Posts from VC & Technology

Reserves

Reserves is the term VCs use to describe funds they “reserve” for follow-on financings of their portfolio companies.

Here are some things entrepreneurs should know about VCs and reserves:

  • One very important thing that separates a strong VC firm from all other sources of capital is that the best VC firms reserve capital for follow-on financings for their portfolio companies and can be counted on to participate in subsequent financing rounds. This is not true for angel investors, seed funds, growth funds, and strategic investors.  I don’t mean to be disparaging of these other sources of capital. They all are important at various stages of development. But if you want someone you can count on in your cap table, that would be a VC firm, particularly a top tier VC firm.
  • Most top VCs will choose to take their “pro-rata share” of follow-on rounds. That means they will invest enough capital to avoid being diluted by the follow-on financing round. If a VC owns 15% of your company, they most likely are going to want to take 15% of follow-on rounds. That means that you can’t raise your next round from your VC investors, but you can count on them for a material part of the round. There are exceptions to this rule, and they are called “inside rounds”, but entrepreneurs should not count on inside rounds. It is generally preferable to raise an outside round, although there are exceptions to that rule.
  • VCs raise money in discrete funds. These funds are pools of capital that are capped at some number. That number could be $100mm, $500mm, or $1bn, or more. VCs generally do not like to, and are often prohibited from, “cross investing” between these discrete funds. That means if your company raised money from USV 2004, LP (the name of our first fund, a $125mm fund), it will be hard for us to invest in your company out of USV 2008, LP (the name of our second fund, a ~$150mm fund).
  • For this reason, experienced VCs have learned to create large reserves in their funds for supporting their portfolio companies. That means that a firm like USV might go back to its investors for a new fund (USV 2008) after only investing a portion of a fund (USV 2004). At USV, we generally go back to our investors for a new fund after investing about half of a fund. That means that we reserve roughly half of a fund for follow-on investments.
  • VCs also have a tool called “recycling” at their disposal to supplement these reserves. At USV, we have the right to take some of our realized proceeds in a given fund and reinvest them in the portfolio companies of that fund. That recycling capability is typically capped in the agreement between the VCs and their investors. At USV, that recycling cap is roughly 25-30% of our funds.

So, given all of this, here is what entrepreneurs should understand:

  • VCs, particularly top VCs, can be counted on to support a portfolio company from round to round, particularly for their pro-rata share.
  • But VCs don’t have unlimited resources to invest in your company. If they are investing in your company out of a $150mm fund, that is the total amount of capital they have at their disposal as far as you are concerned.
  • And a typical VC fund will have 20, 30, 40 portfolio companies in it, so those funds are allocated to the entire portfolio, not your company.
  • If a VC invests $3mm in your company, they likely have another $3mm reserved for your company and may have as much as $6mm (2x the initial investment) reserved for it. Don’t expect more than that.

At USV, we take reserves very seriously. We know that early stage companies require a fair amount of capital to grow into profitable sustainable businesses and we work hard to make sure that we have the staying power that our portfolio companies require from us. Specifically, we have done two things to help us manage this reserves issue:

  • For each fund we raise, we build a model of the portfolio that lays out all future financing rounds as far as we can predict them. We estimate the timing, size, and probability of that financing round happening. We then run a “monte carlo simulation” of that portfolio to develop a statistical distribution of outcomes. That looks like a normal distribution and we make sure we have a 95% probability of being able to participate in all of these future funding rounds. Practically speaking, this tool allows us to determine how many portfolio companies we should put in each fund before we go back to our investors for another fund.
  • We have raised two Opportunity Funds which allow us to continue to participate in funding rounds for our most successful portfolio companies that start raising very large growth rounds. We also use these Opportunity Funds to occasionally participate in later stage rounds of companies that we did not invest in at the early stage.

One of the most common mistakes I see new “emerging VC managers” make is that they don’t sufficiently reserve for follow-on investments. They don’t go back for a new fund until they have invested 70 to 80% of their first fund and then they run out of money and can’t participate in follow-on rounds. They put too many companies into a portfolio and they can’t support them all. That hurts them because they get diluted by those rounds they can’t participate in. But it also hurts their portfolio companies because the founder and/or CEO has to explain why some of their VC investors aren’t participating in the financing round.

Most people think that VC is all about the initial portfolio construction, selecting the companies to invest in. But the truth is that is only half of it. What happens with the portfolio after you have selected it is the other half. That includes actively managing the portfolio (board work, adding value, etc) and it includes allocating capital to the portfolio in follow-on rounds, and it includes working to get exits. And it is that second part that is the harder part to learn how to do. The best VC firms do it incredibly well and they benefit enormously from it.

What Is Going To Happen In 2017

Happy New Year Everyone. Yesterday we focused on the past, today we are going to focus on the future, specifically this year we are now in. Here’s what I expect to happen this year:

  • Trump will hit the ground running, cutting corporate and personal taxes, and eliminating the preferential treatment of carried interest capital gains. The stock market has already factored in these tax cuts so it won’t be as big of a boon for investors as might be expected, but the seven and half year bull market run will be extended as a result of this tax cut stimulus before being halted by rising rates and/or some boneheaded move by President Trump which seems inevitable. We just don’t know the timing of it. The loss of capital gains treatment on carried interest won’t hurt professional investors too much because the lower personal tax rates will take the sting out of it. In addition, corporations will use the lower tax rates as an excuse to bring back massive amounts of capital that have been locked up overseas, producing a cash surplus that will result in an M&A boom. This will lead to an even more fuel to the fire that is causing “old line” corporations to acquire startups.
  • The IPO market, led by Snapchat, will be white hot. Look for entrepreneurs and the VCs that back them to have IPO fever in 2017. I expect we will see more tech IPOs in 2017 than we have since 2000.
  • The ad:tech market will go the way of search, social, and mobile as investors and entrepreneurs concede that Google and Facebook have won and everyone else has lost. It will be nearly impossible to raise money for an online advertising business in 2017. However, there will be new players, like Snapchat, and existing ones, like Twitter, that succeed by offering advertisers a fundamentally different offering than Facebook and Google do.
  • The SAAS sector will continue to consolidate, driven by a trifecta of legacy enterprise software companies (like Oracle), successful SAAS companies (like Workday), and private equity firms all going in search of additional lines of business and recurring subscription revenue streams.
  • AI will be the new mobile. Investors will ask management what their “AI strategy” is before investing and will be wary of companies that don’t have one.
  • Tech investors will start to adopt genomics as an additional “information technology” investment category, blurring the distinction between life science and tech investors that has existed in the VC sector for the past thirty years. This will lead to a funding frenzy and many investments will go badly. But there will be big winners to be had in this sector and it will be an important category for VCs for the foreseeable future.
  • Google, Facebook, and to a lesser extent Apple and Amazon will be seen as monopolists by government and individuals in the US (as they have been for years outside the US). Things like the fake news crisis will make clear to everyone how reliant we have become on these tech powerhouses and there will be a backlash. It will be Microsoft redux and the government will seek remedies which will be futile. But as in the Microsoft situation, technology, particularly decentralized applications built on open data platforms (ie blockchain technology), will come to the rescue and reduce our reliance on these monopolies. This scenario will take years to play out, but the seeds have been sown and we will start to see this scenario play out in 2017.
  • Cyberwarfare will be front and center in our lives in the same way that nuclear warfare was during the cold war. Crypto will be the equivalent of bomb shelters and we will all be learning about private keys, how to use them, and how to manage them. A company will make crypto mainstream via an easy to use interface and it will become the next big thing.

These are my big predictions for 2017. If my prior track record is any indication, I will be wrong about more of this than I am right. The beauty of the VC business is you don’t have to be right that often, as long as you are right about something big. Which leads to going out on a limb and taking risks. And I think that strategy will pay dividends in 2017. Here’s to a new year and new challenges to overcome.

What Did And Did Not Happen In 2016

As has become my practice, I will end the year (today) looking back and start the year (tomorrow) looking forward.

As a starting point for looking back on 2016, we can start with my What Is Going To Happen In 2016 post from Jan 1st 2016.

Easy to build content (apps) on a cheap widespread hardware platform (smartphones) beat out sophisticated and high resolution content on purpose built expensive hardware (content on VR headsets). We re-learned an old lesson: PC v. mainframe and Mac; Internet v. ISO; VHS v. Betamax; and Android v. iPhone.

And Fitbit proved that the main thing people want to do with a computer on their wrist is help them stay fit. And yet Fitbit ended the year with its stock near its all time low. Pebble sold itself in a distressed transaction to Fitbit. And Apple’s Watch has not gone mainstream two versions into its roadmap.

  • I thought one of the big four (Apple, Google, Facebook, Amazon) would falter in 2016. All produced positive stock performance in 2016. None appear to have faltered in a huge way in 2016. But Apple certainly seems wobbly. They can’t make laptops that anyone wants to use anymore. It’s no longer a certainty that everyone is going to get a new iPhone when the new one ships. The iPad is a declining product. The watch is a mainstream flop. And Microsoft is making better computers than Apple (and maybe operating systems too) these days. You can’t make that kind of critique of Google, Amazon, or Facebook, who all had great years in my book.
  • I predicted the FAA regulations would be a boon to the commercial drone industry. They have been.
  • I predicted publishing inside of Facebook was going to go badly for some high profile publishers in 2016. That does not appear to have been the case. But the ugly downside of Facebook as a publishing platform revealed itself in the form of a fake news crisis that may (or may not) have impacted the Presidential election.
  • Instead of spinning out HBO into a direct Netflix competitor, Time Warner sold itself to AT&T. This allows AT&T to join Comcast and Verizon in the “carriers becoming content companies” club. It seems that the executives who run these large carriers believe it is better to use their massive profits in the carrier business to move up the stack into content instead of continuing to invest in their communications infrastructure. It makes me want to invest in communications infrastructure honestly.
  • Bitcoin found no killer app in 2016, but did find itself the darling of the trader/speculator crowd, ending the year on a killer run and almost breaking the $1000 USD/BTC level. Maybe Bitcoin’s killer app is its value and/or store of value. That would make it the digital equivalent of gold and the likely reserve currency of the digital asset space. And I think that is what has happened with Bitcoin. And there is nothing wrong with that.
  • Slack had a good year in 2016, solidifying its position as the leading communications tool for enterprises (other than email of course). It did have some growing pains as there was a fair bit of executive turmoil. But I think Slack is here to stay and I think they can withstand the growing competition coming from Microsoft’s Teams product and others.
  • I was right that Donald Trump would get the Republican nomination and that the tech sector (with the exception of Peter Thiel and a few other liked minded people) would line up against him. It did not matter. He won the Presidency without the support of the tech sector, but by using its tools (Twitter and Facebook primarily) brilliantly.
  • I predicted “markdown mania” would hit the tech sector hard and employees would start getting cold feet on startups as they saw the value of their options going down. None of this really happened in a big way in 2016. There was some of that and employees are certainly more attuned to how they can get hurt in a down round or recap, but the tech sector has also used a lot of techniques, including repricing options, reloading option plans, and moving to RSUs, to mitigate this. The truth is that startups, venture capital, and tech growth companies had a pretty good year in 2016 all things considered.

So that’s the rundown on my 2016 predictions. I would give myself about a 50% hit rate. Which is not great but not horrible and about the same as I did last year.

Some other things that happened in 2016 that are important and worth talking about are:

  • The era of cyberwars are upon us. Maybe we have been fighting them silently for years. But we are not fighting them silently any more. We are fighting them out in the open. I suspect there is a lot that the public still doesn’t know about what is actually going on in this area. We know what Russia has done in the Presidential election and since then. But what has the US been doing to Russia? I would assume the same and maybe more. If your enemy has the keys to your castle, you had better have the keys to their castle. And as good as the Russians are at hacking into systems, the US has some great hackers too. I am very sure about that.  And so do the Chinese, the Israelis, the Indians, the British, the Germans, the French, the Japanese, etc, etc.  This feels a bit like the Nuclear era redux. Mutually assured destruction is a deterrent as long as both sides have the same tools.
  • The tech sector is no longer the belle of the ball. It has, on one hand become extremely powerful with monopolies, duopolies, or nearly so in search, social media, ecommerce, online advertising, and mobile operating systems. And it has, on the other hand, proven that it is susceptible to the very kinds of bad behavior that every other large industry is capable of. And we now have an incoming President who doesn’t share the love of the tech sector that our outgoing President showed. It brings to mind that scene in 48 Hours where Eddie Murphy throws the shot glass through the mirror and explains to the rednecks that there is a new sheriff in town. But this time, the tech sector are the rednecks.
  • Google and Facebook now control ~75% of the online advertising market and almost all of its growth in 2016:

  • Artificial Intelligence has inserted itself into our every day lives. Whether its a home speaker system that we can talk to, or a social network that already knows what we are about to go out and purchase, or a car that can park itself and change lanes on the highway automatically, we are seeing AI take over tasks that we used to have to do ourselves. We are in the age of AI. It is not something that is coming. It is here. It may have arrived in 2014, or 2015, but if you ask me, I would put 2016 as the year it had its debut in mainstream life. It is exciting and it is scary. It begs all sorts of questions about where we are all going in the next thirty to fifty years. If you are in your twenties, AI will define your lifetime.

So that’s my rundown on 2016. I wish everyone a happy and healthy new year and we will talk about the future, not the past, tomorrow.

If you are in need of a New Year’s Resolution, I suggest moving to super secure passwords and some sort of tool to manage them for you, using two factor authentication whenever and wherever possible, encrypt as much of your online activities as you reasonably can, and not saying or doing anything online that you would not do in public, because that is where you are doing it.

Happy New Year!

Venture Deals 3.0

Like a great software product that keeps getting better and better as it ages, the classic book by Brad Feld and Jason Mendelson, Venture Deals, is now on its third version.

Here is the forward I wrote for the first version of the book and that continues to provide the opening context for it:

I remember the first week of my career as a VC. I was 25 years old, it was 1986, and I had just landed a summer job in a venture capital  firm. I was working for three experienced venture capitalists in a small  firm called Euclid Partners, where I ended up spending the first 10 years of my VC career. One of those three partners, Bliss McCrum, peeked his head into my office (I had an office in Rockefeller Center at age 25) and said to me, “Can you model out a financing for XYZ Company at a $9 million pre-money, raising $3 million, with an unissued option pool of 10%?” and then went back to the big office in the rear he shared with the other founding partner, Milton Pappas.
 
I sat at my desk and started thinking about the request. I understood the “raising $3 million” bit. I thought I could figure out the “unissued option pool of 10%” bit. But what the hell was “pre-money”? I had never heard that term. This was almost a decade before Netscape and Internet search so searching online for it wasn’t an option. After spending ten minutes getting up the courage, I walked back to that big office, peeked my head in, and said to Bliss, “Can you explain pre-money to me?”
 
Thus began my 31-year education in venture capital that is still going on as I write this.
 
The venture capital business was a cottage industry back in 1985, with club deals and a language all of its own. A cynic would say it was designed that way to be opaque to everyone other than the VCs so that they would have all the leverage in negotiations with entrepreneurs. I don’t entirely buy that narrative. I think the VC business grew up in a few small of offices in Boston, New York, and San Francisco, and the dozens—maybe as many as a hundred—of main participants, along with their lawyers, came up with structures that made sense to them. They then developed a shorthand so that they could communicate among themselves.
 
But whatever the origin story was, the language of venture deals is foreign to many and remains opaque and confusing to this day. This works to the advantage of industry insiders and to the disadvantage of those who are new to startups and venture capital.
 
In the early 2000s, after I wound down my first venture capital  firm, Flatiron Partners, and before we started USV, I started blogging. One of my goals with my AVC blog (at www.avc.com) was to bring transparency to this opaque world that I had been inhabiting for almost 20 years. I was joined in this blogging thing by Brad Feld, a friend and frequent coinvestor. Club investing has not gone away and that’s a good thing. By reading AVC and Feld Thoughts regularly, an entrepreneur could get up to speed on startups and venture capital. Brad and I received a tremendous amount of positive feed- back on our efforts to bring transparency to the venture capital business so we kept doing it, and now if you search for something like “participating preferred” you will find posts written by both me and Brad on that first search results page.
 
Brad and his partner Jason Mendelson (a recovering startup lawyer turned VC) took things a step further and wrote a book called Venture Deals back in 2011. It has turned into a classic and is now on its Third Edition. If Venture Deals had been around in 1985, I would not have had to admit to Bliss that I had no idea what pre-money meant.
 
If there is a guidebook to navigating the mysterious and confusing language of venture capital and venture capital financing structures, it is Venture Deals. Anyone interested in startups, entrepreneurship, and angel and venture capital financings should do themselves a favor and read it.
 
Fred Wilson
USV Partner
July 2016

The Dangers Of Being Too Early

I have been reading Whiplash, a book I recommended here last week. It starts with the story of the Lumiere brothers, who are credited with the invention of “the moving picture.”

As told in Whiplash, the Lumiere brothers started showing films to audiences in 1895 using their patented cinematograph. But by 1900, they were out of the film business and had moved on to color photography. The industry they helped to start went on to be one of the biggest new industries of the 20th century.

I often think of the formative years of the Internet, in the early/mid 90s. There are a lot of people from that era that remind me of the Lumiere brothers.

I was in a Board meeting on Friday in my office and one of the executives of the company that was having the Board meeting left to get coffee or use the rest room. When he came back, he said “why do you have one of the Josh Harris Gilligan paintings in your office? I explained that the reason Gilligan hangs in my USV office is to remind me that being first to something doesn’t mean you will profit from it. Josh Harris was the first person to show me audio streaming over the Internet. Josh was the first person to show me video streaming over the Internet. He did both of those things at his Pseudo Programs company that he started in 1993. Around the same time, 1993 ish, Josh predicted to me that auctions would be one of the first big businesses to take shape on the Internet. That was roughly two years before eBay was founded. Josh didn’t profit much from any of his visionary efforts or insights. But there is a Josh Harris painting in my office because I respect being early more than I respect making profits. I think the latter is easier than the former.

Which takes me to some things we have been thinking a lot about at USV recently. Things like Blockchain and Genomics. We think we are very early in these two important technological revolutions. We are investing actively (but not heavily) in one of them (blockchain) and trying to find the right entry point to the other one.

I think that the investing we are doing in these sectors right now is more likely to be like Psuedo Programs than YouTube or SoundCloud.

But I also think that you have to be early to learn the technology and the markets and build the networks and relationships that will allow you to see, understand, and invest in YouTube when it shows up. What you don’t want to do is lose patience or interest and move on, like the Lumiere brothers did.  Early stage VC is a marathon, not a sprint. That is true in everything, from the hold periods, to the work you do with a portfolio company, to the patience you must show towards a sector you think will be important. It is hard to sustain the enthusiasm sometimes, but if you have conviction about something, you have to stay the course.

Fun Friday: What Is Exciting These Days In Tech and Startup Land?

I figured I’d follow up a post taking a shot at the AVC community with one that should engage the AVC community, including me.

And what better to talk about than what excites us these days?

It is no secret to the regular readers that it is hard for me to get excited about the current state of tech and startup land. David said as much in his comment yesterday.

With the exception of blockchain stuff, which seems very early and not yet investable except for fools and the foolhardy (me), I am struggling to find things to get excited about in tech and startup land.

So, let’s all jump into the comments and talk about what excites us about tech and startups right now. Not yesterday, not last year, not five years ago, right now. And if its your startup you are excited about, that’s cool, but please don’t turn the comments into a pitch fest. That’s my life already 🙂

Founder Dilution

I saw a blog post this weekend that looked at the IPO filings of 79 tech companies and calculated the ownerships of the founders and the VCs at IPO.

The result of that analysis is that the average founder ownership at IPO was 17% and the average VC ownership at IPO was 56%.

I’ve written a bunch on this topic and here are two posts that address this exact issue:

Founder Dilution – How Much Is “Normal”?

Employee Equity: Dilution

In both posts, I lay out how the equity gets shared with employees and investors as the company grows and scales.

Here’s the most important quote from those two posts:

In my experience, it will generally take three to four rounds of equity capital to finance the business and 20-25% of the company to recruit and retain a management team. That will typically leave the founder/founder team with 10-20% of the business when it’s all said and done. The equity split at 20% for the founders will typically be; 20-25% for the management team, 20% for the founders, and 55-60% for the investors (angel all the way to late stage VC).

I wrote that seven and half years ago, but on this topic, not much has changed over the thirty years I’ve been doing VC.

Raising round after round of venture capital is expensive. There are some entrepreneurs who figure out how to get profitable and not raise round after round (or avoid VC altogether), there are some entrepreneurs who are able to raise a very high valuations and avoid a lot of dilution, and there are many entrepreneurs who choose to sell the business before they take a lot of dilution. But for the entrepreneurs who raise four to six rounds of VC before going public, the math is the math. If you end up owning more than 20% at IPO, you are beating the averages.

NYC’s FinTech Innovation Lab

Applications are open for New York’s seventh annual FinTech Innovation Lab, a 12-week program that I have blogged about a bunch here on AVC. This proram is for early and growth stage companies that have developed cutting edge technology products targeted at financial services customers. The program has a particular interest in: Augmented/ Virtual Reality; Data Analytics using Artificial Intelligence/Machine Learning; Digital Customer Engagement Tools; Enterprise Dev Ops; RegTech; Security, and other Disruptive Financial Services Models.  For a complete list of focus areas, click here.

The FinTech Innovation Lab is run by the Partnership Fund for New York City and Accenture. Accepted companies will get the chance to refine and beta test their financial technology products in New York City in partnership with the world’s leading financial services firms and receive mentorship from the Lab’s Entrepreneurs Network.

Through a competitive process, the chief technology officers of the participating firms will determine which proposals are accepted for further development and deployment. The participating firms are:  AIG, Alliance Bernstein, Ally Financial, Amalgamated Bank, American Express, AQR, Bank of America, Barclays Capital, BBVA, BlackRock,  Capital One, CIT Group, Citi, Credit Suisse, DE Shaw, Deutsche Bank, Fidelity, Goldman Sachs, Guardian Life Insurance, JPMorgan Chase & Co., KeyBank, MasterCard, Morgan Stanley, New York Life Insurance, Pitney Bowes, Rabobank, Scotiabank, Synchrony, UBS and Wells Fargo.  Several venture firms also support the Lab, including Bain Capital Ventures, Canaan Partners, Contour Venture Partners, Nyca Partners, Rho Ventures, RRE Ventures, and Warburg Pincus.

For more information sign up for their information session on Monday, November 7, 2016 from 5:30 – 6:30 PMRegister

Application deadline is December 1, 2016APPLY

What Are App Coins?

Last week Coin Center published a primer on app coins. It is very good.

I particularly like this part:

Open platforms have proved difficult to create because it has been historically difficult to monetize them even if they become successful—by nature they are public goods. Now, however, the developers of a cloud storage service can incorporate a scarce access-token, an appcoin, into the design, distribute that token to users, retain some amount of the token for themselves, and if the platform proves popular, the token (alongside the holdings of the developers) will grow in value and remunerate the developers for providing a public good. This new model challenges the concept of equity as traditionally understood, and carries entirely different risks and rewards.

The idea that we now have a monetization model for creating and maintaining a public good (ie Twitter) is something that makes me incredibly happy and poses all sorts of interesting questions about the future of venture capital.