Posts from VC & Technology

Burn Baby Burn

Andy sent me a WSJ piece with Bill Gurley yesterday. I don’t like to link to paid content so here’s a good Business Insider summary of the article that is open for anyone to read.

Regular readers know that I’m a huge fan of Bill’s. He’s as smart as they come and I generally agree with him on things. As I was reading the WSJ piece, I found myself nodding my head and saying “yes”, “yes”, “yes”.

The thing I like so much about Bill’s point of view is that he does not focus on valuations as a measure of risk. He focuses on burn rates instead. That’s very smart and from my experience, very accurate.

Valuations can be fixed. You can do a down round, or three or four flat ones, until you get the price right.

But burn rates are exactly that. Burning cash. Losing money. Emphasis on the losing.

And they are indeed sky high all over the US startup sector right now. And our portfolio is not immune to it. We have multiple portfolio companies burning multiple millions of dollars a month. Thankfully its not our entire portfolio. But it is more than I’d like and more than I’m personally comfortable with.

I’ve been grumpy for months, possibly for longer than that, about this. I’ve pushed back on long term leases that I thought were outrageous, I’ve pushed back on spending plans that I thought were too aggressive and too risky, I’ve made myself a pain in the ass to more than a few CEOs.

I’m really happy that I’m not alone in thinking this way. At some point you have to build a real business, generate real profits, sustain the company without the largess of investor’s capital, and start producing value the old fashioned way. We have a number of companies in our portfolio that do that. And I love them for it. I wish we had more.

Next Wednesday Is The Internet Slowdown

We’ve talked a lot here at AVC about Net Neutrality. I hate that term because it’s got so much baggage now that it is essentially meaningless to me. What I want to see is a framework that everyone agrees to (application developers, bandwidth providers, last mile access providers, and the regulators) that says you can’t prioritize one bit over another in the last mile access network and you can’t charge application developers to deliver their bits to the end user.

This issue is coming to a head at the FCC as the comment period is ending and some sort of decision will be made this fall. So next Wednesday, September 10th, is the Internet’s opportunity to stand up and be heard.

If you are with me on this issue, please consider joining the Internet Slowdown campaign next Wednesday. There are all sorts of ways you can do this. You can change your avatars on your social media profiles, you can send push notifications if you operate a mobile app, you can put a slow loading graphic on your blog or website (there are WordPress widgets if you are on WordPress like I am).

And if you still aren’t convinced, please read Chad Dickerson’s piece in Wired this week on why this issue is important to businesses and everyone who uses the Internet to reach their customers and/or audience.

Video Of The Week: A Lunchtime Talk In Larkin Square, Buffalo

A few weeks ago, I spent most of the week in the upper midwest. I started out on Tuesday in Buffalo, NY, the location of my first venture capital investment, Upgrade Corporation of America. I did office hours at the Z80 accelerator and then did a lunchtime Q&A in the beautifully renovated Larkin Square with Eric Reich.

This is a video of that talk. If you want to skip all the intros, go ten minutes in. The talk is about 40mins long.

Q&A With Fred Wilson and Eric Reich – Aug 2014 from Z80 Labs Technology Incubator on Vimeo.

Reblog: Let Your Winners Run

One of the things I am going to do on this extended vacation is go back into the archives and reblog posts that I think are still fresh and relevant. I’ll start with this one from Feb 2012.

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I met with a group of very experienced and sophisticated investors yesterday who make up the investment committee of a large charitable foundation that is an investor in USV. I gave them a two minute brief on our macro investment thesis (large networks of engaged users that can disrupt big markets) and then took them on a tour of some of these large networks (Lending Club, Kickstarter, Etsy, Twitter, and Codecademy).  Then I took questions.

This group doesn’t spend a ton of time on AVC, Techmeme, Hacker News, or the tech industry in general. And yet the questions they asked me were as good as I ever get. I guess four decades of investing teaches you a lot.

One of the best questions I got was “when do you decide to sell?”. Such a great question and such a hard one to answer. I’ve got scars from this one.

I explained that first and foremost, we generally don’t make that call. The entrepreneur and her management team generally makes that call and the board is asked to ratify it.

But when and if we get to weigh in on the timing of the exit, my view is that you look to exit your weakest investments as soon as you can and you let your winners run as long as you can.

USV 2004 is instructive. Between 2004 and 2008, we made investments in 21 companies. So the youngest portfolio company in that portfolio is four years old now. Most are five to six years old. And a few, like Meetup and Return Path, are ten years old or more. We’ve exited six of the 21 investments, you can see them here, under past investments at the bottom.

We still have fifteen investments active in that portfolio including Zynga and Twitter and we own large blocks of stock in both of those companies. We own stakes in thirteen other portfolio companies most of which we believe are super strong companies that are building large and sustainable businesses. We will likely exit a few weaker investments in that portfolio over this year and next. But there are at least ten companies in the USV 2004 portfolio that we would be happy to own for the rest of this decade.

This does create a bit of an issue in that we raise ten year venture capital funds. So we are supposed to wind things up in the 2004 fund in another two years. But I am fairly sure that my partners and I and our limited partners will be happy to let this fund play itself out over a longer period of time.

I’ve made the mistake of exiting investments too quickly. Back in the middle of 2007, my previous firm Flatiron exited our investment in Mercado Libre at the IPO selling our entire position for about a 10x gain. In the almost five years that MELI has been public, it has gone up 5x. So had we held our position for another five years, we’d have made 50x instead of 10x. That stings. Lesson learned.

When you have portfolio companies that are category creators, category leaders, who are well managed, and growing 50% per year or more and delivering 20-30% pre-tax margins (or more), and who have no existential threats to their market leadership, you might want to hang on to them for a bit. They may be just getting going on the valuation creation thing.

Reblogging An Old Post: The Word Bubble

I wrote this in 2011. I think it’s as true today as it was then. It’s interesting that Marc Andreessen, in the video I posted over the weekend, also links the word Bubble in his mind to the Internet bubble that we all lived through. I guess for a certain cohort of investors, that is a very definitive moment in our lives that we will always be scarred by.

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In all the posts over the past year or so outlining my thoughts on the financing and valuation environment in the internet sector, I’ve avoided using the word Bubble. It is intentional. For me Bubble will always be inexorably linked to what went down in 1999 and 2000 in the internet sector. And I agree with Mike Arrington that what is going on now is different. I do not think we are in a Bubble per se. That is why I don’t use the word.

But I am equally sure that we are in the glass is half full part of the cycle. Investors are focusing on the upside and ignoring the downside. That part of the investment cycle lasts for a while and then things change and investors focus on the downside and ignore the upside. Markets are defined by greed and fear. We are in the greed mode right now.

I don’t view this as whining. There is nothing to whine about. Investors are making money hand over fist. Why would I whine about that? But I do think it is important to point out the inevitability of the market cycles. There will come a time when the environment we are in will be in the rear view mirror. And entrepreneurs should be crystal clear about that. This is a time to raise money and sock it away for a rainy day. Because it will rain.

And investors should recognize that the current valuation environment will not exist at some point in the future. The companies we invest in will need to grow into these valuations or we will face writedowns and writeoffs. We should not let the greed emotions cloud our judgement. Yes, that hot deal sure looks damn good right now. But deals are actually companies and most venture investments are held for five to seven years. I’ve likened them to marriages over the years. Don’t let the lust for the deal lead to a bad marriage that you have to be in for the next decade.

I’ve made all of these mistakes. I know what happens. I am prepared for it. That doesn’t mean we aren’t investing in this cycle. We are as active as we’ve ever been. But we are investing at this stage of the cycle with our eyes wide open. And I’m writing about it in the hopes that others do the same.

Tearing Down The Teardown

CB Insights published a “teardown” of USV’s investment strategy last week. It’s a pretty solid piece of work considering they did not have access to any of our internal data.

The got some stuff wrong, however.

1) We did not participate in Zynga’s “megaround” in Feb 2011.

2) We only have six main investment vehicles;

USV 2004 – $125mm

USV 2008 – $160mm

USV Opportunity Fund – $125mm

USV 2012 – $200mm

USV 2014 – $175mm

USV Opportunity 2014 – $175mm

3) We have invested in a lot more than four YC companies. I think the number is closer to ten. I think YC is by far the investor we follow the most, particularly in recent years.

But, as I said, they did a pretty good job considering they don’t have access to our internal data. And I do not believe our limited partners are sharing our reports with them.

What this shows is that the venture capital business is becoming more transparent because so much of our investment activity, and the activity of our peers, is being tracked as it happens. When we raise a fund, that is reported (we must disclose that fact due to securities regulations). When we make an investment, that is generally announced by the portfolio company. And there are reporting requirements for that too. It is possible to do a stealth financing, but it’s not easy. When we make a follow-on investment, that is often announced and/or disclosed. And most exits are disclosed.

What is harder to figure out is what our ownership levels are in our portfolio companies. If you knew the amount we invested and the valuation of the round, you could figure that out. But that would be very hard to do accurately and consistently. I don’t think anyone is going to be able to do a teardown of a VC fund and its returns any time soon.

But even so, it’s impressive what CB Insights and others are doing to track and measure and report on VCs and their investment activities. Entrepreneurs should be able to get some third party assessment of the quality and performance of the VCs they might work with. That’s totally possible now and I think that’s a good thing.

The Dentist Office Software Story

I’ve been telling this fictional story about Dentist Office Software for years to describe why we are so focused on our “networks” investment strategy. Yesterday I told it at a HackNY event we did at the USV office and my partner Albert provided a finishing touch that really drives it home. Since I’ve never told the Dentist Office Software story here at AVC, I will do that and then I will add Albert’s alternate (and better) ending.

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An entrepreneur, tired of the long waits he is experiencing in his dentist’s office, decides that dentist offices are badly managed. So he designs and builds a comprehensive dentist office management system and brings it to market. The software is expensive, at $25,000 per year per dentist office, but it’s a hit anyway as dentists realize significant cost savings after deploying the system. The company, Dentasoft, grows quickly into a $100mm annual revenue business, goes public, and trades up to a billion dollar valuation.

Two young entrepreneurs graduate from college, and go to YC. They pitch PG on a low cost version of Dentasoft, which will be built on a modern software stock and include mobile apps for the dentist to remotely manage his office from the golf course. PG likes the idea and they are accepted into YC. Their company, Dent.io, gets their product in market quickly and prices it at $5,000 per year per office. Dentists like this new entrant and start switching over in droves. Dentasoft misses its quarter, citing competitive pressures, churn, and declining revenues. Dentasoft stock crashes. Meanwhile, Dent.io does a growth round from Sequoia and hires a CEO out of Workday.

Around this time, an open source community crops up to build an open source version of dental office software. This open source project is called DentOps. The project takes on real life as its leader, a former dentist turned socialist blogger and software developer named NitrousOxide, has a real agenda to disrupt the entire dental industry. A hosted version of DentOps called DentHub is launched and becomes very popular with forward thinking dentist offices that don’t want to be hostage to companies like Dentasoft and Dent.io anymore.

Dentasoft is forced to file for bankruptcy protection while they restructure their $100mm debt round they took a year after going public. Dent.io’s board fires its CEO and begs the founders to come back and take control of the struggling company. NitrousOxide is featured on the cover of Wired as the man who disrupted the dental industry.

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That’s the story. I hope to fine folks at YC, Sequoia, and Workday don’t mind me using their names in this fictional story. I picked the very best companies in the industry and my use of their brands is a compliment. I hope they take it that way.

This story is designed to illustrate the fact that software alone is a commodity. There is nothing stopping anyone from copying the feature set, making it better, cheaper, and faster. And they will do that. This is the reality that Brad and I stared at in 2003 as we were developing our initial investment thesis for USV. We saw the cloud coming but did not want to invest in commodity software delivered in the cloud. So we asked ourselves, “what will provide defensibility” and the answer we came to was networks of users, transactions, or data inside the software. We felt that if an entrepreneur could include something other than features and functions in their software, something that was not a commodity, then their software would be more defensible. That led us to social media, to Delicious, Tumblr, and Twitter. And marketplaces like Etsy, Lending Club, and Kickstarter. And enterprise oriented networks like Workmarket, C2FO, and SiftScience. We have not perfectly executed our investment strategy by any means. We’ve missed a lot of amazing networks. And we’ve invested in things that weren’t even close to networks. But all of that said, our thesis has delivered for us and we stick to it as much as we can.

So here’s Albert’s alternate ending (with my editorial license on the colorful aspects of this story):

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A young dentist, named Hoff Reidman, just starting up his own private practice, decides that he wants to network with other dentists. Because Hoff went to CMU before going to dental school, he’s pretty technical and he hacks together a site in Ruby called Dentistry.com. He emails all of his friends from dental school and they sign up. Every dentist wants to be on Dentistry.com and the site takes off. Hoff realizes he has to quit his dental practice to focus on Dentistry.com. Albert Wenger, who happens to be a patient of Hoff’s, convinces him to let USV do a small seed round of $1mm to help build a company around Dentistry.com. Hoff comes up with a product roadmap that allows patients to have profiles on Dentistry.com where they can keep their dental records, book appointments, and keep track of their dental health. It also includes mobile apps for patients to remind them to floss and brush at least twice a day. While Dentistry.com is free to use for anyone (dentist or patient), it monetizes with native advertising, transactions between dentists and their patients, and transactions between patients and providers of consumer dental health products, and transactions between dentists and providers of dental equipment and products. Dentistry.com ultimately grows into a $1bn revenue company and goes public trades at a market cap of $7.5bn. Wall Street analysts love the company citing its market power and defensible network effects.

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I hope you enjoyed this fictional story. I find it explains our network thesis simply and easily. I will keep telling it to groups I talk to, but now with Albert’s ending. I like it very much. Thanks Albert.

On Getting An Outside Lead

There are some “truths” in the venture capital business that I have been hearing since I got into this game in the mid 80s. One of them is that getting “third party validation” by going outside of the current investor syndicate to find a new lead is good for the investors. I have come to believe this “wisdom” is nothing more than lack of conviction on the investor’s part.

What “super powers” do VCs have that allow them produce above average returns year after year after year? Well you could argue that some of us have the ability to see things before others see them. That might be true but it is hard to sustain that for a long time. You might argue that some of us have brands that allow us to get into the conversations with the best entrepreneurs when others can’t. That is most certainly true. You could argue that some of us have a tight focus on an investment strategy and work it tirelessly and don’t veer from it. That is most certainly true.

But short of those three things, I am not aware of a sustainable model that produces above average returns on investing in “new names”. However, there are two “super powers” that VCs have at their disposal that can produce above average returns year after year if they use them correctly. Those are the right to a board seat and the right to invest in round after round after round. I talked a bit about the latter one last week.

Taken together, these two rights put VCs in a position to intelligently invest in their existing portfolio companies. I believe that you can turn an average portfolio producing average returns into an average portfolio producing above average returns by intelligently investing in your existing portfolio companies.

It is one thing to take your pro-rata, and I talked a lot about that last week. But it is another thing to lead the next round and increase your ownership. It’s this latter move that I think many of us in the VC business instinctively avoid for fear that we are “falling in love with our companies.” Anyone who has been in the VC business for a long time has made the mistake of believing too much in a portfolio company and supporting it beyond when you rationally should. I have made that mistake so many times I can’t count them on two hands. It is my signature failure and I have not been able to stop doing it.

But, I would argue, the worse mistake is to know you’ve got a winner in your portfolio long before anyone else knows it and you allow a new investor to come in and lead the next round when you easily could and should. The upside on your best investments is the thing that allows an early stage VC to take so much risk and lose money on so many investments. Increasing the upside on the best investments is a rational move in light of the distribution of outcomes in a VC fund.

I would caveat all of this with a few things:

1) You have to let the entrepreneur do what they think is best for them and their company. If they want an outside lead, then by all means you should support that and work as hard as you can to make it happen.

2) You have to think about the amount of “dry powder” the current syndicate has and make sure that you aren’t using all of it up by leading a round when you should really be bringing in a new investor.

3) If an insider is leading a round, you should put a very fair deal on the table for the entrepreneur and the company. An inside lead is not about getting a “sweetheart” deal. It is about putting in place a fair deal for everyone.

4) If the valuation expectations of the founder and the company are unrealistic, then you should suggest that they go test the market. If there is a better offer out there at a better price than you would pay, that is always a good outcome for everyone.

There is a lot of signaling risk in all of this. If you are known to be aggressive in offering to lead inside rounds, and you don’t make that offer, then that puts the entrepreneur in a tricky spot. Of course the entrepreneur can say that they don’t want an inside lead and they want to expand the investor base. But even so, smart investors may know. Truth be told, there is signaling risk in everything that the existing investors do and anyone who thinks otherwise is just not seeing straight.

Two of my favorite examples of this strategy are YouTube and our portfolio company Etsy. At YouTube, Sequoia led the Series A and as far as I can tell (I’m not 100% sure), they led every round after that until the company sold to Google. That allowed Sequoia to allocate more and more capital to what was an incredibly great company and investment and get a massive return on a sale that sure felt like a monster at the time. At Etsy, USV participated in the seed round with some angel investors. We led the Series A and the Series B and increased our ownership substantially by doing that. On the Series C, Rob Kalin decided to get an outside lead and we were totally supportive of that decision. In both cases, I expect (or know) that the VCs had a better idea of how things were going (well!!!!) than anyone outside of the company.

There was a meme in the comment thread on my post last week (104 comments) about “insider trading”. I’d like to say something about that without getting legal or technical. In my view, insider trading is taking advantage of someone buying a stock from you or someone selling stock to you when you know something that they do not. It is illegal and should be. Purchasing stock from a portfolio company is unlikely to be insider trading because how can anyone suggest that you know more about a company than the company knows about itself? I guess that’s possible, but it’s a hard argument to make with a straight face. So while this insider lead thing may smell to some as insider trading, I am very confident it is nothing of the sort.

So in summary, when you have conviction that one of your investments is doing really well, you should have the courage to offer to lead an inside round (assuming you have sufficient capital including future reserves to do that). You should make the case to the entrepreneur and the board why that is a good idea. And if they decide to go outside and find a new lead, you should support that decision and do everything you can to make that strategy a success. I don’t think enough VCs do this and I think they should.

The Pro-Rata Opportunity

Mark Suster has a good (and long as is his wont) post up on the topic of the changing structure of the VC business.

Mark focuses on something important that is probably not getting talked enough about when people talk about the VC business these days. I like this slide from his post:

suster slide

“Capturing pro-rata” is sooooo important in early stage venture. You make 20 investments in a fund. One is going to return the entire fund. Two more are going to return it again. A few more are going to have strong outcomes and return it again. The rest are noise when it comes to fund returns (but you better not treat them like noise).

Guess what? Early stage VC is a lot like poker. You want to go all in on your best hands. And if you make a seed or Series A investment, you get something called the pro-rata right. That means you get to invest an amount in every private round going forward that allows you to keep your ownership at the current level. A pro-rata right in Facebook, Twitter, Dropbox, Airbnb, Uber, ……….. is worth a lot. And early stage investors get those rights for free in the early stage rounds.

At USV, we recognized this early on but did not know what to do about it. So we let our pro-rata rights go unused in Zynga and Twitter because we did not have the funds to take those allocations. Brad agitated about it. It bugged him. I was also unhappy about it but did not want to increase our fund size so that we could take these allocations. I strongly believe in small fund sizes. It’s a core of our strategy at USV.

So we came up with The Opportunity Fund. It’s a companion fund that is designed to “capture pro-rata” as Mark puts it. We raised our first one in late 2010 and our second one earlier this year. It has been a big success. It is now so much a core of what we do that we now raise an early stage fund and an opportunity fund as a pair. You can’t invest in one without investing in the other. They have different economics for the LPs because they require different amounts of work on our part and because we don’t want to commit to put the entire Opportunity Fund to work (we did not put the entire initial Opportunity Fund to work).

When a company hits escape velocity, the investors in the inside are the first (after the entrepreneurs) to realize it. And if you’ve watched hundreds of rockets go up in your career and dozens hit escape velocity, you start to be able to smell escape velocity coming. That means that “capturing pro-rata” is an opportunistic thing. Seeing something before others see it is one of the few legal and sustainable ways to make money that I know of in the investment business. And so having a vehicle to do this aggressively is a huge weapon in the hands of an experienced VC firm.

Yes it is true, as Mark points out in his post, that public market investors are also coming into the private markets in a big way to capture all of this valuation expansion that used to happen in the public markets. But they do not have the one thing that we have – the pro-rata right. And so using it becomes even more important.

I am glad that Mark took the time to write his post on this topic. It’s a big change that has happened fairly quickly in the early stage venture capital business (all post financial crisis) and the ramifications of it are important to entrepreneurs, VCs, public market investors, and LPs. I’m very pleased that USV has been early to this theme and a thought leader in it.