Posts from October 2010

In prior years, this community has participated in the Donors Choose Bloggers Challenge during the month of October. We've won the Bloggers Challenge in the tech category three years in a row with total giving amounts of about $30,000 each year. We were dominant in the tech category and a few other blogs were equally dominant in their categories. As a result Donors Choose has decided to stop doing the Bloggers Challenge and encourage the blog communities that were regular winners to do something on their own.

What we are going to do here at AVC is make November our Donors Choose Month. We are going to try to raise a bunch of money for Donors Choose projects this coming month. In that respect it will be a lot like prior years. However, there are two important twists (one borrowed from last year).

The first twist is that we are going to focus on science and math education for young women. We've curated a giving page for this community and we've filled it with projects that focus on science and math and young women. I have kicked off a month of giving with $250 of contributions to five projects. Here are the five that I selected:

Our Giving Page is full of projects like this and we will keep it filled with them for the entire month. I am excited to be doing something real and tangible for young women to get them prepared for the world we live in. I hope you all are too.

The second twist, borrowed from last year, is that we are doing a Meetup on December 8th from 6pm to 8pm in NYC. The Meetup will happen in a public school in NYC. I will be there and I hope the Gotham Gal will be as well. We will have a number of NYC public school teachers and a few people from Donors Choose as well. Anyone who participates in this month of giving and contributes via our Giving Page will be invited to attend.

So that's what we are doing this coming month. I'm excited about this new way of doing this. The competition with other blog communities was getting boring because we beat them so badly three years in a row. Now we can make this all about our community and the projects we are supporting. We will launch a giving widget for this effort on the right sidebar sometime in the next couple days. Until then, go to the Giving Page and get started.

The digital technology revolution was, from the day the transistor was invented in the late 40s until the early part of last decade, largely about engineering. It is still very much about engineering but I've been thinking for a while now that as this revolution matures, it is becoming more and more about creativity and less about engineering.

Why the distinction between engineering and creativity? Can't engineers be creative. Of course they can and are. Maybe there is a better word to use. But what I am trying to delineate between is the hard work of designing and building systems and the more abstract efforts to entertain, educate, and emote with these systems.

You could call it the difference between the front end and the back end. You could call it the difference between the lower layers of the stack and the upper layers. All of these are imperfect models for what I see and feel is happening.

Here's a paragraph from Steven Johnson's excellent analysis of what has happened in NYC in the past decade:

One secret to New York’s technological success lies in the Interactive Telecommunications Program (ITP), a two-year graduate course at New York University. In spite of its focus on technology, the ITP is nonetheless based in the Tisch School of the Arts, and its official description emphasises an “imaginative use of communications technologies.”

Was it accidental or intentional the ITP was located in an arts school? I don't know. I should find out. But regardless of why it was done that way, the result has been impactful. ITP churns out talented people who are half engineer, half artist. And the things they build reflect that view of the world.

When we look at our portfolio and analyze what has worked and what has not, we see a high correlation between having that "creative element" firmly ensconced into the founding team and success. The teams that are engineer heavy and creative light have not worked nearly as well as the teams that are creative heavy and engineer light.

Our portfolio is not a definitive sample. It could simply reflect our biases and therefore mean nothing. But I encourage everyone out there in tech startup land to think about this distinction and see if it rings true. Because I think we are in new territory in the digital technology revolution and some of the old rules matter less and new rules matter more. And if that is true, we ought to figure out what the new rules are and make sure we are focused on them.

There are a lot of "falsims" being bandied about in startup land these days. And one that really bothers me is the idea that returns on startup investing are "bimodal".

For those who don't talk in geek speak, bimodal means there are one of two possible outcomes. And in this case, those two outcomes are a total bust or a huge Google style win.

If you buy into that logic, then you want to be in every deal because if you are going to take a massive number of hits, you need to absolutely be in that Google style win or you are toast.

But startup returns are not bimodal. They exhibit more of a power law curve. There will certainly be one or two venture deals every year that generate 100x or more. And there will certainly be quite a few total busts. But there are a lot of outcomes in the middle of those two. And you can make a great return investing in startups without being in the 100x deal.

Here is the distribution of current returns in our 2004 fund. To be confidential, I am not listing company names and have "fudged" the top returning deal number so nobody plays a guessing game with that one.

A couple things about these returns. First, many of these returns are unrealized and carried at valuations forced upon us by our auditors under the auspices of "FAS 157". If we were working under a different accounting paradigm, we would be carrying many of these investments at much lower values. Second, this fund is only six years old. And so we are still carrying one third of our portfolio at cost. When this fund is fully realized, I am pretty sure there won't be a single investment that is worth exactly its cost.

So don't get too caught up in the total numbers here. The point is that startup returns are not bimodal in any way. They exhibit a power law curve. And you can make great returns playing in the middle of the curve.

I've spent my entire career playing the middle ground of this curve. With the exception of Geocities, which my partner Jerry led at Flatiron, I have never seen a 100x return. I suspect our first Union Square Ventures fund will change that. But from 1990 to 2005, a span of fifteen years, I built an excellent personal track record that helped me and Brad raise our first fund working exclusively in the middle of the return distribution curve.

And the way you do it is you keep your "busts" to less than a third of all of your deals and make sure you don't put a ton of capital into a bad investment. And you work the middle third to make sure you make a decent return on them. And you follow on agressively in your winners. You do that and you can post gross returns in the range of 50% annual returns gross before fees and carry.

The thing you most want to avoid is "doing every deal". You need to select good deals and avoid bad ones. That's what bothers me most about this "bimodal" argument. It suggests that you need to be in every deal so you can catch the one big winner. That's a bad strategy for everyone but the one person who can actually get into every deal. Because there is a good chance that you can't get into every deal. And there is also a good chance that the one deal you can't get into is the one that is going to be the home run.

So pick your deals carefully. Accept that you may not get into the next Google. Work the middle part of the return distribution curve. Recognize your bad decisions quickly. Work your deals hard. And follow your winners. And you'll do just fine.

If you want to read more on this topic, please check out this post by my friend Bryce on mostly the same topic. He wrote it last week and it was one of the inspirations for this post. I was also inspired by this post by Ron Garret.

If you've never been to a Boxee launch event, you owe it to yourself to change that. They are somewhat wild and crazy events, with a good dose of geeking out. On November 10th, in NYC, Boxee will host yet another launch event, this time to celebrate the shipping of the Boxee Box in partnership with DLink.

 The event is from 7pm to 10pm at Irving Plaza, in the Union Square neighborhood. The RSVP page is here.

I will be there along with a bunch of friends. I hope I'll see you there.

In the world of "mobile first, web second" we are seeing a significant uptake in mobile engagement across our entire portfolio. I think this is only the beginning. If you follow the trends out a few years, it could well be that mobile usage of many internet apps will surpass web usage. This is already the case with apps like Foursquare and Instagram. But think about apps like Facebook, Twitter, Tumblr, and Yelp. I can see all of these services having more usage on mobile than web in the not too distant future.

This shift to mobile usage will not be limited to social and local media. I think it will impact every service on the web in some sense. Ecommerce will be affected. Streaming media will be affected. News will be affected. Etc. Etc.

Most everyone uses some form of web analytics these days. Most likely you are using Google Analytics and possibly a lot more on your web app. But are you doing the same thing on your mobile apps? If not you are flying blind. Furthermore, you are missing out on a lot of usage that your employees, investors, and the "market" might want to know about.

We have a portfolio company in this sector, called Flurry, that can help. Flurry's free analytics service is used in tens of thousands of mobile apps across iPhone, Android, Blackberry, and JavaME.

Whether you use Flurry or some other mobile analytics solution, you need to instrument your mobile apps. If you don't you are missing out on a significant amount of usage and it will only grow over time.

Many people, including some of our investors, think of our firm as New York centric investor. That has never been true. We are focused on one thing, internet services of scale, and are willing to travel to find them.

But you can only spend so much time on an airplane unless you are Dave McClure or Joi Ito. And I am not in their league when it comes to air travel.

So I thought I'd show some data this morning. I went back over all of our investments since we started in 2004. And I added three term sheets we have signed but have not yet closed on (yes, we've been busy).

Here is the data:

What you see is that we have never been focused exclusively on NYC but over time we have started to stretch our wings. And our "wings" go in two places, SF and Europe. Basically, we fly the NYC-SF and NYC-London routes.

Europe is particularly interesting. We have sourced investments in London, Berlin, Holland, Israel, and Slovenia. I know that Israel is not technically in Europe but I put it there anyway. Of the six investments we have sourced in Europe, three are now headquarted in NYC and one other has significant operations in NYC. We like finding great teams in Europe and helping them set up the headquarters in NYC. I expect we will do more of that as well as more investments headquartered in Europe.

We will have eight SF based investments by year end assuming everything closes. That is roughly 22% of our portfolio by names. I suspect we will continue to do between 20% and 30% of our investments in SF for as far forward as I can see.

NYC is our home and where we do the majority of our investments. That is how it should be because we are primarily early stage investors and it is best to be close to our companies. We have 25 companies headquarteed in NYC, including two who have exited. I think that is one of the largest portfolios of venture stage (not angel stage) companies in NYC. Maybe the largest. We are proud of that fact and plan to keep adding to it as long as we see opportunity. And we see a lot in NYC right now.

This post might leave the impression that we won't go anywhere other than NY, SF, or Europe to look for investments. That is not true. We have companies with operations in Boulder and Austin and go there regularly. We see opportunity in Seattle, LA, Boston, DC, Chicago, Toronto, and elsewhere. But it is also true that once you start going someplace regularly, start working with the local investors and the local entrepreneurs, you tend to focus your energies there. We'd like to add a few more geographies to our routines so keep the opportunities outside of our big three locations coming. As I said in the start of this post, we are focused on internet services of scale and will travel to find them.

We're five posts into this MBA Mondays series on Employee Equity and now we are going to start getting into details. We've laid out the basics but we are not nearly done. I am just starting to realize how complicated the issues around employee equity are. That's not good. It's like paying taxes. Everybody does it and nobody but the tax accountants understand it. Ugh.

Anyway, enough of that. Let's get into the issue of liquidation overhang.

When VC investors (and sometimes angels) invest in a startup company, they almost always buy preferred stock. In most startups, there are two classes of stock, common and preferred. The founders, employees, advisors, and sometimes the angels will typically own common stock. The investors will typically own preferred stock. The easiest way to think about this is the "sweat equity" will mostly be common and the "cash equity" will mostly be preferred.

For the sake of this post, I am going to talk about a simple plain vanilla straight preferred stock. There are all kinds of preferred stock and it can get really nasty. I am not a fan of variations on the straight preferred but they exist and they can make the situation I am going to talk about even worse.

First, a quick bit on why preferred stock exists. Lets say you start a company, bootstrap it for a year, and then raise $1mm for 10% of the company from a VC. And let's say a few months later, you are offered $8mm for the company. You decide to take the offer. If the VC bought common, he or she gets $800k back on an investment of $1mm. They lose $200k while you make $7.2mm. But if the VC buys preferred, he or she gets the option of taking their money back or the 10%. In that instance, they will take their money back and get $1mm and you will get $7mm.

In its simplest (and best) form, preferred stock is simply the option to get your negotiated ownership or your investment back, whichever is more. It is designed to protect minority investors who put up significant amounts of cash from being at the whim of the owner who controls the company and cap table.

Now that we have that out of the way, let's talk about how this can impact employee equity. Anytime the value of the company is less than the cash that has been invested, you are in a "liquidation overhang" situation. If a small amount of venture capital, let's say $5mm, has been invested in your company, it is unlikely that you will find yourself in a liquidation overhang situation. But if a ton of venture capital, say $50mm, has been invested in your company, it is a risk.

Let's keep going on the $50mm example. It comes time to sell the company. The VCs own 75% of the Company for their $50mm. The founders own 10%. And the employees own 15%. A sale offer comes and it is for $55mm. The employees do the math and multiply 15% times $55mm and figure they are in for a $8mm payday. They start planning a party.

But that's not how the math works. The VCs are going to choose to take their money back in this situation because 75% of $55mm is roughly $41mm, less than their cash invested of $50mm. So the remaining $5mm is going to get split between the founders and employees. The investors are now "out of the cap table" so the final $5mm gets split between the founders and the employees in proportion to their ownership. The employees get 60% of the remaining $5mm, or $3mm. The party is cancelled.

This story is even worse if the company that has $50mm of investment is sold for $30mm, or $40mm, or even $50mm. In those scenarios, the employee's equity is worthless.

I know this is complicated. So let's go back to the basics. If your company has a lot of "liquidation preference" built up over the years, and if you think it is not worth that amount in a sale situation, your company is in a liquidation overhang situation and your employee equity is not worth anything at this very moment.

You can grow out of a liqudation overhang situation. If this hypothetical company we are talking about decided not to sell for $55mm and instead grew for a few more years and ends up getting sold for $100mm, then the liquidation overhang will clear (at at sale price of $65mm) and the employees will get $15mm in the sale for $100mm.

So being in a liquidation overhang situation doesn't mean you are screwed. It just means your equity isn't worth anything right now and the value of the company has to grow in order for your equity to be worthwhile. But it also means that a sale of the company during the liquidation overhang period will not be good for the employees. As JLM would say "you won't be going to the pay window."

This issue is front and center in the minds of many employees who worked in tech companies in the late 90s and early part of the 2000s. The vast majority of companies built during that period raised too much money too early and built up large liquidation preferences. Many of them were sold for less than the liquidation preference and the investors lost money on their investments and the employees got nothing. That has hurt the value of employee equity in the minds of many.

We are in a different place in the tech startup world these days. Many of our companies have raised less than $10mm in total investment capital. And the ones that have raised a lot more, like Zynga, Twitter, and Etsy, have enterprise values that are 10x the lquidation preferences (or more). This is the gift of web economics. It doesn't take as much investment capital to build a web company anymore. That has made investing in web companies better. And it has made being an employee equity holder in web companies better.

But liquidation overhangs still do exist and when you are offered a job in a startup where equity is being offered, it is worth asking a few simple questions. You need to know how many options you are being offered. You need to know where the company thinks the strike price will come in at (they can't promise you an exact price). You need to know how many shares are outstanding in total so you can determine the percentage ownership you are being offered and the implied valuation of the strike price. And finally, you need to know how much total capital has been invested in the company to date so you can decide if there is a liquidation overhang situation.

Just because there is a liquidation overhang doesn't mean you shouldn't take the job. But it's a data point and an important one in valuing the equity you are being offfered. Figure this stuff out going into the job. Because standing at the pay window and finding out there's no check for you is painful. Don't let that happen to you if you can help it.

Most people assume that price is what matters most in a financial transaction. When you are raising money, you want to get the money at the highest price (least dilution). When you are selling, you want to get the highest price for your company. But that is not always the case.

Price matters, but my experience says that it often does not matter the most. In many of the venture deals we have done in the past few years, our transaction valuation was not the highest price offered to the entrepreneur. But the entrepreneur chose us as their partners anyway.

In the majority of the sale transactions that have happened in our portfolio, there were higher bidders for the company than the chosen acquirer.

You can get away with this behavior if you have a closely held business. If you have a public company, then you cannot. The Board has a fiduciary responsibility to get the best deal for the shareholders. And if you are a public company, that effectively means the highest price. That is one of many reasons I don't like being on public boards and operating as a public company.

Let's say you are one of two or three investors in a closely held startup company. Let's say that between the investors and the founders, the group owns ~90% of the company. And let's say that there are two purchasers. One is willing to pay $250mm in a clean transaction and the Board thinks they will be good owners of the business, will do everything possible to keep the team intact and the service vibrant. The other is willing to pay $300mm in a complex transaction, has a reputation for blowing up teams, and has been known to mess up the services they acquire. That would be a no brainer. The board should take the lower offer in a heartbeat, assuming they really want to sell the business.

When you are doing an important financial transaction that brings a new influential owner into the company, price matters but is not the most important issue. The most important issue is the chemistry between the existing owners and the new investor/owner and the reputation of the new investor/owner. You want to use the market to surface the right valuation band and you should do the transaction in that band. But once you have done that, you should optimize for chemistry and fit. And let price fall somewhere in the "market band."

If you cannot find an investor/owner who is a good fit in the "market band" then you should kill the process and not do a transaction unless you need to transaction to stay in business. If you are doing a transaction to stay in business, you have screwed up and put yourself in a bad position. And you should be prepared to be in a worse position soon. But that's the subject of another post.

So price matters but don't optimize for it. Not in a financing transaction. And not in a sale transaction. If you do, you will often regret it.

Yesterday afternoon, I hopped onto the F Train and got off at Bergen Street, my old subway stop. It brought back memories. I love that area of Brooklyn. Court Street between Atlantic and the Gowanus is my favorite street in all of the five boroughs of NYC.

I strolled up Smith a half block to The Invisible Dog to attend an event called Brooklyn Beta. This is my kind of conference. There was one other VC in the room, Charlie O'Donnell, who makes it a practice to be everywhere something is interesting happening. The rest of the room was filled with designers, coders, and especially designers who code. That last group is a special breed and the heart and soul of many of our best companies.

It was a great group, in a cool space, talking about building web and mobile web services. I saw Kevin Cheng (@k) talk about product managing the creation of #newtwitter. I saw Marco Arment talk about building Instapaper on the side while he was CTO of our portfolio company Tumblr. And I saw a bunch of demos of beta services spliced in between the talks.

 

The kegs arrived, everyone got a beer, and then I gave a refreshed version of my Ten Golden Rules For Web Apps talk. And then I took questions for 20 minutes and then the pizza arrived.

This is the way to do a web conference. Fill the room with talented people who are actually building stuff and let everyone show and tell. I loved it. Nice job Brooklyn Beta team. I'll be back next year for sure.

It also bears saying that Brooklyn is the coolest part of NYC by a long shot. It is filled with super talented creative people who live and work in a dense urban environment that is still borderline affordable. I have great affection for Brooklyn and hope to see more companies starting up there in the coming years.