Posts from July 2010

Dave McClure’s Investment Thesis

I’ve been a fan of Dave McClure since I met him some time ago. He has strong opinions, he shares them liberally, spices them up with foul language, and finds himself involved with a lot of interesting entrepreneurs and companies. In a nutshell, he’s my kind of investor.

Yesterday he outlined his investment thesis on his blog. I’ve heard this thesis verbally from him a few times now, but I am so happy to see him write it all down for everyone to see. If you are a web/mobile entrepreneur, go read it.

Dave clearly articulates the new realities of tech investing. Here is the way he puts it:

Fast Forward to Twenty-Ten, and let's take a look at these fundamentals, with a specific lens on the consumer market & internet startups:

•    PRODUCT now typically means a website or service, run on low-/no-cost open source software, hosted in the cloud on low-cost servers, developed in a few months (or a WEEKEND!) by a small team of 1-5 developers, who continuously test & iterate in real-time with online customers

•    MARKETing now typically means using a variety of online distribution channels via paid & organic search (SEM/SEO) on Google, viral/social amplification on new media platforms & social networks like Facebook, Twitter, & YouTube, and the quickly-growing mobile platforms of Apple iPhone & Google Android. With the exception of search, most of these distribution channels didn't exist 5 years ago, yet they now easily reach over 100M-500M+ users, with very low cost and measurable marketing campaigns such that even a small team can reach billions of people globally.

•    REVENUE can now be collected easily via a variety of online payment, transactional e-commerce, digital goods, subscription billing, lead generation, CPM/CPC/CPA advertising.  Many people buy things online now, and many companies are even bought for usage & users ahead of revenue.  

Longtime readers of this blog will recognize all of these themes but even so, I like the way Dave lays them out. The world has changed a lot for tech entrepreneurs and VCs are adapting to the new realities. Some VCs will adapt. Others will decide not to raise another fund, spend the next five to ten years winding up their older funds, and then retire.

Dave’s thesis is different in some ways than our thesis at Union Square Ventures. We are not as interested in smaller revenue focused companies that aim to be sold for $25mm to $50mm. We’d like to see our portfolio companies aim a bit higher than that. Even so, we will certainly end up with more than a few companies that will sell in that range. That is a successful outcome for us too if we can own 15-20% of the business and have less than $5mm invested, which is the case for many of our companies.

We tend to favor big networks of scale, like Etsy, Meetup, StackOverflow, Twitter, Zynga, Foursquare, Indeed, Tumblr, Disqus, among others. We believe that there are going to be a lot more opportunities like these that we can invest in.

But regardless of whether you are Dave McClure or Union Square Ventures, you need an investment thesis and you need to stick to it. And I believe that you need to make it public, articulate it well, and make sure everyone, particularly your target entrepreneurs, know what it is and why.

Dave did that yesterday and he did it well. Kudos to him. I think it will serve him very well.

Lead Investors, Dipshit Companies, and Funding Every Entrepreneur

Sounds like a great conversation yesterday at Y Combinator's AngelConf in Silicon Valley. Anthony Ha of Venturebeat had a couple posts on it that I just read, one on Paul Graham's comments, and another on Ron Conway and Mike Arrington's comments. I would have enjoyed being part of that discussion so I'll join in now.

I second Ron Conway's hope that "any entrepreneur that has “the guts” to start a company gets funded." That is my kind of thinking. We need more entrepreneurship, not less. So I'm with Ron 100% on this. Of course getting funded does not means 10s of millions of dollars of funding for every entrepreneur. It means enough funding to actually build something and see if the idea and the team has the right stuff to build a company. Then market forces should take over and determine what ideas and teams get more funding and which ones should close the doors and think about what is next for them.

Mike Arrington expressed the contrary opinion, apparently held by many VCs (not me), that this mini explosion in angel investing is creating a bunch of "dipshit companies." I don't know what a dipshit company is. I haven't seen one. If you listen to the chatter on the Techcrunch comment threads, you will see that people think Twitter and Foursquare are dipshit companies. Fine. Many great companies have been built on a wall of derision and I personally think those two are going to join that list of laughed at great companies (and maybe already have). My point is you just don't know what is a crazy idea and what is a brilliant idea. And you don't know what is a great team and what is a weak team. Of course, we have our opinions on that. We make those judgment calls every day. But we are often wrong. VCs are wrong more often than they are right. It is good for VCs if 10x or 100x companies get angel funding. That is more opportunity for us.

Paul Graham rightly points out that that there is a "larger trend where founders have more power than investors." I've been saying that on this blog for a long time. And I also agree that founders are determining the financing structures that make the most sense for them. But I do not agree with Paul's opinion that the notion of a "lead investor" is going away and that is good for entrepreneurs.

This may just be me being defensive and protective of my chosen role. I am a lead investor. It is what I do. I don't follow very well. I like to get behind an entrepreneur and company and help them raise capital, hire a team, and build the business. And I think the entrepreneur needs a lead investor to play this role. Obviously they should pick a lead investor that will not "screw them over" and sadly too many times lead investors do just that. But there are many high quality VCs out there and thanks to the power of blogging and social media and the web, you can find out who they are and who to avoid.

Roger Ehrenberg had a great post on this yesterday. He says:

Coming to the table as a two- or three-headed syndicate beast without a
clear leader is a big, big mistake. How many VCs like investing into
situations where there is “management by committee?” Answer: zero. Why
should syndicate-building be any different?

Just like the entrepreneur needs to run the business, he or she should find an investor to run the investor group. I am someone who does that so if you are looking for a lead investor for your company come talk to me. If you don't want a lead investor, then don't knock on my door because I don't know any other way to be.

Seedcamp 2010

I had the pleasure of spending all day yesterday, from 9am to 6pm, listening to pitches from the finalists selected out of the mini seedcamps from all over europe this year. Seedcamp is Europe's premier startup accelerator. It is like Y Combinator, Techstars, Seedstart, and many other programs of this sort. Like Techstars, Seedcamp heavily emphasizes mentors and mentoring. It is a big part of the value proposition of going through the Seedcamp process.

I am not going to talk about the companies/pitches I liked best right now. But I will say that I came away with three interesting opportunities (out of about 20 pitches I saw). That is a good percentage. In talking to the other judges (there were about a dozen judges), there were another handful of companies that others took an interest in. So almost half of the presenting companies interested at least one or more judges in taking a closer look. That is a great percentage.

The thing that is most interesting about Seedcamp is that it selects teams from all over Europe and Israel (and now South Africa). They do mini seedcamps in Zagreb, Prague, Barcelona, Paris, Tel Aviv, Copenhagen, Berlin, Lodon, and they just added one in Johannesburg South Africa in a couple weeks (Aug 11th). This allows Seedcamp to find teams that might not fly to London on a whim but will travel to a regional hub to see if their project is interesting to Seedcamp.

I was particularly impressed with the quality of the teams coming out of places like Zagreb and Prague. Eastern Europe, from Ljubljana to Tallinn and everywhere in between, contains a ton of smart entrepreneurial technologists looking to build businesses on the web and on mobile devices. I am not going to leave NYC and focus on this emerging market but someone should. It is ripe.

Kudos to Saul Klein and Reshma Sohoni for creating and building Seedcamp. It is building an ecosystem, slowly but surely, throughout Europe and other emerging technology markets that I believe will result in new vitality to startups in this part of the world.

The Seedcamp finalists for 2010 will assemble in London for Seedcamp Week this September. If you are in the VC business and want to see what is going on in Europe firsthand, Seedcamp Week is a great place to start.

Startup Showcase

I want to let everyone know about an opportunity to showcase your startup at Web 2.0 Expo in NYC in late September. On Sept 29th in the late afternoon/early evening, the Web 2.0 conference will have 30 startups demo their products/services to the attendees and a number of investors.

The way this will work is each startup will be given a demo table. And the Web 2.0 attendees and investors will move from table to table. Each demo will last about five minutes long. So if you are participating, you'll give about ten demos in less than an hour.

At the end of the hour, Tim O'Reilly and I will each pick our favorite startup. And the audience will pick one. And then those three startups will each be invited up to the stage for a conversation with Tim and me.

It sounds like a fun format and I am looking forward to it. Tim has one of my favorite minds in the web/tech space so I am particularly excited to be doing this with him. If you want to participate, you need to apply by August 2nd. The details are here.

This is aimed at young startups that are in need of attention, not startups that are well known and heavily funded already.

Comment Spam and False Positives

Every successful social media system I have ever been involved with has to tackle the problem of spam. It is one of signs that you are successful. When the spammers start targeting you, it is a sign you have arrived.

Over the years Disqus has had to fight comment spam and they've done a pretty good job of it. Their spam filters catch most of the comment spam. Occasionally one gets through and I manually delete it, most often via email with a reply with just the word "delete" in it (without the quotes).

In the past month, I've noticed a significant uptick in the amount of comment spam being targeted at the AVC comment threads. More is coming in and more is getting through. I asked the Disqus team about this a few weeks ago and they told me they are seeing a significant uptick in spam across all of their communities and they are dedicating additional development resources to fighting it.

One of the costs of tightening up the spam filters is you get false positives. And thanks to Harry Demott, I noticed this morning that a bunch of legit comments by AVC regulars had been marked as spam. I just went in and manually approved those comments and notified Disqus of this issue. I suspect they tightened something up in the past week a bit too much.

If you have been having trouble getting a comment to post in the past few days, this is likely the source of the issue. If it continues to happen, please let me know via email. I will make sure to visit the spam page in my Disqus moderation panel regularly for the next few days to make sure this isn't continuing to happen. And I am confident that Disqus will get this fixed in short order.

Sunk Costs

Today on MBA Mondays we are going to talk about another form of costs; Sunk Costs.

Sunk Costs are time and money (and other resources) you have already spent on a project, investment, or some other effort. They have been sunk into the effort and most likely you cannot get them back.

The important thing about sunk costs is when it comes time to make a decision about the project or investment, you should NOT factor in the sunk costs in that decision. You should treat them as gone already and make the decision based on what is in front of you in terms of costs and opportunities.

Let's make this a bit more tangible. Let's say you have been funding a new product effort at your company. To date, you've spent six months of effort, the full-time costs of three software developers, one product manager, and much of your time and your senior team's time. Let's say all-in, you've spent $300,000 on this new product. Those costs are sunk. You've spent them and there is no easy way to get that cash back in your bank account.

Now let's say this product effort is troubled. You aren't happy with the product in its current incarnation. You don't think it will work as currently constructed and envisioned. You think you can fix it, but that will take another six months with the same team and same effort of the senior team. In making the decision about going forward or killing this effort, you should not consider the $300,000 you have already sunk into the project. You should only consider the additional $300,000 you are thinking about spending going forward. The reason is that first $300,000 has been spent whether or not you kill the project. It is immaterial to the going forward decision.

This is a hard thing to do. It is human nature to want to recover the sunk costs. We face this all the time in our business. When we have invested $500,000 or $5mm into a company, it is really easy to get into the mindset that we need to stick with the investment so we can get our money back. If we stop funding, then we write off the investment almost all of the time. If we keep putting money in, there is a chance the investment will work out and we'll get our money back or even a return on it.

Even though I was taught about sunk costs in business school twenty-five years ago, I have had to learn this lesson the hard way. Most of the time that we make a follow-on investment defensively, to protect the capital we have already invested, that follow-on investment is marginal or outright bad. I have seen this again and again. And so we try really hard to look at every investment based on the return on the new money and not include the capital we have already invested in the decision.

This ties back to the discussion about seed investing and treating seed investments as "options." Every investor, if they are rational, will look at the follow-on round on its own merits and not based on the capital they already have invested. But the venture capital business is a relatively small world and reputation matters as well. Those investors who make one follow-on for every ten seeds they make will get a reputation and may not see many high quality seed opportunities going forward. Our firm has followed every single seed investment we have made with another round. In most cases, those investments have been good ones. But we have made a few marginal or outright bad follow-ons. We do that for reputation value as much as anything else. We measure that value and understand that is what we are doing and we keep those reputation driven follow-ons small on purpose.

When it is time to commit additional capital to an ongoing project or investment, you need to isolate the incremental investment and assess the return on that capital investment. You should not include the costs you have already sunk into the project in your math. When you do that, you make bad investment decisions.

Angel vs VC?

AVC regular Charlie Crystle asked me this question yesterday in the comments:

Fred, it might be helpful to some of your readers to explain when a startup should seek angel vs seed/early stage VC. 

If I need $250,000 to get to 100 customers, or $1 million to get to X, and I can raise both amounts from either Angels or VCs, where do we turn? 

And let's say both have significant interest, and the terms are the same, which is a better choice? (I no longer have an opinion on this, having gone both directions).

There are really two questions in here. The first is when you should SEEK angel vs VC and the second is if you have the option of taking money from both what you should do.

On the first, I believe entrepreneurs should seek angel money when their product is not yet complete, is not in the market and thus they cannot demonstrate real market traction to investors. There are multiple reasons for this and I'll try to articulate the most important of them.

A company without a product in the market is a very risky proposition. Some VC firms will invest at this stage but I am not sure its entirely appropriate for VCs to invest at this stage. Our firm will do it when we are backing a serial entrepreneur with a super strong track record that we are very familiar with. Otherwise, we stand on the sidelines and watch with interest but no capital at risk. A syndicate of angels, each with a small amount of capital at risk in the project, is a much more appropriate source of capital for a company at this stage because the risk has been well syndicated among the group.

Angels are also more hands off and I believe hands off investors are better for a company where defining, building, and tuning product is the primary exercise. VCs have a responsibility to their partners, both the partners in their firm and the partners who fund their firm, to be highly engaged in the business. So like it or not, they are going to be engaged in the business. I think it is best when that engagement is applied to a product that is in the market and gaining traction, and building the business is the primary exercise.

Finally, selling a VC on a concept on a whiteboard is a very hard sale. It is extremely time consuming with very little chance of success. Selling an angel on a concept is much easier. So simply in terms of where you should spend your time raising capital, angels are a better target in the "concept to product" stage.

The second question, what to do if you have the option of taking money from both sources on the same terms, is more interesting in many ways.

My answer is do both, if you can. When we participate in seed rounds, we most often do it by ourselves with a syndicate of high quality angels. We have done this at least a dozen times now and it works extremely well. We behave as if we are one of the angels and try to be relatively hands off. And we hope that the angels will add value just as they do in their other syndicates where there is not a VC firm involved.

But when the company needs another round of financing, we are there to provide more financing. Sometimes the angels follow in the successive rounds. But mostly they do not. It really doesn't matter, because we can fund the company on our own as long as the capital requirements are modest.

This is our preferred model and we have used it with great success. I think it benefits entrepreneurs the most as well. There are a number of VC firms that use this model. I first saw it practiced by Brad Feld about a decade ago in the seed deals he was doing in the Boulder area when he was at Mobius and I admired it immediately.

If for some reason, you must choose between VCs and angels, then I would choose a VC firm, as long as you have a very good relationship with the firm and the specific individual who will be leading the investment from the firm. In almost every situation, you are going to need more than one round and VCs can and will do multiple rounds and angels often cannot.

I will end this with a comment on the emerging seed and super seed fund models. They exist somewhere between angels and VCs and some are growing and turning into full blown VCs as I have mentioned recently in another blog post on this topic. Seed and super seed funds are "institutional angels" and as such I would mostly categorize them as angels. But many of them do have more capital at their disposal and can, at times, provide additional rounds of funding. So in some ways they are a hybrid. A syndicate of a seed fund or super seed fund and angels is a great way to go if you can put that together. A syndicate of a VC, a seed fund, and some angels might even be better.

To finish this post, I think entrepreneurs should target angels and seed funds when they are pre-launch but if they have the opportunity to pair a VC firm with angels and seed funds into a single syndicate they should do that because it will provide most stable funding platform for the business going forward.

The AngelList

There are a growing number of resources for entrepreneurs on the web, but certainly one of the very best is Venture Hacks. And their AngelList service is particularly useful for entrepreneurs trying to get angel rounds done. I found myself recommending it to at least a half dozen entrepreneurs this past week.

I particularly like this case study of the BlockChalk angel round on the Venture Hacks blog. For those who aren't going to click thru and read the whole thing, here's a quick summary.

Joshua Schachter had already committed to invest in the BlockChalk angel round and he suggested they use AngelList to fill out the round. That resulted in commitments from Mitch Kapor, Thomas McInerney, and Josh Stylman. But then Josh Stylman introduced BlockChalk to Chris Dixon and Eric Paley who joined the round. And then with the strength of that syndicate in place, AngelList added Satya Patel, Michael Dearing, and David Liu to finish off the round.

What this shows is that the old model of angel deals is alive and well. Angels love to share deals with each other. It is how angel rounds come together. But AngelList adds at least two things to the mix. First, it adds a place where the deals can come together online. And second it adds people to the mix that would not be part of the offline deal sharing networks that already exist.

I am on AngelList. I see all the deals come together. I don't personally invest in angel deals in the web/tech space because of potential conflict with USV down the road. But even so, I find it immensely useful to see what companies are getting traction in the angel market. It's part of my radar/early warning system. And it is entirely possible that we will decide that USV needs to participate in an angel round that is coming together on AngelList, although that has not yet happened.

So if you are putting together an angel round, particularly if you already have it partially raised but need to finish it off, I strongly suggest looking into AngelList. It's a great service.

Sony Dash

A couple months ago, my friends at Sony sent me a new device called the Sony Dash. I brought it home and gave it to the Gotham Gal. She is using it as a bedside clock radio and not taking advantage of very many of its features. But my son expressed an interest in having one on his bedside table and so I got another.

He set it up to do four things; tell him what time it is, tell him what the weather is, give him his ESPN fix, and give him his Facebook fix. The clock rotates through sports news from ESPN, and photos and status updates from his friends on Facebook.

Here's the clock showing sports news from ESPN:

Josh's dash espn 

And here is the clock showing status updates from Facebook (sorry about the blurry photo):

Josh's dash 

In light of all the buzz about Flipboard, which I still can't connect to Facebook and Twitter, I think we are seeing an important new development. Social media clients are moving beyond the desktop, laptop, and smartphone onto new kinds of devices like the iPad and the Dash.

I was skeptical about the Dash when I first used it. It is a bit clunky to set up. The UI could use some serious simplification. But once you set it up, it's largely a "set it and forget it" kind of thing. And every time I walk into my son's room, I learn something about sports and his friends. It is actually an excellent user experience for a bedside clock, at least it is for my son.

You can connect the Dash to much more than ESPN and Facebook. It does Twitter, of course, and YouTube, and a ton of other web services too. It's a bit pricey for a bedside clock, but I expect the cost will come down pretty quickly for devices like this and we should be looking at sub $100 price points in the next year. If you are into gadgets and the web, this could be for you.

Terms, Term Sheets, and Terminal Value

Mark Suster has a great post on calculating valuation and the things that VCs can throw at you to make the deal better for them (I guess I should say us) than it actually looks. Go read it. It's complicated stuff but you should try to wrap your head around it. I've written a bunch about this as has Brad Feld and other VC bloggers have too. The VC world is changing. We are talking about this stuff, explaining it, and discussing it. That's progress.

But here is the thing. Terms and term sheets are a necessary evil of the venture business but most venture returns don't come from terms. They come from terminal values. Meaning the size of the exit. One deal often returns the entire fund. The next three to four deals return it again. The rest of the portfolio might return it again and if you can do 3x gross, you'll raise another fund, and another, and another.

In my talk with John Battelle yesterday at Geo Loco, where I said some controversial and partly tongue in cheek things that were widely reported, I did talk about this. And I wish it was as widely reported as the sound bites. What I said was that there are only a few things that really matter in a venture investment. The first is the amount being raised, the second is the dilution to the entrepreneur and the ownership the investors are buying (largely the same thing), and the third is the relationship between the investor and the entrepreneur. Everything else is pretty much noise.

I do care about and want a plain vanilla one times liquidation preference because I think it is fair. If the company is sold for less than the valuation that we invest at, I think it is fair that the investors get their money back in that scenario. Any multiple of liquidation or participation should be avoided at all costs by both sides. VCs often use those tricks to bridge valuation gaps but I have come to believe you should resolve valuation gaps with compromise or just don't do the deal if the gap is unbridgeable.

I think the VC business is changing in many ways and one good way is that more and more VCs are thinking less about terms and more about terminal values. And that is best for everyone.