Pacing Yourself

I've been pretty clear as of late that I think the market for investing in web startups is getting overheated. When I talk to some people about this, they say "you should shut down and ride out the bubble on the beach." To which I say "we don't think we can time markets."

If you had a crystal ball, then doubling down when the market is ice cold and folding your hand when the market is white hot would be a great investment strategy. But nobody has a crystal ball and timing markets is a lot harder than it seems.

So I prefer to focus on pacing ourselves. What I like to say is "we should add the same number of names each year to our portfolio and put out about the same amount of cash each year." The number we try to add each year is 6-8 new portfolio companies. USV has been investing since November 2004 so we've been in business exactly six years. And we will have 37 portfolio companies soon. So that is almost exactly 6 new investments per year. We had 31 portfolio companies at year end 2009, so we've added 6 new names this year.

I don't have the cash outlay numbers handy this sunday morning but I do know that it took us four years to put the 2004 fund to work. And or current forecasts are that it will take us four years to put the 2008 fund to work. So that's a good proxy for cash outlay per year.

This strategy works particularly well in the venture capital business because we generally will make three to four investments in each company, spread out over a five to six year period. So no one investment at a "bubble valuation" will impact our average valuations across our portfolio. Said another way, we will invest in 20 to 25 companies per fund and we will have three to four investments in each company, so we will make 60 to 100 individual investments in any fund. If we spread those 60 to 100 investments over a six to eight year period, we can average out the valuation spikes and valleys.

I observed this strategy at work in the first VC firm I worked for. The partners had been investing for fifteen years when I showed up and they had evolved into this strategy and taught it to me. When I left that firm and started Flatiron Partners in 1996, Jerry and I started out with a reasonable and steady pace. It took us about three years to put our first $150mm fund to work. But when we got our second fund of $350mm in 1999, we adopted a different approach. The first mistake was to raise a much bigger fund just as the market was getting overheated. The second mistake was to put that fund to work in 18 months. We went from putting out $50mm per year to putting out $250mm per year, just as the bubble was reaching its peak. The results speak for themselves. We made greater than 5x on that first fund. Eleven years later, we will be lucky to make 2x on the $350mm second fund.

So when I look at where we are right now, it reminds me so much of 1999 and frankly it scares me. But we are not pulling back. We are sticking with our investment strategy and putting out cash and adding new names to our portfolio. But we are doing it with a very close eye on pace, both in terms of names and cash outlays. I think that is the right approach and that it will serve us well as we navigate the tricky waters we find ourselves in.