Angel Investing Skill 2 – Domain Knowledge

Posted on Sep 14, 2010 | 30 comments


This is the second article in a series on what it takes to be a great angel investor (and why this should matter to entrepreneurs).  Part 1 – Access to Great Deal Flow – is here.

I have talked extensively about “social proof” in fund raising in the past.  But the problem is that most deals – even really promising ones – fail.  Just ask the people who poured money into once “hot” companies like RazorGator or Friendster.  And we all know that Ron Conway is considered the savviest of angel investors and yet by definition not all of his investments succeed.

So being buddies with “all the right people” clearly isn’t enough to be successful.  AngelList – as great and innovative as it is – does not guarantee success for investors.  Obviously.  In fact, sometimes seeing social proof (e.g. lots of brand names piling on) can lead to group think and price creep.  I personally try to avoid many of these club deals.  I like to invest where I have a personally strong connection with the entrepreneur and/or a strong intuition on the market from prior experience.  I like to be early – usually first or near enough to it.

Basically, I’m talking about being an angel leader and not follower.  Lead investors and follow investors can both win equally but in each case you know why you personally are writing the check.  I have been at cocktail parties where I have heard prolific angels upon hearing that a buddy was backing a deal say, “count me in for 25″ even without knowing the details of the deal.  I think that’s sloppy.

It requires domain knowledge to know what you’re talking about and success long term as an angel.  We are all thrown some good cards from time-to-time.  That’s called luck.  Consistently winning like Keith Rabois takes skill.

2. Domain knowledge – Unfortunately  many individuals overrate their own abilities in the “domain knowledge” area.  They have a very good sense for what is going on a market but not a well-honed knowledge of an industry and what will define success or failure.

I see this all of the time in financial services. So many deals seem like obvious money makers.  But then I talk with my partner Brian McLoughlin who has worked in the field for 20 years and he’ll run through the 10 reasons why similar companies haven’t succeeded.  Not in a cynical way – he just has the domain knowledge to know what has been tried before.  It’s sort of like having an Encyclopedic history book before just launching your product and seeing whether anybody uses it.

Just because you use all of the products, read all the tech journals, back-channel at all of the right cocktail parties and know a couple of guys at Twitter or Facebook does not mean that you necessarily have well refined domain knowledge.

Remember that you’ll be investing against people who have worked on the Google algorithm and REALLY know what drives SEO.  MySpace may not have been as successful as Facebook in the end but the executives there learned how to deal with user growth at scale.  They have real stories about what drives user engagement and viral adoption.

Here’s the thing – as Michael Lewis talks about in his book, the adage of investing is that “if you’re reading about something in the papers it’s already too late.”

Think you know a thing or two about location-based services?  You’re going up against Dennis Crowley who built Dodgeball before ever founding FourSquare.  Oh, and he was acquired by and worked at Google.  Connections.  Domain knowledge.

Who ultimately invested in FourSquare? Fred Wilson who had learned much as an early investor in Twitter.  And before that Bryce Roberts who working alongside Tim O’Reilly (famed publisher and originator of Web 2.0 Expo) gets advanced access to and domain knowledge of the who’s who of the tech world.

Want to do a Q&A website? The founders of Quora were respected technologists at Facebook and knew a thing or two about bacn and toast before setting up their highly sought after venture.  And when they wanted money they turned to none other than Matt Cohler, ex VP of Product Management at Facebook.  Access to Deal Flow.  Domain Knowledge.

I know you have good knowledge of how the Internet is developing and have good intuition of what drives viral adoption, what local services are needed, what API’s need to be developed, etc.  But before you get out your check book at least have a gut check on whether your instincts are likely as refined as the other players sitting at the table.  It’s not good enough to win at the weekend warrior table – you need to win at the WSOP table.

The most interesting thing I’ve learned by being an investor and sitting on boards & seeing so many company pitches is how different reality of what is going on at companies is from what you’re reading about them in the press.  So it’s not good enough to only mine Techmeme every day.

In the Tony Hsieh analogy – it’s the difference between a weekend player and a professional.  In the former you place a couple of casual bets knowing you may lose.  Some early wins can be deceiving and give you a sense of invulnerability.  The same happens in poker before you lose big.  Professionals play day-in, day-out for years at a time.  They spot the tells.  They count the cards.  They control outcomes.

Yet the truth is that I see angels with great deal flow & great instincts whom I believe will only perform well in times that favor angel investors (like 2010) where there are early exits.  I don’t believe these times will last.  And the best investors over the long-haul will need three more skills.

Part three is about cultivating relationships with VCs.

  • http://www.upnext.com Danny Moon

    Not sure if you are putting these in order of importance, but I am surprised to see domain knowledge as the second quality you wrote about. If the team you are backing has domain knowledge (one example being Foursquare, as you mentioned) does it really matter if you as an angel investor has domain knowledge?

    Also, would this lead to someone passing on new spaces/categories? In some ways, domain knowledge seems a more important trait for a VC than an angel. Afterall, at the stage the angel is investing, the company might pivot their way out of that domain in a couple months.

    But I agree with your overall point, “Basically, I’m talking about being an angel leader and not follower.” To lead, understand what you know and what others know better than you.

  • http://www.hypedsound.com jonathanjaeger

    I was thinking something similar to you. Would it not be in the best interest of the founders to have someone to complement the expertise of the founders (e.g. founders know their product and industry and the angels would give good advice about scaling and running the business)? I guess the post is in the point of view of the angels themselves, and they are better off knowing the industry they are investing in so they can make the best decisions and thus make better returns.

  • http://bothsidesofthetable.com msuster

    Analogy – you want to invest in public stocks. You read about banks all the time in the press and think you know a thing or two about which bank is best. You don't spend all of your time reading through their financial reports, understanding their balance sheets or knowing their projected cashflows. Does it really make sense to invest in individual stocks this way? Probably not.

    Angel investing is no different. In fact, it's riskier so you really should have domain knowledge. Otherwise well-connected dentists would have the same track record as industry insiders. They don't.

    So long answer – yes, I believe you need domain knowledge. GRP was the fifth best performing fund in the country in 2000. My colleagues invested in the areas they knew best: tech meets retail / auto (Zag) or retail alone (Ulta), tech meets financial services (BillMeLater, DealerTrack, Envestnet), SaaS (Qualys), Digital Media & Mobile (MobiClip, mFoundry). We weren't scatter gunned. Angel investing should be no different. Pivoting is an excuse. You don't pivot into unrelated industries / functional areas.

  • http://bothsidesofthetable.com msuster

    Complementary skills – sure. But as an investor putting money in an area they don't know – caveat emptor.

  • http://www.linkedin.com/in/rajatsuri rajatsuri

    What happened to 'its all about the team' for early-stage investing ? Surely if you know the team and think they are winners, domain expertise is mostly irrelevant?

    As long as the market seems reasonably big, I think investors should spend more time evaluating teams rather than focusing on domain expertise. Can you imagine all the people who would have passed on Google because they didn't understand search? Mike Moritz said himself he didn't really know search was going to be big, but just liked Larry and Sergey

  • NBeezzy

    So how does a entrepreneur who has (what I feel is) an awesome idea, in a big market, get access to someone like you to get the social proof needed? My idea exists in the fitness and wellness space. Should I go after VC's that have domain expertise in that area? Brad Feld just put some money into Fit Bit. (That company is not a competitor, but it could complement my business.) Getting a few sentences out of Brad isn't that hard. Tim Ferris, busy. Dave Mcclure, busy.

    Full disclosure – I'm not ready to raise money yet. I need to finish the MVP. But I've talked to a few people about angel list and they've said that I need to get some social proof before I put my name in the hat. Hence, I'm shopping for advice…

  • http://hdemott.wordpress.com Harry DeMott

    Warren Buffet calls it a circle of competence.

    Invest in what you know the most about – and with people who know it better.

    I think the initial comments belie a common misperception on the issue. If you rely solely on the domain expertise of others, you are bound to make errors – for how can you really judge whether or not they really know their stuff – if you don't know it. All you can tell is that they know more than you. That might not be a good enough reason to invest.

    Your point about being a sheep is right on. Handing out cash to other to invest is a dangerous activity – and speaks of amateur status. Professionals do their own work, have their own opinions, and come to their own conclusions

  • http://twitter.com/L1AD LIAD

    another poker analogy – if after 5 minutes at the table you can't spot the fish (i.e. the lame player) it's you. – same with domain expertise

    mark – would love to get more involved in the comments and I'm sure others do too but the font is to small it makes it quite painful.

    can you get someone to tweak the Disqus CSS and enlarge the text

  • Yavonditte

    As an entrepreneur and very active angel investor, I wear two hats. I have investors and I am an investor.

    As a founder I want investors that can help me or not hurt me. In the early days I want investors that can help recruit, then I want them to use my product, then I want them to help with strategy.

    As an investor I want to invest in ideas I understand. I have direct operating experience in a number of big ticket categories: Search (AltaVista), Advertising (Quigo) and now Social (Hashable). I can clearly be of some help in these areas. In fact, I am sitting down today with management of one of my investments to talk about building a proprietary ad system. Why? Because they have amazing data and will be a very large company if they can deliver ads based on this data.

    This company is filled with smart people but none have built ad systems. I can help!

    I cannot help as much with biotech or enterprise software because I lack direct experience — both as operator and as investor. So, what do I do? I stick to what I know.

  • http://twitter.com/c_sheehan Chris Sheehan

    Good post Mark. Having done this as a professional angel investor for a while, there is a lot of good wisdom in your comments. Excellent domain knowledge, superb instinctive people judgement, and deep understanding of the ebb and flow of startup company building are all solid building blocks for being a successful long term angel investor IMHO. Look forward to your next post.

  • http://twitter.com/TylerBeerman Tyler Beerman

    You should mention Sacca in this article. Worked at Google as VP of Special Initiatives. Also invested in Twitter. Access to Dealflow. Domain Knowledge.

  • Alaskanpoet

    Very incisive and astute article. Ironic that on this day in 1835 Darwin reached the Galapagos Islands we are looking to our mamalian kin the lemmings and their ability to control population relative to resources by the rush over the clifts for insight on angel investing. your quote about if you read it in the newspapers it is too late is right on point. Looking forward to the next installment

  • http://bothsidesofthetable.com msuster

    Disagree. I might love two founders of a biotech company but I have no ability to judge whether or not it will be successful. Yes, 70% of my decision is the founders and no, I don't expect to know more about their market then them. But lack of domain experience is a bad starting point.

    re: Moritz – can't use that as a method of investment.
    1. He was already super successful and rich. Meaning each incremental investment wasn't a huge deal if it didn't succeed
    2. He is a professional investor investing other people's money – not an angel.
    3. It was the Internet boom 1.0 so people did a lot of things different back then
    4. He had the right network around him. They were obviously talented individuals with strong endorsements from Stanford's engineering program
    5. In a sense he might have just gotten lucky on Google. I know that sounds crazy in hindsight. But do you think that Peter Thiel really knew Facebook was going to become Facebook? Or was $500k on a super smart guy with some traction just a reasonable bet for a large fund? We can rationalize many things post hoc.

  • http://bothsidesofthetable.com msuster

    I wrote about it in my “social proof” article that is linked above. You should also watch the This Week in VC episode with Farb Nivi who talks at length about it. It's linked on the right side of the blog under the list of TWiVC episodes.

  • http://bothsidesofthetable.com msuster

    Man, how did I miss that! Of course my article should have talked about Buffet. Didn't think of it. Thanks!

  • http://bothsidesofthetable.com msuster

    Yes, the old saying, “if you don't know who the sucker in the room is – it's you” rings true with me.

    re: font size – I don't have a problem. Did you try a different browser?

  • http://bothsidesofthetable.com msuster

    Exactly. And Keith wrote me a Tweet saying exactly the same thing. re: Ad Server – wish I had reached out to you on a couple of deals I've done! Could always use more expertise in this area. I'll ping you the next time I'm in NY. Or I'll send you a message on Hashable ;-)

  • http://bothsidesofthetable.com msuster

    Of course I should. But I mentioned him in the first article so couldn't make it too much of a love fest ;-)

  • http://www.marketing.fm EricFriedman

    This paragraph towards the end really resonated with me: “The most interesting thing I’ve learned by being an investor and sitting on boards & seeing so many company pitches is how different reality of what is going on at companies is from what you’re reading about them in the press. So it’s not good enough to only mine Techmeme every day.”

    This is so true from now being in both a VC firm and multiple operating roles – perception is not reality. This is both a help and a curse for many companies and management teams.

    The domain expertise gets you through the hard times as you mentioned, but also through the positive times as well by keeping a company and team focussed and energized on the issues without resting on their laurels.

    I have consistently found that entrepreneurs pitching companies use generic terms for expertise, all the while knowing that the terms are in fact nebulous.

    Great real world examples:
    So-and-so is a “great business development guy”
    Such-and-such is a “great CTO”
    “great designer”
    etc…

    The reality, as you mentioned, is that each of these roles is very different when you are talking about enterprise sales, fortune 500 bureaucracies, or actual startups in the trenches.

    My point is that drilling down into the domain someone worked in is the only way to define the roles I mentioned above and actually gauge their so called “knowledge” as it applies to the company at hand.

  • http://www.victusspiritus.com/ Mark Essel

    You mention the 20 years in financial investing your partner Brian McLoughlin has, and how he can spot the 10 reasons why a play will fail. But along that line of reasoning how could Facebook ever have exploded, seeing as how Myspace and Friendster were failing. The leadership/team and a constantly changing environment make for highly unpredictable outcomes.

    It's incredible that even within the chaos of startups, there is money to be made with that killer combo – domain expertise, and inside connections.

  • http://www.victusspiritus.com/ Mark Essel

    Yeah Steve Blank warned against the mis-communication of hiring a “VP of Sales” recently. Far different when hiring a VP of Sales from a big co versus the market research needed with startups.

  • http://reecepacheco.com reecepacheco

    Excellent comment re: leader vs. follower angels.

    While I don't expect every angel to lead deals, I laugh when angels get really hot on a deal and then say “what does so and so think?” and/or “come back to me when you have the first 25%.”

    Paul Graham has some great insight on this in a recent essay.
    “Most investors, unable to judge startups for themselves, rely instead on the opinions of other investors. If everyone wants in, they want in too; if not, not.”
    http://www.paulgraham.com/future.html

  • http://www.linkedin.com/in/rajatsuri rajatsuri

    There's a reason why repeat successful entrepreneurs command such high valuations when raising money. People don't care what they are working on, but trust that they are brilliant enough to figure out a successful way to do it.

    A typical example: http://techcrunch.com/2010/08/01/feeding-frenzy-as-delicious-founder-joshua-schachter-raises-round-for-new-startup/

    I think basic domain expertise probably matters though – clearly an IT person shouldn't necessarily be investing in Cleantech or biotech unless they have background or a high motivation to immerse themselves in the area. But all of IT seems pretty reasonable for a smart person to understand.

    Rebuttal re: Moritz
    1. Although Sequoia was a well known firm, I don't believe Moritz had huge hits before Google? From a recent TC article, it seems most of his big wins were a bit later (Paypal, Zappos, A123)

    2. Shouldn't professionals be good investors too? I guess there is a difference between VC investing and angels, but 'domain expertise' seems like a universal thing

    3. People did do things different in Internet 1.0 – like invest in Pets.com and other major losers. Clearly some people won and others didn't

    4. Definitely agree with this. His network helped him evaluate the team, which is what investors should spend 90% of their time on (other 10% to evaluate size of market)

    5. He might have gotten lucky with Google, along with John Doerr and Andy Bechtolsheim – already two of the most successful people in the Valley. Given Moritz 's subsequent track record, I think it's safe to say that whatever method he has works.

  • Dave Baldwin

    Like your answer. You can add to pivoting, the better company knows the pivot coming. Otherwise, the developer is looking for sloppy 25's at a cocktail party ;D

  • http://hdemott.wordpress.com Harry DeMott

    Funny thing is that what you are writing about – while it has nuances

    specific to the industry – is no different than investing anywhere.

    On Wall Street, where I sit – you started out wanting to invest alongside

    Goldman and other big banks – who had all the flow – controlled the cash -

    and generally were able to get better exits. That moved to the PE funds -

    and to some degree to the hedge funds. Everyone knows each other (it is a

    small community like VC) and people want to be seen to be investing with the

    guy on the cover of the Journal who just made $1B by shorting sub-prime.

    Sooner or later everyone just piles in post a 13-D filing and you have your

    self fulfilling prophecy.

    the guys invested in and working for Slide epitomize this – as I wrote – you

    have prolific and plugged in angels – successful players all – and you know

    both the sources of money to start the company – and all the buyers. It is a

    small world – so why not take a chance on them – as if anything they work on

    hits – it is worth multiples of that.

    Following that is the Buffet circle of competence. No difference out there

    than on Wall Street – or anywhere else in the world.

    Get in with the insiders. Make sure you understand what you are investing in

    with the insiders. Make sure you have reasonable rights. Make sure you can

    somewhat control or influence the exit.

  • Dave Baldwin

    Something to think about Mark…it is not so much the 'BIG' company as we move thru the next 5 yrs., but putting together complimenting products/services.

    The BIG companies have delivered the vehicle. There will be cut throat competition, which at this point will deliver one incredible year after the next. This competition will lead to so many avenues for the startup.

    You are on the money.

  • http://www.victusspiritus.com/ Mark Essel

    Its ok on my phone and desktop Liad, what browser/version?

  • http://www.hypedsound.com jonathanjaeger

    I agree. However, in your next blog post you say you wouldn't invest in biotech because you don't have the domain knowledge. There is obviously a huge difference between biotech and consumer internet companies, but there are also differences in domain knowledge within the consumer internet category itself. If you are angel investing in dozens of companies, it's going to be difficult to have first-hand knowledge of every consumer internet subcategory that you might invest in. Even if there is some overlap, you will probably invest in some things that you can wrap your head around but don't know all the ins-and-out of.

  • http://twitter.com/garrettkocher garrett Kocher

    If we continue the poker analogy: Sure it's a bet on the founders, but if your hole cards happen to be AA it certainly helps the board.

    On the flip side, founders should be looking for angels who have more to offer than just money, domain knowledge from an investor brings a lot to the table.

  • dshen

    For me, the simplest reason why you must have some domain knowledge is to tell whether or not the entrepreneur is selling you snake oil or not. This is even if an entrepreneur is backed by prominent VCs/angels/etc, you still have to do your homework because they may be investing for other reasons besides whether or not it's a great business venture; it still might be snake oil but just in another form. (People who know me know I hate social proof.) How else can you tell but with some sort of domain knowledge?