A preview of the Spearhead podcast: http://spearhead.co

We haven't published an episode here in a while, and that's because we've been publishing on another podcast called Spearhead.

What we're discussing on Spearhead is how to be a good angel investor.

I've collected the first 10 or 12 episodes of Spearhead into 1 long episode and that's going to start here in about a minute.

We decided to put this info into a different podcast because we want to stay focused on health, wealth, and happiness on the Naval podcast.

Spearhead is a project of ours where we give founders million dollar funds to invest into startups.

If you're interested in applying for 1 of these funds, applications are open until November 21st, 2019.

I'll put a link to the application in the show notes.

Here we go with a sample of the Spearhead podcast.

If you like it, you can find a link to subscribe in the show notes.

We're going to be talking about something very different than what we've talked about in the past.

In the past we did venture hacks, which was all about the game theory of venture capital and it helped entrepreneurs raise money.

We talked about how to get rich, which was general advice on wealth creation for the average person who's starting a business.

Now we're going to talk about angel investing.

This 1 is focused on a much more narrow audience.

We expect this podcast to resonate the most with people who are in a technology hub and have started investing but are not yet pros at investing.

So brand new angels, VCs, and founders who are dabbling in it.

Let's say you're living in Silicon Valley, or you're in Shanghai or Beijing, or you're in Bangalore, or you're in London, or you're in New York, and you get access to a lot of interesting tech companies, You're in the tech business, you have some extra money that you've made along the way or you've raised some money.

This assumes that you have some familiarity with investing.

There are some resources we can point you to for the cold start.

Paul Graham wrote a piece called How to be an Angel Investor.

There's How to be an Angel Investor Part 2 on Venture Hacks.

You can look at all of those for the basics.

We're going to focus on some more advanced topics in this conversation.

We're going to talk about things like how to figure out what a fair valuation is, what are the pitfalls of bridge rounds, how pro ratas work, how can you squeeze into a round when their VC's leading, when a co-investor is providing a valuable signal versus when they're just talking their own book, how to size up markets and startups quickly, Should you specialize in single vertical or should you diversify it into multiple verticals?

This podcast is open sourcing some of the knowledge that we teach at Spearhead.

Spearhead is a fund that we built that trains the next generation of angel investors.

It takes founders, gives them small checkbooks, and then teaches them the skill of investing and mentorship for building something that'll be valuable to them for their entire lives.

Now this is the internet and this is America so we got to give you some disclaimers.

Angel investing is a great way to lose your money.

There's an old quip, how do you become a millionaire?

Start as a billionaire and start investing.

This is a good way to lose money if you don't know what you're doing, or if your timing is bad or you're just plain unlucky.

This is not investment advice, but if you're already in the profession or in the hobby of angel investing, you may find this useful.

There are tons of important exceptions to everything we're going to talk about.

Technology itself is changing very rapidly, as does the investment ecosystem.

A decade ago, Y Combinator was brand new.

The first round capital platform wasn't there.

You didn't have a lot of late-stage investments by hedge funds, you still had companies going public earlier, so the market was very, very different.

This is really 1 unique approach to angel investing.

The things we're going to talk about might work for us from time to time, but other people might take the exact opposite approach or completely different strategies and have similar or better results.

We're very focused on early stage technology startups in San Francisco and Silicon Valley.

A lot of this may not translate to other locales, and it almost definitely will not.

We'll also be discussing startups and funds that we've personally invested in and have a financial interest in.

And We're constantly changing our minds and learning.

We hold contradictory and opposing thoughts in our head at the same time.

We have a multitude of opinions that often contradict each other.

This is not math or science or equations.

As Marc Andreessen says, strong opinions, loosely held.

The best way to make money in the technology industry, like any other industry, is to be an owner of a piece of a business.

You're not gonna get rich renting out your time.

You must own equity, a piece of a business, to gain your financial freedom.

So how do you gain substantial equity in a business?

The classic models are you start a company and you become successful.

This works as a founder, you own a big piece, it's high stress, very grueling, very few companies succeed.

You may have to get back up at the plate and take a few rounds of bat, it may take you a while.

A second way is you can be an extremely competent execution person who gets recognized so that when the next successful company is scaling, whether it's an Uber or Dropbox, then Travis or Drew call up their favorite investors and say, hey, who are your 10 best engineers that you've worked with that I can recruit right now?

Who are the 10 best designers you've worked with that I can recruit right now?

And someone who's done a great job at other companies for investors and entrepreneurs before will get paid a fairly large amount of equity for joining a company that's already solved product-market fit and is a rocket ship.

Then finally, you can do it as an investor.

And as the hits become bigger and bigger, and the returns become more and more non-linear, it makes more and more sense to play as an investor and a little bit less sense to play as a founder.

The reason for this is because the upside is non-linear.

When you invest in a startup, you could in theory make a 100x, a 1000x, a 5000x, a 10, 000x return, if you were in a Facebook seed round, for example.

And your own company, You may own a lot more of it, but you may only make a 10x or 100x return.

The human brain is not wired to understand nonlinearities.

But the people who do, people like Paul Graham and Peter Thiel, end up becoming billionaires as investors rather than through companies that they had themselves directly started.

Now being a founder is a lot more fulfilling.

Many of the investors, they wish that they were building something because it does give you a deeper sense of purpose.

There is that sense of teamwork and really being involved.

On the other hand, it burns you out and it ages you quickly.

Being a founder your entire life is a very tough road to go and most people do not have the constitution for it.

Angel investing is something you can be doing when you're 50, when you're 60, when you're 70 years old.

It's something you can do if you're partially retired or if you're in maternity leave or paternity leave.

It's something that you can get better at even if you're not devoting yourself completely to that field.

And it's something that can make you money when you're too tired or too big of a family or have some kind of a health issue.

So you can't just be cranking as an entrepreneur.

Warren Buffett is 1 of the richest self-made people on the planet because he's been compounding for a long, long time.

He started reading annual reports when he was 10, 11, 12 years old and he's been going strong.

If he'd started after college instead of starting when he was 10 years old, he would be nowhere near the top 400 lists on Forbes because the magic of compounding wouldn't have worked.

There's a famous line, know something about everything and know everything about something.

So in that sense, it's great to have been a founder and then also to do some investing.

We're living through a very unique time when, as Andreessen says, software is eating the world.

We're undergoing a phase shift where technology, rather than just being adopted by knowledge workers, is being adopted by everybody.

This transition that we're going through means it is a gold-brush era in technology.

If you happen to be living in 1 of the technology hub cities, there's only a handful of those.

If you have to ask if you're in 1 of them, then you probably aren't.

Usually it's obvious when you're living in 1 of them, there'll be hundreds of startups at least within that city.

There'll have been some people who got rich off of it.

If you're living in a tech hub and you're in the tech industry, you're already halfway there.

And if you're in the tech industry and you're not living in the tech hub, then you should consider moving to a tech hub unless there are strong lifestyle reasons that keep you away, such as family or quality of life, which often is higher outside of the technology hubs.

So getting into the tech hubs to do the angel investing is half the battle.

You can do it remotely, but the odds are stacked against you.

You don't have the trust networks, you don't see enough of the deal flow.

So then it's better to work through a proxy, like investing in a trusted friends venture fund or going through AngelList or coming in for YC Demo Day and so on.

You think this is just for people in Silicon Valley or does this apply in New York?

Does it apply in Seattle, Austin, China, Bengaluru?

I think it applies in probably about a dozen, 2 dozen cities around the world.

The thing that's hard here is that some of these cities are emerging and some are not.

You can probably find good deals there, but you really have to see everything and you have to have access to everything and realize that maybe there's 1 or 2 great ones that'll be created there every year.

Silicon Valley is a little more forgiving in that there's maybe 20 or 30 great companies being created every year, and you just need to get access to 1 of those from a larger pool, of course.

Someplace like Bengaluru or maybe even Kuala Lumpur, these might be up and coming cities, but then timing is hard.

Is this when the tech industry there breaks through.

You're in Australia, if you invest in Canva, great, or if you invest in Atlassian, great, but if not 1 of those 2, then there's not as much of a pool.

So timing becomes a lot harder, but at the same time, your returns can potentially be a lot higher because there's less competition, the valuations are lower, the risks are higher.

What you don't want to be doing is sitting in a city that doesn't have a history of producing good startups, where you only see 1 or 2 startups a year, you invest in half of them and you're paying Silicon Valley prices because they're looking at Y Combinator Demo Day and keying off of the valuations there.

It's certainly much safer and easier to get started in San Francisco or New York or Beijing or Shanghai or Bengaluru.

If you're a pro, you can play in London, Austin, Seattle, Denver, Boulder, Chicago, et cetera.

Anything below that, and you better know what you're doing.

We definitely have seen this phenomenon on AngelList where Angel investors have been investing locally in a city that is not producing good tech startups, will basically surrender and then start investing through AngelList into Bay Area startups.

They just see the quality and the returns are so much higher.

What's the best indicator that a startup hub is working?

Is it a thriving community of other angel investors?

The normal angel investing dynamic starts with founders start a company, company does well, founders and early employees get rich in the IPO or the acquisition, and then they start investing money in their friends and engineers and designers and marketers who work with them at their company.

And they feel a lot more comfortable doing this early investing because that's how they made their money.

They made their money through tech startups, so they want to put it back into tech startups.

There's a lot of false starts where you'll have a lot of angel investors pop up in an area and they'll invest in a bunch of companies, but then those companies get stranded because there's no series A or series B VCs there to invest in them.

Or because there's only 1 or 2 series A or series B VCs, when they come in, they pay low valuations, they wipe out the early investors.

They convert them to common, they cram them down, they put warrants on top.

So funding markets to some extent develop in reverse.

The least risky investments are mezzanine rounds right before the company goes public.

The next least risky investments are series Ds and series Cs, then more riskier series Bs, even more riskier series A, and the most riskier angel investing.

So in a weird way, angel investing is the thing that should develop last.

That's not always the case because if a company can break out with just angel money, then later stage money will find it almost no matter where it is, or that company can move to a later stage hub.

But now you have a big gap between your investment and then when the next investor is going to show up.

And that means the company has to get really, really far and very little money.

The returns in angel investing are kind of interesting.

There's this meme that goes around that angel investors lose all their money and that VC is a terrible business.

It's true if you start aggregating VCs and angel investors from all across the world.

But if you stay focused on technology hubs, it's largely not true.

A competent angel investor in Silicon Valley who's plugged into the network and knows what they're doing and has a broad portfolio can expect to make somewhere between 3 to 10 times their money over a decade.

That's quite a return, although there is a very high specific knowledge and labor that goes into each investment, which is not being counted.

Also keep in mind that these are capital gains, which are usually taxed at lower rates and income, partially because it's a secondary tax on corporate income.

It's already been taxed once at the corporate level.

And also there are tax breaks for angel investors ranging from the qualified small business stock exemption in the US to some very favorable tax investing breaks in the UK and other countries.

From a tax advantage basis, if you're willing to tolerate the high risk and the illiquidity, it's very hard to look at any other asset class where you can make as much of a raw return on your money as you can as a patient, diversified, plugged-in angel investor.

1 way to think about it is the less efficient the market and the more wealth the underlying asset is creating, the better off you're going to do.

For example, art doesn't really create that much wealth.

It's more of a tax haven slash speculation instrument.

The asset itself is not that wealth generating, but the underlying market is very inefficient so you can make money more easily.

So it's not a great asset class to play in unless you're the casino owner, in which case you have an edge on everybody else.

Angel investing is odd in that very few people can plan it.

Very few people have the know-how, the geographic access, the capital, and the risk horizon and the patience.

But at the same time, the underlying assets that you're investing in are changing the world on a daily basis.

I see a lot of people on Twitter who could be good angel investors who are sitting in Silicon Valley, who have access to deal flow, who are in the tech industry.

And I see them spending a lot of time thinking about macroeconomics, what if the Fed's gonna cut interest rates, what's gonna happen to the trade war in China, or they're out shorting stocks, or they're investing in special economic zones, or they're buying and selling real estate and flipping that, or you have a very good friend of mine who's a great VC who's also running a rental business on the side.

And I would scratch my head a little bit.

There are people literally digging up gold next to you.

The returns in this industry are higher than anything else.

You understand it so well, you have specific knowledge, but there is this contempt that you have for investing further into the industry that just comes from your own familiarity.

And if you're in the tech industry, you should be doubling down.

I don't know of a better industry on the planet or a better place on the planet to be investing for today.

The technology industry is becoming the place where wealth gets originated and then it can get spread out.

But increasingly, the Wall Street financiers are coming to Silicon Valley to invest in companies before they get to Wall Street.

By the time a company goes public, you can pretty much bet that anybody who had any connections, who had any appetite, who had any capability, got a bite at it.

So if you're buying a tech company when it goes public, you are literally last in line.

It's not to say you can't make money, but the odds are way down because this fruit has been picked over many, many, many times.

The last bunch of financiers who were sitting in the right place at the right time, we call them Wall Street.

These were the people where you used to get capital for your startup.

There was no other market for fundraising until you had the metrics to go public.

Now Silicon Valley is turning into the new Wall Street, except it's not as formalized and organized and segmented as the traditional Wall Street.

Morgan's haven't popped up and the Nasdaq's haven't popped up yet.

This is going to fly in the face of conventional wisdom.

For the average person, you should be saving for your retirement.

In economics, there's the identity S equals I, savings equals investment.

So even if you save into your 401k, it's actually just getting reinvested, but it's getting reinvested into some very quote unquote safe, but very unproductive parts of society, such as the government.

You're investing in the DMV, the defense department, and their returns to date have not been spectacular.

It's essentially just whatever money they can take at gunpoint from both taxpayers and foreigners.

Generally, it's probably a better bet if you're in the tech industry to invest back in the tech industry, especially if you're young and especially if you can get diversified.

Invest in the smartest and best and brightest people that you know around you, as opposed to faraway people in faraway lands with faraway motives, who are frankly just not as motivated and have trillions of dollars of capital flowing into them.

$50, 000 in your IRA isn't going to make much of a difference to the US government when it gets put into a T-bill, but 50 grand invested into an entrepreneur down the street is going to make a huge difference to their lives.

And if you can find 10, 20, 30, 50 investments like that, at least 1 or 2 of them will pay off, assuming that you listen to us and build up some skills along the way.

Most of my net worth is illiquid and lying in startup companies, but I sleep well at night knowing that I literally have hundreds of teams of brilliant entrepreneurs who study at the top schools and are leveraged through code because they have engineering degrees, great designers.

They're leveraged through capital because they've raised venture money after I invested.

They're leveraged through products that they're building that have no marginal cost of reproduction and using the most modern methods of distribution.

All of them are working very hard to build things that could be massive and change the world.

And it's just going to take a few of them work out for the entire portfolio to balance out.

If you have a 1000x return on your portfolio somewhere, which is not that unheard of in angel investing, you could have made a hundred investments to get there and your overall portfolio will still be a 10x even if the other 99 go to 0.

The 3 things that it takes to get into the investing business are deal flow, judgment, and capital.

Either you made some money before or other people trust you enough to give you capital.

Many of the top VCs are related to, married to, or come from families that have an enormous amount of capital.

Sometimes you look at those people and you scratch your head and you say, how is this person in the venture business?

Well, they had a lot of family money or they married into money.

Or they were managing money for somebody else or they were friends with a billionaire or had access to some large fund.

And that access to the capital is what got them in the business.

If you join Spearhead, we actually give the Spearhead leads who are founders who were training up to be investors.

We give them million dollar checkbooks and then we help them raise more money from limited partners later on.

You can always raise it from friends and family, but this is both the hardest and the easiest depending on who you are.

As they say, good judgment comes from experience and experience comes from bad judgment.

Judgment can often be about applying your highest standards and your taste in the things you know the best to other people.

Very often, as a founder, you have a very high bar for yourself.

You only want to recruit the absolute best.

You're always the worst critic of your own business and your own product.

Every little thing in your product that's wrong bothers you.

But then you meet somebody else and they're raising money and you fall in love with their idea and you ignore the fact the person doesn't seem that smart, or it's not someone that you'd actually work for or even hire, or their product is only half-baked or half-finished or they're executing slowly.

You'll lower your judgment because you start fantasizing about all the things that could go right.

So It's very important when you're investing in other people that you keep a high bar.

Some of the best investors that I know are incredibly difficult people.

It's very hard to please them, and they see the problems in everything.

In that sense, a good investor can often be a lot more cynical or pessimistic than a good founder.

A good founder has to be a rational optimist, whereas a good investor sometimes will bounce maniacally between being optimistic enough to see the future and get into the deal and being pessimistic enough to see all the downsides and pass a 9 out of the 10 that look at.

If you're doing more than 1 out of every 10 deals that you look at, you're probably being too optimistic.

See all Naval transcripts on Youtube

How to Angel Invest, Part 1