This is the last post in my trilogy on how games of chance can teach lessons about investing and business. This first two were:
Ed Thorp: https://25iq.com/2017/07/22/a-dozen-lessons-on-investing-from-ed-thorp/
Poker and Investing: https://25iq.com/2017/07/29/a-dozen-lessons-about-business-and-investing-from-poker/
Blog posts about people are always more interesting and Jason Calacanis is nothing if not interesting. He is an entrepreneur and active angel investor (2-3 startups per month). He also created the six-year old podcast This Week in Startups and the Launch Festival. Calacanis is the founder and CEO of Inside.com, a real-time mobile news app. Calacanis co-founded and was the CEO of Weblogs, Inc., a network of weblogs that was sold to AOL in 2005. He is the author of a new book: Angel: How to Invest in Technology Startups-Timeless Advice from an Angel Investor Who Turned $100,000 into $100,000,000. If there is one word that jumps to mind when I hear his name it is “hustle.” Calacanis is relentless and he works hard.
Venture capital investing is not gambling since it is a net present value positive activity. Venture capital speculation is gambling, since it is a net present value negative activity. With venture capital investing you can impact the outcome (i.e., change the odds) by having skill. You are also playing against other people not just the house. Professionals like Calacanis are investors since they actively impact the outcomes in a positive way by having a high degree of skill in sourcing, picking and helping founders make the business successful. Amateur Angel investors are in contrast to investors like Calacanis often gambling. One way for amateur Angel investors to improve their prospects is to get in the sidecar of a professional Angel investor, which can be accomplished through syndicates with a professional venture capital investor in the lead role.
Richard Zeckhauser in one of his classic papers entitled “Investing in the Unknown and Unknowable” describes the sidecar strategy:
“Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop real estate or new technologies. Those who lack these skills can look for ”sidecar” investments that allow them to put their money alongside that of people they know to be both capable and honest.
…Maxim A: Individuals with complementary skills enjoy great positive excess returns from Unknown and Unknowable investments. Make a sidecar investment alongside them when given the opportunity.”
The usual dozen lessons are below:
- “Poker is a real good analogy for angel investing because of implied odds.” “You have to bet, bet, bet with ice in your veins: knowing that after dozens of failures, you’ll hit a winning bet of epic proportions.” “We want 7 of 10 to fail because that means they are trying high-variance projects that have massive implied odds.”
David Sklansky writes in his book The Theory of Poker: “Implied odds are based on the possibility of winning money in later rounds over and above what is in the pot already. More precisely, your implied adds are the ratio of your total expected win when your card hits to the present cost of calling a bet.” Chamath Palihapitiya pointed out that the in a tweet: “Founders + VCs thrive on the implied odds from financings but don’t realize it also comes with reverse implied odds!” He links to this from a web site called The Poker Bank: “Reverse implied odds are the opposite of implied odds. With implied odds you estimate how much you expect to win after making a draw, but with reverse implied odds you estimate how much you expect to lose if you complete your draw but your opponent still holds a better hand.”
Regarding Poker and venture capital generally, Fred Wilson wrote the classic post:
“Early stage venture capital is a lot like poker. The first round is the ante. I think keeping the ante as low as possible is a good thing. I like to think of it as an option to play in the next round and to see the cards. Clearly, we don’t ante up to just any deal, but it is very useful to think of the first round as the ante. For the first year or 18 months, however long the first round lasts, you get to ‘see your cards’. You learn a lot about your management team. You learn a lot about the market you’ve chosen to go after. You learn about the competition and a whole lot more. Then you have to decide whether to you want to see ‘the flop’, that is the next year to 18 months. The price to see that is usually higher. If you don’t like your cards (ie your management team, your market, the competitive dynamic, etc) then you fold. Cut your losses. Preserve your capital. Wait for the next deal.”
In an interview in San Jose Mercury-News venture capitalist Joe Lacob said about poker:
“No matter how much analysis you do, there’s always going to be things you don’t know. “And what makes somebody good at this business, vs. somebody not good, is the ability to take risk. Calculated risk. And to be OK with that. To be a gambler, to some extent. I like poker. I like the idea… of calculated risk. Doing my homework, and then you have to take a shot. You learn a lot in poker about people. Phil Hellmuth is a good friend of mine and you learn a lot about people when you play that game.”
- “I put $25k or $250k into a company and own one to five percent and most of them fail. So that one to five percent times is usually, 8 of 10 times, worth zero. Then one hand you kind of chop it. Then, hopefully, one hand out of 50 becomes Thumbtack or a Wealthfront. Then sometimes you hit the royal flush like Uber. I was the third or fourth person to invest in Uber and it only takes one of those to kind of make your career. Those are the equivalent of a 5,000 to 10,000 times return.”
What Angel investors accept in a business that has not proven either a value hypothesis or a growth hypothesis is far greater outcome variance due to convexity. Venture capitalists hedge variance/convexity with a portfolio of bets and that is especially true at seed stage. All you can lose financially in venture capital is what you invest and your upside can be more than 1000X of what you invested. Why is an early stage opportunity to invest in a company like Lyft even available? Because most people like the safety of the herd and shy away from risk and uncertainty. Calacanis says: “I have a theory about angel investing, which is basically you’re investing in the person and that the more outlandish the idea is, and the less people understand it, the greater the chances you should invest in it are.”
- “You have to get very comfortable with the concept of losing seven, eight, nine out of 10 bets.” “It’s very hard to sit down at a poker table or a blackjack table where you lose eight or nine out of 10 hands.” “You have to deal with bad news constantly. The companies that are failing take 10 to 50 times more of your energy and emotion and time than the winners. If you are emotionally not resilient, it is not the job for you. Every day, there’s three or four phone calls from founders that come in, or emails us, that they’re running out of money, they’re fighting with their co-founder, they’re being sued, somebody copied their idea, nothing’s working, the company’s sideways, they got hacked. It is a shit show most days. You have to have a certain desire to deal with insurmountable odds. You’ve got to have a little Han Solo in you, not C-3PO.”
Emotionally handling that the chaos that is an inevitable part of an Angel investor’s life is not an easy thing. When startups and businesses in a portfolio fail they are people you know. It can be both a grind and a struggle to do this work but it seems to be something that Calacanis is well suited for. Fred Wilson writes:
“In poker folding is simple. In the VC business, it’s not that simple. Sometimes you can fold by selling the company or the assets. Other times, you need to shut the business down. It’s not easy and many inexperienced VCs make the mistake of playing the hand out because they don’t want to face the pain of folding. That’s a bad move.”
- “[Angel investing] is sort of like playing really bad cards with a very deep stack and seeing a lot cheap flops.” “As an angel you have to be able to focus on the 5% chance that things will go really, really well. As a VC you have to look at the downside a lot more because you make 1/20th the number of bets. I can put $25k into 30 companies a year and if I hit one big winner every 10 years I’m golden. VC doesn’t exactly work like that… you might do 20 investments over 10 years — if you were going fast!” “There are probably 10,000 projects angel funded in technology per year (say 5x the number of venture deals per year, which I understand is around 2,000 here in the USA). If there are 10 angels in each deal (another guesstimate), that means 100,000 angel investments get put into this bucket per year. Over 10 years we have 1,000,000 swings at bat by angels. If we have 40 unicorns every 10 years here in the USA there are 400 angel lottery tickets (40 unicorns with 10 angels each) in the 1,000,000 lottery tickets issued. By this absurdly incorrect math, you would have .04% chance of getting a lottery ticket: 1 in 2,500.’’
Marc Andreessen describes the approach of a venture capitalist as “buying a portfolio of long–dated, deeply–out-of-the-money call options.” Entrepreneurs are in the business of creating those call options and selling some of them to investors to create a pool of capital to fund the businesses. In evaluating each call option a venture capitalist is seeking a mispriced asset. Half crazy ideas are typically more mispriced and have the convexity that venture investors need to generate grand slam financial outcomes.
There are only so many actual exits for investors. Creating a unicorn is not the same thing as getting a financial exit.
- “Angel investing is very similar to poker, where you’re playing against other people, you can increase your chances.” “The big rub in all this is that you have to get access to the unicorns as they are born.” “You can’t be ever embarrassed about hustling.”
Steven Christ writes: “The reason that you can win at poker [is that] you are not betting against the house; you are betting against the other players. This is such a crucial and fundamental difference, and it is lost on the general public. The house is not setting the odds. In roulette, there are 38 spaces on the wheel, and if you pick the correct one, the house will pay you off at 35-to-one, and they will keep the difference. The longer you play, the more you lose and the more the house wins. When the other players are setting the prices, it is an entirely different story…”
- “Why is there such an overlap between angel investor and poker player? It’s a couple of things. One, you’re dealing with partial information and trying to make decisions. You have to make a lot of decisions under pressure with money, exactly like investing. You’re under pressure, there’s time constraint, and you don’t have complete information. If you can have a slight edge in some way, you can outperform everybody else. It’s the same as investing. Also, deception, intimidation, reading people.”
One of the most creative thinkers ever to tackle the theory of poker was John von Neumann, a Hungarian born mathematician, physicist, inventor, computer scientist, and polymath. One biography notes that “…the inspiration for game theory was poker, a game he played occasionally and not terribly well. Von Neumann realized that poker was not guided by probability theory alone, as an unfortunate player who would use only probability theory would find out. Von Neumann wanted to formalize the idea of ‘bluffing,’ a strategy that is meant to deceive the other players and hide information from them.” The Financial Times elaborates:
“John von Neumann believed that if you wanted a theory that could explain life, you should start with a theory that could explain poker – game theory. “Real life consists of bluffing, of little tactics of deception, of asking yourself what is the other man going to think I mean to do, and that is what games are about in my theory.” High quality global journalism requires investment. It was the bluff that interested von Neumann. Novices wrongly believe that bluffing is merely a way to win pots with bad cards. In the 1972 final of the World Series, the famous hustler Amarillo Slim won because he had bluffed so often that when he finally put all his chips in the pot with a full house (a very strong hand), his opponent assumed Slim was bluffing again; called (matching the bet), and lost. A player who never bluffs will never win a big pot, because on the rare occasions that he raises the betting, everyone else will fold before committing much money. Then there’s the reverse bluff: acting weak when you are strong. In the 1988 World Series, the Chinese-born Johnny Chan (dubbed the “Orient Express” because he won money so quickly) passed up every opportunity to raise the stakes and meekly called his opponent’s bets. By the last round of betting, his opponent became convinced that Chan didn’t have a hand and bet everything he had. Chan called and turned over a straight – a strong hand – scooping up $700,000 and the title of world champion.”
- “I know I’m not smarter than Google. Me vs. a Google person playing chess I’d lose. Me vs. anybody at Google in poker, I’m rich; I will win. You have to know what game you’re playing. I would not play chess vs. anybody at Google or write an algorithm.”
One of the best ways to improve your poker results is to play against weak competition and to avoiding being the weak competition. This is essentially the circle of competence principle put to work in poker. The Poker Dictionary defines a few key terms relevant to circle of competence: “In the 1990s the bad players were referred to as fish. Nowadays they are called donkeys. A tournament that is full of donkeys or bad players is called a donkament.” Having some fish or donkeys in a card game wakes winning easier. Amarillo Slim said once: “No river, no fish.” A similar saying is: “You lead a horse to water, but a donkey will follow you all the way to the river.” Some people believe that a donkey is a bit different than a fish because fish are just prey and a donkey can have dumb luck and take your money.
- “Angel investing is gambling in the same way poker is: it involves a lot of skill and discipline on top of the luck.”
In all questions that involve the relationship between investing and games the “go to” expert is Michael Mauboussin:
“Luck plays a huge role in determining results in investing, especially in the short term. Luck is also prominent in business strategy and card games —including blackjack and poker. One way to think about the difference between the results for pianists and poker players is to visualize a continuum with all luck at one end and all skill at the other. Then place activities along that continuum. Roulette wheels and lotteries are on the luck side, and swim and crew races are on the skill side. Most of the action in life sits between those extremes…. there’s no way to know for sure how Phil Ivey will fare in the next World Series of Poker because even if he plays his cards just right, he may suffer from awful luck.”
- “If you’re at the poker table and you can’t tell who you’re better than and who the fish is, you’re the fish. That’s, inevitably, how everybody starts. What you have to do is try to slowly move yourself up.”
An academic paper that looks at poker makes a point about poker that is a lot fancier but less informative.
“The results show that competitive edges attenuate as one moves up levels, and tight-aggressive strategies––which tend to be the most remunerative––become more prevalent. Further, payoffs for different combinations of cards, varies between levels, showing how strategic payoffs are derived from competitive interactions. Smaller-stakes players also have more difficulty appropriately weighting incentive structures with frequent small gains and occasional large losses. Consequently, the relationship between winning a large proportion of hands and profitability is negative, and is strongest in small-stakes games.”
- “It’s a portfolio strategy. If 7 out of 10 fail, 8 out of 10 fail, what you’re trying to do is figure out what those 2 out of 3. Let’s say 2 or 3 out of 10 don’t fail. You want to quickly figure out who those 2 out of 3 are, and then take your 25k investment and make a 100k investment in those 3. Then you figure out, let’s say you’ve done 100, and you have 4 of them that are really breaking out, you want to figure out which those 4 are, so you can put 250k into those. On a name basis, 7 out of 10 of your investments fail. Say you put 10k into each, that’s 70k gone. Then the last 3, let’s say you put 100k in each. Now, you have 300 active, and you put 100 into the first 10. 7 failed, so you have 330k of your 400k is still in play. You see what I did there? You do 10k in 10, 70 goes away, 30,000 is still active. You put 100k in each, now you’ve got 330k still active. Then, 2 of those sell off and you get your money back, fine, you’ve got 110 back. Great, you have 220 back of your 400 committed. Then, you put half a million into that one this really breaking out, and that half a million goes 20, 30, 50x. Holy shit, now you’ve got a $10 million or $25 million return on your hand, and you’ve played the game properly. You’re doubling down, and then you’re going all-in. It is just like poker. When you get pocket aces, or ace, king, or 10, jack suit, or whatever it is, you make an exploratory bet. When the flop comes and your 10, jack is met with ace, king, queen, you’re like, ‘Oh my God, these donkeys probably have ace, queen and ace, king. They’re going to be batting like maniacs, and I have the stone cold nuts right now.’”
Fred Wilson writes about one important idea that Calacanis is talking about in this way:
“If you structure your deals appropriately, you can often get three or four rounds. As your hand strengthens, the cards get better, you increase the betting, putting more money at risk in each subsequent round. That’s how smart poker players win and it’s also how smart VCs win. The poker analogy only works so far. Bluffing doesn’t work in the VC business. If you’ve got a band hand, you really can’t bluff your way out of it. But on the other hand, you can impact the cards you’ve got. You can work with management, beef it up, switch markets, buy some businesses, etc. You can significantly improve your hand if you work at it, something that’s not really possible in poker.”
In a book entitled Venture Investing in Science Douglas Jamison and Stephen Waite argue:
“What the heck are ‘the nuts’?” you might ask if you are not a poker player. The origin story for that term goes like this:
“This poker term dates way back to the Wild West where cowboys would gather round a table, preferably in a saloon but alternatively around a campfire, and play cards. Back then poker players would not always bet with cash or chips. It was a more rustic time, and men would often bet their horse and wagon on a poker hand. Legend has it that when a cowboy bet his wagon he would unscrew the nuts from his wagon wheels and place them in the pot. The reason behind this gesture was that in the event that he lost the pot he could not leap up, hop into his wagon and ride away with his wager. The fact that he was willing to put those nuts in the pot as surety for the strength of his hand resonated through the prairie, and came to be synonymous with the best hand. A cowboy would only bet “the nuts” when he was convinced that his hand was the best out there.”
Bankroll management is an important part of Angel investing and poker. I wrote about this set of issues in my post on Ed Thorp. He is how one poker player manages his bankroll:
- “Poker, like entrepreneurship, is very painful when you start, but then you get better at it.”
Investing, poker and business are skills that you can get better at. Skill matters in poker and venture capital. Freakonomics author Steven Levitt with Thomas Miles did a study and concluded:
“…we analyze that question by examining the performance in the 2010 World Series of Poker of a group of poker players identified as being highly skilled prior to the start of the events. Those players identified a priori as being highly skilled achieved an average return on investment of over 30 percent, compared to a -15 percent for all other players. This large gap in returns is strong evidence in support of the idea that poker is a game of skill.”
Douglas Jamison and Stephen Waite argue:
- “Poker has a lot of things that entrepreneurship is about. Trying to figure out a situation with limited information.” “[Investing and poker] are very analogous and I think reading people is a skill of angel investors. Reading people understanding people. Understanding motivation and then also trying to solve problems with limited information. When you look at poker you’re trying to uncover this riddle and you don’t have complete information.” “Jason’s Law of Angel Investing” states: “You don’t need to know if the idea will succeed — just the person.” “Jason’s Second Law of Angel Investing” states: “Your success is correlated to the amount of time you give to founders.” “I have a theory about angel investing, which is basically you’re investing in the person and that the more outlandish the idea is, and the less people understand it, the greater the chances you should invest in it are.” “People who are crafts persons and who have craftsmanship in their work, they will always happen, whether in the early stage or late stage. When I see a particularly well-designed product, or somebody understands their metrics, I know that person cares. People are in this wacky belief system that their idea matters, when it does not. All that matters is what you build.”
This last item is obviously grab bag of quotes from Calacanis. In this collection of quotes you see his investing thesis come more into the light. These are a good way to end this post since it is getting a bit long. Calacanis proves that great investors hustle, have an extensive scuttlebutt network and read constantly.
Notes:
Angel: How to Invest in Technology Startups-Timeless Advice from an Angel Investor Who Turned $100,000 into $100,000,000 https://www.amazon.com/Angel-Invest-Technology-Startups-Timeless-Investor/dp/0062560700
Click to access InvestinginUnknownandUnknowable.pdf
http://angellist.tumblr.com/post/141199140045/interview-with-jason-calacanis-investor-in-uber
https://newslines.org/jason-calacanis/
http://calacanis.com/2015/01/09/should-you-be-an-angel-investor/
https://www.startupgrind.com/blog/from-the-vault-jason-calacanis/
http://avc.com/2004/11/the_poker_analo/
http://www.thepokerbank.com/strategy/mathematics/reverse-implied-odds/
https://www.cnbc.com/id/49791755
http://thelousylinguist.blogspot.com/2008/01/donkeys-and-fish.html
https://www.nber.org/papers/w17023
https://link.springer.com/article/10.1007/s10899-009-9168-2
https://www.linkedin.com/pulse/20130928204536-24171-the-end-of-venture-capital-sort-of
https://www.forbes.com/sites/jakehayman/2016/04/07/pokermeetsphilanthropy/#5d4f5226a63a
https://cs.stanford.edu/people/eroberts/courses/soco/projects/1998-99/game-theory/neumann.html