Entering the Web 2.0 Innovation Abyss
Fred Wilson put up a great post last week which generated a ton of commentary on the post itself and across the blogosphere on the topic of a ‘new path to liquidity’ for startups. Be sure to scan through the comments. Umair Haque had a supportive follow-on post as well. Fred hit on a very compelling point for me personally as a heavy user of a series of Web 2.0 applications and services which have been acquired by the likes of Yahoo!, Microsoft, Google and others only to see the services and apps stagnate in their innovative capability post-acquisition. One might say upon acqusition, these compelling products and services enter an Innovation Abyss inside their larger parent companies. At the same time, as an entrepreneur and entrepreneurial deal-maker in my current role, Fred’s post and subsequent conversation generated strong interest for me as well on the topics of paths to liquidity and the overall VC model.
I think Fred was spot-on in his post. However, it is critical to really parse what he was saying. Felix Salmon wrote a follow-up to Fred’s post on Seeking Alpha, and I believe missed the point Fred was making. Felix seemed to interpret Fred’s post to be saying he was looking for more or better liquidity opportunities for his portfolio companies in an effort to generate a higher rate of return for his fund - hence the statement about ‘greed’.
Quite the contrary, I suspect that Fred and Union Square Ventures and others like it are generating just fine RORs for their limited partners. What I believe Fred was expressing was the statement I made at the top of this post - that the acquirers are not doing justice to the innovation being funded by VCs. What Fred is looking for is a new path to liquidity which generates returns that are comparable to those he gets by selling to Google et. al., but that the targets will also do something with the innovation and keep the founders and core team behind the innovation incented to continue to build their compelling products or services, only now post-deal with more leverage and resources.
Look at a service like FolderShare. It was quite amazing what was accomplished with that service prior to the acqusition by Microsoft. What has happened since? In my opinion, the quality of the service may even be lower as part of Microsoft. How about del.icio.us, to which Fred refers. I cannot point to anything innovative since the Yahoo! deal. I still use both services, but was hoping for something positive following those deals.
In short, I do not believe Fred was asking for higher returns or even more potential acquirers - he appeared to clearly be asking for more appropriate acquirers for his innovative portfolio companies. He may make better returns if he continues to hold the stock post acquisition, but that is not the point. Also, in the absence of better options, Fred and his brethren have an obligation to maximize ROR for their limited partners and execute their fiduciary duty as board members of their portfolio companies, which will mean to continue to sell their portfolio companies in the manner in which they have been - regardless of it may end up stifling the innovation in a portfolio company. Fred appears to be pleading for better exit options for his portfolio companies to help those companies continue to deliver the customer experience gains he expects as a user of the many products and services in which he invests. I hope plea is answered with new paths to liquidity.
The post and its many responses caused me to think more about why this is happening, and I believe I have a hypothesis outlining the underlying reasons behind the situation Fred outlines relative to today’s VC model and the overall technology start-up environment. I do not think the answer for this particular issue outlined by Fred is a private liquidity market such as Opus-5 or Goldman Sachs’ GS True Market, or, while plausible in its own right, a new private exchange for accredited investors as suggested by Roger Ehrenberg. Smells like an opportunity.
I will address these reasons in a subsequent post as part of this mini series and hopefully suggest some opportunities. Like Fred’s reference to pmarca in his post, I too cannot seem to get through posts which are too long (though pmarca authors a very compelling blog). I’ve made my point here, so I’ll cover other points in the next posts in this series.
Charles River & Quickstart
TechCrunch announced today the new Charles River Ventures Quickstart program. It is a program designed to ensure that CRV gets access to deal flow in this latest startup boom of Web 2.0, where the costs to effectively get a company up and off the ground (and potentially to an exit) are substantially less than even $1 Million.
I like that CRV codified a process for making these seed investments. Namely, they set an appropriate amount ($250k), set a standard term sheet that is not over the top (discount to qualified financing of up to 25%, 6% interest), created a simple decision process (one pitch, and 2 out of 5 partners approve), and they didn’t try to jam a valuation or terms in to the Series A.
The last point is a critical one. Many times VCs will offer seed money, but do it with a structure that is tied to some Series A term sheet. Entrepreneurs should be wary of committing to a Series A deal before being ready to seek a Series A deal. CRV wisely avoided this issue.
Without knowing the exact details of the program, what was made public sounds like a reasonable deal for entrepreneurs looking for a small amount of capital to get their big idea off of the ground and may save time from rounding up 5 angels @ $50k each or at least 2 to 3 angels to fund $250k.
The program is also a statement from CRV that they’re serious about being seed investors. Many times a VC will say that they’ll do a seed investment, yet they end up digging into the business and creating an evaluation process that starts to resemble a Series A financing - taking up valuable time from the entrepreneur looking for information that is not yet available about the business. The CRV process seems efficient, assuming they stick with it as written.
Lastly, in today’s NY Times, David Sze at Greylock, provides a counter point that entrepreneurs should be cautious about commiting to a venture firm this early in the process just because they’re offering $250k.
He is correct to caution in this manner … assuming that CRV is requiring that they be involved in the next funding round as the lead or co-lead. However, if this is treated as a way to get access to deals early-on and to establish whether a longer-term relationship between the entrepreneur and VC makes sense, it could be a win/win approach allowing each side to take the other out for a test drive before committing more formally in a Series A where preferred stock and board representation is at stake.
If it turns out the relationship is not going to work, CRV at least gets a small piece of the company in preferred stock assuming the company raises funding from another firm, and the entrepreneur at least screened out one firm and knows more about what to look for in a prospective venture capital relationship and what to avoid.
– brian
[UPDATE] Fred Wilson posted on this topic as well today and had some interesting insights, and information that I missed on CRV’s approach to the Series A. I agree with Fred that it’s a fair ask for the right to 50% of the round. CRV won’t invest their 50% if they do not like the deal - price, terms, team, market, etc. However, it does not preclude the entrepreneur from getting another venture firm involved or from getting a fair valuation for their company.
paidContent has a post on the topic here.
VentureBeat interviewed CRV here.
And Josh Kopelman from First Round Capital has some interesting thoughts here, particularly on potential downside for the entrepreneur if CRV does NOT exercise its option to invest in the Series A.
Cash (flow) is king!
VC Confidential has a recent post on the power dynamics between VCs and the entrepreneurs they back. It is a worthwhile read for all entrepreneurs, but certainly for those that are or are considering being venture-backed.
The overarching lesson is that until your business is cash-flow positive, you are at the mercy of outsiders that provide valuable resources, such as investment capital, to grow your business. Those providing such resources to companies rightfully expect results in return so that their investment is secure and can realize a gain. If your business gets to cash-flow positive, then you as the entrepreneur have control over your destiny. If you are not cash-flow positive and need to consume more resources for survival, you do not yet control your own destiny and the providers of such resources will rightfully gain the power to make changes to ensure the success of their investment. If the latter situation arises, the entrepreneur should neither be surprise or ticked off about the changes that ensue.
I’ve heard a couple of short statements that reflect the lesson above which entrepreneurs should always keep in mind:
- “Happiness is a positive cash flow”
- “Most startups fail due to a lack of revenue, not poor expense control”
Neither of these quotes can be attributed to me, but I keep these thoughts with me at all times now in my entrepreneurial endeavors and share them freely.
Another interesting insight came from the post, which I’ve highlighted below:
“Good VC’s will give an entrepreneur significant room to operate, will give advice based on past experience and will bring resources or connections to bear as required. He/she will layout core principles or constraints which are important to them as well as define, with the company, critical milestones. Control is not determined by legal clauses or purse strings but, hopefully, by mutual, earned respect between them and the CEO. If law or finance is the basis of the relationship, then much has already been lost. ”
It is true, all of the legal terms and conditions are very important to get right. However, be sure that when it comes to actually enforcing/implementing those, it usually is never a good situation, and in fact is never a desired situation, for anyone.
The best situation is always when the fiduciaries and operators (VCs and Entrepreneurs) are operating on a basis of trust, confidence and respect. When that is lost, things by definition are going badly.
– brian
Technorati Tags: bkmblog, entrepreneurship, investing, startup, vc
The return of tech IPOs?
Paul Kedrosky has an interesting post predicting that 2006 is the end of the misery for venture-backed technology companies seeking an IPO exit and that 2007 will see a resurgence. It seems that he is suggesting that the supply of attractive tech equities is shrinking (or has shrunk enough), yet the demand for tech equities will remain constant or increase and the potential issuers are lacking in attractive exit options in the private market.
We know the tech IPO market will return eventually. I just do not know if the catalysts that Paul suggests are either true catalysts or are enough at this time. It is true that many new tech companies are generating meaningful revenues, and I am a firm believer that Web 2.0 does represent a fundamental value creation opportunity. I am struggling with identifying where the next set of leaders are in this new wave of value creation. Where are the standalone entities such as Amazon, eBay, Yahoo, and Google (among all of the other high-value product line staples, such as PayPal, etc.) in this new mix of prospective IPO candidates?
Reflecting back on the period of 1994-1997, I think many of us back then knew that Amazon, Yahoo, and eBay were going to be successes. Google came along later and became a verb, ensuring it’s place in line. Can you say the same about YouTube or Facebook? Maybe, but it is not as obvious in my view, unless I’m just getting to be too old.
What’s more, did we ever see the Web 1.0 leaders so actively trying to sell themselves to the highest bidder? While I suppose that with the IPO market being so dry, no alternative really exists. But if things are so great, who really cares what your valuation is or should be, and why sell now? So much private equity money is available now that if an awesome growth story exists of Google or even eBay like proportions, and that company needed capital, the private equity markets are awash in investment dollars to fuel the fire. Raise the cash, grow the business, and take it public when the time and market is right.
With all of the talk about how much FaceBook is worth and how much a bidder should pay, it seems that all may not be as great as it seems and some may be desperate to cash out before the party ends rather than just growing the thing like Google did. I don’t believe there has been as much talk about YouTube’s valuation by its insiders yet, and it may actually be the real deal. Time will tell.
I do hope Paul is right and 2007 is a resurgence of tech IPOs, even if it is just a moderate uptick (nobody is expecting a return to 1999 here). I would like to see a little more fundamental support in the prospective candidates that will fuel this return of the IPO market before getting my hopes up too high.
– brian
Interesting VC analysis
Peter Rip at Early Stage VC has an interesting series of blog posts that he is producing on Venture Capital 2.0. This post caught my attention for some data that was in it regarding ways for limited partners to successfully pick VC funds which will earn the outsized returns.
I copied the paragraph below:
Last year Alignment Capital published a really interesting analysis of fund managers that speaks to these two criteria. After analyzing 645 separate venture funds, they found:
- Longevity weakly correlates with IRR, showing continuous improvement between funds I and III, leveling off thereafter.
- Second quartile funds were nearly as likely to have a top-quartile follow-on fund as the current top-quartile funds.
Point #2 above was very interesting and unexpected. Essentially it means that the next set of funds that will earn outsized returns can come from a pool of half of the funds in existence. As a limited partner, where fund selection is this asset class is critical to achieving proper risk adjusted return, how does one pick which funds to allocate capital for this asset class?
– brian
Dissecting and pattern matching the venture business
Paul Kedrosky, blogger behind Infectious Greed, has a couple of interesting posts again dissecting the venture business and looking for best practices to identify what makes a stellar venture capitalist. A lot of time, effort, words and echo in the blogosphere is dedicated to this task in general, though Paul is certainly qualified to address these issues.
I enjoy reading Paul’s articles and blog posts, and think he addresses some interesting points in this article looking for best practices in venture capital. I think Paul’s conclusions here are mostly right, but would build on the gut conclusion in terms of how to make successful venture investments.
VC is a hits business and the biggest ones matter the most - i.e. a fund maker (or in today’s multi-billion dollar funds - fund makerS). You know these … Apple Computer, Cisco, eBay, Google, ….
What is common?
1. Big friggin markets. Obscenely big.
2. Persistence - have the balls (metaphorically of course) to bankroll the sucker through to win
3. Team - either you have it or you bring in on when you know you don’t (think Cisco)
4. Technology - either you have it or you know you can build it & the barriers to entry using step #2.
5. Hang out (actually actively troll) in a well stocked pond and kiss a lot of frogs
If the market is one that you know is huge, then be sure you back the best team & technology combo among all of the other choices, so that with persistence and bankroll you can win.
The art / gut is betting on the market and the team/technology combo, and having the balls to see it through (& know when to cut your losses).
It’s a well known fact that the asset class as a whole really stinks on a risk/reward basis. It’s the top funds that matter ….. and not many exist. Per Paul’s "VC is a Bubble Business" post, I don’t exactly agree unless you’re trying to invest outside of the top decile (mayby quartile if you’re being generous). The top funds always seem to find the next Apple, Cisco or Google (oh, were all of those Sequoia?), bubble or not.
Lots of money is salivating to get into the class (a psychology that would be interesting to understand), so an adverse selection process is in play (and has been for most of the existence of the asset class) ….. chances are good that unless you’re running a huge institutional fund, are close personal friends with one of the few top funds, or can really identify the next wunderkind of the industry, if you’re offered an opportunity to invest in a VC fund, you should politely decline and run away fast.
– brian
What enables a great startup hub?
Recently Paul Kedrosky initiated an interesting discussion about the top technology startup hubs in the USA. His article was an excellent summary of the topic. He even posits how Buffalo could make the list!
The discussion that followed included Fred Wilson arguing that NYC should be #3 on the list, ahead of Seattle and Austin. Of course, Silicon Valley and Boston are #1 and #2 respectively.
This all culminated in this study by O’Reilly Radar that attempts to finally truly rank these startup hubs with relevant data and synthesis. I’ve read too many articles that make claims to ranking the top US startup hubs, yet do not believe the results. My skepticism is mainly because my current hometown is Austin, TX, and it routinely ranks #3 or #4 in these articles. In living the startup scene in Austin for over 9 years now, spending a ton of time in the Bay Area, Boston, and NYC, and having many friends working in Seattle, I am absolutely sure that it is not ranked #3 or #4. Austin does a great job marketing itself, but the substance can be lacking in its marketing claims. It is a very hip town, has a major university turning out solid technical talent and major companies with R&D centers, and a large percentage of its activity is startup-oriented. Also, a lot of rich people live here. However, on a comparative basis, it is way behind Silicon Valley, Boston, Seattle, NYC, and maybe other areas.
Take Austin versus Seattle. These routinely tussle for the #3 spot in most of the startup hub articles. Austin has Dell (which by the way has little track record of people spinning out to do their own startups). Seattle has Microsoft, which has spun out a large number of entrepreneurs. Austin has Whole Foods, Seattle has Starbucks - these help create some rich people and contribute to the startup culture. The next level down makes a big difference. Seattle has Amazon, Real Networks, Blue Nile. Where are these companies in Austin? They do not exist . Silicon Labs is the lone $1B in market cap startup success that I can find. There is no $15 Billion comparable to Amazon (yes, entrepreneurs spin out of Amazon too). Seattle has also had a lot of smaller liquidity events that are not as prominent than what we see happening here.
The O’Reilly study gets to the core of some true metrics of startup activity - the jobs data. It’s one thing to say you have a lot of startup activity, it’s a totally different thing to prove that in terms of true economic value-added activity, such as jobs creation.
Austin has all of the ingredients that Paul Kedrosky outlined in his article on startup hubs, and it does a great job with PR. What it lacks is a significant group of profitable, growing startup companies. My purpose here is to highlight the gap between hype and substance here, becuase without the substance the hype eventually wears out. Every other ingredient seems to be here in Austin, we just need more startups that turn into growing profitable entities …. soon.
– bkm
PS - if you don’t believe me, read the comments on the O’Reilly and Fred Wilson pieces. You’ll see Austinites and former Austinites living in NYC or Boston making similar claims
Back to basics - filling the early stage funding gap
An interesting trend is underway in the venture capital industry. Most of us are well aware of the trend to very large funds, which started in the Internet bubble with the first $1 Billion and up venture capital funds appearing. Well, the necessary reaction to that action of large fund formation has finally begun to take shape, and it’s being led my some of the savviest (early stage) investors in the world.
- Alan Patricof leaves Apax, a firm he founded that is managing billions of dollars of capital and was behind such hits as Apple and AOL, to start Greycroft Partners, a $50 Million (yes, million with an "M") fund to focus on early stage opportunities in technology and new media
- Kathryn Gould leaves Foundation Capital, a firm that she co-founded and too was managing over a Billion in capital, to invest her own money $200k or so at a time in promising early stage ventures through her new firm Gould Investments
- Robert Greenhill forms a $80 Million venture fund with Silicon Alley Partners - Greenhill-SAVP - to, yes focus on early stage investments in New York.
These investors are in a league of their own and can personally throw around the kind of capital that make up their total new funds without denting their own new worth. So, why are they messing around with deploying funds worth a total of less than $100 Million?
They sense an opportunity that has been apparent for some time now. That is, a great opportunity exists for outsized returns and the creation of great companies by deploying less capital early on in today’s technology startups. This is the way it was when these VCs were pioneering the industry several decades ago and seized on opportunities like Apple, AOL, Oracle, etc.
Read through Kathryn Gould’s website and she will explain it succinctly and clearly. VCs are sitting on piles of cash and need to invest large sums for big ownership stakes in order to generate a proper risk adjusted return on their funds. Initial investments can be as large as $10 Million and above. On the other side are entrepreneurs. Today, the capital needs to start up companies are smaller. The smartest of the entrepreneurs do not need the large amounts of capital (and associated dilution and loss of control) that today’s huge VCs need to deploy. However, with a small amount of capital and the right strategic assistance from savvy investors, entrepreneurs can focus (1) build great companies, rather than flipping research projects and (2) generate outsized returns for the early investors, themselves, and their shareholders. The VCs will be around for growth capital - priced accordingly - at the right time. They will also increasingly need to compete with other private equity firms, structured debt, and hedge funds for the opportunity to invest in growth opportunities. I image this line of work is less interesting to those VCs that were around in the pioneering days of the industry.
As an entrepreneur that grew up in the bubble, it’s taken some time to wean myself from the capital addiction. The past three years have been my first three as an entrepreneur without venture capital in my projects. I’ve found it to be a very rewarding and educational time, and have found that taking this approach has generated a quick focus on the right things - understanding customer needs and drivers of urgency, ensuring the right things are being built, and finding a quick path to adding value and hence generating revenue. My projects are still alive or just getting started, but are tackling the issues that too much capital would have hid for a long time.
I also see quite clearly the gap in the market between a bootstrapped startup and a full institutional round of capital from today’s venture funds. There is a need entrepreneurs have today for early stage capital, but not of the size and type of today’s Series A rounds, and the associated responsibilities that ensue. It seems that Gould, Patricof and Greenhill all sense this need and the opportunity. I would take capital today, but it does not exist in the right doses and from the right investors.
It would be great for any entrepreneur to have the opportunity to work with these individuals with their new funds. I have had the honor of meeting both Greenhill and Gould, and they are among the absolute best in their respective professions. Also, my apprehension about being a venture capitalist would totally go away if there was an opportunity to work with any of these investors on their new, small, early-stage funds. What a training ground that would be, and what a lot of fun it would be to work on several projects and make an impact at that early of a stage!
I for one will be keeping a close eye on the investments that these pioneers are making over the next several years.
– bkm
A better seed investment structure
There has been a fair amount of discussion on seed / angel investment structures recently in the blogosphere. Below are two great postings that cover most of the discussion to-date:
- Brad Feld - discusses the two main structures currently used, preferred equity and convertible debt with a warrant
- Josh Kopelman - discusses the positives and negatives of each and when to use one over the other
I think Josh’s analysis is exactly right. I’ll illustrate a main reason why from a perspective of an angel. However, the added complication comes when you want to use the preferred equity structure. Most companies at this stage do not want to go through the hassle or cost of structuring a preferred equity instrument. Josh offers the NCVA standard documents, which is certainly an option.
After speaking with several angels I came across a structure used by a successful angel investor in the Austin area. The structure is a Debt Note and a Warrant. It goes as follows:
- Debt Note is for a term of 2 or 3 years at simple annual interest, and is payable in full plus interest at the earlier of term of a financing event
- Warrant is good for a fixed percentage of the company in its most senior equity security on a fully-diluted basis at a fixed price (which is the amount of the Debt Note); warrant has a term as well, maybe the same as the note maybe longer.
An example will illustrate how this works.
Say the seed round is for $200k and the postmoney valuation is $2MM (MM = Million). In this case, the debt note would be for $200k and the warrant would be for 10% of the company ($200k/$2MM) with an exercise price of $200k. If the company raises a Series A round for $10MM postmoney valuation, the angel is paid his debt note back and can exercise his warrant for 10% of the company by paying $200k. The reality is this can be a swap of the note for the warrant so that no cash need change hands again (i.e. the company simply keeps the angel cash and the angel gets 10% of preferred equity).
This effectively puts a valuation on the Seed round, but Josh addresses that issue well in his post. There is no need to structure the preferred equity terms here, since the angel simply assumes the most senior security at the time of conversion.
The angel with whom I spoke allows the exercise of the warrant to happen any time during its term (which may be up to 5 years). So, in this event, the exercise isn’t forced at the next financing event, but it could be 1 or even more financing events later than that (e.g a Series C or D round) and still be good for the fixed percentage ownership fully-diluted then. This is likely to be viewed as extreme, as it survives dilution through multiple capital rounds and gives the angel a free option since his note is paid back. I have not grappled with that yet, but the right solution may be an exercise of the warrant at the first financing event.
In addition to the misalignment of interests between the angel investor and the entrepreneur, the other problem I have with the convertible note with warrant coverage structure is the implied valuation. This is probably why one of Josh’s cases for using this structure is "when a venture round is imminent or already underway" and a timing of "60 days or less to close." If it falls outside of these parameters, the valuation of the company on this structure is way too rich.
Let me illustrate. Again assume the company can raise a venture round at $10MM postmoney valuation. Let’s also assume $200k is invested in the seed structure of convertible debt with 40% warrant coverage (the high end of Josh’s range). I’m ignoring the interest since it’s negligible. In this case, the angel will own 2.8% of the company ($200k plus $80k warrants divided by $10MM). The implied postmoney valuation is $7.1MM (take $200k in actual cash invested divided by 2.8% ownership, which includes the warrants).
$7.1MM is pretty expensive for an angel to be paying for equity in a startup that isn’t on the doorstep of venture funding. You can run whatever numbers you would like in this structure and it’s hard to realistically get below $5MM. These are VC valuation levels and can be handled since the VC typically has enough money to carry the company to profitability and has a distributed portfolio to diversify risk. Angels typically have neither and thus play early to get better valuations. Seed investments typically are in the $1MM to $3MM range of valuation (except for those that are bridges to Series A as Josh illustrates). For $200k this get an angel 6.7% to 20% of the company depending on the valuation. A far cry from the 2.8% range on the convert w/warrant structure.
This is new and in evaluation for potential use by me right now. I’m eager to get comments and feedback.
– bkm
A solid VC blog
I’m back after a long absence in posting - just finished a major crunch in launching the pilot of our new Web Game Show, THINK!.
Mike Hirshland from Polaris Ventures just started blogging. I was referred to his blog by another blog, and have begun reading his posts. I am highly interested in following Mike’s blog and think he is on the right track for what a VC blog should be about. Furthermore, I do not know Mike and am not currently seeking funding from Polaris, so this recommendation is purely b/c I think Mike’s blog is going to be a valuable read for many in the tech start-up community.
His mission is great - read one of his first posts here and you’ll get that he will focus on writing about what he knows and where he can add unique insights. Specifically, I’m looking forward to Mike’s investment insights:
“I am also going to take a crack at spelling out some of the thinking that goes into the particular investments I am making.”
I believe if Mike stays true to his mission both members of Mike’s value chain - entrepreneurs and limited partners (although I wonder how many LPs really subscribe to the blogosphere right now) - will derive true insight into how and whether Mike will be (or is) a quality service provider.
Furthermore, Mike’s comments on the “why” of choosing specific investments should add value to all enterepreneurs regardless of whether Mike and Polaris invests.
From his initial postings, it seems clear to me that Mike is staying true to his mission. He is also adding an intangible that is not widely prevalent in the overall blogosphere today - sticking to where he adds value. For example, on the hot topic of whether we’re on the cusp of major disruption in the VC industry, Mike simply points to others already blogging on the topic as he feels he either does not have the time or does not have anything new to add to it.
Thanks for your contributions Mike …. I’m a fan and am looking forward to reading future posts.
– bkm
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