to your view - that all the evidence we need to deduce an out come is available in front of us if we have the right model (human farmers are charitable to turkeys is a bad model, 23rd of December will not result in another free meal is a better model)

I am surprised that investing, especially with Mr Altmans connections and experience, is still a 1/8 crap shoot and that's with no IPOs / exits. It indicates that the model we hold for what the world will look like in 5,10,20 years is far far from complete.

cwal375• 12 years ago

I think that 1/8 sounds amazing actually, let's look at some totally theoretical and extremely simple numbers (basically all we can work with in this case without doing some significant legwork to try and sniff out the actual investments).

To keep it simple let's invest $100 in each of those 40 companies. He defines success as companies that have grown at least 100x over. We know 5 companies have hit that mark and know basically nothing about the other 35 that we'll just consider failures (even though they might only be 10x or 50x[a success in other areas for sure]).

Failed$ = ($100x)35 x is the multiplier on that money across all 35 companies. Perhaps he lost it all and it's 0, maybe it's slightly above 1, who knows. Regardless, in this totally mad eup case the total potential loss (ignoring potential to be invested elsewhere) is $3,500 or 87.5% of initial outlay.

The remainder using the simple information and interpretation available to us looks like this:

Success$ = ($100* 100) * 5 = $50,000

That is 12.5x the initial outlay of $4,000. Making 12.5x your outlay in presumably only a handful of years is massive. Obviously growth doesn't mean exactly 100X, but I just wanted to show that a handful of hits (and I think 5/40 is bigger than a handful) can easily pay for everything else and more.

Reread the article, this is only 2-3.5 years of duration. That seems insanely quick for these kinds of results.

jmtame3• 12 years ago

I don't follow your logic here. What rules do seed stage startups break when it comes to Black Swan theory?

spinlock2• 12 years ago

It simply doesn't apply. A black swan is a rare event that is almost certain to happen (or at least one of them will) that will destroy vast amounts of wealth. Because they are so rare and it's so hard to predict which one will actually happen, people don't prepare for them so they do an incredible amount of damage to the financial system.

The idea is orthogonal to seed round investing.

mehwoot• 12 years ago

The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities).

Success rate is computed and regularly measured by VCs. Otherwise rule of thumbs like 7/2/1 (On average 7 startups will just fail outright, 2 might make your money back, 1 will make you a profit) wouldn't exist.

jdh• 12 years ago

Almost by definition, if it were a black swan, you couldn't hit 5/40 no matter how good or lucky you were.

Alex3917• 12 years ago

Taleb's book is basically anti-science, in the sense that he's making a (good) case about the dubiousness of the epistemology underlying the scientific method. In the colloquial sense though a black swan has just come to mean an event that most people didn't expect.

mseebach• 12 years ago

I've only read Fooled by Randomness and The Black Swan, but those at least aren't anti-science at all. The argument is that in physics as our ability to measure the world goes up, so does our ability to accurately predict it to an extremely high degree of precision, and we've relied on this fact to build an expectation that the same is true of all sciences, and this is simply wrong, especially because it looks like any fault in prediction is just a flaw in measurements. As soon as we humans making our imperfect decisions enter the equation, a treacherous but inherent element of pure unpredictability appears and unless we temper our faith in our ability to predict the world through models, we stay prone to being surprised by black swans.

zmitri• 12 years ago

What's an approximate range of $ raised/valuation that makes for a Black Swan seed round in your opinion? It's hard for me to understand what the implications are of this besides "don't believe the hype" without having some relative sense of that.

tormeh4• 12 years ago

A recent blog post [0] from the Economist stated that buying random stocks on the stock market actually performs better than valuation-weighted investment and conscious investment. I wonder if the optimal strategy is to just invest randomly?

[0] http://www.economist.com/blogs/freeexchange/2014/06/financia...

chimeracoder• 12 years ago

That's really an argument for buying index funds, since the costs and fees of buying and selling random stocks would eat away any profits very quickly.

(Even just buying and holding truly random stocks is still less likely to be a better investment strategy than index funds after taxes and fees are taken into account, let alone the volatility).

tormeh4• 12 years ago

Sorry, I think I wrote hedge fund when I meant index fund. To clarify I've just replaced it with "valuation-weighed investment".

josu• 12 years ago

What about a random fund? Is there such a thing out there?

applecore• 12 years ago

That strategy only makes sense for markets that are close to "informationally efficient", e.g., the public stock market.

tormeh4• 12 years ago

I don't get it. The strategy involves throwing darts at randomly sorted stock listings. It uses absolutely no information other than the fact that the company is public. It actually implies that information is harmful. It's vulnerable to people setting up lot's of companies to win the investment lottery, so everyone can't do it, but otherwise I don't get what you mean.

MaysonL• 12 years ago

Here's an interview with a guy who runs indices that are not valuation-based and seem to do better:

http://www.ritholtz.com/blog/2014/07/masters-in-business-rob...

prostoalex3• 12 years ago

A random buy is likely to be smallcap-biased, as there's simply more of them.

Smallcaps performed quite well over the past decade. Same strategy would not backtest with the same levels of success during any period.

snowwrestler• 12 years ago

"Make your own decisions" is good advice, but I think the main question is whether there exists any reliable means of distinguishing the good contrarian vs. bad contrarian investments--or whether it's just luck. The title seems to imply that the answer might be just luck.

silverlake• 12 years ago

So investing at the seed stage is random. I'm surprised that VCs don't help new companies more in the early stage to mitigate some of the common failure patterns, for example the list PG had in 2006. Perhaps couples counseling for YC founders? Every little bit reduces investor risk even a little.

http://www.paulgraham.com/startupmistakes.html

prostoalex3• 12 years ago

"Engineered random". Sam still gets a better deal flow than most of angel investors are out there, so even "meh" companies with high risk have passed some initial filter.

Any angel investor without the name or brand recognition gets much worse deal flow plus the companies subject to negative selection bias, as they've been rejected by sama, SV Angel, YC, etc.

sama3• 12 years ago

to be clear: i don't think seed investing is random. far from it. i just think it's really important to think independently and take the time to really get to know founders and understand businesses instead of just following other investors.

holoplus• 12 years ago

This is intuitive - Startups that follow all fail - Investing in startups should be the same

Curious if there are patterns in why the hot ones Fail ?

S4M• 12 years ago

Don't forget that any startup has by definition a low probability of success - maybe the best ones have something like 20% (a ballpark) - so I don't think there's a definite pattern to predict successful startups.

edanm6• 12 years ago

Curious thought- you mention the (unsurprising) thought that people who are good at fundraising aren't necessarily good at running a company.

But, all other things being equal, I'd expect someone who's good at "winning" at the game called "raising money" to be the type of person who is better at winning at other games, e.g. running a good company. In other words, while being good at raising money doesn't necessarily mean they're good at running a company, I'd still take them over the "average person".

You seem to imply the opposite in your post - is that really right? Maybe people who are good at fundraising have spent too much time/energy on that vs. getting good at building a company? That sounds specious to me.

nostrademons4• 12 years ago

If the skillsets needed to found a company are largely independent and time spent learning them is a limiting factor - both of which are true in my startup experience - then time spent learning the fundraising skillset cuts into time spent learning customer development, or the particulars of your market, or engineering, or hiring, or management. You'd expect skill at fundraising to be anti-correlated with some other important skill, then, because you don't have time to get good at some other skill you need.

I've never seen a startup where the founders knew everything they needed to at company formation. Usually it's one giant, steep learning curve.

amirmc2• 12 years ago

You could think of it this way. If someone is really, really good at sales, would you expect them to also be great at (say) general management too? I wouldn't.

A company needs all kinds of complementary skills but in the beginning it only has whatever the founders can bring with them.

robg• 12 years ago

it's really important to think independently and take the time to really get to know founders and understand businesses

Will this view carry over to YC interviews? 10 mins does not engender this outcome.

sama3• 12 years ago

no. at the stage of YC, we're looking for something very different. (though we do try to think independently :) )

we put a small amount of money into a large number of companies. the most important thing is that we not miss a potential huge company; we're willing to make a lot of mistakes of inclusion to that end.

when you're making just a small number of high-dollar bets, you have to handle it very differently.

tmuir2• 12 years ago

Isn't basing the multiplier on valuations at the latest investment round disingenuous? After all, its just a number the owners and investors hope someone will eventually pay for the company. It's the asking price set by people hoping for large returns.

rgbrgb• 12 years ago

Well it's a number that some people (the investors in that round) DID pay for a chunk of the company. If those investors have any sway on the board then it's well below the asking price for the entire company.

tmuir2• 12 years ago

A valuation based on an investment round is the valuation of the complete company, not just the amount invested. So if I invest $1M for 10% of a company, that "values" the company at $10M.

bthomas• 12 years ago

There's no evidence here that successful seed companies are more likely to look like bad ideas than unsuccessful seed companies. If 4/5 black swans look like bad ideas when they start, but 4000/5000 of this year's startups also look like bad ideas, then there's no effect to explain. The only lesson is that seed investing is just throwing darts.

foobarqux• 12 years ago

And being wealthy and well connected.

recalibrator3• 12 years ago

Teespring and Zenefits I've never even heard of until today. Are they rolling in the bank and disrupting their respective industries?

And Stripe, there was huge pent-up demand for a PayPal alternative before they came on the scene. How could anyone say that was a "black swan" bet? It doesn't make sense.

bellerocky2• 12 years ago

When Stripe came out it did not compete with Paypal, it competed with companies like Braintree. Stripe was never just a traditional payment gateway. It created an API for payments and a dashboard for managing invoices and recurring customers.

Pent-up demand for a PayPal alternative are from sellers who have a customer facing PayPal payment mechanism. Customers know they're paying with Paypal and customers usually have a PayPal account they use to pay you with. PayPal can hold on to customer funds like a bank.

With Stripe, a customer doesn't know you're using Stripe and if they had a Stripe account they wouldn't be able to see all the purchases they made at various sites that used Stripe, they're just not the same thing.

PayPal now owns Braintree, so they now do compete with Stripe.

recalibrator3• 12 years ago

I recall Stripe was being positioned as a PayPal alternative to collecting international funds, but that wasn't the point.

My point is there is no black swan here. Far from it. It makes no sense in this context.

tomazstolfa• 12 years ago

Did you invest in Stripe (or start a similar company)?

It obviously was a difficult bet - young founders, powerful incumbents - plenty of risk and unknowns.

That said, I believe a good seed investor will spend a lot of time with the founders and the team before pulling the trigger. You'd be surprised at how few investors actually do that.

sbisker• 12 years ago

Teespring at least is doing very, very well. Their affiliate program is incredibly successful, allowing people to procedurally design, test and sell t-shirts through various channels.

imjk2• 12 years ago

Sam, could you (or any other Angel investor) talk frankly about the money your put in and what your exact returns have been. How much have you had to reinvest in later rounds too. I can't find any really experienced angel to talk frankly about this with me.

sama3• 12 years ago

in 5 years, when the numbers should be real, i will shared all my aggregate data.

the normal warning i give people: seed investing has always been hard, and likely to continue to get harder. valuations are up on average maybe 3x since i started, and it's not clear the companies are 3x more valuable.

ChuckMcM• 12 years ago

   > valuations are up on average maybe 3x since i started,
   > and it's not clear the companies are 3x more valuable.

This is something I've been thinking about as well. Are companies creating less value? Or is the value being going elsewhere?

In a constrained supply there might be an argument that things that wouldn't have been funded before, now are, and those represent less value creating ideas. But it seems YC is always oversubscribed, would that keep the quality high?

Is the vision of the investors getting cloudy, or more specifically are there still companies that are 3x as valuable but they are being funded elsewhere?

Or is just the capital availability pushing down the yield price on seed rounds?

I don't have any answers, but its interesting to think about.

arbuge• 12 years ago

Can you comment in general on when you consider a seed round to be overpriced, and what exactly goes into that determination?

I see several seed rounds (~$1-2m rounds - not sure if this is also the size you're referring to) on crowdfunding sites priced at $10m or so pre-money, with revenues just starting to approach ~$100k per month, and so far haven't invested in any because they all struck me as overpriced. They would definitely have been way cheaper a few years back in that same situation.

kristiandupont• 12 years ago

[...] it's not clear the companies are 3x more valuable

However, companies are probably somewhat more valuable, right? I mean, the world seems to be learning about entrepreneurship the same way it was learning about manufacturing during the industrial revolution. That to me would indicate that the average value of startups is increasing.

erohead• 12 years ago

Paul Buchheit has blogged very candidly about his angel investing numbers: http://paulbuchheit.blogspot.com/2011/01/angel-investing-my-...

imjk2• 12 years ago

Cool, thanks. That's def the type of insight I was looking for. It's surprising that someone as credentialed as Paul Buchheit has had such "modest" success/returns on his investments. $1.2MM also seems like a very conservative sum for someone of his net worth.

mikeryan• 12 years ago

That post is dire need of a follow up. Would be great to see where some of the more final numbers end up of his three he's still looking forward to Weebly is still kicking at a $500M valuation, Meraki was acquired for 1.2B and Wufoo got a small acquisition at $35M

razvanr• 12 years ago

I suspect there's also an inverse correlation between the amount of money raised at an early stage and founder focus going forward.

It's easy to interpret a large seed round as early success and become side-tracked or overestimate what your company's impact really is at that stage. Which can impact focus and lead to disaster.

ameister142• 12 years ago

While there might be a point where an effect like this would take place, I think you'd have to raise an extremely substantial seed round for that. I don't think it would be a truly inverse correlation, at least not a normally distributed one. It would probably be one sided as well, because getting no funding shouldn't increase focus.

panabee• 12 years ago

he lists four: teespring, zenefits, stripe, and optimizely. anyone know the fifth?

chatmasta• 12 years ago

A few more reasons raising a quiet/controversial seed round might be a good signal:

1. Publicly raising a large seed round creates a lot of hype when the product might not be ready yet, or even before there's any product/market fit. As a founder, that creates a lot of pressure to satisfy the hype, and also might cause you to attempt building a product that satisfies the opinions of the blogosphere, rather than your customers. In contrast, when you raise a quiet round, you can build your product and achieve product/market fit without worrying about the outside world, instead focusing purely on your customers.

2. If no investors are questioning the model, you should be alarmed. Almost by definition, no company seeking a seed round has proven revenue model. Knowing this risk, you should expect some fraction of investors to be questioning it. If none are, then it's likely a signal that they've been swayed by smooth-talking founders who are very good at raising investment, but, as you mention, not necessarily fit or ready to build the business they're hyping.

So if we assume quiet seed rounds help with success, this leads to some questions about YC, which is essentially a loud seed round. Namely: should you announce your YC acceptance before you have product/market fit? Should you go through YC in stealth mode until ready to capitalize on hype?

It seems your observations can tell us a lot about the value, or anti-value, of product hype. The lesson seems to be, in the words of Denzel Washington/American Gangster, "the loudest person in the room is probably the weakest."

wunderlust• 12 years ago

This essay might be remotely insightful if Sam explained why great companies "often look like bad ideas at the beginning" and "look really risky at the seed stage".

EGreg• 12 years ago

Does Sam Altman continue to do angel investing or now that he's running YC he's stopped as part of their policy?

hharrisbrown• 12 years ago

In the case of competitive seed rounds (like mentioned Optimizely), would be interesting to hear why someone like Sam's money was accepted over others -- any thoughts?

Black Swan Seed Rounds

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