What Makes Lateral Capital Different
To say that Lateral Capital has a different approach to Early Stage investing is something of an understatement. But frankly, so many of the “absolute truths” we learned about investing when we first came to this business turned out to be false. Or at least not supported by data. Other investors frequently remark that the elements of the Lateral Capital investment approach detailed below are not “industry standard.”
- Lateral Capital has no category or geographic restrictions. We have made investments in 19 states and more than 20 different industry sectors. This is based on the belief that the best companies have the greatest chances of success, irrespective of where they are located or what market they serve. Focusing on a specific geography risks confusing the Fund’s investment objective with that of an economic development fund. Likewise, working in only one industry segment – B2B software, for example – assumes it is possible to pick the “one best” business category at any given time. Unless you believe in the “genius” school of investing, we have concluded that finding the “one best” of anything is pretty unlikely.
- We stay away from investments which have to be big before they have value. We worry about businesses where the product or service has to become ubiquitous before it has any real value to an acquirer. This is typical of many “Silicon Valley-style” deals where successive rounds of capital investment are assumed into the business model; on the way to national/global scale and (hopefully) profitability. This money is required to drive the network effect, which in turn depends on gazillions of users. It is not that we don’t believe this can happen: Facebook had 7 rounds of private financing before it went public. But we don’t believe it is the place for Early Stage investors. We would gladly trade a lower return multiple (2.6X our money on average) for a more certain, less showy, less distracting focus; based on reasonable, believable growth assumptions. Said another way, we don’t want to invest in companies which require follow-on investments from Venture Capital funds to become salable.
- We like businesses which strategic investors – typically large companies – will want to buy. We are not in business to de-risk investments for Venture Capital funds. Among other things, VC firms can make it difficult for Early Stage investors to get out successfully. So, if we can prove that a business model works and that it is sustainable, we target to have the next owner be a large company – a buyer who can bring distribution muscle to the party. By and large, big companies know that they are smarter to “buy in” innovation than to invent things internally.
- We do not invest only in what we know. For example, we see consumer products – where we have so much experience – as a difficult place to invest. This is despite the fact that dozens of new consumer products (CPG) companies are launched every day. Unfortunately, these businesses typically have no patent protection, require huge distribution investments and require consumer marketing investments with very long payouts. By the way, we are happy to reapply our experience to industries which are vendors to the CPG industry. To-wit: we have never been in the trucking business directly. But having used hundreds of freight carriers to deliver Tide or Pampers, we know that fuel savings is a big idea. This made it easy, for example, for us to invest in the Halo Truck Tire Inflation System – and to introduce the entrepreneur to major fleet operators.
- We do not want a Board seat. While having a Board is a requirement for all Lateral Capital invested companies, we do not serve on any Boards. We believe we can be more helpful by influencing the CEO directly – with insights, ideas and coaching from the side. This is delivered as a steady stream of written perspectives and two to three in-person meetings per year. We do not serve or ask to serve on the Board of any of our invested companies. We are “hands in,” not “hands on” investors.
- We do not invest more in our “favorites”. Early Stage investing is its own asset class, not a “stock-picker’s” business. When we meet a new company, we can’t tell what the investment outcome will be. (If we could, we would invest everything in that one company!) So, we have learned to invest the same amount in each company – $100,000 each beginning in Lateral Capital IV. Using the 2007 Willamette University Study [https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1028592] as a guide, we invest in groups of at least 15 companies at a time. On average, this research shows that 52% of investments fail to return their capital and that 7% produce a return of 10X or more, with the rest returning 1X to 5X. So unless you invest in at least 15 companies at a time, you are unlikely to get one 10X investment (7% x 15 = 1). And the 10X companies produce 80-90% of the total return. Here are the size of Lateral Capital funds to date:
- Lateral Capital I – 15 companies
- Lateral Capital II – 16 companies
- Lateral Capital III – 16 companies
- Lateral Capital IV – 24 companies
- Lateral Capital V – 40 companies (Fall 2018)
- We don’t try to pick “the one best” technology. We aren’t qualified to know if any new technology is “the one best” in its field. This is particularly true in MedTech where there are hundreds of possible solutions to every health problem. So, we look for Techtilities™ – products or services which everyone in any given field will need as research progresses. As an example, we are “playing” the stem cell industry by investing in three companies which serve the needs of all stem cell researchers:
We don’t invest in “really cool” technology. We invest in what customers want to buy: Benefits. This is because that’s all buyers care about: What the product actually does for them. We do not care so much about technology Features. What’s the difference between Benefits and Features? Here are some simple examples:
What’s a Feature?
- “This new Prius® gets great mileage … 100 miles per gallon.”
- “Horizon®soy milk is made with all Organic ingredients.”
- “Scott’s® lawn fertilizer has a weed killer built in.”
- “Uber® is the easy, fast way to get from here to there.”
What’s the real Benefit?
- “This new Prius® is so efficient; you will look smart – and environmentally conscious – by driving it.”
- “When you serve Horizon® to your kids, you are doing what’s best for them.”
- “When you use Scott’s®weed killing fertilizer, your lawn will be the envy of your neighbors.”
- “Uber® is like getting a ride from a friend.”
We don’t confuse investing with charity. It is sometimes tempting to invest in “helping people.” To really help people, however, the business providing the help has to be economically sustainable, or it won’t be around. “Double Bottom Line” investing sounds good, but it is not well defined and the concept is unproven. So, we have moved to a “multiple stakeholder benefit” standard. We believe the very best Lateral Capital investments will deliver five outcomes:
- Compelling financial returns for investors.
- A highly successful outcome for the entrepreneur.
- Increased sales or profit for the customer/buyer.
- Clear benefit to the end user/consumer/patient.
- Positive impact on the environment/sustainability.
- We look to learn from – and teach from our failures. We collect all our failures and talk about them as openly as possible – without embarrassing anyone unduly. Our list includes deals we did that went badly, deals we passed on that went well and deals we passed on that were “bullets dodged.” Blaming the economy, the entrepreneur, etc. is simply no help. You can find a description of several of these companies in the website section, Investments Not Made.
- We are open to long shots, but from new angles. Doing the impossible is what Early Stage companies are uniquely qualified to do. The folly comes from trying to do the same thing in the same way as everyone else and expecting the marketplace to pay you to do it. For example, there are thousands of computer security companies promising “better algorithms” as a way to protect client data systems. We can’t tell one from another – and generally, neither can they.
Rather than trying to find someone with the best “old” idea, we look to invest in approaches that take a well-calculated risk to do things differently. For example, we have invested in Cognition Therapeutics (CTP), a company looking to arrest the progression of Alzheimer’s disease with a small-molecule drug. This area has received billions of dollars in research investment from the world’s largest pharma companies, with consistent failures. But they have all been aimed at the same “theory of the case”; that amyloid beta oligomers (ABOs) can be bound up and flushed out of the brain. Think of the way statins work as an analog.
The approach from Cognition Therapeutics is completely different. Rather than trying to “soak up” ABOs, this company has developed the equivalent of silicone which protects the “antennae” in the brain where memories are formed. Will this work? We don’t know yet, but so far, so good. Our bet is that this model – or a variety thereof – has a good chance of success and breathtaking return potential. One good sign: They have raised as much in research grants as they have in equity investment.
We love technologies that are “Stupid Simple™”. If technology is so complicated conceptually that we can’t understand it, there’s a good chance that potential customers won’t understand it either. This isn’t likely to be true for the engineers, but there’s a good chance the decision-maker will be befuddled. Not good
So we look for really simple concepts. Stupid simple. For example, our invested company Onboard Dynamics makes a low-cost compression pump for natural gas. It will allow companies to refuel CNG (Compressed Natural Gas) trucks anywhere there is a household-size, low pressure gas line. They can do this at a price one-fourth of that of a public compressor station which requires a $1.2MM electric-powered compressor. Do they do this with some new-fangled approach to “stacking” methane gas molecules? By developing a new scrolling impeller pump? No. They did it by modifying an off-the-shelf GM V8 engine so that half the cylinders act as the pump, while the other cylinders run the engine – using natural gas, of course! This we call “Stupid Simple,” even though the execution was incredibly difficult and took nine years to design.
- We believe companies that sell something sooner will succeed sooner. Our most successful investments have been in businesses which operate on parallel paths – they earn while they learn. On one hand, they target a big problem with a huge global market. On the other hand, they develop a narrowly focused version of their technology which can be developed and sold quickly to produce cash flow. Typically, this means entering a smaller, less demanding market segment; with an entry level-version of technology. Or a secondary use for the core technology. The idea here is that our investment helps get the company started down the path of selling a profit-producing product as quickly as possible; something that generates revenue in the short-term and which helps feed the company’s longer-term development program.
As one example, our invested company Rebiotix has extensive patent protected technology in the human biome arena and someday hopes to address Crohn’s disease. But to get started, the company is developing a simple, enema-based product which repopulates the human gut with the right balance of bacteria. It cures recurrent C.difficile infections in about 3 days; a condition which kills 29,000 people per year. The Rebiotix product is built around a curative approach known for more than 50 years. But Rebiotix put it on a path to FDA approval and an exclusive market position, making the company very attractive to acquirers. The business was sold to a European pharma company for several hundred million dollars.
Said another way, we look for companies that can quickly sell something to someone even if it’s not the product or service they ultimately have in mind. Three reasons:
- Selling something brings in some revenue. This can’t be bad. In some of our invested companies, it not only pays the bills but supports the research which will lead to something big. Example: B-MoGen in Minneapolis sells genetic “knock ins/knock outs” to big pharma companies while they are developing entirely new genetic tools.
- It keeps the company market focused. If no one buys what you can make, it’s a sure sign you are making the wrong thing. Actually being in the market, selling an early version of your product is the best way to find the ever-elusive product-market fit.
- It gives the company “road miles”. There is no way to perfect a product or service without seeing it used in actual customer circumstances. This is the only way to learn if the hardware is durable or the software is bug-free. If something is going to fail, make it early on the curve and learn as much from it as possible.