How does the 'power law' impact startup investing strategy?

The power law states that your single best investment will return more than all your other investments combined. This means angel investing is a business of 'home runs,' not 'singles.' Investors should prioritize companies with very large potential upside, even if most investments fail, and avoid overly cautious approaches focused on reducing failure rates.

How can early-stage investors find promising startups, especially those out of their network?

The best way is through referrals from other founders who have had positive experiences. Investors should actively help founders for free to build a strong reputation and an open network. Being receptive to random emails and introductions, even if they don't seem promising on paper, can lead to discovering the next generation of successful companies.

Why is investor reputation crucial in startup deals?

In today's market, good founders have many choices of investors. A strong reputation, especially for being supportive when a company struggles, is vital. Founders often conduct reference checks on investors, and positive feedback from other founders can be the deciding factor for getting into desirable deals. Prioritizing long-term reputation over short-term gains from failing companies is recommended.

What traits should investors look for in exceptional founders?

Key traits include obsession, focus, tenacity, and love for their work. Founders should also possess high intelligence, creativity, independent thought, and strong communication skills. A crucial indicator is their execution speed and their rate of personal improvement—how quickly they learn and adapt over time.

How should investors evaluate market size for startups?

It's a mistake to focus on the current market size. Instead, investors should care about the potential market size in 10 years. Small markets growing rapidly are preferable to large, mature markets with many competitors. The goal is to identify and ride the wave of new technological changes that create entirely new, massive markets.

How can investors differentiate between a 'real trend' and a 'fake trend'?

A 'real trend' is characterized by high engagement from a relatively small number of early adopters who use the product intensely (e.g., hourly active users) and spontaneously recommend it to friends. A 'fake trend' might have a lot of buzz but lacks deep user engagement, with products often sitting unused, like early VR headsets.

What is a SAFE (Simple Agreement for Future Equity), and how does it differ from debt?

A SAFE is a convertible security, not debt. It is a simple, short legal document where an investor gives money to a startup now and receives company stock in the future. Unlike debt, it does not accrue interest, doesn't have a maturity date, and there's no right to be repaid.

How does a valuation cap work in a SAFE agreement?

The valuation cap is the highest valuation at which the SAFE will convert into shares. It rewards early investors for taking on more risk. If the company's valuation in a future priced round is lower than the cap, the SAFE converts at that lower valuation. If the priced round valuation is higher, the SAFE converts at the cap, giving the early investor more shares per dollar.

What happens to a SAFE during a company acquisition or failure?

In a successful acquisition (home run), the SAFE converts into common stock, and the investor participates in the proceeds alongside founders, expecting a significant return. In an 'aqua-hire' (talent acquisition with little money), investors usually elect to be paid off, often receiving pennies on the dollar. In outright failure, after creditors are paid, SAFE holders are next in line, but rarely receive much.

What is the 'handshake protocol' in SAFE investing?

The handshake protocol is a set of emails confirming key investment terms (amount, cap) in writing to avoid misunderstandings between optimistic founders and investors. Once this confirmation is exchanged, it's considered bad practice for either party to back out, preserving reputations.

Why is it difficult for SAFE investors to know their exact ownership percentage at the time of signing?

The exact number of shares a SAFE converts into depends on the terms of the future priced round, which are unknown at the time of SAFE signing. Factors like the final priced round valuation, the size of the options pool, and new money dilution all affect actual ownership. Modeling tools like AngelCalc can help estimate scenarios.

How should angel investors handle being asked to sign conversion documents quickly for a priced round?

While it's important to be a 'good citizen' and not delay a closing, investors should not sign documents until they have carefully reviewed the conversion calculations (pro forma cap table) and are satisfied. Lawyers can make errors, and investors must ensure their rights and ownership are correctly reflected before signing.

Is it possible to receive pro rata rights in the SAFE conversion round?

The standard SAFE model typically does not grant pro rata rights for the conversion round itself, but rather for subsequent rounds (e.g., Series B if converting in Series A). However, some angel investors negotiate a side letter with the company to secure pro rata rights for the conversion round to buy additional shares beyond their SAFE conversion.

What are the risks of investing in 'lifestyle companies' with a SAFE?

A SAFE is designed for high-growth startups aiming for a priced round or acquisition. If a company becomes self-sustaining but never raises a priced round or gets acquired (a 'lifestyle company'), the SAFE may never convert, and investors might not get liquidity or a return, as the SAFE doesn't address this scenario. Choosing mission-driven founders with high growth potential is key.

Key Moments

Startup Investor School Day 1 Live Stream

Y Combinator

Science & Technology6 min read128 min video

Mar 5, 2018|19,636 views|248|6

Startup Investor School Y Combinator Sam Altman Geoff Ralson Kirsty Nathoo Carolynn Levy YC Investing Live Stream Live Stream

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Key Moments

TL;DR

Startup investing hinges on the power law, where a single massive success can outweigh all other failures, yet most investors focus on avoiding losses instead of chasing home runs.

Key Insights

The top 5 companies from Y Combinator represent about two-thirds of the value created, with the single top company accounting for about one-third.

The number one mistake new investors make is caring too much about what other investors think, leading to a 'herding' effect.

A successful startup is often a good idea that sounds like a bad idea; the best investments are the easiest to talk yourself out of.

Focus on founders' obsession, focus, formality, and love, alongside intelligence and communication skills, as key indicators of potential.

The market size today is a poor metric; investors should prioritize the potential size of the market in ten years, preferring small, fast-growing markets.

The SAFE (Simple Agreement for Future Equity) is a convertible security designed for early-stage startups, not debt, with only the investment amount and valuation cap negotiated.

The power law dictates startup investment strategy

Startup investing is fundamentally driven by the 'power law,' meaning a small number of investments will generate the vast majority of returns. Sam Altman highlights that the top five companies from Y Combinator, for instance, account for about two-thirds of its created value, with a single company contributing roughly one-third. This counters the common investing approach of aiming for many small wins. Instead, the focus must be on identifying potential 'homeruns' – investments that can grow immensely, rather than trying to avoid losses or achieve many 'singles.' Investors should ask 'how big could this be if it works?' rather than focusing on failure rates. A 95% failure rate can be acceptable if one investment returns a billion dollars.

Common investor mistakes and mindsets

A significant pitfall for new investors is the tendency to over-rely on the opinions of other investors, leading to a 'schooling' effect where trends dictate investment decisions rather than fundamental analysis. Altman identifies this as his number one mistake early on. Another common error is focusing on downside protection and avoiding risk rather than seeking out massive upside potential. Many investors also chase 'bad ideas that look like good ideas'—ideas that are currently popular or follow past successes, rather than identifying truly novel concepts that might initially seem counterintuitive or unappealing. The best investments often sound like bad ideas because they are less obvious and face less competition.

Identifying exceptional founders is paramount

When evaluating startups, the focus should be heavily on the founders, as good ideas are less predictable than truly exceptional people at the early stage. Traits to look for include obsession, focus, formality, and love for the venture, as identified by Paul Buchheit. Beyond these, intelligence, creativity, the ability to think independently, and strong communication skills are crucial. Founders must be able to constantly generate new ideas and evangelize their vision. Relentless execution speed—the ability to iterate quickly, test hypotheses, and implement changes—is also a strong predictor of success. Importantly, investors should look for founders on a rapid trajectory of improvement, rather than comparing them to established figures. A founder's mission-driven nature and integrity are also critical, especially when navigating difficulties.

Market assessment and trend identification

Assessing market size requires looking beyond today's figures to the potential market in ten years. A small, rapidly growing market is often preferable to a large, stagnant one, as it allows startups to surf waves of technological change without immediate intense competition from established giants. Differentiating between real and fake trends is key: real trends are characterized by high engagement and spontaneous advocacy from early users, even if the user base is small initially (e.g., the early iPhone). Fake trends, often marked by hype without deep user adoption, are less reliable indicators of future growth. Investors must be skeptical of trends and look for genuine user behavior that indicates a market is truly emerging.

The SAFE: A simple agreement for future equity

The Simple Agreement for Future Equity (SAFE) is a convertible security designed for early-stage startups before a priced round. It is not debt and does not accrue interest. The SAFE's primary advantage is its simplicity, requiring only two negotiated terms: the investment amount and the valuation cap (or discount rate and, less commonly, no cap or an 'MFN' clause). The valuation cap serves as a reward for early investment risk, ensuring conversion at a favorable effective price in a future equity round. Unlike preferred stock, the SAFE does not include rights like voting or information rights. However, it typically includes pro-rata rights, allowing investors to maintain their ownership percentage in subsequent funding rounds, though not typically in the conversion round itself.

Understanding SAFE conversion mechanics

When a company raises a priced round, SAFEs convert into equity. This process generally occurs in three steps: an options pool is created or increased (often to 10% of post-money shares), SAFEs convert into shares based on the valuation cap or discount (usually pre-money), and then new money comes in. The key to understanding SAFE returns lies in the calculation of the conversion price, which depends on the negotiated valuation cap and the company's capitalization (issued shares plus the option pool). While the exact ownership percentage is uncertain at the time of signing the SAFE due to future funding terms and new money dilution, investors are encouraged to model various scenarios. The valuation cap ensures early investors receive more shares per dollar invested compared to later-stage investors, providing their promised reward.

Navigating liquidity events and company failure

In the event of a merger or acquisition, SAFE holders convert their investment into common stock using the target valuation and participate in the proceeds, ideally yielding a return far exceeding their initial investment. In an 'acqui-hire' scenario, where only talent is acquired with minimal cash, SAFE holders typically elect to be paid back. If a company fails and enters dissolution, creditors and employees are paid first, followed by SAFE holders, with common stockholders last in line. Often, there is insufficient capital to repay investors fully. If a company becomes self-sustaining without pursuing a priced round or acquisition, the SAFE offers no specific mechanism; founders and investors must negotiate a resolution, underscoring the importance of choosing founders with integrity.

Process, reputation, and long-term investing

Using the correct process, including the 'handshake protocol' via email to confirm terms before signing, is crucial for managing expectations and maintaining reputation. Platforms like Clerke facilitate signing SAFEs, but founders might use others. Investors must verify all details, especially legal entity names, before signing and be prepared to wire funds promptly, as the SAFE is ineffective until funded. At conversion, reviewing the cap table and conversion calculations is vital, as errors can occur. The overarching advice emphasizes the power law, being helpful to founders, tolerating inevitable failures and pivots, and understanding that startup investing is a long game requiring patience and passion. Reputation is paramount; treating founders fairly, even in difficult times, is key to long-term success.

Mentioned in This Episode

●Products

●Software & Apps

●Companies

●Organizations

●Concepts

●People Referenced

SAFE Investing Best Practices

Practical takeaways from this episode

Do This

Focus on the power law and potential for massive upside (100x+ returns).

Be open to random emails and introductions from out-of-network founders.

Cultivate a good reputation with founders, especially when things go badly.

Help founders before and after closing the deal, offering tactical advice and recruiting help.

Prefer small, rapidly growing markets over large, established ones.

Look for 'good ideas that look like bad ideas' with a unique insight.

Prioritize truly exceptional, mission-driven founders with strong communication, execution speed, and high rate of improvement.

Understand the mechanics of SAFE conversion and model out ownership scenarios.

Review conversion calculations and cap tables carefully.

Be ready to wire money quickly once a handshake deal is made.

Exercise pro-rata rights in up rounds (if the lead VC is top quartile).

Tolerate failure and be supportive of founders, especially during pivots.

Avoid This

Care too much about what other investors think or try to follow trends.

Obsess over failure rates; focus on magnitude of success.

Filter out companies based on initial flaws or 'what could go wrong' first.

Brag about exclusivity or make it difficult for founders to meet you.

Damage your reputation by fighting over failing companies.

Try to 'value invest' in early-stage startups; best deals often feel most expensive.

Chase 'bad ideas that look like good ideas' or rehash past successful trends.

Underestimate exponential growth; model it out instead of relying on intuition.

Assume being on the board is necessary to be helpful.

Withdraw or delay funding after committing to a handshake deal.

Use the SAFE for lifestyle companies or expect repayment if the company doesn't scale.

Common Questions

Angel investors are often motivated by the energizing environment of working with innovative founders, the opportunity to help shape the future, the leverage on time to work on multiple projects, the potential for huge financial returns (100x or 1000x), and the deep gratification of helping founders succeed. It's also a way to stay optimistic about the future and continuously learn.

Topics

Mindset & Self-Improvement Business & Entrepreneurship Money & Investing Power Law Venture Capital Investor Relations Market Analysis Angel Investing Startup Investing Founder Evaluation SAFE Notes

Mentioned in this video

People

George Doriot

An early venture capitalist who made a significant seed investment in Digital Equipment Corporation in 1957, demonstrating the potential for massive returns in venture investing.

Sam Altman

President of Y Combinator, who discusses motivations for investing in startups, the power law, and how to evaluate founders and markets.

Paul Buchheit

A YC partner who identified four key traits of founders that create giant companies: obsession, focus, formality, and love.

Carolyn Levy

The person who invented the SAFE document and a presenter discussing its mechanics and conversion scenarios.

Kirsty Nathoo

CFO of Y Combinator and a co-presenter discussing the mechanics of SAFE conversion, valuation caps, and ownership calculations.

Jeff Ralston

Introduces the Startup Investor School and emphasizes the importance of angel and seed investors in the startup ecosystem.

Michael Seibel

CEO of Y Combinator, scheduled for a conversation later in the Startup Investor School program.

Brian Chesky

Co-founder and CEO of Airbnb, mentioned as an example of an incredible leader whose early potential might not be obvious but can be predicted by observing a founder's rapid rate of improvement.

Dalton Caldwell

Upcoming speaker for the next day of the Startup Investor School, planned to discuss founder meetings.

Companies

Y Combinator

A startup incubator mentioned as the host of the event and the organization that developed the SAFE document.

Uber

Mentioned as an example of a company that created a new market, initially perceived as a small market, but grew by shifting consumer behavior beyond just limo services.

Google

Mentioned as a large company that competitors assumed would crush Dropbox, but Dropbox eventually found success.

DocuSign

A signing platform mentioned as being similar to Clerky, used for digital document signatures.

Microsoft

Mentioned as a large company that competitors assumed would crush Dropbox, but Dropbox eventually found success.

AR&D Corporation

The venture capital firm associated with George Doriot's early significant investment.

Clerky

An online platform commonly used by YC founders to send and sign SAFE documents in a templated form.

Dropbox

Mentioned as an example of an idea that seemed good but everyone assumed big companies would crush, illustrating that such products can still succeed.

Airbnb

Used as an example to illustrate that the specific investment instrument (SAFE, convertible note, or equity) matters less than the company's growth potential when achieving large returns.

Apple

Mentioned in the context of the iPhone as an example of a 'real trend' where early adopters were highly engaged and became spontaneous advocates, even with low initial sales figures.

Digital Equipment Corporation

A computer company that received a $70,000 seed investment in 1957, which grew to $35 million, demonstrating the potential of early-stage startup investments.

Facebook

Mentioned as an example of a company that started when its market was small, illustrating the importance of identifying rapidly growing markets rather than large existing ones.

A YC-funded company in 2005, used as an example of a 'good idea that seemed like a bad idea' because many people initially dismissed it.

Software & Apps

Startup School

An online platform where information for investors can be found and feedback can be submitted.

AngelCalc

A modeling software tool built by Jeff to help investors understand various scenarios for SAFE conversions, especially with multiple caps and discounts.

HelloSign

Another signing platform similar to DocuSign that founders might use instead of Clerky.

Products

iPhone

Used as an example of a 'real trend' product that saw massive engagement from early users, indicating a rapidly growing market despite initial low sales.

Concepts

Virtual Reality

Used as an example of a 'fake trend' where despite widespread talk, users do not exhibit high engagement, indicating it has not yet become a real platform shift for investment.

Organizations

Sequoia Capital

A venture capital firm whose philosophy on technology waves is cited: you cannot create a technology wave, but you can surf one.