Michael Kosic: VC Diversification Free Lunch, Sortino vs. Sharpe Ratio and Open-Ended Funds - E245

Michael Kosic is a Managing Partner of the Loyal VC, founded in 2018. Loyal runs a global venture fund with flexible redemptions and a proprietary gate-stage process, reducing investment bias and unlocking greater returns. Loyal draws on Michael's lifelong experience as a technology entrepreneur, professional Industrial Engineer, and Angel Investor, while heavily leveraging his INSEAD network, where he earned his MBA, and the Founder Institute accelerator.

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Jeremy Au: (02:20)
Hey Michael, really excited to have you on the show. I met you at INSEAD at the Venture Capital Conference. And I thought there was a tremendous amount of truth in what you were saying about what needs to change and more importantly, you're actually doing something about it. I'd love for you to introduce yourself.

Michael Kosic: (02:38)
Thank you so much, Jeremy. My name is Michael Kosik. I am the founder of Loyal VC. But before that, I consider myself a lifelong entrepreneur an active angel investor, and a father to two great children.

Jeremy Au: (02:50)
Amazing. So how did you get into investing and tech?

Michael Kosic: (02:56)
With the Lifelong Entrepreneur kind of path that I talked about, this is in many ways arch typical. So it's paper route mini concession store in my locker in junior high school, developing applications and installing networks in high school, doing people's tax returns.

Moved on, and did some industrial engineering and that was really about adding technology to businesses to create new value and opportunity. Then went and got a degree from INSEAD to my MBA there and joined a startup shortly after that. There's always been tech there and in the background, being trained as an engineer first and a love of business and finance and venture, I guess.

Jeremy Au: (03:36)
I think it's a big transition, right? I mean, you were an operator and builder, and then you decided to do venture capital investing. So what was that motivation for you to start exploring and investing?

Michael Kosic: (03:50)
First it was about fixing things, and then it was about building things. And then several startups later on in my life, I'd known what it takes to actually build up a business and get it from nothing to something profitable and successful.

And thought that I could be involved in several businesses, not just the one that I was running myself. And I could actually take part in, live vicariously through and maybe create more value by working with more entrepreneurs. And yet put me in a position where it's not just about everything coming down to me as the founder, cause that's something that isn't necessarily sustainable your whole entire life. So put differently, I don't want to ever retire. I've got the best job I think in the world now. But it took me a while to figure that out and get in a position where I could actually make a living out of that job.

Jeremy Au: (04:44)
And what did you learn about that transition from being a builder and operator to doing a first set of investments?

Michael Kosic: (04:53)
Wow. A lot of things, you hear a lot of people saying kind of embrace failure. I mean, I'm very much a let's try to chase a success. I don't want to embrace failure, but I certainly want to learn from it. Try not to repeat it. Build up some muscle memory and share those lessons when they're relevant.

But at the same time, I think it was really important for me to do this in a way and do it with someone whom we would be humble about our own experiences. Because I didn't appreciate people who weren't when they were giving me advice when I was an entrepreneur. And there is, wisdom is a wonderful thing.

But often when you're a founder, you're the one who's out there taking the real risks and often having the insight and foresight that others don't or just the perseverance to push through it.

Jeremy Au: (05:39)
So what's interesting is that as you built this, you built Loyal VC, right? Which is a VC fund. And what is interesting is that you approached it in a very different way. You built a very different fund. But before we talk about the fund itself, how did you discover that you didn't want to build it the normal, conventional way? Describe that.

Michael Kosic: (05:58)
So I would say it was 20% ignorance in the sense that I didn't know how to do it differently or how you were supposed to do it and 80% it was how I believed you should do it or one should do it. So when I was working with my partner Kamal, on the fund, it was interesting cause we got together and we were talking about problems and opportunities in early stage investing, both from the perspective of the angel investor and the entrepreneur. And there was probably about an 80% overlap in some of the problems or opportunities we've identified.

But what was amazing, there was a 90% overlap on what we thought we should do it or how we thought we should do it differently. So those things really led us to build a fund structured in a way that we would want to take money from it as entrepreneurs and we would want to invest in it as angel investors.

Jeremy Au: (06:48)
So what's wrong with venture capital? I mean, because you're implying something, right? Which is like, oh, I didn't know how to do it the conventional way, but I built it in a totally my way. And then we're kind of skipping something here, right? It's like, so what's the current way?

Michael Kosic: (07:04)
So a few things. I think ego's a big issue in venture capital. And we don't believe that you can necessarily predict the future. For example, we do psychological testing of our entrepreneurs before we allow them into the program. And it's not that the attributes that we test are predictors of success. It's the opposite. We found that they're highly covariant with entrepreneurial failure. So let me give you a few examples of that. So if you are too agreeable, then you're not necessarily going to make a good entrepreneur if you don't have fluid intelligence, or that's the ability to realize that the pieces on the chess board have changed. The environment around you has changed, and you have a need to pivot from your own idea. You may have been in an industry for 10, 15 years, had a great insight. You're driving your startup towards taking advantage of that opportunity. If the landscape does change, and you're still stuck in that mindset of two years ago when you left and launched, this great adventure then you're going to steer the whole company and also the staff and all of the human and financial capital down the wrong path.

If you're a sociopath, this test will flag you. Now sociopaths might be able to pitch very well. They might be able to inspire people to give them that first check. But you're not going to be able to coalesce a team around you long-term and create value.

And that's an example of one of the things that we believe that it shouldn't be about just the ego and me knowing how to predict entrepreneurial success. We don't have a crystal ball. So we really wanted to build a process oriented VC that allowed winners to emerge and then rewarded them based on their performance, not on their intent or their pedigree, or their background or the last great thing they did. So that was important to us.

Jeremy Au: (08:46)
So you just said that there's a bunch of factors, for example, like fluid intelligence not being too agreeable not being a sociopath. So how do you test for that or how do you screen for that? Because before we talk about process, but how do you actually screen for it?

Michael Kosic: (09:00)
So, we source from three places. At Loyal, we source from INSEAD. We source from the Founders Institute, and we source from our own LPs. On the third one the logic there is if you trust us enough with your money, we should trust you enough with your opinion of who we should invest in.

We'll give them a chance to compete with everybody else. Now the Founder Institute has a entrepreneurial DNA test or assessment. So that's the one we currently use. All of the founders have already taken that test. When we source from INSEAD, we actually make the INSEAD founders go and do that test.

And interestingly enough, we have a company in our portfolio called SquarePeg Hires. They've made it actually to the scale stage. Claire McTaggart is the CEO there. She's based out of New York and they do this attributes-based hiring and assessment. We've used it very small sample size to hire the amazing staff and people we have currently at Loyal, which is wonderful. And some of our startups themselves have used her product. But what I'm getting at is there is science there. Claire's, company takes that science maybe a step further than the Founder Institute test. And that entrepreneurial DNA test does.

But that test is there, it's free. Go check it out, it's fi.co and take the entrepreneurial DNA test and you can see the results. If you like assessments like I do, I'm always interested in looking at data. I don't necessarily have to agree with it. Remember that agreeableness thing? Yeah. That type of thing fascinates me. Yeah.

Jeremy Au: (10:16)
I mean, I think it's interesting, right? Because at one level you're saying I don't want to measure people by the pedigree and all these other things. The last great thing they did, and I'm willing to screen people based on their personality traits and so forth. So there are different criteria and I actually was reading a paper recently that said schools do predict for some level excess return in terms of, because they're highly correlated other things, right? Like fluid intelligence and all these other things, but also because some schools are really correlated with great networks, right?

Fundraising networks and capital is something that is a tough skill to master, let alone something to snowball and push it forward, right? In terms of network and alumni so what does that mean? I mean, I think all of us are like we want the best people, but the best people tend to come from these pegs, right?

Michael Kosic: (11:06)
Yeah. so that's why I like our two sources. Founder Institute is a lot more inclusive than INSEAD. And by that, we draw from the top performers in each of the cities. And they have 150 different cities that they run this in. To be a top performer, you need to enter the program.

To enter the program you need not much. I think it's anywhere between $500 and $1,500 tuition. It's not an expensive type of program. So that makes it a lot more accessible to different socioeconomic levels. While INSEAD, it's a top business school, top global business school, it's expensive to go there.

Yes, some people are there on scholarship, but most people who graduate from INSEAD, have at least one rich uncle or aunt that can help them launch that business. They're both global networks. They're both powerful networks. We're not saying that INSEAD and Founder Institute are better than Y Combinator and MIT.

If somebody came to us, especially so early on in our networks from MIT, we'd have to ask ourselves why couldn't they get funding from their own network? So there's an adverse selection problem there. So we very much do rely on the power of these networks the trust associated with these networks.

And it's enough. We add six new companies per month three from each of the networks, three from INSEAD, three from FI, and we've been doing that for years globally. So we're up to almost 300 companies. We'll hit 300 companies in March. If the figures keep going as we're going. And INSEAD, it's one of the top unicorn. It's a top non-US school for unicorn founders. So it is a good place to fish. Venture capital, VC, is definitely about access and access to those networks is an important correlator of success. There's enough entrepreneurs for us to still, and world class entrepreneurs. We believe that we still need to discern from within that population and take bets or not take bets on some of them. So we do reject entrepreneurs.

Jeremy Au: (13:01)
And what's interesting is that you're obviously making these additions all the way up to 300 companies. And you talked about the process, right? Which is that you often start with that small check, and after that you double down and you double down after that. But doesn't every VC do that? Sequoia or make up VCs do that. But it was interesting obviously is that you're starting like at about what, $10,000 it's very small.

Michael Kosic: (13:25)
10k. Oh, yeah. That 10k, there's three different analogies I like to use for that 10k. If you're a poker player, it's anti, if you're a mathematician, it's an option on a time series of asymmetrical inside information. And if you're a marketer, it's a marketing expense.

Choose the analogy that most resonates with you. But the simple fact, this is the paid due diligence stage. Okay, so the next check is the check where we discern and we do two and a half of these 200k checks per month and with about a hundred companies ready for and buying for those checks.

That means about 2%, the top 2% of the companies we select for the 200k checks the following month. So we've chosen the check size very specifically to avoid some decision making biases. And again, comes back to that ego point I made earlier. You're not going to spend 200k to save a 10k investment to be right about that.

Our next stage is a million dollar check. You shouldn't spend a million dollars to defend a $200,000 investment that you made, right? So while many VC models, they reserve half the capital for follow-ons, right? This is a five x. Our next check is 3 million.

So if you look at it that way what you're doing is you're putting in a structural barrier so that you don't fall into that, throw good money after bad. And we're very honest and open with our entrepreneurs. We never say we will be that VC that is there to support you throughout the entire journey with funding when you need it.

We say we are the VC that is there, that will support and issue the checks to the entrepreneurs who are performing the best in our portfolio. So that very competitive nature and it's systematic and it's disciplined, right? 40% from every previous stage moves on to the next stage.

But one of the things that when we were setting up our fund is we want to be patient capital. We've both been entrepreneurs. We know what a meandering path this is. As data driven as we are, if you're not within 89% of your KPIs within 8.3 months, then we're done with you. It's not like that at all. You are constantly competing with all of the other companies in the loyal stage that you're in. We've had a company that we fund, if you look at the kind of distribution of when we write our next checks, the median is about 10 to 11 months in between checks.

We've written some of those follow on checks in as little as three months and as much as three and a half years. Now that three-and-a-half-year entrepreneur, just to pick one of the upward outliers, she was a Silicon Valley company that she was a good leader, good business but her valuation was at Silicon Valley levels.

And from our perspective, compared to the global choice that we had for investments, she had to grow into her valuation. And she did. She got the revenue, she built the business and the day that we felt that she was appropriately priced we made her the offer. That kind of process that we use is very important to us.

Jeremy Au: (16:21)
And one of the things that I get, of course, is that what you want to do is you want to double down on a witness, right? That's what every VC says, right? And then I think what's interesting, of course about this approach is that I think first of all, you're starting for a very small check, right? All the way at 10k. That's like pretty much the pre-seed, right? The angel check.

Michael Kosic: (16:38)
I like to say for 15% maybe of our portfolio that, that's 10k is life giving for where they are, for where they're operating in it can pay for some developers, it can pay for survival. It gets credibility. It helps them gather other funding to get started. For the other 85% it's an expensive lunch in San Francisco.

I mean, it doesn't move the needle. And when we went back and we asked our entrepreneurs, well, why did you take this money from Loyal, this 10k check? Half of those, of the 85%, half of them say we like the fact that you are there with successively deeper checks, which some of my angels can't do.

And all I have to do is beat two other entrepreneurs in your portfolio. And I get your money. And most entrepreneurs I know think they can beat two other people in the room. If you and I and our third buddy were sitting around having beer and we would each say, Jeremy, I love what you're doing, but my business is better.

If I didn't think that I would be like, Jeremy, I'd like to join your business. That's an interesting kind of dynamic and mentality with entrepreneurs themselves. The other half say, I'm not worried about money. I'm not interested in money. Money's not really the issue for me and fundraising is an issue.

We want access to your network. So we have over 700 advisors located all around the world. And the advisor piece of our program was also really important for me to design and design properly. So I had, in addition to being an angel investor and an entrepreneur several times, I'd also been an advisor and advised many and multiple companies, startups before I even launched the fund.

And worked with enough accelerators and incubators where they kind of take advantage in many ways of a lot of advisors who are in that pay it forward mode. They create a lot of value for the entrepreneurs, which is captured by the incubators and the accelerators and not necessarily shared with the advisors.

We share 20% of our carry with the advisors. And we do that on a merit basis. So only the advisors who've worked for that particular entrepreneur. And let's say you're a portfolio company, I'll ask you, when you exit, I'll say, Jeremy, of all of the loyal advisors you've worked with, rate them on a relative value creation basis.

And you might say I only worked with Jennifer. I maybe only talked to her three times in the eight years before my exit but her advice or her connections or her timing, whatever it was, created 10 times more value than Mary. And Mary was amazing. She rolled up her sleeve. She put in 20 hours. In our world, Jennifer gets 10 times what Mary gets because you believe and you tell us that's where the value is created. So again, very important part of the model that I'm very proud of.

Jeremy Au: (19:07)
So what's interesting of course is that when you talk about that advisor network, are you looking at it from like a fund carry perspective or do they get like deal by deal, like only the companies to help?

Michael Kosic: (19:19)
It's deal by deal. We don't like freeloaders. We never have and that merit is really important. Look I am a Canadian white male engineer with an INSEAD degree. I've received very little discrimination in my life.

Where I have received discrimination is ageism, right? So I was typically the youngest person in the room doing a lot of the work while the old and bald guys were getting all of the comp. It was one of the reasons why what I was driven to get a big brand name, a degree so that I could justify higher rates.

I mean, that's how I thought about when I was young, but, life's obviously a lot more about a lot more things than that. So it was always very important for me to make sure that people, regardless of their level of experience or gender or race or whatever but rather their merits, so their value, what they contributed was recognized and rewarded. So as much as possible we've designed a system, we believe that does that.

Jeremy Au: (20:15)
And what's interesting of course is that all this is supposed to create this early double down winners, early checks, like you said, to either get in insight information, or way to get in asymmetric information or to be a marketing expense and it's supposed to deliver in better returns, right?

Every VC fund basically they have some spiel. They have that 20 minute explanation and so how does that translate to returns and how should we think about performance?

Michael Kosic: (20:44)
So my favorite, and I know this isn't a show you slides otherwise, I would've already showed you four slides. It's not that kind of a podcast, which is totally fine. But what I consider our money slide are our winning slide. If I could only show you one slide, it's two lines and one shows the performance of the 10k checks.

So this is closest to spray and pray. As you may have heard at the industry term, because it's broad diversification, and we've got 300 now of these 10k checks and in 54 countries they're returning about 10%. And the interesting thing is the follow on all the checks we're writing are returning three times that. So to me that is showing that our follow on decision making is creating value. Now, the whole c might go up and down in terms of what returns in the asset class are. But if I look at that, that, that baseline, that spray and pray approach of a venture grade of portfolio investments then our performance is if we continue to push that performance with our processes, with our ability to identify and support and pick those winners if you will and invest more in them, then that will continue to drive these excess returns. So the interesting thing about fund, our fund is it is open-ended. We price every quarter. So if you can cash out, you can realize these returns with us, which you can't necessarily do in most funds. Cause most funds are closed.

Jeremy Au: (22:22)
And so what you're saying is that you have a blended set of performance, right? So your first trench, you're not outperforming most index VCs.

Michael Kosic: (22:34)
No, Definitely not. But that only represents because of the nature of how we wrote these check sizes and the increments is that only represents 10% of the deployed capital.

Jeremy Au: (22:45)
So I get because what you're saying is oh, this is a learning point for me. I'm learning something here. What you're saying is, even though it's industrial returns, that's okay because it's that's like the small blind, right?

Michael Koisic: (22:56)
That's it. That's it. Or if you think about it the third analogy was the marketing expense. It's just to have us known out there to get into these these deals globally. And the interesting thing is because we're so early on in the process, we will never be the biggest fund in the world.

This is a 500 million fund when it's at steady state, right? Making 50 million of investments a year with six new companies in the coming month, and then six companies either dying or exiting. In steady state, that's what it looks like.

Jeremy Au: (23:26)
How should we think about performance, right? Because obviously I think everybody's looking for the largest top line return, right? How do you think about ratios or performance how do we benchmark performance across VCs? And how should your approach differ?

Michael Kosic: (23:41)
It's funny to talk about lower risk and venture capital in the same sentence. We believe that our approach really drives that. You may have heard that diversification is the only free lunch in investing. You may have heard that expression. So we're applying that portfolio theory directly into this asset class. We put that very question out to our advisors our advisor 90% of the time, well actually 99% of time they're advising our portfolio companies, but we take advice from them as well. So we put a question out to them how can we measure and communicate our own performance and risk performance?

They said take a look at something called the Sortino ratio. And the Sortino ratio is like the sharp ratio, but it doesn't punish upward volatility. So we have a fantastic Sortino ratio of it's north of four. Two is very good. I think that Berkshire Hathaway is at 0.8. We've closed now 20 quarters, so we raise every quarter, and only three of the 20 quarters since the inception of our fund had been down and they've been down a very small amount. So this diversification and our processes are creating this remarkable return profile.

Now if you look at the underlying venture capital math, 68% of portfolio companies will fail. 30, 31% will return one to 10x making up for the first batch leaving you with approximately 2% of the portfolio companies really driving the big returns. A typical VC will invest in 15 to 20 of those. If you just do a Montecarlo simulation. If you do a mathematical brute force a bunch of rolling the dyes if you will, you're going to get a wide distribution of returns. Loyal and this nature of our fund, the structure of our fund, we cannot and will not be what's mathematically not possible for us to be in the top decile of funds.

However, when we say we're in the top quartile and the process is driving, it's based on a lot of data. So we invite anybody who's really interested in making investments to come and we're an open book from that perspective. They can look at the investments that we've made. They can look, and see them over time and what the performance is. So we're very proud of that. We're not the fund that you're going to brag about that you got a hundred bangers from because that a hundred bangers is going to be shared with 200 other investors.

And currently 300 other investments. So you're more likely to be in a Grab when you're with Loyal. But you're not necessarily going to obviously make the type of direct returns that you would if you were gambling. And picking these by yourself. We do a talk secrets of angel investing where we talk about different options you have available to you as an angel because fund-to-funds is a great way to get a similar fund, return profile. But you're going to be paying management fees twice there. So with loyal, you get it in one fund.

Jeremy Au: (26:35)
So you said something interesting, right? Which is, we have the Sortino ratio and we're to deliver that consistent return, but we're not going to be the top decile of returns. And I'm like, you lost me there. So you lost me there because I'm like, why would I want to be in a fund desk, not in the top decile of returns.

Michael Kosic: (26:56)
Because, it's the lower risk really. It's the more reliability we believe, the more reliability of the returns compared to what you're going to get other asset classes, certainly. But even if you took an approach, a properly diversified approach and you invested in enough funds so that your money was spread out over 200 companies you're going to get, we believe better returns through using Loyal as that vehicle. So yes, if you do your digging on actual fund returns. Funds tend to only brag about the funds that they've done well in the fund, a subsequent fund. There's not massive amounts of correlation between the success across funds, right?

So just because you managed to get lucky in a previous fund doesn't necessarily mean you're going to get lucky in a future fund, when you're only making 15 bets. So we're telling you to bet on the math. Let me put it to you differently using that gambling analogy, wouldn't you rather bet on the house, right? Wouldn't you rather run the casino than be the person sitting at the table, right?

Jeremy Au: (27:59)
Boo lies, I mean, there's so many VCs, right? Are you saying like all the VC funds are all like fundamentally if they're doing 20 investments, like it just doesn't work? Or, they don't have a way, yeah.

Michael Kosic: (28:15)
No, no, no. I think there are brilliant and excellent funds out there that pursue specific thesis and when they get it right it's fantastic. We diversify across not only sector, but vintage. You just can't get that out of other funds.

So there will be great years to be in I don't, let's just pick blockchain. There'll be great years to be in, in blockchain or Web3 funds, and there'll be great years to absolutely be away from those funds and the criteria for the decision making sometimes the skill of the people who run their funds is very high there.

They're good, generally people to bet on, but there are sectoral moves. There are timing moves that you can't get around. In fact, we step aside whenever we can when there is a VC that we work with that wants to come in and lead around that we had started the ball rolling on with our founders.

We're like, yeah, so we don't need to lead this. As long as we get the same terms as the other investors, they're better known in this specific industry or currency. We're happy to work with those funds and we're glad that they're there. It's just not our approach and it's not what we sell and how we position our investors. I hope I didn't come across like everyone else is doing it horribly, and you should never invest in another VC fund.

Jeremy Au: (29:27)
I mean, what's interesting is that this is kind of like an iron sharpens iron here, right? So you're saying that there are ways for a fund that is not of your approach to succeed, and this if they are clear about the thesis or themes that make sense, whether that's geography or whether that's thesis on a vertical or approach.

And then, of course, the other one that you mentioned was that there are actually individual outperformers, right? Which is there are partners who are better than others. And lastly, you just talk about being lucky. Are those the three major strategies within this large crowd of VCs, those that treat strategies that you think outperform over the long run.

Michael Kosic: (30:07)
So look, I don't underestimate the value of luck and timing, but there's certain things you can do to engineer some of that luck. I think that the judgment that comes with judging people, and entrepreneurial teams. There are people who are good at that, and that's a great skill. So that helps when you're deciding where to concentrate, where to follow in. And I think that there are people who are not good at that, at making those types of decisions. And those people will be outperformed by the other people that have those skills.

So there are funds and fund managers that put that front and center and have a track record. And I think that if the decisions they made really drove that value in the past. Then they are definitely to be respected for that. And they deserve investment. What we wanted to build a fund with Loyal, where those things were all bonuses, but we didn't necessarily have to have those superpowers, if you will.

Jeremy Au: (31:11)
I'm so curious because actually if you see enough companies, then actually you get to see which funds actually have superpowers versus rhetoric. Any trends that you noticed? I guess because you know your following, you're adjacent to all these other funds who are leading, they're taking the board seat, they're leading the capital. And you're observing, you're watching any patterns or observations that you've seen over time.

Michael Kosic: (31:36)
You know what? I think please have me back on this podcast, in eight years. And the reason I say that is because many of our top companies are still in that kind of series A bucket. So as more time goes by. We will, because we start so early and we're there consistently through, we'll have a lot more exposure and insight into seeing some of these operators and decision makers. I don't think I have enough data. That's the short answer for you. I don't think I have enough data for that.

Jeremy Au: (32:06)
You know what I love? No, I love that so much. I mean, you just said I don't have enough data for the answer and I just wish more people said that all the time because it's so true, right? It's not yes. Sometimes it's not. No, I just don't have enough data to support a good answer. I could say something.

Michael Kosic: (32:21)
Yeah, yeah, yeah.

Jeremy Au: (32:23)
I like it so much.

Michael Kosic: (32:24)
It's funny when we do this half as a joke, but it's half as a joke, but you're always making the same joke. We tell our portfolio founders when we're onboarding them, we say 70% of the time everything that we tell you, you should just do without question. And then we say, but the problem is we can't tell you which 70%. So put differently we'll try to have an opinion that's based on some wisdom and experience. It's not gospel, get enough opinions so that you have some contradicting advice. Make the decision for yourself. Ultimately, we're supporting them, and often learning from them. We try to be humble and when we're on calls, I'm like, okay, well, I must know if we have 700 advisors in our network, there's gotta be somebody in the network that can answer this entrepreneur's question or help them with that problem much better than I can. I'm often saying, that's a great question. Let's go ask somebody else. Right?

Jeremy Au: (33:14)
And what's interesting of course, is that you're choosing to be a follow VC, right? But you're making these decisions independently of the cycle. So how, I guess from a founder perspective as a former founder and you yourself have been right?

Let's just say it. To build this thing. Okay, I got it right because I have the ideas, and then once you get a money, you bunch of investors sitting around and then you're like, okay, this one's good for that and I trust and respect this person. This other person brought the money, but maybe we don't have a relationship.

So where does Loyal sit in the mind space of a founder? Because I think the one thing you mentioned earlier about spray and pray slash index funds is like, they're not there, right? I'm just they're absent. Right, because which makes sense. I mean, they're taking care of, in your case, for example, 300 startups, right? And the team is small and focused and so on, so forth. So how would you think about that?

Michael Kosic: (34:08)
So we had a great onboarding call with a company today. One of the things the founder said is she said, we didn't end up taking money from that program we were in because we didn't feel that enough of them had really in-depth knowledge about our industry.

Look, there's different ways of creating value. As much as we've had really great returns for our investors, my north star metric, our north star metric is that 98% of our portfolio companies have accepted our follow on offers when we've made them. And when Kamal and I were doing the mathematical model for this fund, we said, okay, if 50% of the time our money's accepted by the founders, this thing's going to work.

And we're at 98%. And the one that got away she said to us, I'm not raising right now. Right guys? I'm not raising right now. Can you guys wait six months? Because that was the month that she came to the top of our allocation process. And we said to her, we don't know what the world's going to look like in six months.

So we can't promise you that. but we counted that as a loss, right? The good thing about us is that we do have those successive abilities to write more checks. Some of the advice that we give is often to make sure that you have a shareholder agreement earlier on that is written in such a way that someone with a board seat that might have been a big check at the beginning is forced to either re-up or kind of create value for the organization.

And you can do that with a variety of techniques, but mostly set a reasonable ownership percentage for them to be granted a board seat, we try to earn the respect from the entrepreneurs by creating that value. We're in touch with the founders on a monthly basis.

It's a check-in and we spend some time talking about their kind of KPIs and performance. We try to prepare ahead of time so that we're utilizing their time in a respectful way. And we always end every session with entrepreneurs. What's the biggest way we can help over the next month?

If they have asks and they have asks on a regular basis, and we help them on a regular basis, then they're going to keep calling us and or taking our calls. So it's about that. And I think you can poll our entrepreneurs. And I believe that's what you'll hear.

So I'm happy It's a big thing to live up to. And we have to be vigilant that we're continuing to create value, not that we earn that 98% so as I said, it's my North star. So we gotta do a lot to keep it where it is.

Jeremy Au: (36:29)
Wait, you blew my mind a little bit here. You just said something that you offered money to somebody and that person wasn't even raising at all. So what does that mean? So, okay. So I'm starting to get a sense here. So first you put in a small check of like $10,000, right? And then you're doing a following check.

So are you saying that because of the way you're looking at it, the way that you are thinking about the process, you're going to be like, okay, you're going to put capital without a lead, without someone else.

Michael Kosic: (36:55)
That's right. Well, we're happy to lead. Because look we have this relationship with the entrepreneur. We're seeing their data on a monthly basis. We think we see the inflection points before they happen. So you're sharing your data with us.

We're talking about your performance. And because we're an open-ended fund, we have to value the portfolio companies every quarter. So we are making decisions about what we think is the fair market value for all of these companies, regardless of whether or not there's been a transaction, if there's been a transaction that has the most weight, obviously, but we are then making decisions, and estimates of what that company's worth is. So if your value continues in that kind of upward trajectory and your valuation hasn't moved in a while, that's an opportunity for us to say, hey, Jeremy, why don't you take some money from us now? Maybe delay around or, collect from your other investors at the same terms. But fundraising is an absolute waste of money. It's a necessary evil. It's a distraction. It doesn't actually create real value. Talking about building a business, isn't building a business, right? I had a very, a great mentor and he said something very simple that stuck in my mind for, I guess over, this was over 30 years ago, but he said, if you're not building something or selling something, you're wasting somebody's money. And it was so simple and so powerful that it really stuck with me. We're in that position.

If I can have that honest conversation with you saying we would love to put money in you, we think that it's great. And look if we'll be happy cause we got our money in earlier we'll all be collectively happy. If you delay that maybe we all dilute a little bit less later, maybe you build up your value more. That's investing lockstep with you in thinking like a founder, right?

Jeremy Au: (38:37)
Amazing. And as you look forward in the future, what do you think is going to be the risk to this approach that you're doing? So in all of this is up with load outside risk. I mean, everybody likes that, right? So what do you think are the break points in the model? I think you mentioned one thing just now, which I recall is you said everything said series A investments so far.

So, people, valuations obviously show that performance. So more time will let us prove or kind of like show things have changed. But what are the factors do you think are key things to watch out for.

Michael Kosic: (39:09)
We believe based on kind of the initial mathematical model that we should be continuing to see these gains across different stages. I definitely do now have the data on our 200k investments to say that it's absolutely clear that we're creating value here.

And we're starting to get to that level on the 1 million, we haven't done any of the 3 million investment levels yet. We're raising $70 million to bring our fund up to a hundred million. It's at just over 30 million now. And again, this is like building a winery, right? There's only a certain amount of hectorage and it's building up a risk could theoretically be is that the returns of the later stages are significantly lower than the returns of the earlier stages, right?

Now again, it's not what the historical data would lead you to believe, but the future wouldn’t be what it used to be, right? So again, when we have the data we can pat ourselves on the back and say everything went according to plan.

But right now the process seems to be driving these returns, the diversification continues across these stages. We can respond and flex the model in the future if we find that there is an issue with it. But right now, it is looking like it is the right way to do things.

Jeremy Au: (40:31)
That's a really interesting approach, which is saying that you've derisked at the early stages of this approach but in the later rounds, that value differential order, insider information that you get may not be as privileged, right. Or as asymmetric.

Michael Kosic: (40:45)
Yeah. But at the same time, think about it like, we were probably like, I think as the entrepreneur now we were probably the first VC to write you a check. We may have led one or two of your early rounds if we've treated you well we've been there from the start, right?

The thought that we would lose that trusted position with the entrepreneur. That would keep me up at night. That would mean that we're not doing what we should be doing to earn that place. Now, we're not saying treat us better than other investors. We're just saying we listen and we want to support you and we want to share the wins, and especially share the wins with the companies in our portfolio that are doing the best.

Jeremy Au: (41:26)
Amazing. And the last thing is one thing you've done is, and which is very rare, is that you decided to be an open fund. That's actually a very big difference. I mean cause again, it goes back to things like you're actually doing things very differently, right? So most funds have that 10-year time period you're deciding to be similar to Sequoia. So what's the reasoning?

Michael Kosic: (41:45)
Wait, sorry, sir. I've been humbled this whole time, but I actually have to say we did it four years before Sequoia. Okay. All right. So look, there have been about 200 open-ended funds since the dawn of venture. When we look through the numbers. Part of this comes back to how we opened up, this podcast which is we built the fund that we would want to invest in as angels, Kamal and I, as angels and entrepreneurs. We were like, what? Lock away our money for 10 years. That's an eternity, right? That's a long time to lock away money that you could deploy elsewhere.

This open-ended aspect has actually made it quite difficult. They say that raising money for a fund is 10 times harder than raising money for a startup, raising money for an open-ended fund. It's probably 20 and I don't know, cause I don't have the experience, but I'm going to make up that number.

I think it's probably twice as hard because it's non-standard and innovation in a core financial model is not it's interesting. It's, it might be appreciated by some, but it's not necessarily rewarded. And where the biggest obstacle is when there are gatekeepers.

It's different. If I'm talking to you and as the LP, if I get to you and which is all I ask for, just let me get in front of the decision maker. Then I have a pretty good chance of convincing you that you should invest your money with us. If I'm talking to a gatekeeper, one of your staff. Then they've got a checklist that they're going through. And checklists are good. I'm an industrial engineer by degree. Checklists are great but every non-standard thing that they have on that list is something else that they're going to have to explain to the person making the decision.

So I love it. It's the right thing to do. It's going to be about eight years, and I'm so glad that Sequoia went in that direction. But it's still going to be about eight years before is something that is common for institutional investors to invest in. Which is why we target family funds, endowments and ultra high net worth.

Jeremy Au: (43:39)
Got it. What you're saying is that this structure allows the best of both worlds, right? Because it allows for that more longer term thinking on your end, which is you don't feel like you have to sell before 10 years to everybody. And some of your investors would like to stay longer, as long as you are pulling up returns, but you're also giving them options to get out. I guess it's something they structure on your end, I guess, for them.

Michael Kosic: (44:02)
Yep.

Jeremy Au: (44:02)
Interesting.

Michael Kosic: (44:03)
Yeah. So yeah, we say treat us like a normal 10 year fund if you want, or stay longer. That's the simplest way we communicate it. But it's that optionality you're not going to get in many other places.

Jeremy Au: (44:13)
And is it more expensive or is it harder to run? I mean, it feels like every VC fund should do it that way. I mean, I guess as you said, institutions are not used to it, so that's a big problem, is that the biggest reason?

Michael Kosic: (44:23)
So for a start before the 10 years, it's not guaranteed liquidity. I want to be very clear on that. We would have to hold a large pool of capital to service those redemptions if that was the case. And that would drag down returns.

It's almost like a market making, if you will. If there is ever a situation and we haven't had one to date where there are more requests to take out money than there are actually we reserve half of the capital that's coming in for these redemptions. And if ever there's more requests then people will get their pro rata out that round, and then the next round, which is 90 days later they'll be at the top.

Jeremy Au: (44:59)
Yeah, that makes sense. So basically it makes it more difficult from a capital allocation internally to make sure that redemptions are viable. On that note, could you share with us a time when you personally have been brave?

Michael Kosic: (45:11)
So look, I used to do a talk for the founder institute called don't do the math and it was really about making that entrepreneurial jump. I think I've been brave every time I've done anything entrepreneurial. But one of the biggest ones for me was I did, what I call my corporate tour of duty at a big Canadian bank.

And I did that shortly after I had my first child. Three years later I had my second child. I had ruffled a whole bunch of feathers in the bank. Got some good learnings. And I left that job to join, Kamal my partner at Loyal, a very ambitious startup that failed shortly thereafter called Sky Meter. My parents had actually asked me, where did we go wrong? Why would you leave such a great job at a bank to run off and do a startup?

Essentially, I said, because the worst that can happen to me is that, I'd have to what? Come to my family and have them feed me. That's not a bad, that's not a horrible outcome to me. And I thank you guys for being there for me, for providing that net for me, and enabling me to take that jump.

And so second kid along the way, a wife, who wasn't working at the time. These are the types of decisions, that brave entrepreneurs make all over the world. I want to find those ones that can meet our criteria. And I know it's a subset of all of the great entrepreneurs out there. I'm honored to meet them, support them and vicariously live through their eyes and participate in their journey. As I said, I got the best job in the world.

Jeremy Au: (46:40)
Amazing. On that note, thank you, Michael, for coming to the show. I'd like to paraphrase the three big themes I got from this conversation. The first of course is to thank you for sharing something that you said like, diversification is the only free lunch. And I think that's true in investing, but I think this was really interesting in the context of venture capital.

I think it shows in what you're doing in terms of talking about the concentration of various VC portfolios, the conventional norms. That was contrasting to your approach to obviously like really be rigorous in how you're thinking about how this diversification in your initial pilot investing with the small checks.

But then of course using the asymmetric insider information to, as you said, then double down, right? And you talked about it from the context of marketing and the context of getting access information or in a context of getting in and building a relationship. I thought it was all very fascinating.

And I think a very strong antithesis or thesis, that I think stands as its own pillar, right? Separate from strong individual performing partners who can pick well versus strong thesis driven funds versus lucky funds, right? So I thought it was a really interesting strategic overview.

The second of course is thank you for kind of talking a little bit about Sina versus sharp ratio and got a little technical there, but I think it's a great way to think about what are the industry returns versus average excess returns versus top decile of returns. And I think it was a nice way to talk about it from I think LP perspective, what they're thinking about is quite different from how, for example, most retail investors would be thinking about their approach.

And lastly, thank you so much I think for really sharing about, I think your loyalty to founders, right? I think very good apt point of view and loyal VC to talking about how you want to promise and deliver about what you want to do and you're really delivering the capital, but also the speed and decisiveness component to it, which is I think what founders really want as long as well as all these interesting tweaks that you've done about making merit-based advisory and so on, so forth. So as I want to say, thank you so much Michael for coming on the show.

Michael Kosic: (48:45)
Thank you so much Jeremy. Really appreciate it. And yeah, keep up the good work.