Ashesh Shah (The London Fund): Be Brave!
20 Jan, 2022
Adrian Lloyd is Founding Partner at Episode 1 Ventures. He has a management and strategic consulting and entrepreneurial background in Europe and Asia and an MBA from Stanford Graduate School of Business. After his MBA he spent 2 years working on on- and off-line startups before founding Episode 1 Ventures with Simon Murdoch and Damien Lane. Immediately prior to his MBA, he established Marakon Associates’ presence in China. He speaks Mandarin fluently. He is also a mentor at TechStars London.
In my early career, I worked as an advisor to large multinational corporations, mostly European and American, on their long-term strategies, organisational design – all the kinds of things a consulting firm would advise on. I felt that all this world was far too removed from the coalface of what was really going on in those businesses day-to-day. I set up my our subsidiary to do similar work in China within the organisational framework of a large American consulting firm, this provided me my first taste of starting a business, hiring people and winning clients.
The advisory business became moderately successful, but to be honest I didn’t really enjoy it so I left and went to Stanford to do my MBA. When I was in Silicon Valley, I was exposed to a lot of software engineers, and technology entrepreneurs, the whole business school was oriented around entrepreneurship – that’s what it is strongest at. I entered the school wanting to learn more about being an operational CEO and I left the school wanting to become an investor in software startups, I discovered my personality did not suit being a CEO of one business, putting all my eggs in one basket.
I admire those who do that role, those who have that characteristic that I don’t – the ability to manage that kind of pressure. However, I’ve seen enough, spoken to enough people to understand that the more operating experience I had under my belt, the better investor I would be.
In 2010 when I left school I came back to Europe, I wanted to live in Europe, and it was a great time for European tech. I joined a series of startups in short-term operational roles to learn as much as I could. That was very helpful, and then through at a fortuitous meeting through connections I met my Managing Partner and co-founder of Episode 1 Simon Murdoch. Simon is a successful entrepreneur and super angel in the UK, we decided to build Episode 1 together with Damien Lane, my third partner. Now we are 5 partners and continue to grow.
For us all of our startups are high-risk, extremely bold ventures, so they are all unusual in that respect. We invest in very ambitious founders who are innovating their industries.
One of our companies that comes to mind is CloudNC, they have created the first what they call ‘Factory in the Cloud’ for anyone who needs to have anything made from metal through a milling machine (most metal in this world is not printed but cut in a CNC milling machine).
They’ve created algorithms that allow for the extremely efficient conversion of a CAD drawing into a pathway for these machines, removing a whole bunch of steps and people between a CAD drawing and a cut piece of metal. That idea has developed into a business to allow someone all around the world to get details he or she needs from a factory elsewhere. It is a massively ambitious idea and in that way is very unusual. That is one example of how I would define ‘unusual’. Many of our companies are doing things at the cutting edge of what’s possible, which is unusual, very rare, and exciting.
Each year the longlist is about 2000 deals, the shorter list of those that are within scope and relevant is about 1000. Those from this 1000 that gets real attention we probably look at about a quarter of those quite seriously. We meet probably 200 of those 250. We invest in about 8 per year.
We absolutely do both our Associate Hector Mason searches all the databases that are available, looking for signals of companies that are interesting. We are also looking for people who left big tech companies and have changed their title to ‘founder’, founders who are starting a new company, a new business – we then reach out.
We are very active in looking at what the most successful angels in the UK are backing, that’s outbound. Inbound and other sources of deal flow come from my network: a lot of Angels work with us closely; we support and help the major accelerators in the UK. Of course, there will always be cold inbound, sometimes out of scope but we do make the effort to look at everything that reaches us and we are very quick at assessing whether it is suitable to pursue further.
We operate at the seed stage where a company often hasn’t even finished developing its MVP, sometimes it has developed an MVP and has some early customer interest, maybe a few clients. Most of our businesses are right at the beginning of their commercial journey, probably halfway all the way through to building an MVP that works, so there is not a lot of data to make our decisions.
What we do most of the time is build our own conviction based on as many signals as we can around the founding team and the potential market size. If those two things line up and we have a good feeling and a reasonably strong belief that the problem they try to solve needs a solution, we do understand that both the problem and solution may evolve in the first year or two of our investment. We will then go deep into due diligence around the founding team and the market size.
A lot of it revolves around how convinced we are that the founder really knows what he or she is talking about and has great skills and knowledge in that market. They need to be able to persuade not just us that it’s a great idea, but the next 10 senior hires he or she will make. One of the greatest validations is that really smart people will give up other opportunities that are available to them and join that founder that can’t pay them very much and can’t give them much equity, but still, they join. That is a fantastic sign for us.
The due diligence process starts from the first meeting to when a term sheet being signed. If we feel there is a lot of competitive tension we can move fast, can be as quick as 3 weeks.
We can get to conviction within 2 weeks, but we do need probably one more week of doing our initial reference checks on the founder and the co-founders, maybe one or two commercial calls with customers or people that we know are operating in the market, and some more desk research to build some data for our investment committee paper.
That can take another week. Then from term sheet to actual closing of the deal and a formal contract is probably about a month. That is taken up with the lawyers doing their due diligence and negotiations between the two parties and, of course, more due diligence on the commercial side. Most of the time is taken with the articles in the investment agreement being written up and agreed upon.
Our checks are on average about £1M to buy roughly 20% of the business, that’s our current average.
The minimum that we expect is 10x. We’re looking for 30x or more and we will be wrong much of the time. Currently, we rank in the top decile for companies going from our first check to Series A. We’re doing analysis now but something about 60% of our businesses will go to Series A, 80% of our businesses will make a further round of funding, maybe not led by us. That’s a very important metric for founders to look at is the track record of the fund in getting the portfolio to the next round of funding. Companies will fall away that’s why we need to believe that when we invest it will be at least 10x, and with those companies that fail, we’ll return to our investors at least 3x after all fees, which usually means about 4x on the money we invest.
I think diluting by 25% in each round is probably the upper limit of what is sensible, a founding team needs to be motivated, so do the rest of the senior executives. We’re very keen for our companies to have a reasonable size option pool, usually 10%. If it’s a very early stage, that will be 15%. If there’s a clear gap in the senior leadership team, maybe even as high as 20% in an initial round, but usually it’s just 10%.
We want to see those options being sensibly used rather than hoarded. On average, a dilution that takes place in our Seed round is around 22.5%. We take 17.5 to 20% with 2.5% for other angels and other strategic investors. When the valuation of the company goes up during the later stages, the smaller ownership stakes by the founders become more valuable. We want to see the founders highly motivated by the equity, not by salary. We’re all former entrepreneurs, operators, and Angel investors, so we’re very sensitive to founders’ equity stakes and all Angel investors who supported the business even before us. In return, we want to be treated fairly by other Seed-stage investors and Series A investors in those businesses where we are Angel investors.
At the seed stage, we are only looking at the senior executives, and most Seed stage businesses we’ve invested in only really have senior executives at the time of investment or between 4 and 8 people in total. What we’re looking for is an extremely strong founder who has attracted extremely strong co-founders. The opportunity cost of giving up a job at Google or Goldman Sachs or Facebook or Darktrace or DeepMind is very compelling to us – we want to see people who clearly could get extremely highly paid jobs in other technology firms but have chosen this one.
We’re looking for complementarity between those co-founders: we don’t want them to be expecting of thinking to do the same job as each other going forward, because that leads to complications. We’re looking for social chemistry between the founders. Feuding founders can cause complications and be very messy. Finally, we want to get on well with those people – emotionally and socially, because we spend a lot of time with them, we want to build a good rapport.
We want to get on and respect the founders and vice versa, we are paid to make money for our investors and for ourselves as the biggest investors in the fund. We don’t want to struggle every time we have a board meeting because we really don’t like the person. If we think the person is very difficult, that probably means the people who work for them do too making it harder to hire great people. It’s not just that we want to have nice board meetings and enjoy our time – we want to reduce potential future hiring challenges.
The smallest team we have supported so far is just 2 co-founders with no formal team but a fantastic business plan. To date, we’ve never backed a single person with no other employees, but we have supported solo founders with employees.
It’s impossible really to say – I don’t know enough about either of them to answer the question with any real insight. But Steve Jobs succeeded and built Apple and his other businesses to their great success. We all in Episode 1 are people who realise that we don’t know it all and we love to learn from every experience and from founders we work with.
Not being an engineer by training, as Wozniak is, I think, I’ll probably get on better with Jobs.
Dishonesty. Having extremely high salary expectations straight up from the Seed round. Having technology built entirely out of the house but claiming the understanding of the technology IS deeply in the house while evidence suggests otherwise. And, of course, a sense that there’s tension between the co-founders.
Yes, we have a couple of experiences of that. We had great conversations early on with Deliveroo. I think we’re one of the first institutional investors who had got meetings and conversations with Will Shu before he had his round with Index Ventures. We negotiated but we did it badly when Will was trying to raise a pre-Seed round. At the time we didn’t have our fund launched, so it was difficult for us. I think we negotiated too hard on price and then he decided not to do the round and just bootstrap for another 6 months before successfully getting Index onboard. Perhaps if we’ve been more generous with valuation, we could have bought a nice stake in Deliveroo which would have been great.
There’s another business which I won’t name – a company that I and my partner Paul were leading on, we got to the closing stage but there was a sticking point with another major investor on the cap table. We tried to iron it out, but we couldn’t so we decided not to do the deal because of that issue. That company’s gone to be very successful and the issue was resolved quite naturally 6 months later. It was the wrong judgment on that deal that would have hit the top quarter of our fund. There’re always errors with every fund, and we learn from them – regret them terribly, but hope we won’t make the same mistake twice.
If we really like a company, we would invest in them. I have 4 kids, my sister who has 3 so I find education a fascinating industry for technology. I find the potential in wanting to help education move beyond where it is today with technology fascinating, but I’m also nervous about my children using technology too much, because it’s designed to be addictive for them, from my experience.
There’s a tension between wanting the education industry to evolve and move faster using technology but technology can be dangerous, young minds which are very plastic, very vulnerable, very impressionable. And then, of course, on the commercial side schools are not high margin businesses, particularly state schools – in every country. It’s difficult to see big businesses being built in education in a regular way.
In Healthcare in the UK, the NHS controls about 90% of the healthcare budget in the UK, it’s a very difficult institution to build a business and scale. We have invested in Healthcare in the NHS. MediShout – looks very promising they help the NHS with operational issues with hospitals by allowing doctors and anyone who works in a hospital to log any issues with any equipment in the hospital. That information is gathered centrally and updated about what’s working, what’s not, and communicates directly with the manufacturers of the faulty products. They know exactly what’s going wrong in real-time and send the right engineer to fix it.
We choose investments in Healthcare very carefully, with conviction that the person leading a company really understands how to navigate the NHS or it’s the business that will sell very effectively into other areas of the Healthcare world.
The Venture business is different at each stage of the stack. Chess, clearly, the most strategic of all those games, but it probably requires less instinct. Checkers and backgammon are a little bit simplistic as the analogy. I’ll probably go with Mario Kart: you have a lot of information coming at you very fast and you must decide very quickly on a competitive deal. You must assess the information very quickly, be very nimble and go with instincts as much as the data that is provided to you.
ARM is incredibly important in today’s world with the chips they designed that we use in every device that we use. That’s been a magnificent success. Deepmind has generalized AI to the next level and has been very successful because of that. The third one, I hope, will be CloudNC, who are revolutionising manufacturing.