20 VC 089 Eric Paley @ Founder Collective on Outliers, Inspirational Founders and Pro Rata

Abstract

Abstract

In this episode of the 20 Minute VC, host Harry Stebbings interviews Eric Paley, Managing Partner at Founder Collective, delving into his journey from CEO and co-founder of Brontes Technologies to angel investing and eventually co-founding the seed-stage venture fund. They discuss the firm's investment strategy, including their typical check size range of $200,000 to $2 million and their philosophy of not engaging in follow-on rounds to maintain founder alignment. Eric shares insights on the human aspect of VC, the importance of founder-friendly practices, and how his experiences as an entrepreneur influence his approach to venture capital. Key takeaways include the significance of building strong relationships with founders, the potential for high returns even with small initial investments, and the belief that a fund's success is not solely dependent on outliers but on a well-crafted portfolio strategy.

Summary Notes

Introduction to Founder Collective and Eric Paley's Background

  • The episode features Eric Paley, managing partner at Founder Collective.
  • Founder Collective is a prestigious seed fund with notable investments.
  • Eric Paley co-founded Brontes Technologies, which was acquired by 3M for $95 million.
  • Paley transitioned from CEO and co-founder to angel investing and then to establishing Founder Collective with David Frankel.
  • The discussion explores investment strategies and the operational approach of Founder Collective.

"Eric was the CEO and co-founder at Brontes Technology before its acquisition by 3M for $95 million. He then began angel investing and it was not long before Eric and David realized the potential for a founder first seed fund and founder collective was born."

This quote explains Eric Paley's journey from entrepreneur to angel investor and then to the creation of Founder Collective with David Frankel, emphasizing the transition from running a company to investing in startups.

Eric Paley's Entrepreneurial Journey

  • Eric Paley had an early interest in entrepreneurship.
  • His first job was in consulting, which he did not enjoy, prompting him to seek more challenging and creative work.
  • Paley started a web development company, Abstract Edge, with his brother and cousin during the dot-com boom.
  • The company survived the dot-com bust by having non-startup clients and is still operational.

"I was a founder of two different companies. I think growing up I was always quite interested in entrepreneurship. I didn't know exactly how to go about it. My first job out of undergraduate was in consulting and I didn't actually enjoy it very much."

This quote introduces Eric Paley's initial foray into entrepreneurship and his dissatisfaction with consulting, leading him to establish his own company.

The Role of Business School in Entrepreneurship

  • Business school provided Paley with a deeper understanding of traditional marketing, finance, and entrepreneurship.
  • While not necessary for entrepreneurship, business school can offer valuable insights and networking opportunities for entrepreneurs.
  • Paley met his future partners, David Frankel and Micah Rosenbaum, at business school.

"I think there are a lot of people quite critical of business school, but for me it was awesome. I learned a ton. I met extremely excellent people."

This quote highlights the positive impact business school had on Eric Paley, providing him with knowledge and connections that would later be instrumental in his career.

Founding Brontes Technologies

  • Brontes Technologies was founded during Paley's second year of business school with a focus on three-dimensional imaging technology.
  • The company explored over 40 markets before settling on dentistry due to the potential for mass customization.
  • The goal was to digitize the dental impression process, enabling a shift from analog to digital, thus revolutionizing the industry.

"And that company is called abstract edge and it still exists, still run by my brother and my cousin, and they've been at it for quite some time now and done great work with lots of neat clients."

This quote mentions the continued success of Abstract Edge, the web development company Paley co-founded, which has thrived under the management of his brother and cousin.

Transition from Brontes to Founder Collective

  • Brontes was acquired by 3M, a leading company in dentistry, which understood and supported the vision for the product.
  • David Frankel, Paley's partner at Founder Collective, was an early investor in Brontes, contributing significantly to its success.
  • After the acquisition, Paley spent time at 3M before transitioning to full-time investing, influenced by Frankel's investment activities.

"So Bronze was acquired by three M, which is one of the largest companies in dentistry in 2006, and three M is the most innovative company in the space."

This quote describes the acquisition of Brontes Technologies by 3M, emphasizing the strategic fit between the two companies and the innovative nature of 3M within the dentistry sector.

Early Beginnings of Founder Collective

  • David, along with Eric Paley and classmates from business school, began co-investing in startups.
  • They collectively built a portfolio of 13 companies that performed very well.
  • David had invested in 26 companies since 2004, showing significant success.
  • Eric Paley compared this success to the performance of top-tier funds he was considering joining, noting that their portfolio was underwhelming in comparison.
  • This comparison led to the realization that their investments were outperforming the market substantially, sparking curiosity about the underlying reasons for this success.
  • They identified better alignment with founders at the seed stage and filling a capital gap as key factors.
  • Founder Collective was created to capitalize on these insights, focusing on seed-stage investments.

And by the time 2008 2009 rolls around and we start talking about creating founder Collective, we actually had a 13 company portfolio that was doing extremely well.

This quote indicates the timeline and the successful track record that led to the creation of Founder Collective.

It wasn't just one deal or being very lucky. It was a number of companies performing very well, companies like Mediaradar and Opower and trial pay, and it was exciting to think about.

The quote highlights that their success was not due to a single fortunate investment but rather a consistent performance across multiple companies.

Investment Thesis and Strategy

  • The investment thesis was based on a deep understanding of what to look for in founders at the seed stage.
  • David's intuition about what makes a great founder was a starting point for their investment criteria.
  • Alignment with founders was seen as crucial for generating high returns.
  • Investing at the seed stage was viewed as advantageous for returns.
  • Founder Collective chose not to emphasize Parata rights (rights to maintain ownership percentage in subsequent funding rounds) due to misalignment with founders' interests and the potential to dilute returns.
  • Eric Paley argues that excessive focus on Parata rights can lead to higher cost bases and lower overall returns for investors.
  • Founder Collective's average dollar investment remains at the seed stage, in contrast to some peers who effectively operate at a Series B level.

I think there's actually a pretty big returns benefit to investing at the seed stage.

This quote emphasizes the belief that seed-stage investments can yield significant returns.

And instead of investing at aggregate post money valuations of 8 million or 10 million or 15 million, over time, you're investing at aggregate post money valuations of 30 million, 50 million, 100 million.

Eric Paley explains the downside of overusing Parata rights, which can lead investors to contribute at higher valuations, potentially reducing returns.

Founder Alignment and Industry Ethos

  • Eric Paley views the industry shift toward being "founder friendly" as positive.
  • He recalls a time when VCs were more focused on being shrewd rather than supportive of founders.
  • The notion of being "founder friendly" is now a common claim among VCs, which Eric Paley sees as beneficial if it leads to genuine alignment and support for founders.
  • The industry's focus on founder alignment is seen as a positive change from previous attitudes.

But if the whole sort of ethos of we're also founder friendly is something that keeps VCs focusing on the importance of being founder friendly and understanding that what the founder is doing is so much harder than what the VC is doing, I think that's a pretty good thing overall.

This quote reflects Eric Paley's approval of the industry's shift towards a more founder-friendly approach, as it recognizes the challenges founders face.

Seed Stage Investment Sizes

  • Founder Collective writes checks ranging from $200,000 to $2 million at the seed stage.
  • The decision to lead or participate in a round depends on the opportunity and who is best qualified.
  • Leading a round typically involves checks of a million dollars or more, while participating usually means investing $200,000 to $400,000.
  • The fund does not prioritize leading rounds for the sake of ego but rather focuses on the potential to add value.

We write checks at the seed stage between $200,000 and $2 million.

This quote specifies the range of investment amounts Founder Collective provides at the seed stage.

Significance of Investment Amounts

  • Eric Paley discusses the impact of investment size on fund returns.
  • Even small investments, like their initial check in Uber, can have substantial value and significantly affect a venture fund's performance.
  • Venture capital is characterized by outlier successes that drive most funds' returns.
  • Eric Paley suggests that outliers are an integral part of the venture business and should not be discounted when evaluating a fund's strategy or success.

Even though our check that we started with was small, the current value of it would move the dial on any venture fund in the world.

This quote illustrates the potential for even a small initial investment to become highly valuable over time, as evidenced by their investment in Uber.

We are in many ways in an outliers business, and most venture funds are driven by outliers.

Eric Paley acknowledges that the nature of venture capital relies on exceptional successes, which are central to the industry's investment logic.

Venture Capital Fund Performance

  • The fund has been employing its investment strategy since 2004.
  • The fund's Internal Rate of Return (IRR) has exceeded expectations.
  • Investments are not limited to small checks; they lead investments and write bigger checks too.
  • The fund has invested in successful companies such as Betray Desk, SeatGeek, Integral Ad Science, PillPack, and Bookbub.
  • Performance remains strong even when removing the best outlier from the portfolio.
  • The current success is acknowledged but with the recognition that it's partly due to favorable market conditions and that valuations are on paper.

"We've sustained IRR that is beyond my own, meaningfully beyond my own expectations of what's possible." This quote reflects the speaker's surprise at the fund's performance, which has surpassed their own expectations for returns.

"But even if you remove our best outlier, the performance is really surprisingly good." The speaker emphasizes that the fund's performance is robust, even when excluding their most successful investment.

"But we do also lead investments and write bigger checks, which we've done in terrific companies like Betray Desk and SeatGeek and integral ad science and Pillpack and Bookbub." The speaker is highlighting their strategy of not just writing small checks but also leading investments with larger amounts in successful companies.

Investment Strategy and Founder Alignment

  • The fund generally does not engage in follow-on rounds to maintain alignment with founders.
  • This approach is believed to prevent altered judgment calls in the future.
  • The fund captures a significant upside of growth even without participating in all funding rounds.
  • The strategy is seen as a rational averages play rather than relying on outlier successes.

"David stated that you don't do follow on rounds, generally speaking, because he said it aligns you with your founders, and then you don't alter judgment calls down the line because you're both on the same side." The quote explains the rationale behind not engaging in follow-on rounds, which is to maintain alignment with the founders and avoid conflicts in decision-making.

"But if you really know, I won't do the math because I can't share all those numbers. But if you sit and you simulate that math, what you find is we capture a tremendous amount of that upside." The speaker suggests that their investment strategy still allows them to capture a large portion of a company's growth, even without participating in every funding round.

Reflection on Fund's Success and Challenges

  • The speaker expresses pride in their portfolio's accomplishments.
  • There is recognition of the inherent humility required in the venture capital business.
  • The fund's success does not guarantee that recent investments will perform equally well.
  • Losses in the portfolio are felt deeply, emphasizing the high-risk nature of venture capital.
  • The speaker acknowledges the current favorable period in venture capital.
  • There is an understanding of the sacrifices founders make, both professionally and personally.

"So it's been a great experience. Right. I work with two of my best friends and we're having a lot of fun, and we're working with great founders, and it feels like it's working." The speaker reflects positively on the experience of working within the fund, highlighting the enjoyable and successful collaboration with colleagues and founders.

"And yet we take those losses every bit as hard, maybe even harder, than we enjoy the multiples of gains in terms of how it affects our day to day." This quote reveals the emotional impact of losses within the venture capital industry and the seriousness with which they are taken.

The Human Aspect of Venture Capital

  • Investing in early-stage companies often means betting on the founder as an individual.
  • Venture capitalists engage with the personal challenges founders face.
  • The speaker values the relationships with founders, even when they have to leave their companies.
  • Success in venture capital is not just about financial returns but also the human connections and support provided to founders.

"There is a very human side of this business that is completely real." The speaker acknowledges the personal and human elements inherent in the venture capital industry, particularly when investing in early-stage companies.

"We value these relationships, we value the founders, even the ones who end up having to leave their companies." This quote emphasizes the importance of maintaining strong relationships with founders, regardless of the outcome of their ventures.

Importance of Understanding Probability in Entrepreneurship and VC

  • Recognizes the significance of the book 'Fooled by Randomness' for entrepreneurs and VCs.
  • Discusses the concept of probability and its impact on decision-making.
  • Emphasizes the need to tilt probabilities in one's favor through talent and strategy.
  • Warns against attributing success solely to skill when luck may play a role.
  • Advises maintaining an open mind to the potential of ideas that have failed previously.

"It really is easy to be fooled by randomness and get convinced you're doing things really well that are just random distributions."

This quote highlights the central idea that success in entrepreneurship and venture capitalism can sometimes be a result of chance rather than pure skill, underlining the theme of understanding probability.

Respected Seed Funds and Influential Figures in VC

  • Lists respected seed funds and influential figures in the venture capital industry.
  • Mentions First Round, Lear Ventures, Floodgate, Nextview, Baseline, OATV, and IA as notable entities.
  • Acknowledges the contributions of SV Angel to the approach of supporting founders.
  • Expresses difficulty in listing all the respected individuals and organizations due to the abundance of talent in the industry.

"I think very highly of first round and lear ventures and floodgate, and here in Boston, I think very highly of Nextview."

This quote identifies specific seed funds that are held in high regard, contributing to the theme of respected entities in the venture capital space.

Founder Role Models and Mentoring

  • Shares personal experience with a founder role model, Kelsey Worth of Invisalign.
  • Describes the mentorship and support received from Worth, highlighting the importance of guidance without dogmatism.
  • Emphasizes the value of mentors who are willing to engage deeply with the problems faced by mentees.

"Kelsey had built a billion dollar company in five years in that industry, enabling mass customization, but on the output side, and we were on the input side and she really played a great mentoring role with me."

This quote underscores the significance of having a founder role model who has achieved success and is willing to provide mentorship, which is a key aspect of the theme of founder role models and mentoring.

Measuring Success as a VC

  • Considers the cohesiveness and enjoyment of the partnership team as a primary measure of success.
  • Values the impact and support provided to founders as a significant indicator of success.
  • Shares a personal success story with the investment in the Trade Desk and the ongoing relationship with its CEO.
  • Measures success through the quality of relationships built with founders and the contributions made to their companies.

"So I think we measure, and it's not just me. I think it's true of Dave and Micah, too. We measure ourselves based on the ways we're contributing to those companies and the relationships we build with those founders."

This quote explains the philosophy of measuring success in venture capital, which is not solely based on financial returns but also on the quality of relationships and support provided to founders, aligning with the theme of measuring success as a VC.

Recent Investment Decisions

  • Discusses the decision-making process behind recent investments.
  • Highlights the investment in Cuvet, a company aiming to revolutionize wine distribution and packaging with technology.
  • Points out that the full potential of a company is not always apparent at the time of investment.

"Cuvet is trying to reinvent distribution in the wine industry, packaging and distribution using technology."

This quote reveals the rationale behind a recent investment decision, focusing on innovation in an established industry, which relates to the theme of recent investment decisions.

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