Who Should—and Shouldn’t—Become A Tech Investor? Freestyle Weighs In

1/17/13Follow @wroush

It is a truth universally acknowledged, that a former entrepreneur in possession of a good fortune, must be in want of investments.

Or to put it another way: If you’re a 30-year-old startup founder who’s cashed out of your first company and you suddenly find yourself with a life-altering amount of money (and a lot of time) on your hands, it’s de rigueur to start spreading the wealth by becoming an angel investor. Before you know it, you’ve spent a couple of years and a couple million dollars, dropping $50,000 here and $100,000 there on the companies your friends are starting.

There’s nothing inherently wrong with that. Indeed, it’s one of the engines that drives new startup creation and keeps Silicon Valley and other regions innovating.

But not everyone is cut out to be an investor. And if you’re not careful about it, you’re apt to lose your shirt (or at least your investments)—and in the process contribute to the feeding frenzies that have been driving startup valuations to unsustainable levels.

Or so say Josh Felser and Dave Samuel. Former entrepreneurs themselves—they sold their first company, the music service Spinner, to AOL Time Warner for $320 million, and their second, video network Grouper, to Sony for $65 million—they’re now the founders of Freestyle Capital, a seed-stage venture firm in San Francisco. Their own transition from operating startup guys to part-time angels to full-time venture partners was not without its difficulties, and when I visited right before the holidays they were in a mood to share some of what they’ve learned with other entrepreneurs considering making the leap.

The upshot, as you’ll see from the Q&A below, is that investing is no game. It takes both discipline and detachment; the ability to cultivate a specialty and build a brand; a willingness to answer to your own investors (the LPs); and the ability to say no. A lot.

But perhaps more than anything, venture investing takes commitment. Maybe not quite as much as being a startup founder—Felser and Samuel say they’re investors in part because they couldn’t figure out how to make startup life mesh with family life—but enough to keep you busy full-time, and then some. “If you are a lifestyle investor and you are dabbling in it, or if you are just doing it to make money, you are not likely to be successful,” Felser says.

Felser and Samuel, who are both in their 40s, have invested in some big winners like co-browsing startup GoInstant (acquired by Salesforce.com last summer for $76 million), some hot up-and-comers like meme-sharing site 9Gag, and some still-struggling startups like Q&A site Formspring. They raised $26 million for their first fund in 2011 and said they intended it to last for two years, so it would be reasonable to conclude that they’re back on the fundraising trail—and therefore interested in talking with reporters and raising Freestyle’s profile. Regardless of their motivations, it was a fun conversation that should be enlightening for anyone thinking about getting serious about tech investing, or about working with Freestyle.

Xconomy: Why do so many entrepreneurs who have had a wealth-creating event in their careers suddenly become angel investors or venture capitalists?

Dave Samuel: I can definitely answer why Josh and I chose to do it, and this may also be why other people choose to do it. One reason is diversification. If you’re a little ADD, you get the ability to not just focus on one company but be involved with numerous companies. There’s the advantage of simulation from all the different ideas going forward.

Second, being an investor I’m not managing anybody directly. So, honestly, it’s less stressful. Josh and I work just as hard as when we were running our companies, but we work with more freedom because we don’t have anyone reporting directly to us.

And I think probably the third reason is that we like to start new things. Josh and I had done both Spinner and Crackle [fka Grouper] and we said, let’s try something new. It’s refreshing being on the other side of the table.

Josh Felser: If I could figure out the right life balance, I would probably be starting another company. It’s only because I can’t figure it out that I have chosen the next best thing, which is to work with entrepreneurs, help them find success, and also help them have a financial gain from that.

X: How did you decide to make the switch from angel investing to venture investing?

JF: If you go back, there were three phases to our investing lives. There was the dabbling phase—and I think we were terrible investors then. Then there was the full-time angel phase, when we started to show some success. Early on, we were undisciplined. We didn’t take it seriously enough. We didn’t have enough deal flow to be finicky. We knew nothing about investing. And we didn’t care as much about generating a superior financial return.

Our due diligence typically consisted of meeting with the entrepreneur, and going on instinct. And investing is much more than instinct. We didn’t have any filters written down. We didn’t put entrepreneurs through the gauntlet, our network of experts. We didn’t even have a network of experts that was formalized. We just invested in things that looked fun. It wasn’t a business.

At the time, Dave and I were not investing together, we were investing separately. We realized that to be successful, we needed to work together. We were successful as entrepreneurs together, even though we are quite different, and we felt like our two ways of looking at the world combined would increase the odds of being successful.

We also realized that if we were really going to try and prove whether we were good at this or not, it needed to be full-time. So we decided to work together full-time and build up a codified network of partners and peers who would help us evaluate companies, and we started collaborating on investments with other angels and form syndicates. Eventually we felt like we became the drivers and leaders instead of the followers, and I think that allowed us to help shape the rounds that companies were raising.

X: What are some of the prerequisites to being an investor—things you should really figure out first if you want to do it well?

DS: If you are going to do angel investing, I think the most successful ones have a thesis, and they have a filter and a process for how they invest. And you need to create a track record. There are also some things you want to test.

One of the things that Josh and I were concerned about was, could we invest in a company and give them advice and then have them not listen to the advice? Would that frustrate us? And it turns out we are okay with it. We want to invest in entrepreneurs who will listen to our advice, but they don’t necessarily have to agree or follow it. We have been comfortable with that.

Another big test is, do you have good deal flow? Since Josh and I have been in the industry for the past 15 years, we have a great network of people that we have worked with in the past. Friends in the industry. That is basically where our deal flow comes from.

X: What kinds of entrepreneurs make good investors, and which ones make bad investors?

DS: I think having a unique background is beneficial. The Freestyle “brand” is two for one—meaning you have the Dave-Josh team who have been working together for 15 years and we are recent startup founders turned investors. Other angel investors have unique backgrounds that they can leverage within the community. An example is Gary Vaynerchuk, who is kind of a social media expert. I don’t know if you have met Manu Kumar at K9 Ventures. He just raised a $40 million fund. His filter is definitely more of a technical one, where he wants to confirm that the team is solving a tough technical problem. That is the brand and the area he has focused on. Then you have Kirsten Green at Forerunner Ventures. She is an e-commerce specialist. Entrepreneurs are seeing the press you have going on, and hearing people talk about VCs here and elsewhere, so brand is important.

JF: You really have to know why you are doing it [investing]. If you are a lifestyle investor and you are dabbling in it, or if you are just doing it to make money, you are not likely to be successful. If you are doing it to stay connected to entrepreneurs and trends, that is not a bad reason to do it, if you invest small amounts. I think anyone who invests as a part-time job is likely not to make money.

X: What were your biggest challenges as early investors?

JF: The whole process of raising capital felt hard. We set out to raise as much capital as we could in seven months. We ended up raising a little over $26 million. The process of raising capital from LPs was not fun. We met with 20 institutional funds and three invested. We had hoped that we were over that whole experience of pitching, but you are never really over it. There is always another level. But it was probably good for us. Now that we have LPs, we have someone to answer to. It also helps us remember what it’s like for entrepreneurs who are raising money.

The other challenge was that we had to get used to advising, not directing. That was hard at times. There were moments when I knew the entrepreneur was making a mistake, and I just had to advise and hope that eventually they would turn it around. I couldn’t force it; it’s not my company. That was more of a challenge for me than for Dave.

So there are tradeoffs. There is nothing more stimulating than being an entrepreneur, when you have control. But now we are in control of our lives, rather than any one company. Our hours are long but we don’t have to work in an office. I can go home at 6 and have dinner with my family and not worry about setting the tone for someone else.

DS: I think one of the biggest lessons that you learn going from being an entrepreneur to being a VC is it’s difficult saying no, and you’ve got to say no a lot. Josh and I, as entrepreneurs, talked to easily 50 VCs raising capital for both of our companies, and 90 percent of them were nos. Now that I’m on this side of the table, we listen to 100 pitches and we say yes to only one of them. I think that will always be difficult, and it is honestly the biggest downer to what we do.

X: Have you gotten any better at saying no?

JF: It’s not any easier, but we have gotten better at it. We never just say no—we say no and explain why. Typically, it’s not enough and the entrepreneurs will rebut. And I always respond one more time.

DS: We try to say, “We have been in your shoes, that’s just how it works.” And we try to give feedback in most instances. But sometimes we have so much deal flow that we just have to decline, and sometimes we are not able to really give a reason, which I feel bad about, but I just don’t have enough time in the day.

X: You mentioned that good investors should have “filters,” meaning, I guess, rules they use to sift out the companies they will and won’t invest in. What filters do you use? What do you want to see in a company’s pitch, and what would automatically disqualify them?

JF: Our filters continue to change over time, and like Google’s, they are unpublished. But I don’t think it would necessarily be a bad thing if the world found out. There are a few surprises in there. I’ll share one of them: We don’t invest in startups founded by anyone who is still employed by another company. We want them to be passionate. If they are not passionate enough to have left their current employer, then how are they going to be passionate about the company they’re starting?

We also have other standards that are more obvious. We only invest in “never-give-up” entrepreneurs. We had a meeting last week with two entrepreneurs who are building a company in the mobile consumer space, and we were talking about their fundraising and exit strategies, and they said, “We can totally see selling this for $30 million.” And that was it, the conversation was over. When I heard that, I said, “You should really raise money from angels, not from institutional investors,” because angels would be excited about that kind of exit, but institutions really want to invest in people who want to change the world or build something that’s going to have an impact.

DS: Josh and I are closely engaged for the first year after we invest in a company. So we want to confirm that, with their seed raise, they can prove that they are on to something big within the first year. So when we meet with entrepreneurs, we are like, “Okay, this is your product today, but what is your goal for a year from now, and is that attainable, and if you hit that goal, does that mean you can go and raise a Series A and take the company to the next level?” That is our biggest filter when we look at companies. We want to confirm that you can prove you are on to something in the first year.

X: What other types of questions do you guys ask at Freestyle that might not come up at meetings with other VCs?

JF: Most entrepreneurs will say they want to build a big, disruptive company, and they want to swing for the fences, but you have to really probe beneath that. We try to get at the validity of that statement by asking questions that aren’t as obvious. It’s important that they are honest about what they want out of the experience, because then they will choose investors who match that. For example, I think it’s great that those mobile entrepreneurs we talked to were honest about a $30 million sale being reasonable for them. The last thing you want is to be matched with an investor who is expecting you to swing for the fences and then they fight with you over your exit. That will not end well for anyone. So we try and paint scenarios for the entrepreneur to get to the bottom of what they really want.

Another area we have been focusing on more and more is, what kind of work culture are you building? Mainly, we want to see that you have thought about it. There are some wrong answers. Not necessarily wrong for the entrepreneur, but wrong for us. We want you to be able to explain why you’re choosing the work culture you’re choosing and how you are going to bring it to life. There’s one mindset where people come in at 9:00 am and work until midnight. Another is that you might want people to come in at 10:00 am and go home at 6:00 pm and exercise and then go back online from 8:00 to midnight. That can work too. But the more they’ve thought that through, the happier everyone will be. If you end up hiring people who have different work ethics, it’s going to be divisive.

X: Can you share some of your best mistakes—the errors you really learned from when you were starting out?

DS: I would say one of our main learnings was, “Don’t invest in a company just because they are on fire.” Which goes hand in hand with, “Don’t invest in a company just because there is a frenzy around that company.”

What matters is, was that traction generated because the founders were lucky, or because they were skilled? The reason that’s important is that traffic doesn’t matter if it doesn’t continue to grow. So you have to evaluate whether founders are going to be capable of turning that traction into business.

We made an investment in Formspring, for example, where they were wildly successful in the beginning. We only partially understood their product, and they had tremendous traffic, and there was a frenzy. We kind of got sucked in for all those reasons. But they had a hard time turning it into a business.

That was a learning for them and for us. Now we spend a significant amount of time checking out the entrepreneurs and getting to know them and doing our own research. If that delays the process and allows another investor to lead the round, that is okay. We can live with that outcome.

X: Are there too many people doing angel and seed investing in Silicon Valley these days?

JF: Far be it for me to judge, but for the moment the demand for capital is kind of matching the supply of capital. I think we are in a good place at the moment, at the seed stage. There was a time when demand and supply were out of balance—there was too much supply for the demand and we saw valuations rising. I think the market is more balanced now.

But what I am afraid of is that we have more lifestyle investors joining the fray who are not as concerned about valuation. Because for them, the economic return is secondary; they are insensitive to valuation. Those smaller investors start to add up in a seed round, and encourage entrepreneurs to seek a higher valuation. On the other hand, if somebody wants to invest because they want to stay current and meet interesting people and they have the cash to burn, there isn’t really any good reason, outside of my selfish interest, to keep them away.

X: But there’s a lot of talk about whether there’s a “Series A crunch” coming, as all of these seed-funded companies try to raise their next round.

JF: There is all this seed capital funding, so there are more entrepreneurs than ever. But not all of these companies can raise money at the Series A level, because the funding there is static. So I don’t know if it’s a “squeeze,” but probably a greater percentage of companies than we have seen in the past won’t make it to the Series A phase. I don’t think that’s a bad thing.

The door that is opening for us, which we are excited about, is that we’re going to institutionalize our role as a bridge funder for companies we have invested in. We are going to make it easier for the companies we believe in to raise bridge financing with us in the lead, and maybe postpone the Series A. They can go out and prove more with our financing. We are going to be more active on that.

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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