Famed tech billionaire David Cheriton shares the three big questions he always asks before investing in any startup

  • Billionaire David Cheriton, and famed Stanford professor, was an angel investor in Google and VMware. But he's also cofounded many startups over decades including Arista Networks and his current one Apstra.
  • He's had decades of investing success. Over the years, he's learned how to spot a winning opportunity and when to pass. 
  • In an interview with Business Insider, he shares the secrets to spotting winners.
  • Visit Business Insider's homepage for more stories.

David Cheriton is one of Silicon Valley's most iconic billionaires.

He's perhaps best known as the Stanford University professor who angel invested in Google after mentoring Sergey Brin and Larry Page as grad students. He's also known for backing VMware. And he's the cofounder of Arista Networks, which went public in 2014; Granite Systems, which sold to Cisco in 1996 in a $220 million deal: and Kealia, which sold to Sun Microsystems in 2004. All told, he's estimated to be worth $8.1 billion, according Forbes.

He's currently the founder and CEO of Apstra, which helps companies simplify and automate their data center networks.

With his decades-long track record, Cheriton spoke with Business Insider about what it takes to spot the kind of investment opportunities that will turn into the next Google or VMware. He offered these 5 tips.

1. Start with three big questions.

Ask yourself these three questions, Cheriton said: Why is this startup compelling? Why this team? And why now?

He offers his current startup, Apstra, as a for instance.

"Operating costs of networks had become dominant, the team knew the key areas of networking and their subtleties, and the emergence of network APIs had just made automated network management possible for the first time in the history of mankind," Cheriton said. (APIs refer to "application programming interfaces" which allow software developers to tie different pieces of software together to automate tasks.)

The true trick is to only invest in a compelling product or service that's hard to provide — but not too hard.

"For example, I can build a new website and that's usually fairly easy to do," Cheriton said. "Whereas with Apstra, for instance, we're trying to automate the control of complex systems, which is hard to provide."

He added that if you don't know how hard the project is from the beginning, the risk of successfully tackling it increases.

"Usually, this risk means that there's a lot of factors that you don't yet understand about the potential product or service," he said. "That's the problem you run into — the risk goes up to the point that you don't want to take it on."

2. Know the customers.

While it sounds obvious to do a market analysis before investing, there's one big flag he listens for: who are the first potential customers?

"You go into an area, a market, and you're likely not the first one trying to sell into that space," Cheriton said. "And even if you have a new product or service, there could be other companies there in that space that don't really appreciate your arrival. Or they are selling to the same customers, making them react negatively to you."

To get a handle on the state of the market, Cheriton asks the founders, "Who is the first company that you're going to sell something to?"

If he hears general answers that's a red flag.

"If they can't give me a specific company with a specific reason why that company would actually write the check for what they're doing, I don't think they've begun to understand their market," Cheriton said.

"And if you can't name one company that would be a potential customer, how do you know there's even one customer? If you can name one, then there are probably more. Then it becomes a question on how big the market really is," he said.

3. Hype is another bad sign.

"When you've been in the business for a while, you'll come across things that nobody was particularly focused on or investing in, and then suddenly a large number of people are interested in investing in that area," Cheriton said.

But the herd isn't rarely right. It is often reacting instead of analyzing and choosing.

"They look through the rearview mirror and say, 'If I had just recognized that the next hot thing back in 2000 was social networks and invested in the right one, I would have made a lot of money at that.' So, they look for the next hot thing. And, and there are all these entrepreneurs that are happy to sell you on their candidate for the next hot thing," he warned.

For instance, "I think AI is sort of an interesting area, but I think that it's way oversold for what it can actually accomplish," he said. Other examples are self-driving cars, and the Internet of Things (IoT).

And that, interestingly enough, can lead investors to feel safe because others have also invested. The trap is a "fad focus," as he calls it, meaning a startup is operating in some hot niche that won't last.

But even if the startup's market is truly, really hot, herd mentality isn't great for investing because it creates too much competition in a nascent market.

"I've seen this happen a number of times where there are too many companies trying to do the same thing," Cheriton said. "This dilutes the talent that's required across multiple companies. And of course they can't all succeed. So, it becomes a horse race where we see who gets to the finish line first."

Additionally, fads can lead to many investors wanting to invest in the same thing, so entrepreneurs can negotiate a much better deal. 

"These are the worst deals for the investors," he said. "They lead to over-investment and under-return." 

4. Leverage what you're good at

"There's a saying that goes along the lines of, if you don't understand what you're investing in, you're not investing  — you're gambling," Cheriton said. "And the odds are stacked against you because only a small percentage of startups actually succeed." 

For instance, the computer security market is always hot, but always risky "because there's so many options that customers get confused which makes it difficult to succeed as an investor."

Because of this, it's best for an investor — especially those who're just getting started — to educate themselves deeply in a particular market or particular technology.

"They are then able to assess in what companies they can leverage their background," he said. "This way, the investor can do more than write a check. They can bring some insight or wisdom to the company and have the ability to understand what they're actually investing in." 

5. Trust but verify.

Doing deals with people he knows and trusts is a particular dilemma, he notes. There are some big advantages.

"Investing with somebody that you trust helps because you have somebody to bounce your assessment off of and see whether it aligns with them," he said.

"Additionally, when you're investing in a company, sometimes the investors want to band together and influence the direction of the company. So if you've got somebody else that's investing with you that you feel like you can work with, you have some more leverage," he said.  

But on the other side, Cheriton pointed out that you're "offloading your judgment on your partner," which he said he doesn't "think is fair and it's dangerous." 

"For example, Bernie Madoff worked exactly on that basis," Cheriton said. "He focused on getting somebody well-known to invest. Then other people invested because the well-known person invested so they dropped their guard. Everybody makes mistakes, but you never want to drop your own judgment and put the burden on somebody you know."

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