There ought to be a better way
By: Santiago Roel Santos
Tags: Venture Capital, Startup, Entrepreneurship, Investing

Investing in Flippers

Certain industries have resisted technology or have been slow to adopt it. Bad experiences like going to the doctor, buying a home, and opening a bank account leave us wondering: there ought to be a better way of doing this.

Juxtaposed with great experiences like shopping on Amazon, riding Uber/Lyft, and sending money across the world in seconds with crypto serve as inspiration for how good it can be.

Not too long ago, hailing a taxi was a terrible experience. Ride-sharing apps have transformed bad experiences into enjoyable ones. Bad experiences inspire entrepreneurs around the world to change things. These are the founders I like to invest in.

I call these startups flippers because of their potential to turn an industry on its head. Sounds great in theory but, in practice, it is hard investing in them. For one, flippers start as crazy ideas and it can be a very lonely journey making these types of bets. Second, very few flippers turn out to be transformational and most die trying. But when a flipper creates a 180-degree shift, they achieve explosive growth and unlock meaningful value because they usually achieve monopoly status (for more on this read “Zero to One” by Peter Thiel). And being right on one or two flippers will make up for all the other attempts — it follows a power-law distribution.

Hatching a Flipper

The flipper startups I’ve backed are built by teams that took a bad experience/problem and validated it with their future customers. Before they wrote any lines of code, built a product and raised money, they talked to as many potential customers to verify two things: (1) the problem was real and big, and (2) people were willing to pay if they built an alternative solution.

For example, I met a founder who spent nine months calling on 250 companies and realized only 3 were using any sort of software and would be willing to pay for the solution he wanted to build. This was the “aha” moment that validated his idea. More importantly, it gave him a blueprint of what customers wanted and earned him his first paying customers before launching. Holy grail status.

Identifying a problem is not a breakthrough per se. We all have bad experiences and grand visions of alternate universes. Being methodical about building a solution customers would be willing to pay for is perhaps the most valuable thing any entrepreneur can make to build an enduring company. The best venture investors follow the 10x rule, which means a product needs to be at least 10x better than the current solutions in the market to be worth an investment. There’s nothing better than seeing a startup that has largely de-risked product-market-fit before launching because they have proof that consumers are willing to pay for it. This is what a 10x company looks like.

The story goes like this:

Founder calls on as many future customers. Future customers agree on the problem and decide they would pay for a better alternative. They may even fund the development of the product. Founder builds the product. Future customers in step 2 start paying for the product. Rinse and repeat to build product customers consistently want to pay for.

The result is a highly defensible and valuable company. Little to no capital is required in steps 1–2. Some capital (seed) is required in step 3 depending on the industry. Step 4 funds future development. Sometimes it may be wise to raise money (series A/B) in step 4 to accelerate growth.

Category-Creators

But this framework is not a “one-size-fits-all” (sorry). Some startups create products consumers don’t think they want/would pay for but only realize they would once they see it. These are category-creators and, I would argue, near impossible to find and invest in a repeatable and systematic manner. The best we can do is validate if these new ideas are addressing a fundamental human need. For example, few saw the potential of the Internet in the 1980s while it was being developed. However, if we apply this lens, one could have inferred back then that the Internet is a manifestation of our primitive desire to connect and form communities. Computers, smartphones, and Facebook satisfy (to a certain extent) that fundamental desire.

Perhaps the best case study of category-creating shifts is how the Internet evolved. Pre smartphones, accessing the Internet was done through desktops mainly at work. Naturally, the time users spent online was constrained by cables and working hours. The introduction of smartphones led to explosive connectivity and Internet usage, which unlocked new business models. A peer-to-peer car-sharing company suddenly makes sense when you can order a car on the go. Andrew Chen from Andreessen Horowitz gives a great presentation on this phenomenon here. For more on this subject, I also highly recommend “How the Internet Happened: From Netscape to the iPhone.”

Is it Art or Science?

“Investing is part art, part science.” Cliche. I think finding category-creators is mostly art (i.e. luck). Finding flippers is mostly science with a bit of luck.

When a startup fails to get past steps 1–2, it means customers don’t see much value in their proposed alternative. Their idea fails to meet the 10x bar and/or is a sign that it simply may be too early. There is a high product-market-fit risk here. Startups that dismiss this warning and continue to steps 3 rarely survive. Those that do, either become modest outcomes or achieve category-creator status as they have developed product consumers believed they did not need or be willing to pay for, but end up buying once they see it. Apple is perhaps one of the best category-creators.

The quest to find category-creators is exhilarating but dangerous. My view is that finding flippers is no less of a worthy and exciting endeavor. It is certainly a more repeatable and sustainable form of investing. Both types of investing are necessary. Innovation rarely happens in a sequential manner. Sometimes investing in category-creators (i.e. Internet) is a necessary step in the innovation cycle for flippers (i.e. Uber, Amazon) to thrive.