Chris Lustrino (02:46):

For those who don’t know what private equity is, basically every company that’s not Google or Facebook that trades publicly that you could access in your Robinhood account were the types of companies that I was working on behalf of to sell their businesses to other mega-firms that had lots of money to buy private companies. And it was really during that time that a spark went off in my head where I started to ask myself the question of, “Wait a second, why can I invest in these private companies?” I thought I was seeing some really cool deal flow, and I was the one running all of the research and diligence.

Chris Lustrino (03:15):

And I learned that there was all these rules that existed that said that basically non-accredited, AKA non-millionaires couldn’t invest in startups in private companies. And I thought that was crazy. So back in 2014, I ended up googling around and why that was the case and learned about the regulations that existed, and learnt that something called the JOBS Act had been created in 2012 that was going to let anybody be able to invest in private companies and change that paradigm. And I got super psyched about that idea, and really basically, have ended up dedicating the last many, many years of my life to this cause.

Chris Lustrino (03:48):

Started a Fintech blog, ran that for a while, started getting myself invited to events, finding my way into PR lists even though I still only had a couple hundred readers, going to major conferences, getting on awards list, and meeting all of the major names in financial services and Fintech that were trying to disrupt the space and allow anyone to be able to invest in the private markets. Anyway, then ended up being acquired in 2018 by the founding chairman and CEO of Napster, if you remember Napster back in the day. And now is really the beginning of building KingsCrowd to provide people with investor research tools for this new ecosystem.

Robert Leonard (04:28):

The only reason that I actually even remember Napster is from the social media movie or the Facebook movie, I forget the title. That’s the only reason that I even remember Napster. But you mentioned KingsCrowd into your current venture, it’s the business that you started. It’s a ratings & analytics service for online private markets. For those who don’t know, what exactly is an online private market. And then part two of that question, what is equity crowdfunding? You alluded to it, you mentioned that private investors can invest in these private companies. I’m guessing that’s your equity crowdfunding. So talk to us a little bit about that as well.

Chris Lustrino (05:03):

If we take a step back, if you have a Robinhood brokerage account, a Merrill Lynch account, Fidelity account, whatever your services that you use, when you open it up, then you can invest in stocks. What’s occurring is that brokerage account is integrating with marketplaces like NASDAQ and the New York Stock Exchange where companies actually list their stock for sale. So go to the New York Stock Exchange or NASDAQ, and you’ll say, “We want to list our shares for sale,” and then they become available in those marketplaces. And that’s how the public markets work. That’s what’s happening.

Chris Lustrino (05:35):

What’s happening in this new online private market ecosystem is there are players like republic.co, wefunder.com, seedinvest.com, startengine.com. You can go to any one of these. And what they’re doing is essentially they are building the NASDAQ or the New York Stock Exchange for private companies. So a company like myself, KingsCrowd can file some forms with the SEC, and they can go list on one of these marketplaces, a number of shares that people can buy. And then anyone can go and typically with as little as $100, actually invest into a company like ourselves or any other startup that is deciding to raise capital online.

Chris Lustrino (06:16):

So it’s very much the equivalent of the New York Stock Exchange or NASDAQ, except in this case, it’s for the early days’ companies that typically in the past would have only had access to venture capital, private equity or bank loans, and now there’s a new source, which is retail investors and other alternative financial investors.

Robert Leonard (06:37):

Why do businesses need equity crowdfunding?

Chris Lustrino (06:40):

It’s like new people need air to breathe, a company needs capital in order to thrive. So the lifeline of any early stage venture, you need money. And I joke, but it’s true, capital is a commodity, and wherever founders can get capital, they need to go and get it. You never know what’s going to happen as you move forward as a business and you’re always going to need 10 times more capital than you actually think you’ll need in 10 times more time. So founders and companies are turning to equity crowdfunding as another vehicle of raising capital for their business that’s needed in order for them to take the steps they need as a business.

Robert Leonard (07:20):

Common ratings & analytics businesses that people listening to the show are probably familiar with might be Morningstar, or Moody’s, or Standard & Poor’s. What does a ratings & analytics business do exactly?

Chris Lustrino (07:35):

It’s a great question. Sometimes I get blank stares and I’m always trying to figure out what’s the best way to explain KingsCrowd. Sometimes I say, it’s almost like Yelp for restaurants, but it’s for startups. And I try and find different ways of explaining it, but very simply what you’re trying to do with the rating service is help people contextualize the quality of an opportunity or an investment. So in the world of public companies and Morningstar, and SMP, and Moody’s, essentially they’re looking at the fundamentals of a business.

Chris Lustrino (08:05):

They’re saying, “Okay, let’s look at the financials, let’s look at their competitive advantages. Let’s look at the execution of the management team. Let’s look at the quality of the management team. Let’s look at all of these key factors of the business, and then put it into a score that can help people know whether or not it’s good business.” I’d seen a very simple idea, if you get a one, typically that means there’s a lot of issues here, there’s probably a bunch of red flags. If you get a five, it makes me feel pretty strongly about this investment opportunity, that a lot of the fundamentals of the business are really good.

Chris Lustrino (08:36):

That by the way, does not mean that we’ll end up being successful. And what it does is it says, “In this moment in time when we look at all the backers of the business, it looks like a good investment opportunity, especially in comparison to the other opportunities that are available to you as an investor.” We’re doing that exact same thing, except we’re using the types of fundamentals, things that matter specifically to startups, which by the way, are very, very different from public equities.

Robert Leonard (09:04):

We talk about Morningstar and Moody’s, which provide those types of star ratings that you just mentioned, but you also mentioned, I’ve seen KingsCrowd related to similar services like the Motley Fool and Seeking Alpha. One of the big things that those two companies do is actually provide investment research reports like actual three, five, 10-page reports about companies and not just a rating, a five-star rating or a three-star rating. Is this available for private businesses as well through KingsCrowd? Is that something you’re doing or are you just the star-rating type business right now?

Chris Lustrino (09:38):

We do in fact have both, what we say is we initiate coverage on about 30% of companies. So what we do is for ratings, we rate 100% of companies using all of our quantitative measures. So literally, every company that raises via one of these online marketplaces, we collect over 170 data points and spit out a score for those companies in a quantitative basis. From that, we narrow our universe dramatically to a group of companies that are really interesting. And then we initiate further deep dive coverage of those organizations. And we’ll actually go and write up analysts’ reports.

Chris Lustrino (10:14):

We have top deals, which is our strong buy rating. We have our deal watch, which is an error by rating. We have neutrals, we have underweights where we’re calling out companies with lots of red flags. And like I said, we do that for about 30% of companies, and we do provide that beat. That reason being, there’s still a lot of investors in this market, it’s so new, it only came to fruition about five years ago. It only started to really be known by more of the general masses maybe two years ago.

Chris Lustrino (10:42):

So we’re still in the very early days of this market and a lot of people need extra hand-holding, and they want that deep dive research really to help them understand what it is they’re looking at when they’re looking at a startup, which for them is so incredibly different from the typical investments that they’re making.

Robert Leonard (10:58):

So when you are analyzing a private business, what are you looking for? How is it actually different from analyzing a publicly-traded company?

Chris Lustrino (11:07):

If we focus on early-stage companies, which I think is probably the most exciting investment opportunity for most people and the one that most people want to get into and are doing online right now. So when I talk about an early-stage company, we’re talking about pre-seed, which basically means, “Hey, I have an idea on a piece of paper that I’m going to present to you. I’ve put a small team together and we’re raising these funds to actually make this a real thing.” And then there’s seed-stage companies, which is, “We’ve made this a real thing. We have a product, we’re in market. And now we’re iterating to figure out how to actually sell this thing and make some money.”

Chris Lustrino (11:39):

Those are the early, early day companies, it’s the Apple in the garage, it’s Google in the garage, still very early days companies. So when you’re looking at those companies, it’s funny, as part of regulation crowdfunding, which is one of regulations that enables this space, you have to provide a consolidated pass to your financials that are typically audited. It’s a pretty light touch audit, but by no means can you commit fraud on those things. You can’t make up numbers, they’re real numbers. And in those very early days, companies, I will tell you, typically the financials look pretty poor.

Chris Lustrino (12:10):

In the world of public stocks most people are looking most importantly, at financials and revenue metrics, and earnings per share, and how profitable are they, and how are they growing their profitability? So people really, really focus on the financials. In this world, financials matter a whole lot less, because they’re early day companies and none of them are going to have very good financials. If they do, that’s a boom. That’s fantastic. If they’ve already gotten a way to thrive really early on, terrific. But if not, we have to recognize that, okay, that’s not the most important thing, what are the other key factors that matter?

Chris Lustrino (12:45):

So in early day companies, it really comes down to market opportunity. Do we think that the market bear in which they’re going after, do we think it’s a really huge opportunity that’s going to continue to grow over the next several years? And typically you’re looking for a multi-billion dollar plus type market opportunities that they can go after. And you’re looking for a space where there’s an unmet need, where you think they’re extremely differentiated and can win out because there’s so much more exceptional than anything else that’s out there.

Chris Lustrino (13:13):

Think about the taxi industry with Uber and how absolutely horrible it was, and now Uber comes along and has this really unique, innovative solution. Most people would say, “How are you ever going to win out in this market where you have Medallions and all of these powerful forces that be?” But they came out with something that was just exceptionally better for the consumer, and that’s why they were able to win. And by the way, it was a really huge market. So you’re looking for big market, you’re looking for experienced founding teams, teams that even if the founder’s not the most experienced or the young person with the idea, they’re surrounding themselves with the right people. That’s so important.

Chris Lustrino (13:47):

And then you’re looking at who else is in market and is already trying to compete with them. So it’s a lot more about the things around the business, and then, do I believe in this management team and the ability to execute on the vision that they have? So those are the types of things you’re looking at, whereas with a public company, like I said, you’re looking at lots of financial metrics, you’re thinking about how they’re going to grow two, three, four, 5% per year. While you care about the management team, typically at that point you know the board has put a really exceptional team in place. So that might become a little bit less of a worry.

Chris Lustrino (14:19):

So it’s a lot more data-driven on the financial side, whereas in this world, it’s much more about the fundamentals of the team, the idea, and the opportunity they’re pursuing.

Robert Leonard (14:29):

What are the major red flags then that you’re looking for? I’m assuming that it’s probably the inverse of everything that you just mentioned that you’re looking for good characteristics on. But for me, when I’m analyzing a public company, one of the biggest places that I look for red flags is in the financials. There are a lot of other places too, industry, market outlook, that type of stuff, the more qualitative stuff, but the biggest thing for me usually first is quantitative financial red flag. So with that not really being an option for equity crowdfunding and private businesses, because like you said, the financials just aren’t complete yet, what are the big red flags that you’re looking for?

Chris Lustrino (15:06):

I think there’s three major things that I look for, the first one is team. Again, it’s funny how many people will tell you they’re serial entrepreneurs and you realize that means I had a lemonade stand or they had an ice cream stack. They’re making up their entrepreneurial journey of sorts. There’s a lot of extremely inexperienced folks out there, and that’s okay. By the way, I was extremely inexperienced when I started this business three years ago, I had never run a business before. So what did I do? I tried to surround myself with advisors and people that have been there, done that before.

Chris Lustrino (15:40):

At this point, we had the former chief counsel officer at Bank of America, who’s our chief legal officer. We had the former CTO, Dale Jones, Business Intelligence Group as their CTO. We’re advised by former founder of Napster and the former CIO Citi. But really, really experienced, much smarter people than I around me that I can learn from, grow from and ask questions too when we run into problems. So teams where they hide themselves up and have absolutely nothing around them to support them, that is typically a worry for me because can they actually execute? That’s the first big thing.

Chris Lustrino (16:11):

The second thing that I’m looking at is valuation. Like anything in the public markets, it’s the same thing, you want to look at what their market cap is, or the share price, those types of things. Well, this market, it’s the exact same thing, so what value are these companies putting on themselves? Because it is actually up to the founder to decide what valuation they want to take for a round of funding. Basically for pre-seed through seed-stage companies, for those that don’t know, what we typically see is anywhere between like five and $15 million, that’s the going price of a good idea and a decent management team.

Chris Lustrino (16:44):

When they go above those figures, you want to understand why? So if you’re saying you’re worth 50 or 100 million today, you better have a darn good reason why you’re valuing yourself at that price point. And if you can explain it and you say, “Listen, we’re a biotech company, we develop a special technology, it’s been 30 years in the making. We just formed a company around it.” That’s a much different story than saying, “Well, we’re in the ride-hailing business and all the companies are worth billions. So of course, we’re worth 100 million on day one.” Then that’s a reason to run for the hills and stay away from that investment opportunity.

Chris Lustrino (17:13):

So we definitely look at valuation, that’s a major metric. I think it also just helps you understand how critical the founder is of their own business and how realistic they are about the opportunity. And then the last thing is you want to think about the upside. So when you’re looking at these opportunities, these startups that you can invest in, if the valuation is five million and they’re in a $100 billion market, you go, “Okay, even if they capture a small share of that market, they’re going to end up being a pretty darn big company.” But if they’re valuing themselves at $50 million, and it turns out that their [inaudible 00:17:45] is in San Diego who wants to open up one more location, if you map it out, the whole opportunity is about $50 million.

Chris Lustrino (17:53):

Then that might be a reason to say, “Well, there’s not really any upside here for me, why am I taking all this risk when the upset is essentially not there?” So you want to look at your upside, you want to look at the current valuation, you want to look at the team. If any of those are drastically off, for me, those are typically mega red flags to stay away.

Robert Leonard (18:12):

What is the most common issue with companies looking to raise capital through private markets from the perspective of an investor? What is the biggest, not the biggest, but the most common red flag that you see? 

Chris Lustrino (18:23):

I would say the most common red flag is when founders think that coming to the online private markets is, if you build it, they-will-come-type of initiative. So they’re like, “Well, I created an offering page, I got my financials together, created a deck and a video, and I’m good to go. So the rest will take care of itself.” Typically, those founders fail, and typically, [it] becomes pretty clear that they’re not putting in any effort. So one of the things that a management team needs to do, especially early on, is to prove that they can execute.

Chris Lustrino (18:54):

And there are founders who go out there and they just say, “Yeah, we’re going to raise five million bucks, we’ll probably be done with that in a month. We value ourselves at $50 million today. We’ve got this great idea on a piece of paper. Oh, we got this one amazing advisor who did this thing 10 years ago.” And then they go live and they can’t figure out why they’re not raising any money. They’re not making any phone calls, they’re not cold calling people, they’re not marketing, they’re not doing anything. And I think to me, that’s typically a red flag that if they can’t get a diamond to this deal on their own, why in the world should someone who doesn’t know them invest in that?

Chris Lustrino (19:28):

I’m not sure it’s a privileged thing, I think it’s just an ignorance thing and going into this with the wrong mindset, but it definitely to me signals someone who is not putting in the work that they need to in order to be successful. And that also to me, signals that they’re not going to execute across the business and all the other various things they’re going to have to do as a founder. And it becomes very visual, and you can see that as an investor and say, “They’ve been live for three months and they’ve raised $5,000. Maybe I don’t go over there.”

Robert Leonard (19:56):

Now, on the flip side, we want to invest in every company that has raised a ton of money, there’ll still be underlying issues just because they’ve been good at marketing, or maybe just FOMO maybe, maybe they saw that they were raising a lot of money so people just started piling in without really understanding what was going on underneath the business. I personally have seen that a little bit on the platforms. I completely agree with what you said in terms of being a common issue, but I do invest in some of these private companies through these platforms, and there’s been some that I’ve raised a lot of money and I’m just like, “I don’t know, I can’t get there on that.”

Robert Leonard (20:28):

So I’m wondering if there might be a self-fulfilling prophecy or a false sense of security just by looking at how much money a company has raised.

Chris Lustrino (20:39):

Could not agree more. That’s absolutely correct. When you raise no money, that’s negative signaling. When you raise tons of money, that’s great, but then you need to dive deeper. So I always encourage people not to get caught up in the FOMO, it’s probably one of the largest issues with the venture capital industry and why we saw between Theranos, and WeWork, and Juicero, and Quibi, billions and billions, and billions of dollars just being burned and wasted. It’s really sad. And why did that happen? Because FOMO, because, oh, well they raised a ton of money, they must be too big to fail at this point. There must be something that I don’t understand and that’s why they’re great.

Chris Lustrino (21:20):

And so I always say before you make any investment, do your due diligence, but yeah, they raise a ton of money, first off, ask why. Second, say, “Okay, that’s great. There may be a reason for that, but let me go do my own deep dive.” Go into your own research, make sure you feel confident that it’s not just the FOMO and the hype and people are excited about it, but that it’s actually fundamentally sound. And believe me, we call that some companies where they did raise a ton of money, but when you looked at the fundamentals you went, “Whoa, whoa, management hasn’t executed, their valuation is bloated.” And we have seen that ourselves, for sure.

Chris Lustrino (21:54):

So just because it got to be raised, a lot of money certainly does not mean that it’s a good investment opportunity, and you still need to do your own due diligence, if not more so, because you need to understand why there’s all that hype.

Robert Leonard (22:06):

I’m glad you mentioned Theranos because back in May, just last month, I just fell down a rabbit hole with Theranos. And I don’t really know why I read the book, I read a couple books on it, I watched a couple documentaries on it. I just was totally into it. It was super fascinating to me. And so when you were talking about looking at who the founder has surrounded themselves with, I was like, “Yeah. I agree with that, of course in general, but there are some cases where that’s not always necessarily 100% foolproof.” Because look at what she did at Theranos.

Robert Leonard (22:34):

She had some of the most amazing, amazing people in the world, especially in that space, even military leaders on her board. You would think some of these people that have the highest integrity, that would be some of the smartest people in the world that are around her, so you would think, again, all right, she’s good to go because of who she surrounded herself with. But as we saw, that wasn’t necessarily the case. And of course, all of these businesses aren’t going to be Theranos, but it’s just something you got to consider.

Chris Lustrino (23:00):

Yeah. Listen, you’re absolutely right. And in any world, there’s always going to be an outlier, and Elizabeth Holmes, you’re talking about a pathological liar, narcissist-to-the-moon-type of thing. She’s a very special case, but nonetheless, it goes back to that same thing that I was just talking about which is, just because there’s a lot of hype, just because they have amazing people, still ask yourselves the questions and try and dive deeper because you’re right, you could have a blind spot and we can all get caught up in the excitement of the moment and meeting this amazing founder who really excites us, and you just need to do your homework.

Robert Leonard (23:34):

As a side note, I’m still shocked that the court cases are still going on for that whole situation. It’s crazy. Actually, I believe they just restarted again last month or within the last couple of weeks. So if anybody’s interested, you don’t know what we’re talking about with Theranos or Elizabeth Holmes, I highly, highly recommend you go check out the documentary and read the books, and it’s really, truly fascinating. And might even help your investing as well other than just being a form of entertainment.

Robert Leonard (24:02):

We talked about red flags, we talked about how these private businesses are different than public companies, and we talked a little bit about what are the good things you’re looking for. What about hidden gems? What’s something that not every business is going to have and that’s okay, they could still be a good business, but what’s something like little that you’ve noticed that you’re like, “Okay, this is correlated to success,” that a lot of people are overlooking. Some of the things you mentioned, like a good management team, etc, a good market, those are bigger level things that I think a lot of people will look for.

Robert Leonard (24:33):

What are some of the hidden gems maybe that not everybody’s thinking to look for that might correlate to success in business for a private company that’s raising money?

Chris Lustrino (24:43):

One of the things that I think makes a founder really successful is their ability to be resourceful. And it’s interesting, I’ve definitely seen companies that have raised next to no money and they’ve accomplished an incredible amount. They’ve built out a full-fledged product, they’re in the market through generating pretty significant sales. And you realize if you look at it that maybe they’ve raised hundreds of thousands of dollars, or maybe they bootstrapped the whole darn thing. And it’s amazing because there are so many founders that can raise millions of dollars and still say, “Well, we’re pre-revenue, we’re working on a product. We’re perfecting this, we’re perfecting that.”

Chris Lustrino (25:22):

And there are just some founders where you look at the financials and they’re already generating a million-plus dollars within a year or two starting the business, and they’ve only raised a very small amount of funding to date. And that to me, signals a founder who knows how to get stuff done regardless of the resources that they have. And I’m always really, really impressed by that. And that to me is just an early indicator of extremely good execution. And I always think, well, what could they do if they actually had the resources they truly need at their hands?”

Chris Lustrino (25:52):

And so that’s a hidden gem I look for is, “Let me really think about what has this team accomplished with what they’ve been able to receive to date.” And I think that’s just a really interesting signal that’s a little bit harder to decipher, but really, really good insight on the founder.

Robert Leonard (26:09):

How does somebody who is very quantitative-focused get comfortable with investing this way? And I think a lot of people listening to the show, I know at least me personally, I’m very numbers focused, I’m very quantitative. So sometimes I do have a hard time analyzing businesses from the qualitative perspective and not making investment decisions based solely on numbers. So how does somebody like that that is usually relying on numbers to make investment decisions get comfortable with making investment decisions in very qualitative type investments?

Chris Lustrino (26:44):

There are a few things that you can do, first off, one of the things that we’ve tried at KingsCrowd is find a way to quantify what typically we haven’t thought is quantifiable. So for instance, founder experience, well, how do you quantify that? Well, let’s go look and really figure out, they are a real estate technology company, how many years have they spent in the real estate industry? How many years are the people who were at the C-suite or whatever, executive-level has spent years in the real estate industry? They say that they’re a serial entrepreneur, how many years have they spent building companies in the past?

Chris Lustrino (27:17):

Do they have any exits? How many exits do they have? And if they have exits, was it a low, medium, high in terms of how positive it was? Those are the types of things where you can either create buckets, low, medium, high outcomes for past exits, things like that, or you actually go ahead and quantify things like industry experience. You quantify things like the market size and the market growth rate, you quantify the number of competitors in the space by going and doing your research and figuring out how many competitors are in that space.

Chris Lustrino (27:47):

You quantify how much funds do you think they’re going to need to raise in order to be successful, and do you think that they can get there. So if we try and put parameters on everything, just start to quantify this out, I think that’s one of the best things that you can do. And then as we mentioned before, this is a game of building a diversified portfolio where you’re going to put preferably 20, 30, 40 investments into that portfolio over maybe one to five years. And you’re hoping that, I think, in an amazing world, you’re getting 20, 30%. Ended up having extremely positive outcomes and maybe a bunch of them go under, and some of them do.

Chris Lustrino (28:24):

And that’s the portfolio theory is you have a handful that do exceptionally well, and that nets out your losses and lets you into really positive territory. So as a quant-heavy person, one of the things that you can be looking at is, “Okay, I’m getting at a 10 million valuation. Just to help myself understand what that means, currently, I’m in Google, which is worth over a trillion dollars. So just for Google to double, it has to go from a one trillion to a $2 trillion company. For me to double my investment in this company, it has to go from being valued at 10 million to 20 million. And if it goes to 100, I have 10X. If it goes to a billion, I have 100X.”

Chris Lustrino (29:02):

So it starts to help you understand just how quickly the numbers can get really, really big. So it’s a bit of a different risk for workers, but you can quantify out how much [is the] figure of an upside opportunity you have on each one of these things, which lets you get comfortable with the fact that you also know many of them they very well go to scrap.

Robert Leonard (29:20):

Let’s dive into that diversification piece a bit because overall. I’m personally not a huge fan of diversification. Warren Buffett says that diversification is for people who don’t know what they’re doing. And I generally agree with that. I think it’s more for publicly-traded companies, public investments than it is for private companies. I think it’s different for those. And I generally agree, you should be a little bit more diversified. What about starting small? Can that be another way? At least that’s what’s worked for me at least is when I first got started in this private world of companies, I just started small.

Robert Leonard (29:54):

And I haven’t diversified a ton to be completely honest, but I’ve just kept my positions relatively small so that the downside risk is capped for the most part. And I’m okay with the risk that I’m putting in there. I’m not putting in hundreds of thousands of dollars that would be very bad if I lost.

Chris Lustrino (30:09):

I really like that. At end of the day, it’s decided on a strategy and stick to it. So you might be a person who’s very risk-averse, but wants some exposure to this market. So you might say, “I’m willing to put $2,000 into this market each year, but I want to be super diversified because I want my risk to be as low as possible despite this being really risky.” In that case, you should be putting $100 into 20 different investments and being as diversified as possible. But you might be someone like yourself, Robert, where you say, “You know what, I want to make five real bets on companies that I’m just psyched about and really believe in and understand the business super well, and feel as though I know something that others don’t know, and I’m all in on those companies.”

Chris Lustrino (30:50):

“Oh, by the way, I’ve capped myself to what I’m willing to lose, and that’s okay with me.” If that’s your mindset, it’s your money. So you can do whatever the heck you want with your money, as long as you’re okay with that, and you say, “Let me just start small and make a few handful of bets that I really believe in,” absolutely. I think that makes a ton of sense. I did the same thing starting out. I was like, “I don’t have a lot of money, but what I can do is 250 bucks into four or five companies this year that I’m just absolutely stoked about.” That’s what I was willing to put in and willing to lose.

Chris Lustrino (31:20):

And I was okay with not making a ton of bets because I really wanted to make ones that I cared about. So absolutely, I think that’s a great strategy. And the beauty of this space is that you can start small. It used to be, of course, you got to be accredited and all of that, but you would typically be asked to write 50 to $100,000 checks as an angel investor. Now, you’re being in $100 checks. So it’s much, much easier, the barrier to entry is much lower to be able to do that.

Robert Leonard (31:47):

You mentioned that returns in these companies are a little bit different than public stocks because a lot of those companies are large and you’re going from 500 billion to a trillion, is a double, or at one trillion to two trillion is a double, and that’s a really big gain, whereas 10 million to 20 million isn’t as big of a hurdle. But when we talk about the stock market, generally speaking, I think a lot of people are comfortable with saying seven to what? Nine, 10% is pretty average for the stock market overall depending on which index you use.

Robert Leonard (32:20):

How does that compare to if we could index private companies, what are you seeing for an index return on private companies? What is standard or average if there is one?

Chris Lustrino (32:32):

Unfortunately, we haven’t really had one to date. If you look at the entirety of the venture capital industry, I believe the median return of venture funds goes net to like 20, 13, 14, because typically it takes eight, nine years for funds to start to repair. It’s somewhere north of like 12, 13%. But by the way, that’s like every venture fund in the world. So you have all of the absolute dumpster fire venture funds that have just completely failed mixed in with the ones that have done exceptionally well. Typically, I think what venture funds are shooting for when you do the IRR metrics is somewhere north of 20 to 30%.

Chris Lustrino (33:12):

Now, obviously, the best vintages of funds are funds that have done exceptionally well, I’ve been in the range in the hundreds of percents, and even in thousands of percents. Obviously, that’s what everyone’s looking for, that’s the holy grail. The way that I think about it is you take whatever, three to 5% of your entire investment portfolio, and you say, “Okay, I’m going to put in these much riskier assets.” Personally, I’m looking for a return of north of 10X on whatever money I’m putting in. So if I put in 1,000, I would like to see over the next five to 10 years to come out with at least $10,000 when I’m all said and done.

Chris Lustrino (33:47):

That’s what I’m personally looking for. And the way I think of that is, we’ll have two to three that go to 100X plus, I have a couple coming out neutral, or maybe get a one or 2X, and I have a couple that goes to zero. That’s the blend that I’m looking for, but it can be really, really powerful assets. So that’s the indexing of it. But just to give you an example, one of my advisers, they had put in as a family, I think they put around 25K in Uber, way back in when they were first starting out, like the earliest, earliest days. And then it ended up being worth over $100 million when all was said and done.

Chris Lustrino (34:23):

I am not trying to say that you’re going to wake up and that’s just going to happen, you may end up making hundreds of bets and never have anything like that. But the way that I think about my startup investment portfolio is these are potentially life-changing investments that could become worth something, magnitudes more than I could’ve ever made just by doing my day job. And that’s what I’m hoping for, that’s what I’m looking for, but at the bare minimum index level, I personally am looking for somewhere around a 10X.

Robert Leonard (34:52):

And the chances of those types of 10X, or 100X, or the Uber returns that you just mentioned, it’s going to be very, very, very rare. It’s very rare in the private market, but I would say probably even more rare in the public markets to invest 25,000 and they go to 100 million. I think you have a better chance. I’ll be, it’s still very slim in the private markets than you do in the public markets. What is interesting too is that it is possible though. We talk about it’s a very small chance, but it is possible. There was a company, I believe it was Beyond Meat, but correct me if I’m wrong, that was on, I think Wefunder. And of course, they IPO-ed, and now they’re a publicly-traded company.

Robert Leonard (35:28):

So you could have been one of these people that got in early. And I don’t know if the return numbers were the same as Uber, or 10X, or 100 X, but if you got in that early that they were in equity crowdfunding, and then they IPO-ed, you probably did pretty well.

Chris Lustrino (35:43):

That’s exactly right. And there’s been a few pretty big winners. I know when Wefunder way back, there’ve been Checkr and Zenefits, and even both of those I think are now like 30 to 50X plus territory today. So yes, there are opportunities. Listen, you have to play the game in order to have a chance to win. It doesn’t mean you’re going to win, but you have a chance now. You didn’t have a seat at the table before, you do now. So you have to make those investments and hope that one of them pans out in that big way

Robert Leonard (36:12):

Beyond Meat was actually on OurCrowd, I knew I had heard about it on one of these platforms, but regardless, the point is still there is that you have these opportunities to invest in these types of businesses where you don’t necessarily have that opportunity in the public markets. Now, how do investors actually realize these returns? We’re talking about 10X, 100X returns, how do investors actually get that? How do they get the liquidity? Let’s say they invest in a business that’s worth 10 million, it becomes worth 20 million. How do they realize that return other than just an IPO? I think that is pretty self-explanatory.

Chris Lustrino (36:49):

Right now there are two ways, and then there’s a third emerging way. Very quickly to hint on what you said, [inaudible 00:36:55]So you go and you list your company on NASDAQ, New York Stock Exchange, you hit the roadshow, you display it to the public, and now you’re raising a bunch of money and now you’re traded actively at all times. So that’s the first way. By the way, that way, typically for the past decade or so, was taking eight to 12 years for companies to get to that point, from idea in newspaper to IPO, is typically eight to 12 years.

Chris Lustrino (37:18):

So if you’re investing in pre-seed, seed-stage companies, think about that timeline being where you’re at. The second way is through an exit. A lot of companies just get acquired. They decide, “Hey, we’ve built a really great product or service, something of value add, we’ve grown it pretty big. We don’t think we’re going to be a billion-dollar company on our own, or we’ve already become a multi-billion dollar company and we don’t want to be public. Let’s go get acquired by a much bigger company than our own.” And that happens all the time by the way.

Chris Lustrino (37:44):

If you pay attention to The Wall Street Journal and all these things, there are acquisitions literally happening every day of startups from these major corporations that are just constantly buying up companies. That’s your second way. And I would say that can happen anywhere between two and 10 years. We’ve seen a few companies, I know one that we rated really positively was acquired within nine months. Another was acquired within three months of the raise. So that happens too, where it’s just, they raise some money, they get some traction and someone comes and scoops them up at the right moment in time.

Chris Lustrino (38:16):

So those are the two key ways that you typically could get liquidity, just to be clear, they take a lot of time. The third way that is emerging is called secondary shares. Basically, once you own your shares for a period of time, typically one year as a non-accredited investor, at that point, you can actually sell those shares via a secondary transfer platform. Now, in order for that to work, there has to be a buyer who wants to buy up your shares. There needs to be an aggregate amount of supply and demand. There needs to be enough interest and investing in these private companies and buying and selling their secondary shares.

Chris Lustrino (38:48):

And by the way, you need all the infrastructure in place in the marketplace as the place to enable that. I can tell you that I know StartEngine has launched their secondary transfer platform, I know there’s a couple of others that have begun to do the same. There are some players like Rialto and tZERO that are building out solutions, they might be able to sit between these parties and provide a secondary market for people to trade it. It’s becoming real. There is, in fact, some real liquidity for StartEngine investors if you’re invested in the actual business of StartEngine, but we’re seeing things move in that direction.

Chris Lustrino (39:20):

And literally, if you want to understand what it is, it’s just what the stock market is for anyone, any retail investor, any individual can buy and sell their shares into the market. And there just needs to be a buyer willing to buy it. In the current public equity world, it’s extremely liquid, meaning there are lots of buyers, lots of sellers. In this new private market world, it’s going to take time. So it’s going to be way less likely where you might say, “Hey, I bought at $5 a share, I’m willing to sell at 20, and you don’t get a buyer.”

Chris Lustrino (39:46):

That can happen, but that’s the third way, and it can provide a lot more immediate returns, but we’re going to have to let that play out over the next two to three years here.

Robert Leonard (39:56):

I personally really, really like that third option. I actually personally, full disclosure, have invested in StartEngine, the platform itself, not just on the platform to other companies, but actually in StartEngine itself when it raised money because of that secondary market, I personally think that that’s going to be huge for financial markets in general, but also StartEngine. And so for me, that was actually what got me comfortable with this whole space was I just really believed in that idea. And so I put some money into it.

Robert Leonard (40:24):

We talked about how I struggle with not being quantitative, and I did a little bit with that investment, but we talked about market opportunities, and the leaders, and things like that. One of the great things about having this podcast, and even listening to the podcast is we had the founder of StartEngine on the show. We had Howard Marks on the show back on episode 85. And so I got to talk to him and learn more about the business, and that allowed me to get more comfortable. We even had Kevin O’Leary, who’s the spokesperson for StartEngine on the show. That was episode 58.

Robert Leonard (40:53):

So these types of things were able to let me get a little bit more comfortable with these private investments. One of the other pieces I want to talk about is when companies raise money on these online private marketplaces, there were a bunch of different security types that are offered, which is, I think, new for a lot of people because in the public markets, we typically just see common stock. Of course, there are other types that can be publicly traded, there are warrants, etc, but for the most part, it’s just common stock.

Robert Leonard (41:25):

Of the different types of securities these private companies offer, are revenue sharing, convertible notes, what they call as SAFE, as an acronym, S-A-F-E, preferred equity, common stock. And there was some more. Let’s talk about a few of those. And the first one I want to talk about is SAFE. And again, that’s SAFE as an acronym, it’s not necessarily a safe investment. What does SAFE stand for, and how does it work as a security?

Chris Lustrino (41:50):

It’s funny, I actually don’t exactly remember what it stands for or the actual letters stand for, if you have it written down somewhere, I’d love the refresher because everyone just says SAFE in this industry so you get comfortable just saying SAFE.

Robert Leonard (42:03):

It’s a simple agreement for future equity.

Chris Lustrino (42:06):

There we go. Basically, the SAFE and a convertible note are very similar to one another. SAFE is utilized a lot on a platform called Republic.co, one of the largest platforms out there. And only SAFE and convertible note are, is essentially what you’re saying is, “Hey, this is an early days’ company, to be honest, we have next to no idea what it’s worth. Instead of trying to figure that out now and create common shares to accommodate new investors coming into the round, we’re just going to pay a value to the cap. We’re going to say the cap on the SAFE or the convertible note is $10 million. And then we’re going to apply a discount rate.” And the discount rate is typically 10 to 20%.

Chris Lustrino (42:50):

And what that says is in a future round of funding, and typically it qualifies what that future round of funding looks like, at least a million dollars, it has to be the series A with an institutional investor, there’s typically parameters put in there. Once it qualifies through a funding event, then your convertible note or your SAFE will convert into actual equitization, but you will never pay more than the cap. So if you go out and you raise at $10 million valuation in your series A and you have put in money on a 10 million cap, whether it was a SAFE or convertible note, you will convert at $10 million. You won’t pay any more than 10 million.

Chris Lustrino (43:30):

But if there’s a discount, then you’ll actually only pay eight million. So if you raise it 10 million, you get a 20% discount, so you would only pay $8 million. Now, they go out and they raise at $50 million months of series A, huge valuation boom, and you got at 10-million cap, you will only pay a $10 million valuation. So as soon as that funding round hits, you’re actually being converted at the 10-million cap, even though it’s now worth $50 million. So you’re getting a large discount to what that future round of funding was without having actually had to put a true value on the company on the day that they were raising capital.

Chris Lustrino (44:08):

Basically, it’s a simple agreement to make life much easier for founders and investors to get on the same age and get something done without having to figure out the rate overall of managing individual investors and creating stock certificates and all of that kind of stuff.

Robert Leonard (44:22):

When you buy a SAFE or a convertible note, are you paying for the right to then invest at that cap? Or are you putting money up front and then if and when it gets converted, you already have that equity order? Or are you buying that right, and then when that time comes, you have to put up more money to actually buy those shares? How does that work?

Chris Lustrino (44:42):

There will be explanations that there are things that can happen. Typically, on these platforms., there’s no like, “Okay. And then at a future event, you have to put in more money.” Typically, it’s just, “We’re going to take the money you gave us, and then that’s going to whatever dollar amount you have, whatever the share price is at that point, you’ll convert that share price.” So no, you’re not typically putting in more money. Now for institutional investors, there can be those types of call-outs, where they come up with an agreement and then in the future, that not only is going to convert, but you have to put in an X percentage to the next round, things like that.

Chris Lustrino (45:11):

The one major red flag caveat that I want to call out, in many ways, is when you put into a convertible note in a SAFE, you’re almost putting into like a loan with an interest rate where it technically the money could just be given back to you with interest or the money could just be given back to you if the founder’s decided to do that. That’s the red flag, that’s what I want to call out. There are some provisions that people will put in two SAFES or convertible notes even, where they will say we have the right, we have the option before the end of maturity of this convertible note or SAFE, because typically there’s a time period on these things.

Chris Lustrino (45:46):

They’ll say, “We can actually choose to give you your money back. If we end up getting this explosive offer, we’ll you give your money back with some interest,” which obviously as an investor is a terrible thing, you’ve just taken all these risks and now they could just one day wake up and say, “Actually, we’re doing so well, we really don’t want to give up equity in the company, so we’re just going to give you your money back with some interest.” That’s what you don’t want. And you can look for those provisions, do they have some buyback provision that lets them basically buy you out of the deal in the future?

Chris Lustrino (46:13):

A few people have done that, a few people have gotten called out very hard on that in this industry. And so we don’t really see it, but it’s something to keep an eye out for and just make sure there’s not that clause in a SAFE or a convertible note.

Robert Leonard (46:26):

I’m really glad you brought that up. That’s super, super valuable information. And it sounds like that’s when it would be applicable is when you mentioned a 10 million cap, let’s just say a $50 million valuation. If I was the founder, I would probably want to institute that clause that says, “Hey, I’ll just pay you a little bit of interest because it’s probably going to be less than that $50-million valuation that I just raised money at.” So for the founder, it’s better off, but as the investor, like you said, it’s not what you want.

Chris Lustrino (46:53):

It’s a terrible experience, founders shouldn’t do it. I think it’s really bad behavior. And by the way, when you typically hear from my perspective, when people say, “Oh, convertible notes are bad or SAFEs are bad,” these are the instruments that literally every venture capitalist in the world utilizes. They’re not bad unless there are bad provisions in them. Typically, SAFEs and convertibles are completely fine.

Robert Leonard (47:15):

One of the other things that’s pretty common, at least in the private business space when it comes to valuations is these two terms, pre-money and post-money valuations. I think there’s some confusion around that. Talk to us a little bit about what a pre-money valuation is, what a post-money valuation is, how they’re different.

Chris Lustrino (47:33):

Great question. When you’re raising capital and you’re actually setting a price on the company, so let’s move away from talking about convertible notes and SAFE. This is common shares of preferred equity, where you put a dollar in, each share is worth a dollar, and now you own one share and that’s whatever percent of the total shares cap. So this is when you’re actually putting into a company where they’ve decided to value that company at a certain price on that day. So pre-money is basically, if you say, “Okay, I’m a $10 million pre-money company and I’m raising $5 million.”

Chris Lustrino (48:07):

What that says is post-money, you’re worth $15 million on paper. Pre-money you’re worth 10, you raise five, now your total is 15. So post-money, you’re worth $15 million. What that also tells you is that the company is about to sell one-third of the company. So if you were an existing investor and they say our pre-money valuation is 10 or our post-money is 15, you now know that basically you’ve been diluted about whatever, a third of your total investment. So even though you might’ve put in a million bucks and own 10%, at the end of them raising 15, you’re being diluted at a certain percent.

Chris Lustrino (48:43):

So pre-money is what you’re worth before you raise money, post-money is what you are worth after you’ve raised the money.

Robert Leonard (48:50):

What I’ve always found interesting about this relationship between pre-money and post-money is that post-money valuation is pre-money plus the money you raise, equals your post-money. And I find that interesting because there’s no premium given for the amount of money that you just raised. If you think about it, a $10 million business that raised $5 million, in theory, intuitively, $5 million in cash that you just raised should create more than $5 million in value, so your business is probably worth more than 15 million. That’s what I would argue at least. And so I’ve always found that really interesting between that dynamic.

Chris Lustrino (49:23):

It is an interesting dynamic. I will tell you that a lot of founders, maybe their last round of funding was 10 million. Now, they go out and say, “Well, we’re 20 million pre-money, will be worth 25 post-money.” So typically, they’re building in their own premium and they’re making sure to capture that.

Robert Leonard (49:39):

Yeah, that makes sense, Chris, thanks so much for joining me on the show today. I truly had a great time. I thought this was an awesome episode. I know the audience is going to love it. I know that I certainly did. As we wrap up the show, I want to give you a chance to tell the audience where they can go to learn more about you and learn more about all the different things that we talked about today.

Chris Lustrino (49:58):

Yeah, absolutely. If people want to learn more about KingsCrowd, the best thing you can do is go to kingscrowd.com. That’s K-I-N-G-S-C-R-O-W-D.com. And you can learn everything you want there. Check out our site, figure around, play around, hopefully, you’ll learn a ton. And then the other thing I’d encourage you to do is go and check out the marketplaces we mentioned today, wefunder.com, seedinvest.com, netcapital.com, and learn more about this space. Get comfortable, get your feet wet and make that first investment, because it really is a lot of fun.

Robert Leonard (50:31):

It’s a ton of fun. I think it’s super fascinating. And I personally wish I had known of KingsCrowd before I invested in StartEngine. I think I still did my due diligence and I’m still comfortable with it, but I would have loved to see the research and the ratings on StartEngine on KingsCrowd prior to making an investment. I think it would have been a cool piece of my research. I’m glad to have at least found it now, I look forward to using it as I move forward and make more private investments.

Robert Leonard (50:55):

Chris, I’ll put a link to those different things that you mentioned in the show notes. Thanks so much for joining me.

Chris Lustrino (51:01):

Thank you very much, Robert. Have a wonderful day.

Robert Leonard (51:03):

All right, guys. That’s all I had for this week’s episode of Millennial Investing. I’ll see you again next week.

Outro (51:09):

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