Andy Rachleff - Building Something People Want to Buy - [Invest Like the Best, EP.42]

My guest this week is Andy Rachleff, who is the CEO of the automated investing platform Wealthfront. Andy was also a co-founder and long-time partner at Benchmark capital--one of the most interesting and successful venture capital firms in the world. We spend most of our conversation discussing venture capital investing and entrepreneurship. Andy coined the now ubiquitous term “product/market fit,” and has great insight into how investors and entrepreneurs should think about business. In that vein, we discuss both what we refer to as the value hypothesis: building a product or service that customers love, and the growth hypothesis: scaling that product or service to a large market. We finish our conversation by talking about Andy and his teams mission at Wealthfront, and this conversation is perfectly timed, as Wealthfront just released a new feature that allows investors to buy factor portfolios, similar to Smart Beta ETFs. Above all, I’ll remember Andy’s advice to “put the gun in the other person’s hand,” a strategy that we explore in the middle of our talk. For comprehensive show notes on this episode go to http://investorfieldguide.com/andy For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag Books Referenced The Four Steps to the Epiphany The Lean Startup: How Today's Entrepreneurs Use Continuous Innovation to Create Radically Successful Businesses Millennial Money: How Young Investors Can Build a Fortune Diffusion of Innovations Crossing the Chasm: Marketing and Selling High-Tech Products to Mainstream Customers Show Notes 2:36 – (First question) – The partnership setup and how they came to be 5 equal partners 7:57 – Why benchmark would not take on the chairman role in companies they invested in 9:28 – What made John Doerr the greatest capitalist investor ever 11:59 – Looking at the venture process and what made it an attractive investment for Benchmark, using eBay as an example. 18:06 – If you are willing to help other people, without an expectation of return, it can create other opportunities 20:08 – Andy is asked to explain the idea of Product Market Fit, a term that he coined 22:18 – How does one go about finding a Product Market Fit 23:05 – The Four Steps to the Epiphany 23:19 – The Lean Startup: How Today's Entrepreneurs Use Continuous Innovation to Create Radically Successful Businesses 25:55 – What are the components of the Growth hypothesis 26:51 – Why you can learn more professionally from success vs failure 28:13 – What it’s like to shift from venture capitalist to operator/CEO 30:24 – The rate at which technology gets adopted and what will help Wealthfront 30:53 – Millennial Money: How Young Investors Can Build a Fortune 31:26 – Diffusion of Innovations 31:38 – Crossing the Chasm: Marketing and Selling High-Tech Products to Mainstream Customers 32:38 – What does it look like to innovate on top of current platforms 41:07 – Will platforms like Wealthfront help to democratize access to private markets 44:23 – Kindest thing anyone has done for Andy Learn More For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

  I know firsthand how complex the tech stack is for asset management firms. And seemingly every new tool and data source makes the problem even worse, adding more complexity, more headcount and more risk. RidgeLine offers a better way forward. One unified platform that automates away the complexity across portfolio accounting, reconciliation, reporting, trading, compliance and more, all at scale. RidgeLine is revolutionizing investment management, helping ambitious firms scale faster, operate smarter and stay ahead of the curve. See what RidgeLine can unlock for your firm. Schedule a demo at ridgeline.ai.

• 0:32Patrick O'Shaughnessy?

  This podcast is sponsored by CFA Institute, the global association of investment professionals whose mission is to lead the investment profession by promoting the highest standards of ethics, education and professional excellence for the ultimate benefit of society. CFA Institute serves a global community of investment professionals, working to build an investment industry where investors' interests come first, financial markets function at their best and economies grow. The Chartered Financial Analyst credential is the most respected and recognized investment management designation in the world. The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome everyone. I'm Patrick O'Neal and this is Invest Like the Best.

• 1:15Patrick O'Shaughnessy?

  This show is an open-ended exploration of markets, ideas, methods, stories and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com.

• 1:31Speaker 02

  Patrick O'Neal is a Principal and Portfolio Manager at O'Neal Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Neal Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Neal Asset Management may maintain positions in the securities discussed in this podcast.

• 1:54Patrick O'Shaughnessy?

  My guest this week is Andy Radcliffe, who is the CEO of the automated investing platform Wealthfront. Andy was also the co-founder and longtime partner at Benchmark Capital, one of the most interesting and successful venture capital firms in the world. We spent most of our conversation discussing venture capital investing and entrepreneurship. Andy coined the now ubiquitous term product market fit and has great insight into how investors and entrepreneurs should think about business. In that vein, we discussed both what we refer to as the value hypothesis, building a product or service that customers love, and also the growth hypothesis, scaling that product or service to a large market. We finished our conversation by talking about Andy and his team's mission at Wealthfront. And this conversation is perfectly timed as Wealthfront just released a new feature that allows investors to buy factor

• 2:39Patrick O'Shaughnessy?

  portfolios, similar to smart beta ETFs. Above all, I'll remember Andy's advice to put the gun in the other person's hand, a strategy we explore in the middle of our talk. We start our conversation discussing what has made Benchmark Capital so successful, which started with how the founders thought about their competition. You can find show notes for this episode at investorfieldguide.com/andy. And now, please enjoy my conversation with Andy Radcliffe.

• 3:08Patrick O'Shaughnessy?

  So back to Benchmark and its kind of unique structure. From what I understand, originally, it was five partners and it was sort of an equal partnership.

• 3:15Speaker 03

  Not sort of.

• 3:16Patrick O'Shaughnessy?

  Exactly, an equal partnership. So no, no politics or hierarchy, I guess. So what was the, what was the reason for that setup? How did you, how did you come up with that idea?

• 3:27Speaker 03

  You know, when we started, as I said, that we were, what united the five of us was a desire to build the best firm in the business, not necessarily to make a lot of money. We thought if we built the best firm in the business, the money would follow. But we were really, really oriented toward building the best. And we felt as though whatever platforms we were previously associated with, we could do very well, but we couldn't become the best. And we tried to take the advice that we gave to our portfolio companies, which is pick your closest, who you think is your closest competitor and try to turn their greatest strengths into their greatest weaknesses. So.

• 4:09Speaker 03

  The firm that we perceived as number one by a long shot was Kleiner Perkins back in 1995. Unfortunately, I don't think they are number one any longer, but they were head and shoulders above everyone else. And we thought they were head and shoulders above everyone else for two reasons. Number one, they had the world's greatest venture capitalist in John Doerr. I think he's the best there ever was. And number two, they had a reputation for helping their portfolio companies do business with their other portfolio companies. So they referred to this as their kuretsu. Back in the eighties, it was perceived that Japan was going to beat the US, sort of the

• 4:53Speaker 03

  way people perceive China beating the US today. And so people wanted to emulate Japanese techniques, and there are a bunch of networks of companies that affiliate with one another. And so there was a great attraction to entrepreneurs to be able to join one of these affiliations, their kuretsu, so that if you got backing from Kleiner, they would help you sell products to other Kleiner Perkins companies. So we thought long and hard about how do we turn these great strengths into weaknesses, classic judo. And what we decided was John Doerr was the world's best venture capitalist, and his

• 5:34Speaker 03

  team of partners were also outstanding, but entrepreneurs were often disappointed if they didn't get John. So we wanted to compete with the individual with a team. And we thought that if we built an equal partnership, we could attract a better team than anyone else in the business, because if we were competing with another venture firm for a particular individual as a partner, and they had a choice of being an equal partner with us, or a junior partner at the other firm... That was an intelligence test. Why wouldn't you join us? And it's played out that way. It's an always equal partnership. So if someone joins today, they have the same economic stake in the new funds as one of the founding partners. Now, the only way you can make this work

• 6:19Speaker 03

  is if the old guys leave, which is what they don't do in the venture business. It's usually the old guys suck up the economics and the young guys generate all of the returns. Now, we had been those young guys in previous firms and we said, we're not going to make that same mistake. So we made a blood brothers pact that if any of us got to the point that we weren't willing to work 110% on Benchmark, we had to opt out and take no economics in future partnerships. We could invest, but we didn't get any sweat equity. And we were all cool with that because we wanted to build a legacy. Now, all the five founders have retired and when any of us go to the office, people smile at us because we're not soaking up their equity.

• 7:03Speaker 03

  So they like us as opposed to hate us as you typically do with the old partners in a firm.

• 7:10Patrick O'Shaughnessy?

  One of my favorite thinkers in the entire world is Bill Gurley, who's now, I think maybe the the I hesitate to use the word senior and oldest, longest standing partner. And I read an interview with him that said, the key to the success of Benchmark was sort of, I think he said, at the peak of their powers, the founders handed us the keys.

• 7:29Speaker 03

  Yes.

• 7:30Patrick O'Shaughnessy?

  And so I was reading a novel that I just have to read this quote because I think you'll really appreciate it. So it's about a kind of Middle Eastern, almost fantasy land type little city-state kingdom. In Alabar's Kingdom, a minute city-state, a tribe, if you will, it was the custom to put the king to death at the first sign of old age. Kings were permitted to rule only so long as they retained their strength and vigor. Regarding its rulers as semi-divine, godmen upon whom the course of nature depended, the clan believed widespread catastrophes would result from the gradual enfeeblement of the ruler and the final extinction of his powers and death. The only way to avert those calamities was to kill the king as soon as he showed symptoms of decay, so that his soul might be transferred to a vigorous young successor. Before it had been impaired.

• 8:15Speaker 03

  We believe in euthanasia, let's put it that way. So it was incumbent upon each of the partners to raise their hand. And it was really perceived as bad if you didn't raise your hand.

• 8:26Patrick O'Shaughnessy?

  So could you come up, could you give one portfolio company example?

• 8:30Speaker 03

  So let me just finish the other point and we'll come back to this. So one was team versus individual and the other one was Kleiner would often take the position of chairman of their boards. And we thought that was inappropriate, given the importance, the relative importance of the entrepreneur versus the venture capitalist. And a lot of entrepreneurs, once they were backed by Kleiner, sort of felt pushed into doing business with other Kleiner companies as opposed to wanting the opportunity. And so playing on that, we said, we positioned ourselves whereby the entrepreneur was the star and we were the stagehand. So we never took the chairman title. We never pushed them to work with our portfolio companies.

• 9:12Speaker 03

  We would work hard to make the introductions if they wanted, but we never pushed them. And so those two things, combined with the three of us who had been in the venture business before for more than 10 years, all had pretty good track records and good networks. By bringing all that to bear, we were able to get off to a good start. We started at the best time you ever could have started a venture capital firm in 1995 as the internet was taken over. It's better to be lucky than good. And fortunately, we made some great investments and great investments spawned other great investments. And we recruited great people like Bill Gurley. And they continue, I think the team now is doing a better job than we ever did.

• 9:54Patrick O'Shaughnessy?

  Before I ask that portfolio company question, you mentioned that John Doerr was the greatest venture capitalist ever. Why do you say that? What are the attributes or the skill set that made him the best?

• 10:07Speaker 03

  He didn't lose sight of what was important. So you have to make a leap of faith to make a big return. Without risk, there isn't reward. All of us want return without risk, but unfortunately it doesn't exist. I think that Howard Marks puts it best when he applies the same framework to all of his newsletters. Howard is the founder of Oaktree. Capital, which is probably one of the best distressed debt investors, but he's as well-known for his quarterly letter to his investors as he is for his great returns. And every one of his letters is based on the same framework, which describes investing

• 10:49Speaker 03

  with a two-by-two matrix. On one dimension, you could be right or wrong, and the other dimension, you can be consensus or non-consensus. Obviously, you don't make money if you're wrong, but what most people don't realize is you don't make money if you're right in consensus. All those returns get arbitrage'd away. So, the only way you make money is by being right in non-consensus, which is really hard, because you know you're non-consensus. You just don't know if you're right. Now, with John, I think that he was riveted on what could be big, because if something can be big, that sort of swamps everything else in the venture.

• 11:25Patrick O'Shaughnessy?

  Meaning the market size.

• 11:26Speaker 03

  The market size. But you don't want it to be big today, because it's really hard to take share from big companies. It's a lot better to invest in something that's just emerging. And John didn't let anything get in the way of an opportunity that he thought would be big. So, if it was really high-priced, like Netscape, he paid Forex the then-normal valuation for Netscape. And everybody thought he was nuts. And he had the last laugh. Amazon, he did the same sort of thing. So, he never let the quality, the people, or the valuation, or anything like that, get in the way where others of us might

• 12:09Speaker 03

  have. And I think that's what made him great, number one. Number two, he's exceptionally bright. And because of his success, he built perhaps the best network in the business. And number three, he has the best voice in the business. When you hear him speak, you just want to do whatever he says.

• 12:26Patrick O'Shaughnessy?

  Amazing how powerful that can be. So, maybe now we could choose an example, because I'm always fascinated by the actual, everyone's investment process. And I think the venture process can be the hardest, at least for me, one of the hardest to understand. So, using an example of a particular portfolio company, maybe from the first, or one of the early benchmark funds, would be fascinating to hear what the company was, what it did, why it appealed to you, kind of what the criteria were that seemed attractive, and kind of briefly summarize the story. That'd be really interesting.

• 12:57Speaker 03

  Okay, well, one of our first very successful companies was eBay. Now, this is a classic venture capital story and it incorporates why Bruce Dunleavy is so great. So, the founder of eBay actually started the company as a hobby. He had never intended for it to be a business. Previously, he was the number four, he was the fourth engineer hired into one of the first pen-based computing software companies, a company called Ink. Back in Merrill Picker days, Bruce made an investment in Ink so we could have a play in pen-based computing. He didn't go on the board, but he made an investment.

• 13:40Speaker 03

  But Bruce was such a great advisor that even though he wasn't on the board, anyone in the company who had a serious strategic question would come to Bruce rather than one of the board members. And Pierre Omidyar, the founder of eBay, was no exception. Well, Ink pivoted into e-commerce. It was the first e-commerce company and changed its name to E-shop. It was ultimately acquired by Microsoft. But E-shop was the first company doing e-commerce, I think on top of the CompuServe platform, so before the internet. So Pierre had some e-commerce in him. Now, after, after he left E-shop, I think he joined a company called General Magic and

• 14:23Speaker 03

  he ran this electronic community out of his apartment and he called it eBay for Electronic Bay Area. Now eBay, if you went to the, to the website, you would, you would have found a page with 250 words in courier font, old-fashioned typewriter font, and buried in this

• 14:47Speaker 03

  Narrative were six links to six different applications. One of which, I think the fourth one down was called AuctionWeb, which is what we know of eBay as being today. And he did this sort of just for fun. It was one of the things to draw people to his community. I think he was trying to help his girlfriend sell Pez dispensers, was the famous story. But people were starting to trade other collectibles on it and even some other products. Well, it grew so quickly that Pierre couldn't afford to pay for the 56 kilobit line that he needed to connect his server in his apartment to the internet.

• 15:30Speaker 03

  So he felt guilty about this, but he posted a note on the site that said, "I'm going to have to charge a listing fee just to pay for this higher bandwidth line and maybe a little bit more server capacity." Well, from that day forward, the checks came in faster than the expenses. So, fast forward a year, and I think he was up to about 200,000 of net revenue per month, and he was growing at 10% per month. And the software broke all the time. It was spaghetti code. It was just awful. But he got an acquisition offer from a newspaper chain because, I guess, the newspaper chain

• 16:11Speaker 03

  correctly noticed that this might affect their classified business, which was the most profitable advertising in a newspaper. Most people don't realize that. We don't even see these classified ads. But he had gotten an offer and he called up Bruce to see what he should do about it. Not to show us the investment, but he wanted Bruce's advice. So Bruce listened to Pierre tell the story, and at the end of the breakfast Bruce said, "You know Pierre, I think you're on to something here. Would you be open to raising a little money, a portion of which we would use to buy some of your stocks so you could take some money off the table?

• 16:53Speaker 03

  Because I know this acquisition offer is attractive to you, so you can afford to buy a home." Would you be open to that? And Pierre said, huh, yeah, okay. So then we went back and talked about it. We met the company and it struck us all that this platform that was being applied to collectibles. And when people wanted to insult us, they say, beanie babies? Really? That's what this thing is for? We saw it as an opportunity to sell many other things besides beanie babies or Pez dispensers. That was a leap of faith. That was the non-consensus idea. And it wasn't until the company went public

• 17:38Speaker 03

  that people stopped making fun of us for having made that investment. And that's what usually is associated with the most successful investments in technology. And Bruce didn't go on the board. My partner, Bob Cagle, who was the one most focused on the intersection of consumer and technology, which back in 1997 even, was not considered normal.

• 18:04Patrick O'Shaughnessy?

  I take two things away from that. And I'm curious if you think I'm right here. So the first is that there's a component of success beginning success. That and underneath all of this is the principle of compounding. And the other thing is with Bruce that it seems as though his operating system, if you will, was to kind of always help people, maybe without any particular expectation of a return. But that because he was the one that the eBay founder reached out to, that thereby created the opportunity. So it seems like if you're willing to just help other people in a very productive way without a particular goal in mind, that can create like an enormous compounding network effect that might create the opportunities that these top 20 venture firms capitalize on.

• 18:47Speaker 03

  You know, it's funny. I've always been a really big believer in the golden rule. You know, we teach it to our kids, but we seldom execute it in business. And that always struck me as odd. And so one of the things that bound Bruce and I together was this common belief in operating that way. So much so that he had a philosophy that really impacted me. And this was part of the mentorship. I don't think he was consciously mentoring me. He just set a fantastic example. One of the things that I love about him is he has this philosophy that I call putting the gun in the other person's hand.

• 19:27Speaker 03

  So in any interaction, in any negotiation, Bruce always puts the gun in the other person's hand. Now, if they fire, he just doesn't work with them. So if he negotiates with an entrepreneur on evaluation, he will usually say, Patrick, you tell me what the fair price is and I'll do it. Now, most people will feel pressure to not take advantage and to do the right thing. But there's about 10% of people out there whose eyes will go wide and say, oh my God, really? And then they'll ask for a valuation that's radically higher than what they deserve. And he would just choose not to work with them. And I do that in all of my dealings.

• 20:12Speaker 03

  I always put the gun in the other person's hand. And that breeds great loyalty. I think it's a much nicer world when you treat people the way you would like to be treated.

• 20:23Patrick O'Shaughnessy?

  It's kind of like the Munger Buffett idea of like a seamless web of trust, right? That the gun in the other person's hand is basically another way of saying trust.

• 20:31Speaker 03

  Exactly. Assume good faith.

• 20:33Patrick O'Shaughnessy?

  Yeah, fantastic. So I believe that you were the person to come up with this term product market fit and this kind of idea of a value hypothesis and a growth hypothesis.

• 20:43Speaker 03

  That part I didn't come up with, but the product, the concept of product market fit, I think Steve Blank and Eric Ries came up with the, those two hypotheses.

• 20:51Patrick O'Shaughnessy?

  So I would love to use those as a bridge to kind of describe what those ideas mean along with the innovator's dilemma, which maybe our king, King Alabar was a good example of, to bridge into Wealthfront. And so maybe you could start with your definition of product market fit. It's become a ubiquitous term, given that it was kind of your original idea. I'd love to hear, I'd love to hear straight from you.

• 21:11Speaker 03

  Well, I'm a big believer, based on having observed technology companies for more than 30 years, that if the dogs want to eat the dog food, you can screw up most everything else and you'll still be really, really successful. So the entire goal in starting a business, especially in tech, is to get those dogs to eat the dog food. So my partner Bob Kegel used to say, you want products that are bought, not sold. When people want to pull it out of your hands, that's product market fit. Now, the, the technical way that you can tell whether or not you've actually achieved

• 21:50Speaker 03

  product market fit, at least in a consumer business, is if you grow exponentially organically. Now, the only way you can grow exponentially organically is through word of mouth. The only way you have word of mouth is if people are delighted and love your product. If you achieve that, you can screw up almost everything else in the company and you'll still be successful. This is the only way that I can explain how a 25-year-old can run a billion-dollar business. That if, if the customers pull the products out of your hand, you don't have to be that great at operating.

• 22:26Patrick O'Shaughnessy?

  And what is the method through which, because my favorite part about the venture capital world is taking lessons that tend to be applied in hyperspeed and very tight feedback loops, but taking a step back and applying them to small businesses, or a slower paced business, or even a mature business where innovative dilemma may have set in. So how, how, when you teach, for instance, students at Stanford, how does one go about finding a product market fit? I mean, it's a rare thing.

• 22:52Speaker 03

  Well, that's where I think Steve Blank came up with a business innovation. So Steve was the first person to describe applying the scientific method to business. You know, when we're in third grade, we all have to do a project on the scientific method. We have to come up with a hypothesis, we have to design an experiment, we have to come up with results, and then we have to iterate on that. Amazingly, that had never been applied to business. And Steve just came up with a framework to explain how one would apply that methodology to, in effect, finding the product market fit. Now, he wrote a book that was really just his teaching notes from a class he taught

• 23:35Speaker 03

  at Berkeley called The Four Steps to the Epiphany. One of the people who took the course was a fellow named Eric Ries, who became a disciple. And then Eric wrote a book called The Lean Startup, which I refer to as the New Testament. So you can think of The Lean Startup as the New Testament to Blank's Four Steps to the Epiphany, Old Testament. It's much more readable and more relatable, just like the New and the Old Testament. And so basically, what they came up with was a methodology by which you would first test a value hypothesis and then a growth hypothesis. So the value hypothesis represents the what,

• 24:19Speaker 03

  the who, and the how of your business. What do you want to build? For whom is it relevant? And what's the business model to deliver that product? Now, what's different than what most people expect is that you don't iterate on the what, you iterate on the who. Most people think that entrepreneurs start businesses by looking at a market, finding a problem, and coming up with a solution. That leads to very mundane outcomes. Back to the Howard Marks framework, that's right in consensus. Anybody can do that. The great technology entrepreneurs basically recognize an inflection point in technology that allows them to build a new kind of product.

• 25:03Speaker 03

  Then the question is, who cares? So you might change the way you describe that product or technology, but you don't really change the technology. You change who might want that product.

• 25:15Patrick O'Shaughnessy?

  So it's kind of like finding a market, a large market that no one has really identified or knows exists as a separate thing.

• 25:22Speaker 03

  So you iterate on the who. And that's called pivoting. So that's become a very popular term. And every successful technology company has pivoted. Now, they all revise history to make you think they didn't because that doesn't feel good as a consumer.

• 25:39Patrick O'Shaughnessy?

  Yeah, really like narrative determinism.

• 25:40Speaker 03

  Exactly. Companies have to prove out their value hypothesis, then and only then can they pursue a growth hypothesis, which is a way to acquire customers cost effectively. And proof of the value hypothesis is exponential organic growth. So back to your question, what's product market fit when you've proven your value hypothesis?

• 26:03Patrick O'Shaughnessy?

  So then the growth, interesting switch to the growth hypothesis. So if the value hypothesis is, the indicator is organic growth, exponential organic growth, why, why do you need a growth hypothesis? If you're acquiring customers via something like word of mouth?

• 26:18Speaker 03

  Cause faster growth's better.

• 26:19Patrick O'Shaughnessy?

  Faster growth's better. So what, so what, so what are the components then of, of growth work? So assuming you've got something, the dogs are eating whatever particular branded dog food, what are the important components of scaling a business like that?

• 26:32Speaker 03

  Well, this is a whole new field called growth or growth hacking. The people who are best at it hate the term growth hacking because they don't think it's hacking. They think it's a very analytical process. But the growth function really consists of figuring out what's working and then doing experiments around that to make that even better. So what's really interesting is that fixing what isn't working doesn't help you grow nearly as fast as improving what is working.

• 27:02Patrick O'Shaughnessy?

  Yep. Like amplification in the evolutionary setting.

• 27:05Speaker 03

  Exactly. And it's true by the way of our own, of us personally, that it's a lot better to amplify what you're good at versus fix the things you're bad at.

• 27:14Patrick O'Shaughnessy?

  So, so there's like a kernel in there that I think is counterintuitive to a lot of people. People talk about learning from failures and that failure is necessary or a great way to learn.

• 27:25Speaker 03

  I couldn't disagree more.

• 27:26Patrick O'Shaughnessy?

  Yeah, that's where I was going. It sounds like if you're, if you're following this amplification idea, that you're actually going to learn more from success.

• 27:32Speaker 03

  Well, I think you learn more professionally from success. I think you learn more personally from failure. One of my former CEOs pointed that out to me, Brian Nesmith, and I thought that was a really interesting insight. Think about it, if I'm going to hire you to work here at Wealthfront. I'm not going to hire you for what you know not to do. I want to hire you for what you know to do. So, learning from failure is great. You learn what not to do, but if you work at a really successful company, you're going to learn some tricks that are unbelievably valuable that the person who's never been successful won't, can't possibly learn from reading about it.

• 28:11Patrick O'Shaughnessy?

  I have this idea where if someone-

• 28:14Speaker 03

  This is a really subtle but important difference.

• 28:16Patrick O'Shaughnessy?

  I always think that if I hear some, if someone describes someone else as well-rounded, I almost think that that's an insult, that like, I'm more interested in people that have-

• 28:24Speaker 03

  Although they're really interesting to talk to.

• 28:26Patrick O'Shaughnessy?

  I'm sure. That have some extreme competitive advantage in one particular area, because that's the kind of thing that you can really ride. Fascinating. So, so now let's, let's shift gears to Wealthfront and the transition in your own life from venture capitalist to operator, now CEO. What, what has that been like before we get to the business itself?

• 28:48Speaker 03

  Painful.

• 28:48Patrick O'Shaughnessy?

  Yeah. The, the difference in the roles, I'm fascinated by this. And whether or not, I'm not going to assume there's anything that applies between the two, that like lessons from the venture capital world that have made you a better CEO. Maybe there's nothing, I don't know.

• 29:02Speaker 03

  I don't really think there are many lessons, other than having observed some great leaders. I think that I learned a bunch of leadership tricks that can make me a better leader. Nothing about being good in venture capital makes you good as an operator or vice versa. It's funny that one of the courses that I, I used to teach at Stanford was the formation, was the foundation course for entrepreneurship. And I had the good fortune to teach with an amazing guy named Mark Lesley, who founded a very successful company called Veritas Software. He grew it from zero to about a billion and a half in revenue. And Mark hates venture capitalists, just hates them. Because it was a very non-consensus idea and he got turned down by a lot of venture capitalists

• 29:47Speaker 03

  early on. And he enjoyed teaching with me despite the fact that I was a venture capitalist because we saw things very, very similarly. Well, when I started this company, he was so happy because now I was an operating guy. And I'll never forget about a year in, he said to me, "Think how much better you'd be as a venture capitalist now as a result of this." And I looked him straight in the eye and I said, "Mark, nothing about what I've learned in the last year would make me a better investor. It would make me a better board member because now I don't talk as much when I'm on a board because I realize how little perspective I have that I have to stay at 100,000 feet and I shouldn't get into any of the details with the management team."

• 30:32Patrick O'Shaughnessy?

  It's such an interesting comment because one of the often parroted Buffett phrases is being an investor makes me a better business person, a business person makes me a better investor. And this is very different from that. So I'm curious-

• 30:44Speaker 03

  It might be a definition of business person.

• 30:46Patrick O'Shaughnessy?

  It could be, yeah. So as now CEO and thinking about some of these ideas of product market fit, change in technology, creating a new market, what is the central thing that you think will make you successful going forward? So the audience luckily is going to be very familiar with Wealthfront, with competitors like Betterment, with the automated investing platform idea. So we don't need to go too deep into that core idea, which I think makes a ton of sense. But just to be totally blunt, like, so I think that this type of solution is fantastic for young people in particular. But I had an enormously hard time when I wrote a book called Millennial Money, trying to get younger people to invest, basically through

• 31:28Patrick O'Shaughnessy?

  an automated platform. There's a whole section on automation and the power of it. I found it very hard to get them to go actually do it, to eat that dog.

• 31:35Speaker 03

  Well, that's because there's a rate at which people adopt new technologies. So there's a tremendous misunderstanding in the general public that if you offer something that's better, that everyone will beat a path to your door and immediately use it.

• 31:50Patrick O'Shaughnessy?

  Diffusion of innovation.

• 31:51Speaker 03

  That you'll just immediately, everyone will say, oh God, I should have bought that product. How could I not buy that? Well, actually, the seminal book on this topic is one called Crossing the Chasm, written by Jeffrey Moore in the mid 90s, where he described what he called the technology adoption lifecycle, that every product goes through a path. That's you start with innovators, then early adopters, then pragmatists, the early majority, then the late majority only buy when things are standards, and then the laggards. And that every product goes through this process. Nothing gets immediately adopted, except if it's just a better version of an existing product. When you create something new, it takes a while to get adopted.

• 32:36Speaker 03

  We're actually being adopted at twice the rate that Charles Schwab was when they started. And Charles Schwab was adopted at a much faster rate than Merrill Lynch, because it was a discount brokerage versus regular brokerage. So while you might have had an issue, the rate of adoption of our service is radically faster than anything else in the history of investing.

• 33:01Patrick O'Shaughnessy?

  One of the, one of the lines I saw a quote from you was to say that a successful CEO is someone that's constantly kind of innovating on top of an existing platform, so creating new products. And so I'm curious what that might look like, because on the investment side, the current vanilla portfolio that you might get is I think what people would expect. Modern portfolio theory, you know, risk-based allocations to the major asset classes via low-cost instruments, which you're not going to find many people that would argue that that's a bad.

• 33:31Speaker 03

  Oh, you'd be surprised.

• 33:32Patrick O'Shaughnessy?

  Well, their legion is shrinking and dying by the day.

• 33:38Speaker 03

  Yes.

• 33:38Patrick O'Shaughnessy?

  So, but for me, so when I peruse kind of the Wealthfront products, and obviously I'm not your customer, I'm in the investment business, I manage my own money. But something like a direct indexing, where you are constantly harvesting tax losses, something like that seems very interesting. And the ability of Wealthfront to, in the future, continue to put things out like that across sort of the financial stack, not just necessarily in direct investing. But across sort of the financial technology stack really interests me as a prospective user. So how do you think about that? How are you trying to foster or avoid that innovator's dilemma, kind of sitting on that core product and constantly coming up with new ideas?

• 34:17Speaker 03

  Well, first and foremost, we consider ourselves a software company, not an investment company. So we're a software company doing investing, not an investment company doing software, which is the approach I think everyone else in our world has taken. So we started with a very rudimentary product, and that was a diversified and rebalanced portfolio of low-cost index funds. And I used to say to people that we offer very little value and price accordingly. And that used to drive my colleagues here at Wealthfront crazy, but it was honest, right? It was, you know, net of fees after taxes, it was still radically better than what the vast majority of people in the United States have

• 35:00Speaker 03

  access to. But it was boring and rudimentary. And the beauty of software is that you can, it constantly improves. And if you have some knowledge about investing, you can add value. So from the very beginning, we did something different from any other player in our space. And that was we had a strategy of taking all of the services that are traditionally available through private wealth managers, people who manage, who provide financial advice at places like Goldman Sachs and Morgan Stanley, and who have a minimum investment account of $5 to $15 million, automate what they do through software and deliver them

• 35:41Speaker 03

  to the masses, thereby democratizing access. Now, we focused on young people because we thought they would care much more about a product that was delivered via software. Older people want to talk to someone. We don't want to deal with, we don't think our solution is ideal for them. Will some want it? Yes. Will some young people prefer to talk to someone? Yes. But the vast majority of young people live their lives electronically, and they actually tell us, "We pay you not to talk to us", which is the exact opposite of the way the traditional industry thinks. And the traditional industry thinks that when they get older, they're going to come to their senses and want to talk to someone. That's like saying someone who listens to rap when they're young,

• 36:26Speaker 03

  when they turn 50, they'll want to listen to symphony. I'm sorry, but I think it's a generational change. So we focus on young people who have less than a million dollars, who want to delegate. And why less than a million? Because at a million, you can afford access, the minimums from a financial advisor. Less than a million, you have no alternatives. So we started thinking about, well, what are some rule-based, some peer-reviewed, rule-based strategies that we could apply on top of what we do? So first, we did tax loss harvesting. And it's amazing, in the four years that we've offered this service,

• 37:07Speaker 03

  on average, it's added 1.8% to our clients' annual after-tax return. It's almost too good to be true. Now, this has been around for decades, where people do it at year-end. They harvest losses or recognize losses and replace the securities that have been sold with something similar, so you maintain the risk and return characteristics of the portfolio. But by using those realized losses to lower your taxes, you increase your returns. But software does routine things better than people. Now, it's really hard, if you have 100 or 200 clients as a private wealth manager, to look at your clients' accounts every single day to look for losses you can harvest,

• 37:50Speaker 03

  especially given all the tax lots associated with multiple deposits. But software doesn't care. So we could do it on a daily basis. And offer something better than even private wealth managers could do. And then we recruited Bert Malkiel, who I think invented the index fund in his book, A Random Lockdown Wall Street, as our chief investment officer. And he suggested, why don't you, rather than just do tax loss harvesting, across index funds or ETFs, do it within an index. That's what direct indexing is. So if the S and P 500 is up 1%, but Coke missed their earnings, well, and they traded down 5%, you could sell Coke and buy Pepsi.

• 38:34Speaker 03

  And that adds another 0.2 to 0.5% to your return after tax every year. And we don't charge anything incrementally for either of those services. So these value adds more than pay for our quarter of a percent fee. Now you'll see us add more peer reviewed, rule based strategies that enhance after tax returns. In February, we announced financial planning. Now, again, if you're young, financial planners, you can't afford access to a good financial planner. Because financial planners long ago figured out that they can't make money charging an hourly fee. Or maybe they make a hundred thousand dollars a year.

• 39:18Speaker 03

  But if they want to make half a million dollars a year, the only way they can do that is by charging an asset fee. And you have to have a minimum of a million dollars. Now, they might not be great investors, but that's how they monetize their service. So if you have less than a million dollars, you don't have access to them. But even if you did, what they do is they interview you just to get the inputs into a commercially available software package. It's not like they're adding a lot of value. They all use the same package. And then they type in the inputs, they share the output with you two weeks later. You edit the output. The planner goes back to his commercial software package, puts in the edits. Two weeks later, they share that.

• 40:01Speaker 03

  Well, with application programming interfaces, we can connect to all of your financial accounts, get much more accurate estimates of what you spend and save. We can give you the results immediately. We can give you the interactive tools that you can even work with while you're in line at Starbucks on your phone and give you a far better financial planning experience. Today, we just announced, so we started with retirement planning. Today, we offer college planning. So we can actually tell you what it's going to cost to go to any college you pick, even any type of college. We can even tell you what the financial aid is going to be. You can't get that anywhere on the internet. So the beauty of software, it can do a better job.

• 40:44Speaker 03

  A few weeks ago, we even introduced our portfolio line of credit, another private wealth management service of securities-based lending. So if you invest at least $100,000 with us, then you are automatically enrolled in a line of credit. No credit check, nothing. And you can borrow up to 30% of your account value at interest rates below any interest rates on Wall Street and probably at about 2/3 of the cost of a home equity line of credit. And software, so it's amazing what we can do through software. No one else in our space is doing this. Other people are adding advisors to their, what we did five years ago with our rudimentary software.

• 41:29Patrick O'Shaughnessy?

  It seems like there will be this, because of software, especially in anything pertaining in public markets, that there will be this kind of barbell that gets pushed further and further towards the ends where the big middle of like the old school active stock picking mutual fund manager is having a horrible time right now because money is

• 41:46Speaker 03

  As they should.

• 41:47Patrick O'Shaughnessy?

  Arguably as they should because they're charging fees for what in aggregate has to be a losing proposition, right? Just because of simple fee math. But now I'm finding, because I get to talk to investors of all stripes, a keen interest still in active management. It just seems to be going more esoteric and more private. You come from the world of the ultimate stock picking, you know, ultimate privileged access, top venture firms that nobody can get into, that has these amazing returns, right? And I think that's what always appealed to people about active management was some sort of privileged access. Do you foresee Wealthfront getting into some of those spaces, potentially providing, democratizing access to private markets which have become, you know, enormous?

• 42:30Speaker 03

  You know, it's really funny. One of the things that we will not do that private wealth managers do is offer access to alternative assets. And the reason is because of the old Groucho Marx line, "I would never join a club that would have me as a member." Let me explain what I mean by that. So, one of the primary tools that private wealth managers use is, "Hey, I can give you access to hedge funds, or venture capital, or buyouts." The problem is, the ones that they can give you access to suck. And the reason they suck is, so back when I was a partner of Benchmark, the last person I wanted was a retail investor in my fund. Why?

• 43:11Speaker 03

  Because, as you know, there's been tremendous amount of research done that shows that individual investors, retail investors, buy when the market goes up and sell when the market goes down. The exact opposite of what they should do. They're the opposite of a contrarian. Contrarians make money. So, why do I want an investor in my long-term capital fund who's going to feel the urge either to want to sell when the market goes down, or not want to meet their capital call when I need it? Now, if I'm in the fortunate position to be able to choose any investor I want, that's the last investor I want.

• 43:51Speaker 03

  So, the best investor, the one who's the most long-term oriented, is either a university endowment, or a charitable foundation. All things being equal, and there are obviously exceptions, but on average, those are the best. So, that's true for all the premier venture capital funds. So, the only venture capital fund that would let Morgan Stanley or Goldman Sachs invest in their funds are the ones that are desperate for capital. Why are they desperate for capital? They suck! The same is true of the best hedge funds, the same is true of the best private equity funds. So, by definition, if Goldman Sachs or Morgan Stanley give you access, run away! So, I'm sorry, that's why we're not going to offer it. We can give you...

• 44:34Speaker 03

  Some additional asset classes that are not correlated, that are liquid and that are rules-based and peer-reviewed, but they're not going to be those alternative assets.

• 44:48Patrick O'Shaughnessy?

  Well sadly, we only have time for one last question, but it's my favorite and always my closing question, which is to ask, what the kindest thing anyone has ever done for you?

• 44:55Speaker 03

  Gosh, I've been the recipient of an amazing amount of kindness over the years. I actually think my entire career is a function of kindness and luck. That, God, when I was in business school, it's really funny that I worked in Wall Street for a couple of years after college, and I worked in mergers and acquisitions at Blythe Eastman Dillon. And the head of the M&A department was a Stanford grad, and he encouraged me to go to Stanford Business School because he knew I wanted to get into venture capital. And he wrote a wonderful recommendation, and I was lucky enough to get in. So that was really good. And then turns out, his son was a year ahead of me in business school. So he took me under his wing.

• 45:39Speaker 03

  And his son introduced me to one of his best friends, who as it turns out, his father was then the CEO of Hewlett-Packard, which was the Google of the day. And he had gone into venture capital. And for some reason, he took a liking to me, and he introduced me around to venture capital firms. And that's how I got in the venture business. I started working while I was going to school. And just over and over and over again, people have done amazingly nice things for me to give me an opportunity. And that's why I'm such a big believer in the golden rule.

• 46:16Patrick O'Shaughnessy?

  Yeah, it's been the theme of our conversation, that it's not a short-term edge, but it's a long-term one. And so a great closing answer. Well, thank you very much. This has been as fun as I knew it would be. Have a great day.

• 46:25Speaker 03

  Thank you very much.

• 46:29Speaker 04

  Hey everyone, Patrick here again. To find more episodes of Invest Like the Best, go to investorfieldguide.com/podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com/bookclub. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter @Patrick_OShag. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.