Investing in Edge Cases

February 24, 2020

When looking at investments it can be difficult at a glance to determine which ones are worth more time and effort. Personally, as an early stage investor, I’m working on a few heuristics that help to weed out the companies that I’ll look at in more detail and those that I can politely dismiss. Of the heuristics that I use, which I discuss in more detail below, I typically look for edge cases. Edge cases tend to be things that have binary outcomes. Something that could be exceptional not just average. Something that the rest of the market doesn’t understand well. Then it’s likely that it’s worth digging more.

To give you some background, the heuristics that I’ve found make sense for me are:

1. Team — Teachable + Humble

2. Idea — Interesting + Mandate

3. Valuation — Justifiable + Soft-cap

4. Disruptive — Couldn’t have been done 5+ years ago

5. Value-Add — Can I help?

Keep in mind that this list is still a work in progress. I won’t delve into the first three factors as they’re more mechanical. Those concepts are relatively easy to work through as the propositions either fit within those first three factors or not. The last two can be far more subjective as the company could be adapting a proven idea to a new market which may not have been accessible previously. If they’re chasing a sufficiently large market and the technology or business model is relatively new then it could be hard to define whether it’s disruptive enough. I’m going to spend more time talking about the fourth factor here as the fifth factor is going to be more circumstance dependent for other investors.

I try to focus on the gnarly things. The edge cases. The ideas that other investors don’t want to touch. Marc Andresson and Howard Marks have both addressed this. If you think about investing as having a 2×2 grid with Consensus + Non-Consensus across the top and Success + Failure down the side. You want to be in the non-consensus success cases (check out the links if you want a visual representation). This is likely going to represent 80% of the value that’s created in early stage investments.

It’s difficult to want to sit inside this box because there’s a feeling of not belonging. Human nature would far prefer that you ran with the herd. For investments, if you run with the herd, then you’re going to get market or below market (when you take into consideration fees for your investors) returns.

I like to do a mental exercise where I look at old pitch decks of companies that have been successful and consider whether I would have invested. Now this is hard to do because, honestly, it’s a lot simpler to be an expert when you know what the outcome is. However, I feel that I can be honest when doing this as I don’t have anyone to please. Over time, as my knowledge of various industries increases or as I develop new mental models for looking at various investments, I see that there are situations where I would have bet on what looked like non-consensus businesses.

AirBnb is a model that I revisit from time to time. I wouldn’t have bet on AirBnB in the early days because I was very risk averse and scared about regulatory regimes. It’s likely that I would have been one of the investors that would have been scared about houses getting wrecked and people getting murdered by their hosts. It would have been hard to convince me of the total addressable market because I wouldn’t have been able to get my head around the latent capacity or social shifts that we were undergoing (movement to a sharing economy).

If I had viewed AirBnb this week I likely would have taken a different perspective and thought about the social elements around it. I would also have a better appreciation for the cost and relatively low standard of hotels in the US which I didn’t have before. I probably still wouldn’t have a great idea about the potential market size but I might be able to see that there’s a place for that type of business model. Would I pull the trigger and make an investment if I had the opportunity today? I’m still uncertain. Even knowing what I know today, without the benefit of hindsight and seeing how successful it has become, I don’t know if I would have had the same faith in the model as the founder if it were only at the early stages (and we didn’t have the same level of data about the sharing economy that we now have).

The aim of early-stage investing should be to back those edge cases. Emotionally this can feel more terrifying as it’s unlikely to be a sought-after startup with investors fighting to get on the bill. It’s more likely that you’ll be one of the few believers that are able to stand out from the crowd and back an uncertain thing. I admit that this is still more of an aspirational goal for me than the reality but it’s something that I’m working towards constantly.