Alex Rampell - Investing in Operating Systems - [Invest Like the Best, EP. 248]

My guest today is Alex Rampell, General Partner at Andreessen Horowitz. Alex has a long history in fintech, having co-founded six companies in his career, including Affirm and TrialPay. During our conversation, we cover Alex’s framework for positive selection in investing, why the best investments are often operating systems or systems of record, and Alex’s views on the future of fintech. For those that have listened to our Business Breakdown on Visa with Alex - you know the intellectual horsepower he brings to every discussion. This conversation is no exception. For the full show notes, transcript, and links to the best content to learn more, check out the episode page here. ------ This episode is brought to you by Tegus. Tegus has built the most extensive primary information platform available for investors. With Tegus, you can learn everything you’d want to know about a company in an on-demand digital platform. Investors share their expert calls, allowing others to instantly access more than 20,000 calls on Affirm, Teladoc, Roblox, or almost any company of interest. All you have to do is log in. Visit tegus.co/patrick to learn more. ------ This episode is brought to you by Hall Capital Partners. Hall Capital is always looking for exceptional investment talent at any stage and size, so if you are raising capital or looking for a career change in the San Francisco or New York areas, you should check them out at hallcapital.com or e-mail at [email protected]. ------ Invest Like the Best is a property of Colossus, LLC. For more episodes of Invest Like the Best, visit joincolossus.com/episodes. Past guests include Tobi Lutke, Kevin Systrom, Mike Krieger, John Collison, Kat Cole, Marc Andreessen, Matthew Ball, Bill Gurley, Anu Hariharan, Ben Thompson, and many more. Stay up to date on all our podcasts by signing up to Colossus Weekly, our quick dive every Sunday highlighting the top business and investing concepts from our podcasts and the best of what we read that week. Sign up here. Follow us on Twitter: @patrick_oshag | @JoinColossus Show Notes [00:03:32] - [First question] - Lean into positive selection and avoid adverse selection [00:07:48] - Thoughts on growing capital formation in private markets [00:14:01] - Why it’s useful for investors to think in terms of bonds and call options instead of equity [00:18:39] - Doing more with less and hunting for operating systems to invest in [00:28:08] - His views on infrastructure and the presentation layer conundrum [00:33:32] - The sequencing involved in building an operating system over time [00:40:11] - Rise of the creator class and the coming tailwind post-cloud technology; the rise of the solopreneur [00:43:32] - The pig joke and his thoughts on the FinTech space [00:47:47] - Big financial services functions that will be embedded in non-financial businesses [00:51:07] - Deciding which functions and financial services models are most attractive [00:57:01] - What a shift towards data and FinTech might unlock for the world writ large [01:02:40] - How to improve payment profits by reducing credit rates [01:04:12] - The threat that Buy-Now-Pay-Later companies pose to Visa and Mastercard [01:12:17] - How the struggle between distribution and innovation continues to change [01:15:04] - The kindest thing that anyone has ever done for him

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

• 0:00Patrick O'Shaughnessy?

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• 0:43Patrick O'Shaughnessy?

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• 1:28Patrick O'Shaughnessy?

  not the $1,000 or more that others charge. If you're curious about Teegus, call the top performing investment manager you can think of. They're probably already a Teegus customer and they'll point you in the right direction because customers, myself included, love Teegus. Visit tegus.co/patrick to learn more. This episode is brought to you by Hall Capital Partners. Hall Capital manages more than $40 billion in global multi-asset class portfolios on behalf of endowments, foundations and high net worth families with investments managed by distinguished investors, many of whom have been guests on this podcast. Hall Capital is always looking for exceptional investment talent at any stage and size, with particular focus on diverse teams, which they believe

• 2:10Patrick O'Shaughnessy?

  Better drive decisions and outcomes. If you're raising capital or considering doing so, their team is seeking more great investors with which to partner across asset classes. Alternatively, if you're a passionate investor considering a career change, please reach out to Hall Capital to inquire about joining their teams in San Francisco and New York. To learn more, visit hallcapital.com or email [email protected]. That's [email protected].

• 2:39Patrick O'Shaughnessy?

  Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at joincolossus.com.

• 3:06Speaker 01

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

• 3:31Patrick O'Shaughnessy?

  My guest today is Alex Rampell, a general partner at Andreessen Horowitz. Alex has a long history in fintech, having co-founded six companies in his career, including Affirm and TrialPay. During our conversation, we cover Alex's framework for positive selection in investing, why the best investments are often operating system or systems of record, and Alex's views on the future of fintech. For those that have listened to our business breakdown on Visa with Alex, you know the intellectual horsepower that he brings to every conversation, and this conversation is no exception. Please enjoy my great conversation with Alex Rampell.

• 4:06Patrick O'Shaughnessy?

  So Alex, where the hell to begin this conversation? There's going to be so many avenues we're going to go down. Maybe I'll start with a really simple concept I've seen you put out there. You call it the rules of investing. Rule number one is lean into positive selection and avoid adverse selection. Rule number two is just to see rule number one. So let's zoom in on rule number one. What do you mean by this big overarching idea?

• 4:24Speaker 02

  Well, I think it's particularly relevant for venture capital because if you think about the world as a two by two matrix, there's consensus and non-consensus. And then there's right and wrong. And if you're in the wrong part, if you're in the wrong column, you can never make money as an investor by definition. This is the post facto outcome. It's like you were wrong. You can't actually do well. The company that you invested in went bankrupt or lost to three competitors or whatever the case may be. But in public markets, you typically want to be non-consensus and right because obviously you have to be right to actually make money. But if you're consensus right, then that's probably not that interesting. Whereas in venture capital, it turns out being consensus right is probably even better than being non-consensus right because the challenge with being non-consensus right,

• 5:09Speaker 02

  again, you have to be right because if you're wrong, not going to work. But the challenge with being non-consensus right is if you think, okay, this is a very, very interesting field. It's going to require $100 million of capital for this business to actually get to the promised land and get enough customers and get enough revenue and get enough scale. I'm going to invest in their $10 million Series A, which means they're going to eventually need to raise another $90 million in many successive rounds. And this is a crazy, crazy idea that nobody except for me on planet earth believes in. Well, then who's going to lead the Series B? This is the challenge. So it's fine if you're non-consensus and then it trends towards consensus. But if the investment is non-consensus long enough, that's actually great for the public markets typically.

• 5:53Speaker 02

  It's not great for the private markets because you tend to need somebody else to believe and actually coalesce around what is your consensus. And the other reason why public and private are just so different is there's no concept of winning a deal in the public markets. You go to your interactive broker's account or E-Trade or whatever, and you enter in your order, you place a market order, you place a limo or you... Place a stop order, whatever kind of order you place, I mean, you will get filled if you hit the ask. Whereas on the private side, a lot of times there will be a company, it will only talk to five investors. You have to be in those five investors to be in the consideration set. If you're the only one that's actually bidding, again, that's kind of bad.

• 6:34Speaker 02

  That's a sign of adverse selection, potentially, because it's the old Groucho Marx saying, if you wouldn't want to join a club that would have you as a member. So you want to make sure that this is actually a hard to win deal. But then it typically is not about paying the highest price. If it was paying the highest price, it wouldn't be open to only five firms or 10 firms. It's just not as efficient of a market as the public markets. And in some cases, it's not necessarily unfair. If you're a private company and you want to fundraise in two days and you don't want to leak your financials to potentially 10,000 investors that might tell all of your competitors. Well, of course, you want to actually tighten the circle and only talk to five firms. So the job is again, to be one of those five firms. And it's actually a great sign that those other four firms are highly, highly interested.

• 7:16Speaker 02

  It's a great sign if you have to pay a much, much higher price than you would like. Because it actually shows that there's some element, you might not be right, right, wrong, not clear at that point. But there's a heuristic, which is the fundraising acumen of the founder. So I often say that the best founders can materialize labor and capital. And the ones that are really, really good at materializing capital, again, it just shows that there's a higher probability of the company getting sufficient funding to cross that chasm and get to profitability or get to sufficient scale. That's kind of the high level of where I think about adverse selection. It's like the value investing trap has been very, very challenging in the public markets. If you followed value investing for the last 10, 15, probably 20 years.

• 7:58Speaker 02

  It's even more problematic in the private markets because value investing means that something is wrong with the company. That's why you're getting a cheap price. And it's very, very hard to turn a company around. It happens from time to time. But once you've lost your mojo and once you've lost your market cap, it's very, very tough to turn that around. Because you have to pay people well. How do you do that if you have less money, if you have less market cap, again, private or public? So lean into positive selection, avoid adverse selection. That is definitely a good rule to live by.

• 8:26Patrick O'Shaughnessy?

  What do you think will happen in terms of capital formation and methods or technologies of capital formation in the private markets, especially early stage over the next 10 to 20 years? It seems like the prices, even though they seem really high, if it was just a pure open market and the most savvy storytellers could crowdfund their rounds or something, you could imagine prices that would get just ridiculous. What do you think might happen under those scenarios? Will we see anything like that? What are your thoughts on just more capital formation at the earliest stages?

• 8:56Speaker 02

  The answer is actually maybe. There have been plenty of times throughout recent history where private markets are ahead of public markets. Now, why would private prices be ahead of public prices? Well, there are a couple of reasons for that. One is that you can't shorten the private market, so there's no selling of something that you believe to be overvalued. You just can't really make that bet. But the other reason is by actually constricting the number of bidders, the bidders don't really know that they're overpaying potentially, whereas public markets, you'll get a sense like, okay, here's a company that wants to go do a secondary offering, wants public. There's already an auction that's being conducted every nanosecond that gives a sense of what the price of the security should be, and you don't really have that in the private markets.

• 9:39Speaker 02

  So there certainly is this capability for private markets to actually get ahead of public markets with a subset of the bidders that might exist on the public markets. But I really love what this company, Carta, is doing because right now you have this binary thing, and normally binary distinctions don't make sense if you can have many, many different shades of gray. You're either a public company or a private company. A lot of the value accretion has been in private markets, I think often to the unfairness of the retail investor or public market investors, because look at what Amazon, when they went public more than 20 years ago, I think it went public at like a $550 million market cap or something very, very small like that.

• 10:21Patrick O'Shaughnessy?

  Yeah, there's a sub a billion for sure.

• 10:23Speaker 02

  Yes, under a billion dollars was potentially a lot more money back then just with inflation and whatnot. I'm not talking CPI inflation, but asset Real inflation. About later. Yeah, exactly. Real inflation of real assets, which has been pretty crazy of late. The vast majority of so many companies appreciation was in the public markets. Facebook went public at a hundred billion dollar market cap. And granted, like, Facebook is worth almost a trillion dollars now. So there's been more net dollar accretion that way. But the idea that the public markets could actually participate in a lot of the upside. And to your point, it should, over the long run, actually result in lower cost of capital for companies, which is a great thing for innovation and entrepreneurship. Because if you have this cartel of five investors that just do late-stage deals,

• 11:09Speaker 02

  well, over time, they're trying to arbitrage between public markets and private markets, which is like, hey, I'm going to enter. This was a way that a lot of late-stage funds would make money for a very, very long time, is that they knew there was a liquidity premium and an illiquidity discount. And that's what they would trade on. Another thing that I like to say a lot is that this is maybe a controversial statement, so feel free to call me out on it. But there's no such thing as an equity. There's only a bond and a call option. And a lot of what private markets invest in, in particular, are out-of-the-money call options. All these call options are not in the money or at the money. They're very, very distinctively out of the money. Because how is a company that has two people in a garage and a PowerPoint presentation, how in the world is that worth a hundred million dollars? And it's funny, my father, he's an accountant.

• 11:52Speaker 02

  I often joke with him that it's almost like, when I talk to him about these things, it's almost like Bud Fox talking to his father in that movie Wall Street, where it's like, you know, Bud Fox is making money on these very fast and loose things. My dad's like, when do these companies make a profit? What about their profit? What about their profit? I was like, no, you have to understand, these companies, it's bets on, at some point in time, they might be Facebook. So you're effectively betting on, this is a very, very out-of-the-money call option. If everything works perfectly, then it's potentially the next Facebook. It's potentially the next Apple. And Apple kind of looks more like a bond. Apple's not an expensive company. Facebook's not an expensive company, relative to everything else out there, because they're no longer out of the money. But the vast majority of things early stage are out of the money.

• 12:36Speaker 02

  I know I'm jumping around a little bit here, but the reason why I like something like Karta, which is where I started this little monologue with, is they hopefully are enabling an exchange for people to invest in private markets so that you're not, on day one, doesn't make sense for your shares to be traded on NASDAQ and for you to put out quarterly reports when you have a product that doesn't even exist yet. Nobody uses it. You don't have a finance department. And being Starbans Oxley compliant doesn't really make any sense. Well, of course not. But a year before you go public, doesn't make sense to only have trading in your stock, I don't know, once every year and a half, haphazardly with only two firms that have a right of first refusal on your private securities. Well, that probably doesn't make sense either.

• 13:18Speaker 02

  What Karta has done is they are effectively, they are the cap table management software for almost every single private company out there. And now they're enabling trading of those private securities with, I mean, again, not all of retail, because you still have these accredited investor and qualified purchaser rules and a lot of other things that I think are rather anachronistic and should not exist, but that's a different topic. But they're blending the lines between private and public, which I think is a net great thing. Because actually, like, when a company goes public, what should the reference price of its shares be? Well, it's really hard to tell because it trades once a year. It's not even trading, it's just they're running around and there's somebody who's buying it out of the money call option at that point. So it's a much better idea to have a regular process and to have a non-binary process at that, which is you're not private for nine

• 14:03Speaker 02

  years, then boom, suddenly you're public and you have more shares traded in the first hour than your entire life as a company. Like, no. Transition to a, maybe you trade once a quarter, maybe you trade once a month. You let more people on your cap table. Hopefully, the SEC loosens restraints around who can and cannot invest in private companies because, not because I want brand and grandmothers taking on more risk, but it's actually fundamentally unfair, from my perspective, that the value accretion goes to rich people that pass these accredited investor questionnaires.

• 14:35Patrick O'Shaughnessy?

  If we dig in a little bit more on the there is no equity, there's only bonds and call options, how is that idea useful? It's kind of a fun thing to play with and it makes me think maybe of something like Amazon where in the peak of Amazon's reinvestment story, maybe over the last five years, that would be an example of a stock that I would have a really hard time parsing into bond because there kind of is no bond, there's no real profits to speak of relative to its revenue and it's reinvesting heavily, but it's also like very much a thing. AWS doesn't feel like a call option, like it's working, it's growing incredibly fast even five years ago. So, how did you come to this idea? Why do you think it's useful for investors out there to think in these terms?

• 15:12Speaker 02

  Well, I mean particularly for private companies where it's the only way to really think about it. You're always taking a bet on the future of what if things go right? That's kind of the fun thing about private markets, which is well, you can lose one times your money, that's capped, but if things really, really work, I mean you could make 10,000, 100,000, like there is unlimited upside, but how do you try to quantify that upside? And a lot of the ways that we try to do it, we know it's false precision. Because if we say, okay, here's a company that's two days old, in year nine, we believe they will have $14.3 billion of EBITDA, like of course that's going to be wrong, but you try to look at what they're building, not what is the total addressable market for that product or service as it stands today.

• 15:56Speaker 02

  It's an out of the money thing, which is if you think that the world is going in this particular direction, then let's think about what that looks like at year five or year seven. Wow, that's a really, really big opportunity. So yeah, we're going to say that this two people in a garage with a very, very fancy PowerPoint presentation, we're going to call that worth $40 million or whatever the number is that the investors will put on it. But if that works and we own 20% of it and we get diluted over time, this could be a massive, massive market. We have to think about things in those terms because there are no profits, I mean that just two people in a garage never have profits, definitionally so. I think for public markets, I mean, you could probably use the same framework, which is if every company is worth the present value of future profits,

• 16:41Speaker 02

  just almost objectively speaking, if you were going to go take a company private that's currently public, that's how you would have to value it to make your debt service and whatnot. So it turns out that the long tail of those profits is really what you care about. The discount that you apply to them is very, very high. But if this thing is not working yet, but you think it's going to work and be big in the future, then not really thinking about what year five looks like is probably not very smart. A lot of smart investors that I talk to, it's almost like Seth Karmen has the famous Margin of Safety book, which is out of print. It's like the original NFT. It's very hard to get. But effectively, what you can do, again, with false precision, is you can apply,

• 17:19Speaker 02

  try to apply a margin of safety to a wild, almost hyperbolic guess of if this thing really works, I'm going to invest in things that I think fundamentally can change the world. If they can fundamentally change the world in year five, I mean, any price that I pay today is effectively undervaluing this company relative to where it is in year five or year 10. Otherwise, I wouldn't be buying this out of the money call option. But I'm getting a margin of safety, if you will, of I'm only investing in things that I think can change the world, that can be massive, massive, massive companies in year five or year 10. What's a fair discount? What's a margin of safety that I can get in year 10 if that thing happens? And again, it's kind of binary at that point. Either they succeed in that or they don't. If they do, then you're getting something very, very cheap.

• 18:03Speaker 02

  So like if you invest in AWS, or if you invest in Amazon, when they first announced AWS, and it's like, wow, like actually, I think the entire world is going to be cloud. Let me fast forward in 10 years. If this company, Amazon, gets 25% of the cloud market. Now, again, false precision. Are you going to get the exact size of the market? No, but you can almost apply a margin of safety there in that year or 10. That's one way, I think, of coming up with a framework, which, again, like you have to have enough shots on goal to make this work. I mean, this is where like the best venture firms, they'll have concentrated bets, but You're never going to put 100% of your fund, I would argue, into one highly, highly speculative thing that probably won't work. That's an out of the money call option. You're probably hoping to say, I'm going to invest in 10 things, or 15 things, or 20 things, or maybe 30 things,

• 18:46Speaker 02

  that all have this chance of being completely revolutionary, world-changing. I like hanging out sometimes with other VCs because they tend to be very optimistic, and many cases overly so, around what can be world-changing and to what extent. And most of the time, we're wrong, like any other human. But if you get it right, that's where, again, the out-of-the-money call option that you're getting is, it turns out at the time, to be very, very fairly struck. In fact, unfairly struck in your favor because the upside is so big.

• 19:13Patrick O'Shaughnessy?

  Peter Thiel has this awesome definition of technology, which is really simple, which is just to do more with less. So this tool of leverage that creates more possibility, and maybe therefore world-changing, to use your term. And one fun way I've heard you describe what you're trying to do with your investing is that you're hunting for operating systems, which are sort of the ultimate form of technology leverage, if you will. Can you talk through this investment concept, what you mean by searching for operating systems as companies? And maybe we can go into kind of as much detail as you're able on this really interesting concept.

• 19:44Speaker 02

  My absolute favorite companies or businesses to invest in are ones that I think have an operating system like mechanic. And that doesn't mean that it's Windows or macOS, but it has the same concept, which is, if you ever go to a dentist, or any modern dentist, I should say, almost every dentist in the country runs something called a DPM, a dental practice management software product. And that keeps track of all of the customers. It keeps track of the pictures of all of the customers' teeth. And there are a number of companies that make them. Actually, one of the early ones was Henry Schein, which actually makes dental equipment, but turned out to get into the dental software space. But the retention rate of these products is basically 100%. It's a product that, if you are the receptionist at a dental office, or even the dentist himself or herself,

• 20:29Speaker 02

  you're logging into this product every single day to check pictures of the teeth, to check when the next person's appointment is, to check your outstanding billings, to go charge customers' credit cards. So it is the system of truth. And when I say operating system, it actually means two things. It means system of truth. So it keeps track of everything at the company or even for a consumer. And I'll talk about that a little bit later. It has very, very high utilization and usage. So it is this canonical, in consumer terms, you would call it a DAO, a daily active use product or a weekly active use product. Because in the long run, what really matters the most? You could show evidence of a mode if you have a product that people use every single day. And the margins that you're able to extract from the product that you sell to these customers

• 21:14Speaker 02

  that use it every day are maintained or even increased over time. So an operating system is basically something that runs the business. It is the system of truth. So it keeps track of like what inventory you have, what your sales receipts are, how much you own in sales tax, all of these things. And the reason why that's so valuable is because even though there is this kind of concept, the much valued concept of the app store, you can start adding other things into that operating system. So what does that mean? If you're a dentist, you want to offer installment payments for the crown or cavity that that patient needs. It's very easy and you actually have free distribution of that new product if you are the operating system versus what I would say the very, very uphill battle of I am

• 21:57Speaker 02

  just a financing company that offers financing for cavities and crown. Now I gotta go find every dentist. I gotta sign them up. The person that I signed up that works at the dental office might leave one month later. Then I gotta sign them up again. Then after I've signed them up, I have to hopefully count on the fact that they're going to market this or push this in front of their patients, which they probably won't do. So I have to remarket to them again versus the operating system where it's the system of truth. There are operating systems for a lot of businesses like Toast, which went public recently. That's an operating system for restaurants. They don't just do payment processing. Like a lot of people think of it as like, oh, like I paid for my bill at the restaurant with Toast. Well, Toast actually does payroll for the people that work at the restaurant. They have tablets that go to the kitchen.

• 22:40Speaker 02

  So when the waiter or waitress goes and enters your hamburger order, it shows up immediately at the tablet at the kitchen. So it's basically like a custom built piece of software that runs the business and it will even keep track of. How many hamburger patties are in the back kitchen as well? So these operating systems, they really retain customers extraordinarily well and they are very adept. There's a lot of what I would say, out of the money call option value, if you will, on them being able to position other products and services to either the end customers, like the customer's customers or the customer itself. I actually wrote a blog post on this when I first joined this firm, Andreessen Horowitz, which was my key learning. I called this the TiVo problem. This was at my company TrialPay, which I sold to Visa.

• 23:25Speaker 02

  So the TiVo problem I call this, which is in 1998, TiVo and this other company called Replay TV invented this amazing technology, at least amazing for people that were around it in 1998, like I was, that allowed you to pause live television. And TiVo was a very, very popular thing in the late 90s. But today, in 2021, it's basically a patent trolley. It was sold to another company, which is effectively a patent troll that just sues other companies. I would never want to be in that position and I don't have a lot of high regard for companies that do that. But the reason why that actually happened was TiVo did not control the distribution. They had this great product, but like TiVo was not valuable if you just had a TV set and you lived in Antarctica. It only had value if you had Comcast or if you had DirecTV.

• 24:06Speaker 02

  You needed TV to go, you needed actual television content to go into that TV and then you would have live content to pause, hence TiVo. And I think the problem is that if you build an amazing, amazing innovation, and this is outside of the Clay Christensen framework of disruptive versus sustaining innovations, it really is, do you control the distribution or not? So Comcast has that pipe into your house. I think the problem is if you build TiVo, which is an amazing world-changing thing. It's not a sustaining innovation. It's an amazing thing. But the problem is you have three outcomes that will eventually happen. Number one is Comcast says, you know what? We should buy you. You're an amazing company. But if Comcast goes and buys TiVo, then what about Time Warner Cable and DirecTV?

• 24:48Speaker 02

  They're gonna say, hey, we're not gonna sell TiVo anymore. It's owned by our competitors. So you have this weird case in M and A where you can have not a control premium, which is a term often used, where you're paying more per share for the entire thing than you would for the marginal share. A controlled discount because TiVo is going to lose a huge chunk of their sales from the competitors. So that's option one. Option two is that Comcast says, hey, you know what? Let's partner because we're the ones that have the pipes into all the homes. We're going to take 99 cents on the dollar and you're going to take one cent on the dollar. And TiVo is like, well, that's not fair. I want a better deal than that. They're like, yeah, well, screw you. We're just going to go with replay TV then. So you don't really have that much leverage in a negotiation vis a vis the distributor. And then option number three is basically Comcast says, that's a nice little tool that you have there.

• 25:33Speaker 02

  We're just going to go hire Accenture. I don't know, some consulting firm or a bunch of engineers to go build a crappy version of the same thing. And basically the problem is that one of those three options always happens to the TiVo, the metaphorical TiVo in this example, which is you build this amazing thing. It changes the world. You don't control the distribution, unfortunately. And you either get copied, you get bought in an unfair price, or you get a partnership agreement, which is really tilted out of your favor. So the lesson is, I mean, it sounds crazy to give this to an entrepreneur or a true innovator is like, don't build TiVo, build Comcast. Because if you build Comcast and you have a good product and engineering team,

• 26:15Speaker 02

  or you can actually create stuff, you have unlimited option value to go roll out TiVo, to charge more for TiVo and so on and so forth. Whereas if you're TiVo, you're kind of at the mercy of Comcast and you might get lucky. You probably won't be in 20 years later, you might be a patent troll. And that's kind of how I got to the operating system thesis to begin with, which is you want to look like Comcast. What does that mean? You want to be the pipes that actually control the backend of the business. Because if you do that, and ideally even the frontend, if you do that, you could be a body shop. Body shop should run on body shop software. Who's going to build that software? Well, they're going to have perpetual rights to offer cross-sell of whatever body shops need, whatever the customers of body shops need and so on and so forth.

• 27:00Speaker 02

  Or you've got this whole other category of what I would call horizontal operating systems. QuickBooks is effectively an operating system. They do one thing for lots of types of businesses, which is the backend accounting. Or Square is a kind of operating system for lots and lots of businesses in a very horizontal way. Whereas I use horizontal and vertical as vertical is like focusing on one particular tranche of business. It's like Toast is a vertically focused operating system for restaurants, full stop. Square does that too, but it's not as customized for restaurants, which is why Toast was able to scale a lot. But both of them effectively are operating systems. How do you know if it's an operating system or not? I think this was Supreme Court Justice Potter Stewart said like, and how do you know if something is pornography? And he said, I'll know it when I see it.

• 27:44Speaker 02

  Like, how do you know if something is an operating system? I'll say I know it when I see it, but really it's like, is this thing the permanent system of record? That stores all customer business interactions? And is it used almost every single day? And if the answer is yes, it's probably an operating system. If the answer is yes, there's almost this permanent upsell capability. Where if you have, again, if you have a great management team, there are so many things that they can do with this. I mean, Facebook is kind of an operating system for human interaction. That's maybe a little bit of a stretch because there are plenty of ways of operating outside of Facebook. But what other products and features has Facebook added over the last 15 years? It's really remarkable. So much of their business growth has been from that because again, they had very high retention.

• 28:28Speaker 02

  People use the thing almost every single day. And therefore there was a lot, like if you go add another feature, if you add a TiVo like feature that's really cool. You know that you're going to get the distribution because you already have these daily interactions with customers.

• 28:42Patrick O'Shaughnessy?

  Yeah, I absolutely love it. And I've got like six follow up questions because I think we could kind of pick apart this as an investment strategy. Almost the rest of the conversation. The first is around infrastructure and how you think about things like Amazon Web Services that are on bare metal? Or things like Twilio and Stripe, which are certainly underneath a lot and operating a lot of stuff on top of them. But typically are sort of abstracted away by developers. So end users aren't interfacing with them. So I guess another way of asking the question is, what do you think about infrastructure? And how much does interface with an actual end customer matter in terms of this way of thinking?

• 29:19Speaker 02

  And I think it depends on what you're trying to do. So I often call this the presentation layer conundrum, which is I co-founded another company called The Firm that does point of sale lending. And if you look at payments online, there are very, very few companies that control that presentation layer. And presentation layer means they actually put something in front of the customer and they can actually change the graphics, they can change the text because they're not relegated to the backend, they're actually the frontend. PayPal is one of the very few, I mean, Affirm does this as well, Afterpay does this as well, but most companies that do anything in payments, Visa's worth $500 billion, so they must be doing something right. They are purely on the backend. They have no ability to actually change the interaction with the end customer. It limits what they can do, and that's not

• 30:04Speaker 02

  bad, because again, Visa's worth half a trillion dollars, so they're clearly doing a lot of things right. But there are limitations on that because you basically have to assume that you're going to be this dominant middleware layer, do that as efficiently as possible, or become a protocol, or become like this dominant backend system of truth. But what I often talk about in this operating system thesis, which is you tend not to have this optionality of product expansion unless you own the customer's interaction on the backend. Taking an example like Stripe, you use them as one of the ones that you quoted as like backend infrastructure. So Stripe has no interaction with the consumer, generally has no interaction with the consumer. But Stripe, because they control the backend

• 30:47Speaker 02

  business, I'm a business, I sell t-shirts online, and there is a credit card form on my website, that's how customers pay me, that's processed with Stripe, but customers don't know it's Stripe, just like if I send them a text message, customers don't know it's Twilio, that's all fine. But I, as the business, would rather get paid more quickly, or I would rather, I want to take out a loan secured by my future credit card receivables. Well, because Stripe is the system of truth for me that knows what my chance of selling more t-shirts is next Tuesday, they still have product expansion capability with me on the backend. They can say, I'm going to offer you, t-shirt company seller, a loan,

• 31:28Speaker 02

  because I know it's secured by these credit card receivables that we're first in line in, and it's effectively a lien that I can exercise. But it's very, very hard, if not impossible, because they don't control the presentation. Presentation layer for Stripe to offer a service to the T-shirt buyer, if that makes sense. So a lot of this is really about expansion. There are very, very few companies that have the ability to kind of go what I would say B to B to C, a business to business to consumer. Like a firm actually was kind of conceived as an idea where we could get the end customers of Peloton because we were offering loans to them and Peloton wanted those to be branded as a firm and not as Peloton loans because if you don't pay your loan on time, like they don't want to get mad at you. They want a firm to get mad at you. They want to like wash their hands of that responsibility.

• 32:11Speaker 02

  I think in this framework, Twilio, if they play their cards right, and they clearly have, they have this ability to cross-sell and up-sell other products to the same customers and they have the ability, and this is like the very, very rare thing, but they have the ability to scale with the scale of the business. Like the really cool thing about both AWS and Twilio is that yes, they could both face downward pricing pressure from competitors that offer the same services, but switching costs can be pretty high. So maybe Azure is cheaper this month, but how do I go switch all my servers over? And there are of course tools that do that, but it's hard. But the really nice thing is that somebody like Twilio, Twilio goes and signs up Uber when Uber is one week old. I don't know the exact story on this, but I assume it was something like this.

• 32:56Speaker 02

  And who would have thought that Uber would turn into this giant, giant business for Twilio, but of course it did. Or Amazon signs up this tiny company called Pinterest when Pinterest is one week old. Who would have thought that Pinterest would be such a giant AWS customer, but it became one. It's kind of nice when you're able to retain the customer, grow with the customer, really scale with the customer's success, which is what I mean by that. And then ideally, you then control distribution to that customer. So if you happen to be privileged to have a great product team that builds new products and world-class products, you have instant distribution because you might not be the system of record. Like AWS probably isn't the system of record for Pinterest. In fact, that doesn't really make sense in that context or the context that I use the term.

• 33:41Speaker 02

  They're not the operating system for Pinterest, but they're the means of production, if you will. They go build five new products. If those products are great, or even moderately okay or just good enough, the chance of them getting that distribution is so much higher than a third party that just shows up and says, "Hey, we've got a product that's pretty good. Why don't you go use it?" It's too much work because you've got to go struggle to get the distribution.

• 34:06Patrick O'Shaughnessy?

  What have you learned about the sequencing to build one of these operating systems over time? Because when you take something to market, you're not going to come with every feature. Toast came to market with something that's narrower than what it currently offers its customers. So you have to sort of order things and choose things on the way to becoming the operating system and the system of record. What have you learned there? What do the most effective entrepreneurs do? And this may be different in horizontal versus vertical operating systems. What lessons for entrepreneurs that want to build an operating system in terms of sequencing?

• 34:37Speaker 02

  The sad truth is that even though you're better off building an operating system than building a commoditized feature, you really need some kind of fundamental change in the world, some kind of tailwind that makes your operating system appealing. So what was one that happened recently? It was the shift to cloud. I'm running all of these things on my premises and my IT person was sick again and my system went down and blah, blah, blah. I don't want to deal with that again. I want to go switch to something that I don't have to maintain and I'll just pay for monthly. And this has been a decades-long shift. I mean, there are still plenty of businesses that don't run in the cloud, but that was a massive tailwind for enabling, I want to run Workday and not PeopleSoft,

• 35:19Speaker 02

  or I want to run NetSuite and not Microsoft Dynamics. All of these shifts to the cloud were one part of this enablement because I don't think that customers wake up and say, hey, I want an operating system. That doesn't really make sense. They'll say, I want a feature, just like I as a customer, by the way, would say, I want TiVo. TiVo is awesome. It's very, very hard to lead with the whole ball, if you will, the whole operating system thing is just bad product marketing. What's good product marketing is, hey, do you want a loan? And people say, they raise their hand and say, hey, I want a loan. So to answer your question, what I've seen is the template that normally works is you lead with the very exciting feature that customers want that's different.

• 35:59Speaker 02

  You hopefully have, you're buttressed by this tailwind of a underlying platform shift. So, oh, wow, mobile has come out, or wow, cloud has come out. And now you can do new things, like Toast allows every waiter and waitress to carry around that tablet. I guess you could have done that 20 years ago with your Palm Pilots or something. They wouldn't have worked. They would have been terrible. So again, you've got this tailwind. You probably start off with one very, very narrow feature that you can do better. So for Toast, a lot of it was just credit card processing and payment processing because you had to go upgrade your old credit card terminals to accept the chip and PIN kind of thing, the EMV system. So you start with that, but then if you just do that, you're probably

• 36:44Speaker 02

  running the risk of having a commodity service that's going to get replaced by somebody who marginally underprices you. So you have to very, very quickly figure out, how do I just retain this customer, service their operating system, add three or four other features as quickly as possible? And if I do, I'm probably in good shape. If not, I might kind of be screwed. This is the hard thing as an investor, by the way, which is I'll meet a company that says, okay, we're going to do lending to small businesses by sending out postal mail to them. I say, well, wow, like somebody else is going to come along and send the same postal mail, but offer a 2% lower rate. And then you're kind of screwed. So how does this not become a race to the bottom?

• 37:27Speaker 02

  The smart entrepreneurs, in fact, all entrepreneurs that think about this problem are like, well, here's what we're going to do. We're actually going to do this first. We're going to get them on our loan. Then we're going to handle all of their bookkeeping for them because we built our own version of NetSuite. And we're going to do this and we're going to do that. And it's like, this is the Trojan horse. Or this is what we often call in venture land, the wedge. This is the wedge that we're using to pry ourselves into this particular business and aggressively expand. And then the hard thing to really evaluate from that point is, number one, it doesn't matter what your plan is. Everybody has a plan, but what really matters is, will the customer go for it? Is that an appealing value proposition for the customer? If yes, okay, great. And then number two is, can you actually execute on that quickly enough?

• 38:09Speaker 02

  And then number three, which is linked to number one and number two, is can you retain the customer long enough? Can you basically repel the competitive forces that lower rates long enough with enough stickiness or enough inertia? And inertia is often the thing that you need. The object that's in motion is just kind of wants To stay in motion, the object that still wants to stay still. And both of those actually can work in your favor. But can you avoid these competitive forces long enough to allow your internal execution around product and engineering? To go build these other products that you can then cross sell. And hopefully become over time, the system of record. Versus, I think what you were getting at, which is if you over engineer and you spend five years in that garage with your co-founder and other members of your team. Building what you think customers might want.

• 38:55Speaker 02

  You have no idea. It's just very, very hard to figure out. So you're better off with a wedge. And I think a lot of the best businesses at the early stage. They have an unfair path to getting what I would say five customers. Because if you have an unfair path to getting one customer, because your uncle is somebody who owns something. Well, then you might over engineer the product for that one customer. And it has great applicability for that one customer, but no applicability thereafter. There's a great Simpsons episode where Homer designs a car. It's the stupidest car. It's great for Homer, but it's the worst car in the history of the world. Because there's no applicability for people that are not Homer Simpson. You run into that problem. If you're able to do this with five customers that trust you, and this is really hard, by the way. If I were running a business, if I'm running a dentist office, I'm a dentist.

• 39:39Speaker 02

  My cousin says to me, hey, I've got this dental practice management software. And I asked, how much cash do you have left? And like, how long is your company going to be around? It's like, well, I raised enough money. I had nine months of cash. And I was like, what happens then? Well, we'll probably have to shut down the company. It's, I'm not going to run my dental practice on you. Are you crazy? It doesn't make any sense. If you could come up with some way of not tricking anybody, of course, but really selling this vision of what you're going to accomplish. Come up with a wedge, or even if you don't come up with a wedge, like get five people to fundamentally trust you. Metaphorical five, it could be more. To trust you so that you actually are building a product around what the overall market wants. Then you can really make one of these things work. And you end up with a potentially phenomenal success. I mean, Toast is a great example of that. I don't know all of the different steps that they took to get there.

• 40:23Speaker 02

  But it's a really, really remarkable testament to what you can do when you become the operating system. And I think for companies like them, what other products and services do restaurants want? There are probably 20 other ones, but now that they're with the operating system. Their customer acquisition cost on existing customers is zero. So they should be able to beat anybody who is the metaphorical TiVo in this example.

• 40:45Patrick O'Shaughnessy?

  What about the rise of the sort of creator class and the more individual like sole proprietor type businesses, online, digital only businesses? Is that, in your view, sort of the next tailwind after cloud and mobile? That might mean we're going to see a lot of interesting vertical software businesses that are operating systems?

• 41:03Speaker 02

  Absolutely. I mean, I don't know if it's the same technology or platform change. So I would say mobile and cloud were both things that new technology enabled this. I mean, now it's like COVID tells me that I like staying home and I don't like going to my office and I can do all these things on my own. But shoot, it turns out if I'm a lawyer and I already have 10 clients that love me and I know they'll pay me, there's a lot of stuff that I need to figure out on my own. And there's an essay that we wrote on this called "The Rise of the Solo Preneur." So I want to be a lawyer on my own. Well, I already passed the bar. I already worked at Wilson Cincini or something. So people know who I am. I've got 10 clients that love me that will follow me anywhere, but I need a website. I need to process payments. I need some kind of CRM tool.

• 41:45Speaker 02

  I need to be able to, I don't know, hire people if I want an assistant. How do I do that? Like, there's a lot of work and it's all these disparate, not connected systems. So I love this idea of how do you, I call it business in a box. So you want to go start a law firm. Well, obviously there are some things that a firm does which are getting you clients. Maybe you could do that, but that's not a software problem. That's kind of more of a marketplace problem or an advertising problem. But all of the other back office things, that can be done by software. And it's very, very different for all of these fields. And what I think is interesting is if people decide to, you don't really think of lawyers as being part of the creator economy, to your point, or accountants or doctors.

• 42:27Speaker 02

  If I want to break out from the mothership, I just want to do the things that the firm did for me, but it's going to involve 18 disparate systems and it's a pain in the butt. I think that's definitely a trend. And it's one that we're very, very excited about. It's the operating system, but very, very tightly targeted because the sole proprietor lawyer just has a completely different set of needs than the sole proprietor photographer or the sole proprietor yoga instructor. But there was a great round of software many, many years ago, or still today. MindBody sells to yoga studios. It performs a different function than people who used to work at a larger corporation or a larger entity. They just want to figure out how to branch off and break off on their own.

• 43:11Speaker 02

  And you just have to custom assemble the set of tools for that group of customers. The only challenge with this is, again, it kind of goes back to the thing that I was talking about, the TiVo problem. Like, customer acquisition is challenging, but I think you have a much, much better chance of solving the customer acquisition problem if you have a very narrow set of, this is toast, it only does stuff for restaurants, as opposed to, quote unquote, we're an operating system for you. Like, what does that even mean? It's why I've been skeptical about a lot of tools that come out for what I would call creator economy, or passion economy, or sole proprietors, without really individualizing the product. I'm very not skeptical about the rise of all three of those. It's more of, what does it mean to be a solo worker?

• 43:54Speaker 02

  Well, it's just totally like, an Uber driver needs a completely different set of things for their tax filing and the number of miles that they drove and all of those things. That's a product, but it's very, very different than other verticals.

• 44:06Patrick O'Shaughnessy?

  In addition to this awesome idea of the operating system, another thing, obviously, that you spend a lot of time thinking about is fintech. And I'd love to turn the conversation there for a while. It's where you do a lot of your investing. It's where you founded businesses before. And maybe the right way to introduce our conversation on fintech is with this funny joke you've got about the pig. Maybe you could give us the pig joke as an entry point into the world of fintech.

• 44:27Speaker 02

  I love this one. And I apologize for people that listen to this and have heard me say it 10 times before, but basically, the joke is there are two pigs in a barn. One of them says to the other, it's like, this place is awesome. Everything is free, it's heated, there's free food, the water tastes great. And the caption underneath says, if you're not the customer, you're the product being sold, which of course means that the pigs are being turned into bacon and they don't even know. Yet, but they're living a life of luxury until they do. Basically, those were the two business models. Either you sell a product to a customer, and this is either a transactional business model or a subscription business model. So Peloton sells you a bike and they sell you a subscription and you're the customer. Or it's the Facebook business model, which is you, the user of Facebook are not the customer. You're the product being sold.

• 45:11Speaker 02

  I mean, hopefully the product that Facebook is offering is good. That's why you show up. But the actual customer is the advertiser and that's where Facebook or Google draws in most of their revenue. So when we would meet a company, we'd say, well, which one are you? Are you an advertising company or are you a transaction company? Because there was like bucket one, bucket two, there was no bucket three. Now there is a bucket three and bucket three is effectively what I call embedded financial services. So now, if you were to extend that joke, it turns out it's like, oh no, like the barn is free. We just have to use the checking account provided by the barn owner and hopefully use this debit card that has urban exempt interchange on it, you know, et cetera, et cetera. I joined this firm in 2015 to spin up and run our fintech practice.

• 45:54Speaker 02

  But now, almost every company in some way, shape or form is a fintech company, not because it is a pure play fintech company, but because if you're building the next Facebook, if you're Mark Zuckerberg of 2021, you now see that there are three routes to revenue. You charge transaction fees or a subscription revenue to your customers and you may sell advertising and you might decide, hey, it's very, very lucrative for me to offer financial products and services to my customers because they already trust me, they know who I am. And if I'm able to be the dominant checking account, if I'm their checking account, which I know sounds kind of strange, you would think you'd get your checking account with Bank of America or First Republic or Chase or something like that.

• 46:35Speaker 02

  But if you have your checking account with somebody, they have so much control and ability, going back to the old refrain to upsell and cross-sell you other things. So as an example, it might sound insane, but Uber and Lyft should offer checking accounts to all of their drivers for a few reasons. One is it turns out both of those businesses are historically supply side constrained. So everybody wants to take an Uber. From the airport at 5pm, especially with all the stimulus checks and everything else that's hitting, not as many people want to drive for Uber. They drive for Uber for two weeks, then they quit. What would be very smart is we're going to give them a checking account and that has two benefits. One is when they're running low on money, I can send them a message saying, hey, you're low on money. Why don't you drive for Uber today? We'll pay you twice as much. It's kind of got this daily active use product.

• 47:18Speaker 02

  They don't have to remarket to that customer because they already own the customer. And number two, the way that the whole, you've already listened to my Visa thing, I guess you interviewed for that. But for people that don't know, the way that the credit card and debit card infrastructure works is that there is typically something in the neighborhood of a 2% fee per card swipe, which is assessed to the merchant, which can be retained by what's called the issuing bank or the issuer of the card. So if Lyft gives every driver a card and a free checking account, the free checking account is a lot more appealing than the one that Bank of America gives you that has minimum fees and all this kind of crap. They give you this free thing. They own you as a customer. 2% of all the spend that you get, they get to keep, which is very compelling. And they get to win you back as a driver when you might be low on cash.

• 48:02Speaker 02

  And they've got that real retention at work. And that's again, like you wouldn't have thought of that as a use case 10 or 15 or 20 years ago. But now what we see is that even outside of what I would call the fintech team, a huge number of enterprise software companies and a huge number of consumer software companies are trying to monetize with fintech as a third leg of that stool.

• 48:27Patrick O'Shaughnessy?

  Could you give maybe one example of that that you've seen that you think is interesting? Cause I'm most curious about what big functions, big financial services functions are most likely to start getting embedded in other non-financial businesses. So what's an example that sort of drives home the point?

• 48:42Speaker 02

  I think Toast is probably the clearest one, which is they offer payroll. If you're a restaurant, why would you use ADP? Just use Toast. If you're a restaurant and you need a loan, because you know that you have working capital issues, Toast can actually go extend you a loan. Toast, of course, their primary source of revenue is interchange, where they're charging the restaurant something like 2.9%. And the cost of actually doing that is probably on blank. One point eight five percent or something like that. So they're making that one percent plus spread on all the credit card processing. Toast is fundamentally not a credit card processor. They are a software company, which is very, very different than, I mean, there was a company like Toast. Well, they're still around today, but it's called Heartland Payment Systems.

• 49:26Speaker 02

  I forgot who they're a part of now. It's probably FIS or Fiserv or somebody or Worldpay. But Heartland was basically, they were an independent sales organization that sold credit card terminals predominantly to restaurants. They didn't have any software overlay. That's why Heartland is not as relevant today as Toast is, and certainly not as big of a company. Because Toast is the operating system that runs the restaurant. That's what they are first and foremost. If you ask a restaurant owner, that's what they're going to tell you. But they happen to make money via embedded financial services. And that's probably the clearest one, but the dental practice management software as well. There's a company called Synchrony. They have a business called CareCredit, which is basically point of sale lending for elective medical procedures.

• 50:08Speaker 02

  And it's predominantly for things like LASIK or dental or some kinds of dermatology and plastic surgery. And being embedded at the point of sale at the, or even before the point of sale. It's like the dentist, I went to the dentist, I sadly had a cavity. When I went to go check out and like make arrangements to come back, my very painful filling. They said, hey, it's going to be four hundred and whatever it was dollars, but here's a payment plan if you would like it. Because that's embedded into the software that they're using. And I'm sure they're probably making more money on that. They're probably keeping more of that than if it was just an upfront payment where they had to pay two percent to Visa Mastercard or the Visa Mastercard system, if you will.

• 50:49Speaker 02

  I think there are a lot of examples of this. I mean, I see it now with insurance where a lot of companies are saying, hey, we want to bundle in. When do you want to buy life insurance? Probably when you have a kid. When you buy a house or when something very tragic happens to one of your friends, that's when you might want to buy life insurance. So why not offer a life insurance cross-sell? If you're a mortgage company, I wouldn't be surprised if Zillow decides to say, "Hey, do you want life insurance now?" And maybe there's a way of even lowering the interest rate on your mortgage. This would be a little bit complicated for Zillow to do, but like, that would be a great example where it's like, that's a perfect non-adverse selection point in time. So you don't want to sell insurance to people that are planning on dying, of course, life insurance to people. But you want to sell it when somebody's buying a house. How do you find that point in time?

• 51:33Speaker 02

  That's an embedded financial service where if you can make the cross-sell very, very easy and you have the distribution, again, very, very powerful.

• 51:40Patrick O'Shaughnessy?

  How do you think about like which financial service functions are the most attractive from like a model standpoint? So the Toast example is great because they get to enjoy a piece of all the transactions happening within their sort of ecosystem. You're basically riding commerce. You're taxed on restaurant commerce at that point. Insurance is kind of this more one-off example. It's infrequent that people buy it. Maybe it's very valuable in terms of the individual order. What is that spectrum? Like, how do you think about the different things that we will buy from these different companies that are financial services functions? And are those kind of the same as they've always been or are there new ones popping up?

• 52:16Speaker 02

  There's a third element to that, which is can you underwrite better and more efficiently? Because you have more data. Like, one of the things that actually is the most exciting to me around like what could financial services accomplish? And I'll go back to answering your question in a second, but I think this is pretty germane, which is if you really wanted to revolutionize lending, what you would do is you would link it to payroll. Because I think in the US, there's something like $1.2 trillion, probably more now, of unsecured credit card debt. The average rate is like 18%. Why is it 18%? Well, because you never know if these people are going to pay you back. There's no enforcement mechanism outside of like calling them 100 times and saying they're a bad person and reporting them to a credit bureau, which doesn't always change people's behavior. But where do people get their money from to begin with?

• 53:01Speaker 02

  Well, every two weeks, twice a month, depending on how they're paid, they get paid from their employer. And then they are effectively a slow router and hopefully paying their bills on time and routing the paycheck that came in, the after-tax pay that came into their checking account to all these different places. Wouldn't it be really cool if you could actually get a loan from your employer? Which sounds kind of crazy, like I don't want to take out a loan from the company that I work for. But I would love it if I could, I need a better term for this than wage garnishment, because wage garnishment sounds very, very bad. But if I could say, I want 5% of my paycheck sent automatically, without my interceding at all, to Capital One. And then Capital One will say, I will charge you 3% interest, because I know you're going to pay me every single week,

• 53:46Speaker 02

  or every single two weeks, or once a month, or whatever, versus 18% interest. There's a powerful overlay as well, which is if you bundle these things more tightly, you're often able to underwrite customers better. Because this is the problem, like if I'm loaning money to 100 people, or 100 businesses, and I believe that half of them will not pay me back, I have to charge the entire group 100% interest, just to break even. Whereas if I can either underwrite them better, or if I can link into, just because of the, not necessarily software, but just because of the stack that I control, or I see, I can link into, I can make sure that the money hits me first, I will be able to charge them dramatically less money. So it's not just, where are the limitations on this?

• 54:30Speaker 02

  I think there are a lot of opportunities to unlock much fairer pricing. How many more people would buy trip cancellation insurance when you're shopping at Expedia, which they offer, if it were really, really cheap based on your proclivity to either get sick or not? I mean, I just made that example up. But you can imagine where if you're able to price things more intelligently, either because you're somehow in the flow of funds, you're in the flow of data, and it's customized for that particular customer, I think you can actually broaden the scope of how this works. But going back to your original question, I think there is a very interesting thing to think about, which is, do customers want bundled experiences or unbundled experiences? So Robinhood is effectively, I mean, they've started bundling in other things, beyond obviously core trading.

• 55:14Speaker 02

  If Chime offers trading, is that what their customers want? Or do Chime customers, Chime being the leading neo-bank in the US, do Chime customers want to have a Chime account and a Robinhood account? Or do they want to have a Chime account and a Robinhood account? And maybe a lending account with lending club or upgrade? And do they want a life insurance account with some life insurance company? And, and, and versus the bundled approach? I don't know. I think that's a very, very good question. I think a lot of it is honestly, it's just, it goes back to inertia. If you can get them first, and this is the powerful thing. If by virtue of the fact that you're bundling in the data or you have access to the funds, you're able to dramatically, dramatically price improve for the customer. That's a very, very compelling reason.

• 55:58Speaker 02

  So for something like stock trading, well, it's, it's kind of hard to beat free or very low commissions. But for something like insurance, like wow, that's super interesting. Because if you have data that allows you to underwrite better, like you see this right now where like Tesla has your driving score and Tesla is starting to actually insure you, which is pretty cool. Because GEICO can save you 15%, but if you drive a Tesla and they know that you're a safe driver and always follow the speed limit, which GEICO does not do, I mean, it's not because they don't want to, they just, they don't own the car. But theoretically Tesla should be able to underprice that. Or if Tesla was able to do something where it's like, hey, link your, again, wage garnishment bad, but something that is a positive, non-pejorative form of that, pay us right away and your interest rate on your lease

• 56:43Speaker 02

  or your interest rate on your car purchase is going to be even lower, which would be probably their captive auto finance company that would be doing that. But that would be very, very compelling as well. So I think there are a lot of areas for cross-sell where what excites me is the market opportunity could be much, much bigger when the distributors are again, able to underwrite better based on, on data and potentially controlling the flow of funds, which is like the toast example for giving a loan to the restaurant. Like the cheapest cost of capital for a restaurant would probably look something like a factoring arrangement. It's called a merchant cash advance from the person that actually controls their funds. And normally you think of factoring as being more expensive, but in this case it can be a lot less expensive because the risk of loss

• 57:26Speaker 02

  can actually be very, very accurately measured versus what a bank has to rely on, which is like, we have no idea, we have no bundled relationship with the customer.

• 57:35Patrick O'Shaughnessy?

  I asked Dave Girard at Upstart what his company might enable over 10 years. And he gave this cool answer, which is basically like anyone, anywhere just has a loan and terms presented to them at all times. And it's based on all the data we have about them and they could just hit it or not. They could take the loan and terms are pre-calculated and you're pre-approved and everything's seamless and interesting. It's fun to think about that applied to everything, not just lending, but all financial functions. If we think about finance existing because of basically like the timing of cash flows, finance is just handling cash flow, timing problems for other people, businesses and individuals. If you think about it through that lens, what is most exciting to you about the future of fintech? You get to see this from all angles, companies, big trends, et cetera.

• 58:20Patrick O'Shaughnessy?

  You've built companies in the space. What is the big, exciting future that this shift towards data and financial technology companies might unlock for the world?

• 58:30Speaker 02

  The timing of cash flows, it's almost like this broken thing that doesn't allow for customization and therefore it requires people to go externally to go borrow money. Whereas I should be able to borrow money from, when this company, Bill Me later came out, I was like, well, that's a really good idea. It was inspiration in many, many ways for a firm many years later, but I registered the domain name Pay Me Sooner. I still have that domain name because I just think that there are so many options where it's like, wow, I have to borrow money because my customers are paying me at 15. Those customers might even have too much cash where they're very unhappy with the interest rate that they're getting from their bank or whoever's providing that. Why can't I offer them a small incentive in the form of a lower price for them to pay me sooner?

• 59:14Speaker 02

  It goes in the pile of unused business ideas that I have, but actually there are a lot of these receivables, exchanges and whatnot. But I think it's one of many examples where can you come up with, we started this conversation many minutes ago with DVRs, the digital video recorders like Replay TV and TiVo. I wish you had that for money. By that, I mean, why does a consumer get paid every, not a consumer, but like a worker, an employee, why do they get paid either semi-monthly or bi-weekly? That doesn't make any sense. Well, it kind of does because the employer would rather. Rather pay every two weeks than pay every hour. But then that forces the employee to borrow money to maybe pay their rent on time. And that's kind of not fair. They should be able to customize those terms and maybe the employer would be willing to customize those terms.

• 1:00:00Speaker 02

  Why doesn't that happen? Well, there are many reasons. Sometimes it's the employer's cash flows. But in other cases, it's just like it's combinatorially complex. Like, how do you manage all of this complexity? It was very, very difficult, I can imagine, in the pre Excel, pre software era to introduce, hey, you're GE, you have 300,000 employees, let everybody choose their own payday. That sounds like a bad idea. We're not going to do that, but why? That's not that complicated. It's just moving money around and money is bits, it's not atoms anymore. So like, just figure out that problem. And now you have a massive unlock. You've actually exempted the need for, exactly as you said, finances, the basically intermediating these differences in cash flows and solving working capital issues. Like, now you don't have one.

• 1:00:44Speaker 02

  You can actually solve this. And there are some that look like that. There are others where like, again, like, the reason why I use this grand experiment of lending is so inefficient today because what is a credit score? It's basically trying to figure out a business or consumer's willingness and ability to repay. And generally for businesses, if you actually have a Moody's, Fitch or S and P credit rating, like, it's not about your willingness. You're not going to just say like, hey, I don't really feel like paying my coupon. Like, I'm just not going to do it. But for a consumer, that happens a lot. It's like, ah, I don't really feel like paying Capital One, screw them. And you don't know when that's going to happen. They might get lazy. Like, there are all sorts of reasons why a consumer might not pay on the willingness side. But ability is more mathematical. It's not criminal. I shouldn't say that because it's a very broad term.

• 1:01:26Speaker 02

  But it's really, really unfortunate that you're not able to just make those a little bit more mathematical. And that's why I like, and I will come up with a better term than voluntary wage garnishment. But this idea that I, as a consumer, can choose where my money goes. And you basically take up the willingness score. If Capital One knew that everybody that they loan money to is going to pay them back unless they are killed or fired. Well, that takes out so many other different exigencies that they normally have to think about, which is, well, what if they just decide not to pay us because they decide not to pay us? That's the willingness part. Well, why not make this money movement more automated? This is what smart contracts are in the crypto sense.

• 1:02:06Speaker 02

  I know that the money will get dispersed to me and therefore I can offer a much, much, much lower rate. And I mean, that's the thing that's kind of crazy in the world of finance today, which is you have so many people that are seeking any kind of yield because interest rates are zero. And that's caused all sorts of craziness in the world that I'm sure you keep track of as well. And then you have so many other people that are paying very, very high fees on all sorts of things. And it's like, how do I reconcile the fact that those two worlds exist at the exact same time? It doesn't make any sense. And there are many areas that just have not truly been democratized. Like unless an instrument has truly been securitized and trades and there's a fair market for it.

• 1:02:47Speaker 02

  There are all sorts of these very, very esoteric things that are just one-off areas where, again, you can't really figure out this willingness and ability score if it's anything around lending and credit. And then lots of investors that would clearly lower the cost of capital for the other side, that would happily take a higher interest rate than zero that they're getting with their bank. They have no access to that asset class either. So I think there's so many examples like that, which I'm just super excited about.

• 1:03:14Patrick O'Shaughnessy?

  Is it too much of a stretch to think about this as there's just too much interest paid in the world? Or the profits of the financial services sector, if anything, the quality of life in the world, we want them to go down over time because data is better and better. And there's just smarter and smarter ways of doing this. Is that the right way of thinking about this?

• 1:03:32Speaker 02

  Yes and no. I mean, you can imagine a scenario where the profits go up because the rate goes down. And that's actually the one that I'm more excited about. So you expand the pie dramatically because there are lots of people that are locked out of credit right now. Or there are lots of people that decide not to use credit because they don't want to pay 18%. But they would happily take credit at 5%, but it's all one size fits all, so they don't do it. So when you lower the price of something, and it's like, you know, you have your upward facing supply curve and your downward sloping demand curve. I mean, like what you should see happen is it's like, wow, like we're lowering the cost of something. We're making it much fairer and conceptually you're going to expand the pie dramatically. But right now. It's just too one size fits all and in many cases in transigen in terms of just changing

• 1:04:17Speaker 02

  these things. So yes, I think it probably is good. That's the hard part is like, again, it's kind of prognosticating the future around how much bigger would some of these markets be if the pricing were really, really bare minimum if you take out transaction costs? And I forgot, there's some famous economic study on this, but like basically if you take out transaction costs, you should see a lot more transaction volume. And then there are all sorts of things that get built or get done that just don't happen today because the searching costs of the transaction fees are just fundamentally too high.

• 1:04:45Patrick O'Shaughnessy?

  You wrote a really interesting thread and a good tie back to our original conversation on Visa about the threat that buy now, pay later companies may pose to companies like Visa. This is just like right at the beating heart of financial technology and finance, generally speaking. And I'd love you to summarize your thought process here because Visa has been viewed by so many and we explored it together. I encourage people to go listen. It was like one of history's great business modes. And so the concept that there may be innovation happening in this space that may pose a threat to longstanding entrenched winners, I'll call them, is really interesting. Could you walk us through this concept?

• 1:05:21Speaker 02

  There have been many, many attempts to out Visa, Visa or Mastercard and say, I'm going to build a new payment mechanism. But you really have to appeal to two different constituents. You have to make it very compelling to merchants. And it's very easy to make anything compelling to merchants, which is like, hey, do you want to pay 2% fees or 0% fees? How about 0? And every merchant's like, yay, I want to do that. So very easy to make it compelling to merchants, but then you have to make it compelling to consumers. And you say, hey, I'm going to give you no rewards because I know you like getting rewards, but I'm going to give you none. Does that sound compelling? And nobody raises their hand. But of course, the 2% fees the merchants are paying, most of that funds the rewards that consumers are driven by. So that's one of many reasons why that mode is so high. So there have been many, many attempts to topple or undermine or figure out some kind

• 1:06:04Speaker 02

  of Trojan horse to disrupt this payment system, but nothing has really appealed organically to consumers or merchants. There have been many things that appeal inorganically, by which I mean Target has something called the Red Card. And because Target really hates paying fees on Mastercard and that whole system 2%. They have decided to give consumers 5%, which is of course more than 2% if they don't use a Visa or a MasterCard or American Express card that use the Target Red Card. And it's like, maybe that works and they're able to take away those 5% fees and make them zero. But until they do, it's an inorganic approach. So the thing that's interesting about buy now, pay later is that it actually got organic traction with both consumers and merchants. So that's reason number one. And like, why does it have organic traction with both?

• 1:06:49Speaker 02

  There's a famous clip, and you can look it up on YouTube, where Steve Ballmer is pillorying the iPhone, saying, nobody's going to buy a $700 or $800 phone. And he was wrong, but he was right. He was right, because nobody was going to buy an $800 phone. But a lot of people would buy a phone if it was just $10 a month for the next 80 months on their AT&T bill, which is basically what happened. So that's why all these expensive smartphones took off. I mean, they were better products, but normally better and more expensive doesn't necessarily work better and cheaper does. And that was kind of buy now, pay later for that space. It didn't go on your credit card where you're going to get charged 18%. It was done by the principals involved, like the AT&T and the Apple decided to go make this cheaper and to go sell more units. Real clear benefit for the consumer, and again, real clear benefit for the merchant,

• 1:07:31Speaker 02

  because the merchant's going to sell more stuff if they're able to get out of the one-size-fits-all financing regime that credit cards offer, which is credit cards have, they only see two different items that you're buying. You're either getting a cash advance where you went to an ATM machine, and please don't do this because they'll rip you off, you use your credit card and not your debit card, they're going to charge you like 35% on that thing. Or you are financing something that you bought at the store, in which case it's, I don't know, the 18%. They actually have no visibility in terms of the item that you're buying. So why was this good for merchants? Because merchants were able to customize and say, hey, we have too many of this item in our store, we want to charge 0% interest. That was good for the merchant because they moved more items if they're charging 0%. This is why car companies have their Labor Day sales with 0% APR.

• 1:08:16Speaker 02

  It's good for the consumers because consumers are going to buy something that otherwise they wouldn't because the cost was too prohibitively high. And yes, they had financing available, but it was very unfair financing. So it took off organic. Little spiel on that as the background. But what's really, really interesting, I think- Is that so? Number one, it's this new payment rail that has emerged that it normally doesn't touch the Visa or MasterCard rails at all. And then this is the really exciting thing, which is Visa and MasterCard, because they're both so old, and this is not their fault at all, but because the system has five parties involved for a Visa or MasterCard transaction, you have the cardholder, me, you have the cardholders issuing bank, call it Capital One, you have the card network Visa, you have the acquiring bank, call it First Data or Bank of

• 1:09:00Speaker 02

  America, and then you have the merchant, call it Chipotle. And those are the five parties involved in a transaction. And Visa sitting in the middle has no idea what I bought at Chipotle. They assume it's probably Mexican food, because they're smart, but they have no idea what actual SKU, stock keeping unit I bought. And the same thing is true at Walmart. If I go buy something at Walmart, Walmart probably has millions of SKUs. If I spent $422 at Walmart, Visa has no idea what I bought. Capital One has no idea what I bought. And then even First Data has no idea what I bought, because Walmart doesn't want those three knowing what I bought. And the data infrastructure doesn't even allow it. That's why in many cases, a merchant name will get cut off. It will say like, you spent money at SQ* in like the first

• 1:09:44Speaker 02

  15 digits of the restaurant's name. It's just very, very antiquated technology. And it's kind of hard to change, because it's a standards-based protocol. How do you get everybody to just all five of those parties, really not the consumer, but the other four to agree to use this more modern thing? So one of the other cool things about BNPL is that in order to underwrite effectively, like Walmart doesn't want to offer 0% financing on Purell wipes during the height of the pandemic, because they're going to sell out of Purell wipes anyway. They want to offer 0% financing on, I don't know, the old LG television before the new one comes out, because they know they're going to sell more. If it's 0% to the consumer, well, the merchant has to pay for that. That's going to be a higher merchant discount rate. So they need to customize it based on the item being bought.

• 1:10:26Speaker 02

  The very interesting thing about BNPL, this is a long summary, my tweet stream is a little bit shorter, but number one, it's a parallel network that actually appealed to consumers and merchants, which sounds insignificant, but it's pretty interesting, for a subset of transactions. It To BNPL a $15 purchase. And then number two is it has item specific information. And you can do a lot of things with item specific information beyond just financing. You could say, okay, I want to apply a coupon. How do I do that? How does Visa apply a coupon? Or how does Capital One apply a coupon for an individual item that you bought at Walmart? When they have no idea if you actually bought that individual item? The answer is they can only offer basket level discounts. So what BNPL is, is it's the first parallel network that actually has gotten to scale

• 1:11:10Speaker 02

  with consumers and merchants that has item specific information. And all it does is very expensive purchases of $1,000 or more that it divides up into different payments. It still is a good niche to be in because yes, Visa launched theirs and Mastercard launched theirs, but it's never going to work because they don't know the item specific information. Again, Walmart doesn't want to discount Purell wipes with low cost financing. They want to discount and pay for the discounting, I should say. The discounting being the suppressed or I should say subsidized interest rate to the consumer. They want to do that for very expensive items that they would sell more of if they could offer better payment terms. It's got item specific information and it has pretty good ubiquitous coverage and name recognition with consumers and merchants.

• 1:11:54Speaker 02

  And there just hasn't been anything like that, at least in the offline world. PayPal arguably has done this as well, like PayPal is a parallel set of rails. A lot of PayPal transactions never touch credit cards or debit cards. But PayPal also fundamentally started off as a wrapper for credit cards and debit cards. I use PayPal all the time, but PayPal is effectively an abstraction layer that ends up charging my Capital One card. And that's not the way that a firm works. Afterpay and Klarna are a little bit more like PayPal does because they tend to just charge your card. But what Afterpay does is pretty interesting. They effectively created what I would call a synthetic credit card from a debit card. So if you only have a debit card, can't get a credit card.

• 1:12:34Speaker 02

  Now you kind of have a credit card because your debit card is just getting charged four times over the next six weeks or so. But that's kind of the big idea, which is what else can be done with this parallel network? Given that merchants are not huge fans of the current oligopoly that charges them very high fees.

• 1:12:51Patrick O'Shaughnessy?

  I think it's the perfect excuse to sort of ask a question that puts a bow on the entire conversation, which is your idea about, if you think about business writ large, it's sort of the perennial struggle between distribution and innovation. I just love this simple concept, and I'd love you to summarize that concept in closing here, and also maybe just riff on how you think that has changed across maybe your business and investing career and how it might change in the future.

• 1:13:16Speaker 02

  This quote that I use all the time is, I said, "The battle between every startup and incumbent comes down to whether the startup can get distribution before the incumbent gets innovation." To clarify what that might mean, will Vanguard invent a robo-advisor, innovation, before, I don't know, Wealthfront gets $5 trillion of assets under management? That's kind of the battle. Which one of those two will win? And I think normally in financial services, distribution is just so much more important than innovation, because it's not to say that innovation is not important, but these are not atom-splitting things. These are not very, very hard things to build. You have to build a pretty good product, but the incumbent can fast-follow or slow-follow, as the case might be, and eventually build

• 1:13:59Speaker 02

  it. So it's really informed my investment theory, which is, a lot of the companies that I invest in, I either like the infrastructure companies where I'm not smart enough to figure out which one of the 400 neo-banks is going to win and get the most distribution, or even if I won, I would just buy Google stock and Facebook stock or something, because that's why they all advertise. But if they're all using Plaid, or if they're all using Marketta, or they're all using one of these infrastructure layers, the infrastructure layer actually becomes very interesting. So that's one. Or every now and then you find some kind of very, very distinctive distribution wedge, where it's like, wow, like, these guys built a good product, good for them, but they figured out a way to either make it organic, which almost never happens, where like, people just tell their friends. Yeah, you might tell

• 1:14:43Speaker 02

  your friends about some things, but you're not going to say like, "Wow, I love getting a mortgage at First Republic. It was such a great experience." It's not even relevant to most of your friends. You're not going to tell them. But if you come up with something, if you see something as an investor that has just amazing, amazing rapid adoption and distribution, that is very, very compelling. Rapid adoption and distribution is not like, wow, this company figured out how to buy Facebook ads really effectively. Because somebody's going to figure out how to buy them even more effectively. It's they've figured out a different channel that cannot simply be exhausted as readily as what I would call these democratized channels. Where it's like, it's great for the world that Google and Facebook allow anybody to be the highest bidder. But it's not great for the long-term business value of anybody whose predominant source of customers is simply advertising on one of those two platforms.

• 1:15:27Speaker 02

  Because either a rules change or somebody figures out how to go upside down on their economics. It just kind of imperils the source of oxygen in the form of new customers for the business.

• 1:15:38Patrick O'Shaughnessy?

  Yeah, it's a fascinating framework. I love thinking about things this way, simplifying like some of the other frameworks that you've come up with. And as always, I just learned so damn much talking about not just fintech, but just startups and innovation, more generally speaking. I've loved all the frameworks you've introduced today. I asked the same closing question of everybody that I have on this, the main show. What is the kindest thing that anyone's ever done for you?

• 1:16:00Speaker 02

  Too many to list. I mean, it would definitely have to go with my parents for creating me. So that's the very kind of thing. But there's not just one case, but there are so many examples in Silicon Valley where I live, where you just go email somebody out of the blue. They'll spend time with you. They'll help you because it's really not zero sum. This isn't like, as an entrepreneur, you're not trying to figure out some arbitrageable investment theory that somebody else is going to go steal from you. Like in the way that hedge funds might not share ideas like this with each other. Maybe they do. I don't know. But I mentioned like Max Levchin and I started the firm together and that actually started when I think I literally like blind emailed him saying like, hey, I like you. I like your history of what you've done. Like, why don't we be to do this thing? And many brainstorming later, we ended up becoming friends and doing this.

• 1:16:44Speaker 02

  But there are so many examples like that where I was able to, I wouldn't call it punch above my weight class because I wasn't punching above anything. I think it's that line of death of a salesman. Like I relied on the kindness of strangers to really situate me here. Because I moved here in 2004. I knew nobody. I moved here because my wife kind of talked me into it. I was from Florida. I didn't want to move to California. And then just a lot of kindness of strangers allowed me to meet some really incredible people, get some great ideas and advance my thinking. But I would have never gotten there had I not just taken the initiative, but more importantly, had people not actually responded to my little easily deletable spam emails.

• 1:17:21Patrick O'Shaughnessy?

  Well, Alex, I'm so appreciative of everything you've taught me over the last couple of years, getting to know you. I really appreciate your time today. Thank you so much.

• 1:17:27Speaker 02

  Absolutely. It was great talking to you.

• 1:17:30Patrick O'Shaughnessy?

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