I read a few good stuff this weekend.

One of the best is this “resignation” letter written by Jerry Neumann, a 25-year venture capital investor.

Jerry wishes to tell us how he got into this space and why he is not doing this anymore.

If you are an investor, you might have a glimpse how unique his mental model about risk and investing, compare to your own mental model. If you are a financial adviser or general personal finance junkie, you will learn about something else.

I will pick out the stuff that I connected with the most.

Knightian Uncertainty – Invest in a Portfolio of Uncertainty.

Jerry has this theory that made him largely successful in getting into companies like Datadog and the Trade Desk.

But only a small handful of investors share this theory.

This was interesting because most of the VCs I talked to didn’t really have an articulable theory of company-picking other than “find good people with good ideas”. 

To folks like Jerry and myself, I wonder to be successful in this space, we really have to depend on something so subjective. Jerry wanted a better theory and he found a better one, but an older theory.

My friend Josh Reich and I were sitting in my office talking about startup valuations. He asked me why no one used DCFs, the gold standard valuation technique. I said it was because things were too variable. He countered that that was what the discount rate was for. I thought for a minute and said that things weren’t just risky, you couldn’t even know how risky they were, so you couldn’t rationally pick a discount rate. “Oh,” he said, “Knightian Uncertainty.”

The idea of Knightian Uncertainty, that some things, especially in entrepreneurship, you can’t predict and can’t even assign a probability distribution to, banged into another idea that had been floating around in my head: Taleb had argued in his just-published The Black Swan that unpredictable events drove fat-tailed losses in finance. If every problem is an opportunity, I figured you could take the other side of that bet. If it were true that financiers on the whole make profits slowly for years and then, every once in a while, lose them all and more in sudden “black swan” events, then there should be some way to lose money slowly for years and then suddenly make it all back and more. Black swans are awful in traditional finance, but they’re the winning lottery ticket in venture capital.

Uncertainty around startups and their power-law outcomes were exactly that reverse bet. My theory was that the power-law returns resulted from the uncertainty. You have to invest in startups where there was uncertainty around some key aspect if you wanted to find the occasional black swan. I’d think and write a lot about this later on, but I decided to take a leap and implement it immediately. It became the centerpiece of my investing strategy.

It took me a while in my journey to understand that to get returns, we might need to invest in a portfolio of uncertainty.

If an investment, or a portfolio of investment is so sure, so risk-less in the eyes of everyone, the eventual long term return you get should be closer to the risk-free Treasury bill than the returns in your mind.

This is not intuitive to many because, didn’t Buffett teach us not to lose money and don’t forget rule number 1?

I think Jerry don’t mean to anyhow invest in uncertain stuff but that there are attributes that needs to be certain, but generally, there should be some unknown stuff that will result in outright failure or great investments. We are investing in businesses and the law of large number of business is that it should fail.

So if you invest in 20 to 50, perhaps only 2 will be winners and they will carry your returns. Same as investing in an index over the long run. The median returns of the companies in an index is not good but your returns are driven by a handful of the companies in the index (but you don’t know which ones and not the biggest ones in the index now).

I like the point about the discount rate and why DCF is unusable.

Many learn about the discounted cash flow model in school and use that to calculate the intrinsic value of the stock but was never able to get it to work. So they deem it to be too theoretical or unusable.

I think it is a matter of how deep do you understand concepts such as the discount rate, required rate of return.

These are basically the hurdle rate or the rate of return that would deem an investment today or in the future to be fair, or not fair. If an investment is more risky, you should demand a higher hurdle rate (higher discount rate) and if it is less risky, you should demand a lower hurdle rate.

Jerry explains why he teaches his students to use a 40% discount rate (!!!) and that probably express how uncertain these stuff are (Read discount rates in venture backed startups).

When you think deeper, the goal is not only to derive an absolute intrinsic value but also to see if the market is efficient and how much return reward is embedded in the stock price.

We Don’t Dare to Tell People About the REAL Situation

Jerry shared about how tight money was initially, to the point where it borders on reckless:

Without a fund, I would be investing my own money. I had some from previous endeavors, though after the divorce it wasn’t really a lot. So the first caveat was that investing was my new startup. I had to be all in. The common wisdom is, don’t invest more than 2-5% of your money in venture, you need to plan to lose it all. I didn’t take this advice. In the first five years (and with the recycling of a few small, early exits) I invested more than 80% of my money, leaving me pretty much just enough to pay rent and for food. At one point, when people were paying attention to me as an investor, one founder teased me for driving a Honda Pilot. I shrugged and said something about fitting five kids into a Ferrari, but the truth was, if I had bought a nicer car I wouldn’t have had the cash to invest in his startup. (That cash earned me a 16x return over five years; one of the kids totaled the Honda Pilot six years later.)

I didn’t tell him, or anyone, this because I didn’t want the supercilious lectures on prudent financial management. I knew the risk I was taking. The entrepreneurs were all-in, and so was I. Like them, if I failed I would have to go get a job and start over. Seemed fair.

If you see someone doing something that in your opinion looks dangerous, sometimes they know it is dangerous, just that they have no choice.

When is it Enough to Quit?

Jerry quit for a few reasons:

1. The start-ups nowadays don’t excite him in the way it used to. They used to seem like the business will change lives while the businesses now seem to be like maintaining the status quo.
2. He is going to die sooner. “The actuarial tables say I have about a 15% chance of kicking it in the next ten years, all else being equal (and, as far as I know, it is.) Should I add that to my discount rate? Idk. But it’s certainly true that something has changed in my brain.”
3. He has made enough money. “Twenty years ago, when my kids were little, the thought of having more money ten years later was pressing. Now, having more money ten years from now seems like the epitome of play stupid games, win stupid prizes. Right now I have enough money to do what I want. I don’t have enough money that other people do what I want. To me that sounds like the perfect place to be.“
4. Wants to pretend to be working less. “The easy path would be to do what most VCs seem to do and just pretend I’m still investing. But, man, that’s a lot of time wasted just to get people to return my emails.”

Men have to Do Something

“So what’s next?”

“I can’t do nothing, it puts me in a bad mood.”

On dark days I think of what Jung said in his memoirs: “Only if we know that the thing that truly matters is the infinite can we avoid fixing our interests upon futilities, and upon all the kinds of goals which are not of real importance…The more a man lays stress on false possessions, and the less sensitivity he has for what is essential, the less satisfying is his life. He feels limited because he has limited aims.”

My view of the infinite is probably different than Jung’s, but I think he’s right: the only way to avoid feeling like your work is pointless is to contribute to something much larger than yourself.

I’m working out what that is for me, what I have the ability and excitement to contribute to. And always keeping in mind Bruce’s warning that “time slips away and leaves you with nothing but boring stories.” I hope whatever I do will leave me with something interesting to say.

You can read Jerry’s letter here.

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