20VC: Michael Dearing on 5 Key Principles He Uses To Assess Startup Founders (Transcript)
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20VC : Michael Dearing on 5 Key Principles he uses to assess Startup Founders
Length: 27 mins
Harry Stebbings: We are back for another week in the world of The Twenty Minute VC, with me, Harry Stebbings, @hstebbings, with two B's on Snapchat, I'd absolutely love to see you there.
But diving straight into the show today, I'm very excited for this guest; he's been a huge source of inspiration for me as I've progressed with The Twenty Minute VC and so I'm thrilled to welcome Michael Dearing. Now, Michael has established himself as an icon of early stage venture over the last decade. With his founding of Harrison Metal in 2006, he has backed the likes of Twitter, MoPub, Birchbox, 99Designs, and PagerDuty just to name a few of his incredible companies.
As an addition, I've also have more previous guests suggest Michael than I can remember. Genuinely, it's been incredible to hear. But prior to being in VC, Michael spent 6 years at eBay across numerous roles and, before that, held positions at Shoe Warehouse as CEO, The Walt Disney Company in corporate strategy and then Bain & Co as a consultant. And I'd also love to say huge thank you to both Christopher Jones and Zack Bloomer-Fleasmith for the intro to Michael today, hugely grateful for that.
HS: I'm now so thrilled to hand over to Michael Dearing, founder at Harrison Metal.
You have now arrived at your destination
HS: Michael, it's such a pleasure to have you on the show today. The videos at Harrison Metal have been foundational to my learning, huge thanks to Chris Farmer at SignalFire for the intro, but thank you so much for joining me today, Michael.
Michael Dearing: Thank you for inviting me, Harry.
HS: I'd love to start today with a little on you and how you made your foray into what I call the wonderful world of venture capital.
HD: Well, you are really rounding up to describe it as the wonderful world of venture capital. It is fun, but a very unexpected place for me to land. I left eBay in 2006, I had been there about 7 years and I was convinced that my next job was going to be inside a company and in probably a small company, and so I set about to go meet as many founders and very, very early stage companies that I could. In the process of doing that, I found not one but more like three or four that I really loved and started spending time with them; a day or two a week, sometimes more. After about three or four months of doing that, I said, "This is really fun, I'm gonna keep doing it."
About three or four months later, a couple of them were raising money and I decided to kind of put my money where my heart was and back them. A year later into this, I realized I was having the most fun of my career, I was also doing some really fun work with terrific people and so I realized that this was actually a portfolio. a friend of mine, Jim Jim Goetz at Sequoia Capital, said, "You realize that you could do this full time?" and I asked what he meant and he started telling me about the gap that he saw in the seed market, the space between inception of a company and their A-round. I had noticed that too, and in fact, it was the only reason I was able to invest in some of these great companies, so it kind of organically grew and I was lucky enough to figure out that I loved it. I was pretty good at it and it was making me really happy, which was a new sensation for me when it came to work.
HS: Can I ask? Did anything change fundamentally with the institutionalization, away from spending time and investing personal money, to kind of institutionalizing it with the fund being in Harrison Metal?
MD: Yeah, great question. The main reason why I raised money from outside parties was because I wanted to be part of the longer journey with these companies; I wanted to have capital for reserves to follow on. I also wanted to be able to lead and I couldn't, my nest egg was only so big, and so I couldn't write term sheets and, once I had a fund behind me, I was able to do that and take a bigger leadership role on the cap table and in the governance of the companies.
HS: You said that about kind of spending time with the entrepreneurs themselves and I want to start today with something that's commonly discussed by VCs on the show being it's all about the team. You said to me before, though, that bad management and leadership kills more startups than bad products. So starting on the founder, before we move to the team, you said that founders need to have the sense of personal exceptionalism. How do you look to think about this first and then distinguish between potential brilliance and potential arrogance?
MD: Yeah, it's a hard one. I think my radar for personal exceptionalism has evolved over time, but I think the constant is looking for people who have broken out of the bounds of normal for their peer group. Now that does not mean in business; that does not even mean as technicians or technical talent. It just means that, whatever the circumstances were in their lives, that that was not the determining factor. They were able to break out either because they took some crazy personal risk, they took some very sharp left-hand turn, they ended accomplishing more and seeing more and building a much better experience base because of that risk taking. So that personal exceptionalism, that sense that they are special, that they are destined for really unique outcomes relative to their peer group, I think that shows up early in somebody's life, and it's quite independent of pedigree or brand name work experience. In fact, sometimes those things are negatively correlated.
But the distinction you make between arrogance and personal exceptionalism is an important one. Personal exceptionalism just means that they see themselves as special and that their outcomes are going to be outside the bounds of normal. I think that they, a lot of times, are some most self-critical people I know, and they beat themselves up when they do miss a goal or they fail in a venture, they beat themselves up far harder than any third party could. And so the arrogance piece, I think, is easy to suss out. You see it in the form of the people that they attract around them, the kinds of networks that they build, how much are they a taker versus a giver in those networks? So I actually have, over the years, found it's relatively easy to separate the sheep from the goats, so to speak, the people who have that personal exceptionalism sense, not necessarily the people who are arrogant. I don't want to back the latter.
HS: Absolutely, another balance that I'd love to address is that the early stages, obviously that's this kind of environment of iteration and testing. I'd love to hear how you assess the balance in founders between vision to carry on and pursue the mission, and then stubbornness to continue with something that's not working. How do you look to judge between the two?
MD: I think everybody walks around with these sort of, "I'm a big fan of Daniel Kahneman and Amos Tversky," and their big insight was that every human is walking around with two processors running in parallel. One processor is that gut instinct that intuitive perception of the world; and the other is the analytic, more rational and reasonable one. Now, the gut perception of how the world works is very dominant among founders and very dominant among early teams. It has to be because if you stuck up the evidence, it would all point to, "Please don't do this for a living." So they're following their gut, their instinct, but I like to see the evidence, and it's not hard to find, in people who operate this way. See evidence that they're willing to reevaluate their gut and they're willing to subject their gut to market forces and market discipline. So if they're kind of a high velocity, intuitive, and rational cycle is going I think, then, that that shows up and that's the kind of person I'd like to back. The practical measure of that is how fast do they release prototypes, how many days a week do they push new software to production, how quickly do they start sketching an idea versus just talking about it in very macro terms and how quickly does a pen go to paper. Those are markers of people who operate at the kind of velocity that I think is necessary nowadays, at least in software world.
HS: If we expand that kind of assessment to the wider management team, how do you assess the quality of the management team as a broader spectrum not just a founder, is there a process that you've developed behind it?
MD: Yeah, I'm sort of a disciple of this fellow named Daniel McCallum, who was an executive in the railroads in the mid-1800s. Daniel's story was he was promoted up from within the railroad from inside the New York and Erie Railroad, which was a huge, high growth company of its day. He was promoted up from individual carpenter to bridge builder to superintendent of bridges and then up through the ranks of general management until he found himself, very quickly, at the top, essentially, what would today be called the CEO of the railroad. He wrote this treatise on general management, which I still use to this day in teaching the general management class that I do at Harrison Metal.
His philosophy boiled down to a handful of things. He said, "Look, the general manager has to get everybody aligned behind the right projects, the right investments. Second, make sure that the responsibility and authority is allocated appropriately. Third, measure how things are going along the way. Fourth, stop and make corrections if things are going badly. Fifth, do all of this with humanity and respect for other people." Now, the way he phrased humanity and respect for other people was in a very 19th century way, it was don't embarrass people who are senior etc., but I sort of round that up to treat other people the way they deserve to be treated. So that check list of five things is the same today as it was in 1855 when he first wrote that treatise, and so I very much subscribed to the idea that I could take that checklist into any company, I could talk to a handful of people, and I could come away with a real strong opinion about how are they doing on picking the right stuff to work on, allocating responsibility, checking how things are going, etc. So that very simple five-part checklist is exactly what I use today when I diagnose and try to coach and help these companies that I work with.
HS: You've worked with some of the very best. Is there anything that separates the truly great from the good?
HS: Yeah, I think the personal exceptionalism point is important because that's the reservoir, that confidence that you are capable of building extraordinary things, that confidence is very necessary in the low points to get you through those disappointments. But in addition to that, I'd say high velocity, the fact that their impatience and their ability to iterate their product and their service and their team and every aspect of their business system is hugely important. And I also think this check list of five things that McCallum gave us, if they are good at those five things, they are in the 99th percentile of general managers on earth. Now, that is a pathetic indictment of the state of general management‚Äö√Ñ√§‚Äö√Ñ√Æ‚Äö√Ñ√§that it's that easy to be exceptional‚Äö√Ñ√§‚Äö√Ñ√Æ‚Äö√Ñ√§but it really is, and I'm encouraged by how many people are starting to realize that. It'd be hard to not conclude that general management matters just reading the news.
HS: Going back to the core statement, though, that bad leadership can kill companies easier than bad products, we recently had Mike Dauber at Amplify Partners on the show and he said timing killed more startups than dollars. I'm intrigued, would you agree with this statement as the mortality kind of causation of startups?
MD: Well, I like the point, and I certainly have observed situations where timing was a huge handicap on an otherwise brilliant product or a brilliant team. I would say, though, that if you start with the premise that timing is always slightly wrong, I mean listen, what are the odds that we invent something, we productize it, and we turn into a company at exactly the right moment, it's practically impossible. So if timing is always a little bit off, it becomes a general management problem to figure out how to either accelerate the external conditions such that your product is a fit or pace your product investments so that you don't run out of money before that market becomes amenable to your product. Listen, I'm a man with a hammer; I see a lot of nails, so I'm gonna see every problem as a general management problem and a business leadership problem.
HS: We spoke earlier about the movement to the institutionalize fund structure that you have at the moment. I'd like to dive in on this a little bit. You said about the benefits in terms of being able to lead rounds and ownership stakes. So, if we're to take kind of three core tenets that I always feel are kind of quite crucial, I'd love to start with price sensitivity. Peter Fenton said on the show, "Never turn down a company based on evaluation; it's a mental trap." How would you respond to that and what would you evaluate as your price sensitivityness?
HS: Well, I'm tempted to say that, if I had Peter Fenton's resources, I might feel exactly the same way, but I think where I come down on this is the message I see behind his comment, or the assumption beneath that statement, is that price is but one consideration and that you always have to manage your sensitivity to price against your conviction in the business and the team. And so the way I think about it is I try to stay away, put it mildly, stay away from situations where pricing expectations are totally out of whack with the opportunity and the team's level of progress so far. Look, I mean pricing is the way that we manage our risk, it's the primary tool I have to manage my own risk in the situation, and so as my risk goes up, my price should go down and vice versa. And so I just try to keep a very disciplined view of, okay, given the level of progress they've made, given the level of potential outcomes here, what's a percentage ownership that I feel comfortable with and what's the check size that feels right to go with that and have a very honest conversation with the team about how my thinking evolved around each of those points. I would agree with Peter if what Peter means is that pricing is one consideration and, for those companies that you have strong conviction and you have evidence of terrific progress, you should be willing to pay up for those.
HS: Where do you feel we are at now in terms of market timing and kind of pricing in the market itself?
MD: I think this is a multi-sided market, and this wasn't true 10 years ago. 10 years ago, there was a handful of people doing institutionalized seed investing; there was a relatively small market for seed capital. Today, it's completely exploded and there are hundreds of firms that are organized just like mine; forget about the thousands of individual angels who are chasing convertible debt deals or these so called safe notes. So I would say, on the equity side of the market, I believe, for the most part, companies are priced reasonably, that equity investors that I work with are very conscious of the kind of calculation I mentioned before, how much progress have they made, how much potential is there, and let's price that asset accordingly. On the convertible debt side of market, I think it's terribly toxic and about as undisciplined as it could possibly be. I think there's a lot of factors behind that, the abundance of capital among the angel community. I would say the tulip auction vibe that you get from some of these demo days. But I think, overall, the market's got two sides to it. The equity side of the house, I think, is much more disciplined. The convertible debt side of the house is about as undisciplined as it could be.
HS: No, I agree. In terms of kind of dividing elements into two, I always believe that the best investors not only pick companies once, but pick them twice in terms of the reserve allocation. I'm super interested to hear your thesis, then, around reserve allocation and let's start with that. What's the thesis around reserve allocation?
MD: Boy, if there's anything I've gotten wrong over the years, it's this. When I built the very first spreadsheet model of what would Harrison Metal Capital one look like, reserves was the big unknown to me. because you have to make a range of assumptions, you have to make assumptions about the mortality rate, you have to be cognizant of what the premature M&A exits look like, you have to be cognizant of what's gonna happen in the A and B market 2 years or more after you make the initial investment; it's full of guesses, basically. And so initially, what I did was I used to reserve one dollar of reserve money for every dollar of primary money. And so when I made an investment, I would basically just sort of park the same amount of money in my reserve account. Now, that reserve account is allocated very unequally, so we don't park the money in the name of that company; we park the money in the name of general reserves, and so I funded the reserves separate from the decision about who gets the money. Over time, the way I've funded the reserves pool is varied between taking that ratio all the way up to 2 to 1 back down to, now, I reserve about a buck fifty for every initial dollar. I'm confident that each of those guesses is wrong, but I don't know, for several years, how wrong is it.
HS: In terms of the signaling function and potential negative signaling function, is it a case where you have to at least put some dollars into the companies that you initially go into?
MD: No, and I really straight forward with the founders about that; I mean I have reserves. They also understand that I don't have unlimited resources and so I have to make decisions on the margin and I have to say, "Is this the highest and best use of this one dollar?" and just try to be transparent about that. I've rarely come into a situation where I've completely pulled out. It has happened, but usually for real values violation, dishonesty and, thank god, that's only happened two times out of more than 100 cases. But, yeah, so the reserves strategy for me is to treat it like, as you said, a fresh backing decision. Would I, if presented with this opportunity, make that investment today on behalf of my investors? And so I try to treat very much like a fresh decision.
HS: In terms of kind of another core tenet, recycling is one that's very always very interesting to me, especially with kind of smaller fund sizes and, as you said, not the resources of Peter Fenton. So with a fund size like Harrison Metal, how do you think about recycling and really kind of optimizing every dollar?
MD: Well, we've done a little bit of it over the years, but it's really not a core part of the strategy. And I've talked to people who feel very differently and who run terrifically profitable businesses and who believe very strongly that recycling is an important part of their strategy. I mean if I did it, it was just in a handful of cases where we were slightly off on reserves. I don't consider it a bulk part of the strategy because, let's be honest, my numbers‚Äö√Ñ√§‚Äö√Ñ√Æ‚Äö√Ñ√§call it 80%, 90% of my final outcomes on a fund‚Äö√Ñ√§‚Äö√Ñ√Æ‚Äö√Ñ√§are driven by my initial investment picking. So picking is the primary thing I do. If I pick really well, I should generate great multiples and liquidity for my investors. I just sort of have an operating principle that I want that liquidity back in their hands as quickly as possible. When you stop and think about the mission of these organizations, universities, museums, scientific research foundations, getting that cash back to them is incredibly important, so I tend not to try to hold back liquidity once I get it.
HS: Absolutely, that makes complete sense. I would love to move into a quick fire round where I say a short statement and then you give me your immediate thought. 60 seconds per one, okay?
MD: [Laughs] All right, I'll do my best.
HS: So let's do your favorite book and why.
MD: Confederacy of Dunces, John Kennedy Toole wrote this book about these wacky, wacky figures in New Orleans. I think he wrote this back to the 60s, tried hard to get it published, was unsuccessful, really suffered from a terrible depression, and took his own life. His mother made it her mission to get this book published after his death. It was published and won the Pulitzer for fiction, which was a triple tragedy, but it's a phenomenally funny book, probably the funniest thing I've ever read in my life.
HS: Well done, Mum. I think that deserves a pass on the back. I know you like stories, tell me a story about a time that was transformational to you as an individual, I'm gonna leave it open for you.
MD: Sure. Well, after I left‚Äö√Ñ¬∂ I had a job, a really good job, at Disney after grad school. I worked in corporate strategy, I worked with some amazing people and I got this bug to start a company, and so I joined a business partner, we started a chain of‚Äö√Ñ¬∂ Well, he had one store up and running and then we expanded it to five. It was my entrepreneurial dream come true. These were physical stores, by the way, back in the 90s.
So fast forward to the end, the whole thing fell apart and failed pretty miserably and I was financially wiped out and stayed through to the closing of the very last store, sold the very last pair of shoes, but the transformation for me came when I was out of money personally and I needed to raise cash, much as possible, for the business to pay back our creditors. I started selling on eBay. I started selling on eBay in 1999, I didn't know what I was doing, but I sold some stuff and strangers paid me and a couple of those people who bought from me said, "You know, your listings would be better if you had pictures," and I didn't know how to do that, and so strangers on the internet taught me how to make better eBay listings and that was for me‚Äö√Ñ¬∂ I mean, I was really bummed. I thought my career was over when this business failed and to have that experience and have people say, "Hang in there, let me show you a cool trick on how to sell more stuff better," that was a lifeline. And that lifeline turned into a job at eBay and I couldn't even imagine my life today not having gone through that period.
HS: What do you believe that most around you disbelief?
MD: I think that most people are basically good and I believe that if you leave people alone and you give them the right incentives, they can self-govern.
HS: Why are markets better at capital allocations than CEOs?
MD: Mostly because of the pricing system that's inherent in the market. So one of the biggest problems with internal capital allocation inside a company is very rarely do CEOs have access to true opportunity cost-base prices and the market's really good at that, the market's really good at saying, "Well, if you're gonna use my, fill in the blank‚Äö√Ñ√§‚Äö√Ñ√Æ‚Äö√Ñ√§labor or technology, physical asset‚Äö√Ñ√§‚Äö√Ñ√Æ‚Äö√Ñ√§to build your thing, you got to pay me for the next best use of that asset‚Äö√Ñ√§‚Äö√Ñ√Æ‚Äö√Ñ√§what I could be making from someone else." That doesn't happen inside companies very efficiently. And so when people are confronted with those very clear, crisp pricing signals, they're able to make way smarter choices about what to buy and what not to buy.
HS: Are you a fan of Adam Smith's Invisible Hand?
MD: Very much so, yeah. It was a big moment for me in college when I read that and I realized that some of these wacky ideas that I believed personally were actually‚Äö√Ñ¬∂
HS: Were actually constituted beforehand.
MD: Yeah, somebody else thought of it and they said it better than I did and, by the way, I wasn't alone.
HS: I know. Exactly the same as me, I remember I had a lightning bolt moment with that one. Talk to me, favorite blog or newsletter. What are your must reads? Rainy day, what does Michael sit down to?
MD: Rainy day, I read a lot of economic history, and so I follow this gaggle of economic historians on Twitter and one of my favorite is this guy named Anton Howes. Anton is an historian who was at Brown, my alma mater, he's way younger than me, so he just finished his PhD I think not that long ago. Anyway, he and I met on Twitter and he runs this fantastic daily invention quiz where he puts up an invention from the 17 or 1800s, part of the industrial revolution, puts up an invention, picture of an invention and asks people to guess, based on the design and the look and feel of it, what it was for. It's a fun little contests and I love following along with that.
HS: I will check in and see that. You said before the founders are the benevolent dictator when it comes to product roadmap. Does this change today, then, with the likes of Travis at Uber?
MD: Well, him, I don't know. I only know what I read and I'd hesitate to opine on that. I would say that benevolent dictatorship is a beautiful thing, and when CEOs can master, and notice the word benevolent comes first in that label, if they can manage to be that benevolent dictator, it is a beautiful thing. The benevolent dictator in product roadmap decisions to me is a very listening, focused executive. She or he spends a ton of time listening to people, and then, after the listening is done, there is a judgment call and, listen, this is what we pay people for is to make judgments. We don't pay people to run AB tests, we don't pay people to do boil the ocean analytics on what is the "right answer"; we pay people for their judgment. And so when she or he exercises that judgment, I think that's a magic moment and product roadmap is a particularly powerful place to exercise that judgment.
HS: And then, let's finish today on the most recent publicly announced investment for you, and why you said yes.
MD: Publicly announced, that's hard. I can't keep track all the time of what we've publicized and what haven't. I know for sure, that I just tweeted about yesterday, is Astro. Astro is basically saying, "Look, there is a whole bunch of work that we do in our daily lives and that work can be made much simpler, and the way to make it simpler is to take AI and voice and even rules based heuristics that the user provides, combine all that into a kind of a personal turbo charger, a service they can live on top of Slack and email and chat, and eventually things like Google Docs and Salesforce. What can live on top of that to organize that work and make you able to zoom through a lot faster?" The company just announced voice powered email feature, where you can read and respond to your emails with voice. This is across different email platforms and it's powered by some of the smartest people in the world of work productivity; and so that was a really easy one. This is an accomplished team, knows their domain cold, and is a market that I love, which is bringing productivity tools to business.
HS: I'm literally signing up now. I've been looking for a voice enabled email product for a long, long time, so I'm signing up now. Michael, it's been such a pleasure. As I said, I've learned so much from you and from your content. So thank you so much for coming on today.
MD: Thanks, Harry.
HS: And rarely do I do this, but I do want to give a personal recommendation for Astro. Not an ad, but it really is a must use tool for me and one on the desktop homepage for me on my phone. But I do so also want to say a huge thank you to Michael for giving up the time today to be on the show. As you could tell, I've so enjoyed the episode and I really have learned so much from him in the past, so huge thanks to him for that.
And if you'd like to see more from us behind the scenes at The Twenty Minute VC, then you can follow me on Snapchat, @hstebbings, with two B's, it'd be fantastic to see you there.
Show over from us at The Twenty Minute VC, and we look very forward to bringing you Wednesday's episode.