Diversification (aka How To Survive A Crash)

I was emailing with my friend Harry this past week and we started talking about crypto and the inevitability of a massive crash. I am certain the big crash will happen. I don’t know when it will happen and I think it may be some time before it does. But better safe than sorry. So I’m going to write some thoughts about how to survive it.

I told Harry my personal story of having 90% of our net worth go up in smoke in the dot com bubble and crash.

The only reason it was not 100% was that we owned two significant pieces of real estate that were about 10% of our net worth before the crash and became our entire net worth after the crash.

We were not diversified. We had all of our money in venture capital and internet stocks and had ridden that wave all the way up. Before Flatiron Partners (the venture firm I co-founded at the start of the Internet boom), we had no net worth. So everything we had, we made in the 1996-2000 period. And we essentially lost it all when the bubble burst.

Had we not sold Yahoo! and other stocks to purchase the real estate and pay the taxes on the gains, we would have been wiped out completely.

You might think “you could have sold when things went south” and that is a good point. But when things blow up, your first instinct is that they will come back. They didn’t this time. The selling just continued. A few companies we owned a lot of went bankrupt. These were public stocks that went all the way to zero. So, while it is true that we could have and should gotten out when the bubble burst, we did not, and in some cases could not.

So selling when a market blows up is not the best way to protect yourself from a crash. Selling long before it blows up and diversifying your assets is a much better way. Like we did with real estate, but with a lot more than that.

I like a mix of cash (t-bills, money market funds, etc), blue chips stocks (Amazon, Google, etc), real estate (income producing with little to no leverage), and a risk bucket (venture capital, crypto, etc). I think 25% in each would be a good mix. We have more in the risk bucket but I am in the VC business professionally and have been for 30+ years. 25% in each is where I’d like to get to in time.

I have advocated many times on this blog that people should have some percentage of their net worth in crypto. I have suggested as much as 10% or even 20% for people who are young or who are true believers. I continue to believe that and advocate for that.

But we don’t have that much of our net worth in crypto. We probably have around 5% between direct holdings and indirect holdings through USV and other crypto funds. I think that’s a prudent number for a portfolio like ours.

I know a lot of people who are true believers in crypto and have made fortunes in it. They are “all in” on crypto and have much of their net worth (all in some cases) invested in this sector. I worry about them and this post is aimed at them and others like them. It is fine to be a true believer and being all in on crypto has made them a lot of money. But preservation of capital is about diversification and I think and hope that they will take some money off the table, pay the taxes, and invest it elsewhere.

That is the smart and prudent thing to do. I wish I had done it during the internet boom. I did not, but the next time we made a bunch of money, I did. I learned the hard way. I share my story so that others don’t have to.

Feature Friday: Coinbase Vaults

Vaults are the crypto equivalent of a savings account.

If you have crypto assets that you don’t plan to spend/send frequently, you can put them in vault and get increased security.

Coinbase has had a vault offering for Bitcoin for the past three years and they have now launched the same vault product for ETH and Litecoin.

It appears as an additional account in your Coinbase accounts screen:

With the vault, you get a 48 withdrawal period (so nobody can move funds out of your account for 48 hours) and multiple signers on a withdrawal.

You can have three signers and require all three to sign a withdrawal or you can set up five and require three of five to sign a withdrawal.

I like to keep some crypto assets in my wallet and the rest in a vault. It is more secure.

If you have crypto assets at Coinbase, I encourage you to set up vaults for them.

Happy New Year

Today is Rosh Hashanah, the Jewish New Year.

I’d like to wish a happy new year to all my Jewish friends and colleagues and readers.

I don’t personally identify as any particular religion.

I was brought up Catholic, married into and raised our children Jewish, and I appreciate both of these religions.

I also feel great connectivity to Buddhism and have many wonderful Muslim friends.

There are bits of all of these belief systems that I connect to and appreciate.

But mostly I am a fan of spirituality and belief systems.

Being human is a strange, wonderful, and, at times, unnerving experience.

Spirituality and belief systems help us with our humanity and make our time on earth a bit easier.

If we could have that without all of the other stuff religion brings, that would be a wonderful thing.

Today is a day for my Judaism. I will attend services with my family, hear the shofar, wish everyone Shanah Tovah, and celebrate with a big meal with friends and family.

Rosh Hashanah is my favorite Jewish holiday and I plan to enjoy it. Shanah Tovah.

Mexico City

Mexico City is an amazing place. The Gotham Gal and I were there around this time last year.

The people, the culture, the energy are all great in Mexico City. It feels like a place on the move where good things are happening.

So I was upset to hear about the devastating earthquake last night.

We have had so many natural disasters in the last month and I understand that we may all be fatigued from giving to all of these needy causes.

But I took some time this morning to give and thought I’d share with all of you where I sent some funds in case you want to do the same.

  1. Salma Hayek’s Crowdrise Campaign to UNICEF’s on the ground relief efforts: I donated $1000.
  2. Bitso’s (Mexico’s largest crypto exchange) Campaign to benefit Red Cross and Brigada de Rescate Topos Tlaltelolco A.C.: I donated 2 ETH.

It feels good to send some funds to organizations on the ground that are actually helping people in a difficult time.

Why Amazon Should Come To NYC

USA Today reported that NYC is working on a proposal to encourage Amazon to locate its second headquarters “HQ2” in NYC.

I can’t imagine a better place for HQ2 than NYC.

Here are ten reasons why Amazon should stop thinking about any other place and just pick NYC:

  1. NYC is headquarters to many global companies. It has the transportation systems, building stock, and talent base that companies need and desire for their headquarters.
  2. It has 8.5mm people, enough to satisfy Amazon’s insatiable appetite for talent.
  3. It is home to the entrepreneurs, creators, innovators, and big ideas that Amazon is looking to surround itself with.
  4. It is home to the second largest tech sector in the US.
  5. NYC is committed to teaching computer science to all of the 1.1mm students in its school system by 2025 and is already 1/3 of the way there.
  6. NYC/NYS has embarked on massive infrastructure investment to upgrade its transportation hubs like LGA and Penn Station.
  7. There are something like fifteen direct flights from NYC to Seattle every weekday.
  8. NYC has the largest Amazon customer base of any city in the US (I am guessing on this one. But it has to be true).
  9. NYC will welcome Amazon with open arms unlike some of the other cities that Amazon is considering.
  10. NYC has the most diverse workforce in the US.

So if any AVC readers know how to get this post to the team at Amazon that is making this decision, please send it to them. I am certain NYC is the place for them. They will love it here.

Worry

I remember when I was in my early 20s and just starting out in the venture capital business, I came across an old wall street saying that “a market climbs a wall of worry.” I didn’t understand it and that made me want to. I read a bit about the saying and came to understand that bull markets require an uneasy feeling.

Worrying is a fundamental characteristic of most investors I know. Greed and fear are the two opposing elements of market forces.

I read a board deck this weekend from a portfolio company that is absolutely crushing it and forwarded it to our team at USV with a short memo outlining all of the risks I am worried about. Not a single enthusiastic comment was in that email.

Why is that? Because although we invest on “what could go right”, we manage our investments on “what might go wrong.”

I believe one of our greatest assets to our portfolio companies is to be an early warning sign of trouble. If we can help the founders/leaders and their teams be aware of risks on the horizon, they can manage against those risks. And if there is one thing investors, particularly ones who have been around a while know about, it is how things can and do go wrong.

Of course, how you worry is critical. You can’t weigh down the leadership teams with your worries. You can’t fill up the board meetings with angst.

You have to be supportive, optimistic, encouraging, and positive in your interactions with founder/leaders and their teams. But you must also flag areas where there could be trouble. Getting that balance right has been a work in progress for me for my entire career.

So being a worrier is an important characteristic in an investor. But you have to mostly keep those worries to yourself and your partners/team (this is a place where partners are invaluable). And you have to decide when a worry is significant enough to share it with your portfolio companies and then you need to find the right moment and narrative to communicate it. When you do it right, the teams appreciate it immensely.

Some Thoughts On Burn Rates

The startup and venture capital businesses are based on a general idea that you can and should invest heavily into your business in order to increase value creation, amplify it, and accelerate it.

These investments mostly take the form of operating losses, driven by headcount, where the monthly expenses are larger, often much larger, than revenues.

These losses are known in the industry vernacular as “burn rates” – how much cash you burn on a monthly basis.

But how much burn is reasonable?

I have been thinking a lot about this in recent years.

Instinctively I feel that many of our portfolio companies, and the startup sector as a whole, operate on burn rates that are too high and are unsustainable.

But it is hard to talk to a founder, a management team, or a Board about burn rates objectively.

There are no hard and fast rules on burn rate so you end up getting into an emotional discussion “it feels right vs it feels wrong.”

That’s no way to have a conversation as important as this one.

So I’ve been looking for some rule of thumbs.

One that I like and have blogged about is the Rule of 40.

The rule of 40 makes an explicit relationship between revenue growth rates and annual operating losses. Below 40 is bad. Above 40 is good.

But the issue with the Rule of 40 is that it is oriented toward businesses (like SAAS) where there is a well-understood relationship between value and revenues and ones that are reasonably developed.

So I’ve been deconstructing the Rule of 40 in hopes of trying to get to a more fundamental truth about burn rates.

And what I have come up with is this:

Your company’s annual value creation (valuation at the end of the year minus valuation at the start of the year) should be a multiple of the cash your company has consumed during the year.

That seems simple and obvious and that is a good thing.

But in order to make this work you need to lock down two things;

  • how are you going to objectively measure valuation absent a financing event?
  • what is the multiple?

The latter one is easier I think. The multiple should be large. 1x is clearly not enough. I don’t think 2x is either. 3x is borderline. I like 5x. I would want a 5x return on my annual burn.

I think annual value creation should produce a 3-5x return on annual burn. That feels like a good solid range to me.

The first question is trickier. If you have revenues, then using a revenue multiple to establish value is a good way to do this. You can look at comparable company financings and acquisitions and also public company valuations to figure out what revenue multiple to use. But you should be careful to understand that revenue multiples are a function of revenue growth rates. The faster your revenue is growing the higher they are.

So let’s do an exercise here to flesh all of this out.

Let’s say you are a $10mm annual revenue company in 2017 growing to $18mm in 2018.

And let’s say that you look around at public comps and companies similar to your are trading at 6x revenues.

So you can estimate that your business is worth $60mm this year and $110mm next year.

So there will be $50mm of value creation in 2018.

If you want a 5x return on your burn, you should not burn more than $10mm in 2018.

If you are willing to accept as little as 3x, you should not burn more than $16mm in 2018.

That’s how this rule works.

I like it because it is objective and will lead to rational discussions about burn rates vs emotional ones.

It does break down in pre-revenue companies where it is harder to objectively measure value creation. You can use financing valuations as a proxy in pre-revenue companies but then you quickly get back into emotional territory as the end of year valuation will be an aspirational number and unreasonable aspirations/expectations are what lead to unsustainable burn rates in the first place.

Fun Friday: Crypto Crystal Ball

Chris Burniske posted this Twitter poll a few days ago:

I voted for option one. I think the crypto markets will be under pressure for at least the remainder of the year. But I am a buyer so that may be wishful thinking on my part.

Where do you think crypto is headed for the remainder of this year?