Miss these red flags, and you'll miss your cash
Today in 10 minutes or less, you'll learn:
✔️ The #1 rule to investing
✔️ Red flags for Contrarian dealmakers
✔️ Even the big fish don't take unnecessary risks
The #1 rule to investing
Rule #1: Never lose money.
Rule #2: Never forget rule Number 1.
– Warren Buffett (Le Sage)
Let's not overcomplicate this. The best way to be worth more today than you were yesterday? Don't lose money. We call that framework loss aversion. It feels more painful to lose money than it does to gain it.
So, our entire article today is about one thing: Getting you more pain-free than a recent Vicodin recipient.
Maybe we're late to this party. Sam Bankman Fried isn't even in any of the top tweets anymore on Twitter. How quickly we sweep $51 billion of fraud and theft under the old rug. But hey, what's $51 Billys amongst buds, amiright?
Nobody likes losing cash
Anyway, we got to thinking about red flags in investing while going down a Bill Gurley wisdom rabbit hole. You don't know Bill? Well, Ole Bill is one of the Sages of Silicon Valley, investing in names like Uber, Glassdoor and Nextdoor, to name a few. Meaning he's a very smart investor, who has become incredibly rich and made many other people incredibly rich alongside him.
Here's Bill advising Uber's founder Travis Kalanick.
Just kidding, those are actors portraying him and the controversial Uber founder in the new series Super Pumped. Which is pretty fantastic, if we dabble in TV critiques for 30 seconds.
This is actually Bill. Bill is a bit of a legend for investing in startups, picking stocks back in his equity analysis days, and creating a singular investment focus at his early-stage investing firm Benchmark.
We were reading one of his articles on a red flag checklist for investing in startups, and the article started with this quote from John Ray III, the new CEO and Chief Restructuring Officer at FTX:
I have over 40 years of legal and restructuring experience. I have been the Chief Restructuring Officer or Chief Executive Officer in several of the largest corporate failures in history. I have supervised situations involving allegations of criminal activity and malfeasance (Enron). I have supervised situations involving novel financial structures (Enron and Residential Capital) and cross-border asset recovery and maximization (Nortel and Overseas Shipholding).
Nearly every situation in which I have been involved has been characterized by defects of some sort in internal controls, regulatory compliance, human resources and systems integrity. Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.
Red flags for Contrarian dealmakers
The difference between me and Bill Gurley is, oh I don't know…decades of experience, billions of dollars to invest, probably 100s of millions difference in net worth. I'm still a relatively small fish, like all of you.
So today, we'll outline our own 12 red flags for all of us normies investing in boring businesses. In my experience, these are signs of deeper issues that make me take a closer look (or pull the plug) when investing in a company, doing a deal or buying a business. May the force be with you.
#1: "Jack of all trades"
When someone lists more than 2 jobs or 2 companies they have at any given time, consider the flag waved. No, you do not do 10 "board" positions or startups well simultaneously. I will pass on a startup investment if your resume looks like this. Sorry if this is your LinkedIn.
#2: "Building the brand"
If someone has a new startup and a podcast? Immediate no. Grow the business first, not your brand. Unless you are a media company and the podcast is the business, I do not want to invest in an adtech platform that is launching a podcast to increase its advertising base. I'm on board with TikToks for consumer products (anyone follow Scrub Daddy?) but if it's the founder's vanity play, that's a pass. Straight to jail, do not pass go.
#3: "Look at me"
You walk into a startup founder's office and the walls are covered in articles about them. This is a true story. One of my firms had invested $2 million into a company when we got a phone call no investor wants. "Ahem, turns out we are about 30 days away from insolvency." So we saddled up and flew out to Venice California.
Red flag #1 could have been that they offered us coconut milk lattes from the full-time barista, but it gets better. As I climbed the stairs to the CEO's new office, I walked down his "hall of fame." 20+ framed articles and pictures of him, celebrity selfies, a ribbon cutting ceremony for this office. I almost stopped the financial audit then and there, because I just knew we had a sunk cost on our hands.
Framed self portraits? Run, don't walk, away.
#4: "Lack of adults"
Bill talks about the lack of a legitimate board: "Delaware law requires a board of directors, and these directors are tasked with a 'fiduciary duty' to look after the best interest of the corporation. As such, the task of governance falls squarely on the shoulders of the board of directors."
At my last VC firm, we used to have a process where we'd analyze the cap table of fellow investors and ask to get all their LinkedIn profiles, and sometimes contact information, to make sure the other investors were pros and not neighbors. You'll be amazed how often the board, the cap table, and the co-founders are all "yes" men. You want pros, not bros.
#5: "A crowd of cooks"
If you have a company with 3+ founders, it's a no. Too many cooks means a disaster in the kitchen. One of the companies I almost invested in had 4 founders. I found that curious, so I dug in. Essentially, what they actually had was an ego-maniacal founder who had brought in 3 others who never questioned him and were there to coast on the capital raised.
This happens often in family-run businesses with second- or third-generation family members at the helm. There can only be one, maximum two, decision makers. You can still do the deal, but kick out the crowd with a restructuring.
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#6: "a Thread..."
A founder writes a slew of Twitter threads while in the early stages of their non-media company. I am highly tempted to name names here, but that wouldn't be very classy. I can nearly always predict when someone is about to leave a company, announce their startup is failing, or sell their company…based on when they begin to post Twitter threads.
Like a wandering eye from a cheating spouse, clout-signaling usually means there is a problem on the home front. You can capitalize on it, just don't invest in it.
#7: "EBITDA(C)"
Still makes me chuckle. EBITDA(C) or EBITDA adjusted for Covid. Is there a better red flag than this one? It's basically saying, "Our EBITDA was awful and thus because of Covid we've come up with a fake number to portray what we wish the numbers were during Covid."
Bill talks about these as "unique financial data representations." Which in simple speak means, if you can't use traditional metrics to show your progress or lack there of it, it's a red flag.
- ROIC - return on invested capital
- EBITDA - earnings before interest, tax depreciation and amortization
- FCF - free cashflow
- Net profits
- Revenue
That's really all you need.
#8: "Aversion to audits or tax returns"
In our small world of doing non-public deals, we don't see a lot of audits. Dat's 'spensive. But, we do look at tax returns. Dat's mandatory.
Bill talks about audits as a normal part of getting large checks post series A. I think of it like this. If the person who wants you to invest in their company says they are materially different than their tax returns, either they lied to the government (so they're probably cool lying to you, too) or they are quite bad at financials. Either way, you're going to have to Sherlock Holmes this b*tch. We all need referees.
#9: "Side hustle is you getting hustled"
A potential executive you want to bring on has a side hustle? Nope. The founder of a company you want to invest in has another biz? No thanks. My cash with you still involved means your full attention.
Bill says it like this: "Of all the checklist items, this is the one that is an absolute non-starter. No one operating a venture backed startup should be simultaneously running another corporate entity that has overlapping interest, competing interests or even potentially competing interests. The standard should be the appearance of impropriety. The potential for bad behavior is simply too great. If there was a recipe book for corporate fraud, this would be the first chapter. Just say no. Plain and simple."
I'd make this broader and say forget conflicts of interest – split attention is a conflict in and of itself. Unless you're Elon Musk…and you are not.
#10: "You have a rich uncle in Nigeria"
No you don't. That email is a scam trying to get your cash. When you invest in a startup internationally, 9 times out of 10 I think you're going to lose your money. Unless you are a pro with feet on the ground, it's hard enough to do deals in your native country. Don't f around and find out in a language you can't even speak.
Cayman Islands, the Bahamas, Panama, Switzerland, Hong Kong…tread lightly. It doesn't mean the deal is automatically bad, but it means it's much more likely to be bad.
#11: "Show me your…updates."
The way you give updates to investors shows me the way you run your business. Period. I get hugely annoyed with poor company updates. Quantitative investor updates concisely explained with appropriate context is my love language.
#12:"Beware of Large Founder Exits"
Secondary transactions have become commonplace in venture-backed startups, especially as the company moves to Series C or beyond, and in situations where the time to liquidity may be further out than previously expected. There are many good arguments that allowing the founder to take "some of their risk" off the table is good for the company. As a result, it is common to see $1-5mm early liquidity for founders. However, when $5mm becomes $50mm or many hundreds of millions you are dealing with a different beast. You never want to be a buyer in a pre-public round where the person you are negotiating with is a very large seller. You should assume they know something you do not.
#13: "But they all did it"
The bandwagon framework. You need to invest because everyone else did. Oh, don't wait, because the wagon with all the cool people is pulling away. I have a saying for our investment team: "If it's a rush it's a push." If they need an immediate decision, it's a no. If it's an exploding offer, let it explode.
Even the big fish don't take unnecessary risks
The secret is that, for most investors who are managing billions of dollars, not losing money is more important than making 100x bets.
Your most important decision is your first deal. Because if you lose big on that, you may never do another one. You may think "deals" or "investments" are bad, not that you were unskilled.
Protect the house. Then you can build the castle in the backyard.
Also, if you want to get f-you money through "passive income," the only way I know to do that is through investing. Spoiler: it's the ultimate opposite of passive to start. Eventually your money can work for you, but first you need to learn where to employ it.
I'd read just about everything put out by:
- Bill Gurley
- Howard Marks
- Sam Zell
- Charlie Munger
- Warren Buffett
That should be a good start. Steal 10,000 hours…and a few zeroes.
"To make real money you have to not only be contrarian, you have to be right."
- Bill Gurley
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