Posts from VC & Technology

Using Debt Like Growth Equity

If you are in the venture or startup business and don’t read Dan Primack, consider changing that. He’s great.

From his newsletter this morning:

Indebted: Last week we noted that Wal-Mart subsidiary Jet.com had acquired ModCloth, an online retailer of vintage women’s apparel. No financial terms were disclosed, but this didn’t feel like a success for either ModCloth or the venture capitalists who had invested over $70 million into the business since its founding 15 years earlier. Here’s what happened, per sources familiar with the situation:

  • In 2013 ModCloth went out in search of Series C funding, but the process was felled by a back-to-back pair of lousy quarters. So instead it accepted $20 million in unsecured bank debt.
  • ModCloth effectively treated the debt like growth equity, rather than recognizing the time bomb it could become.
  • When the debt first came due in April 2015, existing ModCloth investors pumped in new equity to, in part, kick repayment down the road for two years. This came amid four to five straight quarters of profitability, and just after the company brought in a former Urban Outfitters executive as CEO.
  • Once the income statement returned to the red, ModCloth again tried raising equity ― but prospective investors cited the debt overhang as their reason for passing on a company whose unit economics were otherwise fundable. Insiders could have stepped up but didn’t.
  • Jet.com heard of ModCloth’s debt coming due debt month, and pounced. We’ve been unable to learn the exact amount it paid, except that the amount left over for VCs after repaying the debt (and accounting for receivables) won’t be nearly enough to make them whole.
  • 2 takeaways: (1) Debt is not inherently troublesome for startups, particularly if it’s supplementing equity as opposed to substituting for equity. But startups must recognize that not all cash is created equal. (2) ModCloth was founded in Pittsburgh, but later moved its HQ to San Francisco. It’s impossible to know if things would have worked out differently had the company remained in the Steel City, but some of its quirky retail culture did seem to get commingled with the “grow grow” tech etho

I have lived this story several times in my career and we are seeing this play out again in the market.

It is tempting to use debt instead of equity to finance a high growth company, particularly when you cannot get equity investors to value your company “fairly.” When a company has achieved “escape velocity” and is growing quickly, lenders look at it and say “there is enterprise/takeout value here and we are senior to the equity so the risk to us is pretty low.” And so they will underwrite a loan to the company even though the market hasn’t made up its mind on how to properly value the equity. So the temptation all around the table is to take the debt and kick the can down the road on the equity in the view that more time, more growth, more market validation will fix things.

This can work out well. Our portfolio company Foursquare is an example of where this did work out well. A debt deal in the middle of a business model pivot gave that company the time to re-engineer its business model and validate it. And time also allowed the company to come to terms with how the equity markets would value it and its new business model. Foursquare went on to raise another round of equity capital and refinance its debt and is in a great place now.

But, as the Modcloth story points out, debt can also work against you. If you can’t execute well post raising debt and get to another equity round or some other transaction (an attractive exit being the other obvious option), then you can have your debt called from under you and lose the control over the timing and terms of your exit. I lived through this story with a company I backed in 1999 and which was sold a few years ago in a transaction that was very good for the lenders and good for the management and very bad for the early equity investors.

Dan’s point that substituting debt for growth equity is a risky bet is spot on. That doesn’t mean it shouldn’t be done. But it should be done with care and with eyes wide open.

Convertible and SAFE Notes

Angel/seed rounds used to be done via priced equity securities, either common or preferred. Then, starting about ten years ago, we started to see convertible debt being used in the angel and seed rounds. By 2010 this was the norm and Paul Graham tweeted this in Aug 2010:

Which led me to write this blog post here on AVC. I was not a fan of convertible notes then and I am not a fan of them now. USV has done a number of convertible and SAFE notes since then. I would guess that we have done a dozen or more of them in seed and angel rounds we have participated in. We are not opposed to convertible and SAFE notes and will not let the form of security the founder wants to use get between us and investing in a company that we like.

But I continue to think that convertible and SAFE notes are not in the best interests of the founder(s).

Here is why:

  1. They defer the issue of valuation and, more importantly, dilution, until a later date. I think dilution is way too important of an issue to defer, for even a second.
  2. They obfuscate the amount of dilution the founder(s) is taking. I think many investors actually like this. I do not. I believe a founding team should know exactly how much of the company they own at every second of the journey. Notes hide this from them, particularly the less sophisticated founders.
  3. They can build up, like a house of cards, on top of each other and then come crashing down on the founder(s) at some point when a priced round actually happens. This is the worst thing about notes and doing more than one is almost always a problem in the making.
  4. They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot actually deliver down the round when the notes convert. I cannot tell you how many angry pissed off angel investors I have had to talk off the ledge when we are leading a priced round and they see the cap table and they own a LOT less than they thought they did. And they blame the founder(s) or us for it and it is honestly not anyone’s fault other than the harebrained structure (notes) they used to finance their company.

The Series A focused VC firms that often lead the first priced rounds get to see this nightmare fold out all the time. The company has been around for a few years and has financed itself along the way with all sorts of various notes at various caps (or no cap) and finally the whole fucking mess is resolved and nobody owns anywhere near as much as they had thought. Sometimes we get blamed for leading such a dilutive round, but I don’t care so much about that, I care about the fact that we are allowing these young companies to finance themselves in a way that allows such a thing to happen.

Here are some suggestions for the entire angel/seed sector (founders, angel investors, seed investors, lawyers):

  1. Do priced equity rounds instead of notes. As I wrote seven years ago, the cost of doing a simple seed equity deal has come way down. It can easily be done for less than $5k in a few days and we do that quite often.
  2. The first convertible or SAFE note issued in a company should have a cap on the total amount of notes than can be issued. A number like $1mm or max $2mm sounds right to me.
  3. Don’t do multiple rounds of notes with multiple caps. It always ends badly for everyone, including the founder.
  4. Founders should insist that their lawyers publish, to them and the angel/seed investors, a “pro-forma” cap table at the closing of the note that shows how much of the company each of them would own if the note converted immediately at different prices. This “pro-forma” cap table should be updated each and every time another note is isssued. Most importantly, we cannot and should not continue to allow founders to issue notes to investors and not understand how much dilution they are taking on each time they do it. This is WRONG.

Honestly, I wish the whole scourge of notes would go away and we could go back to the way things were done for the first twenty years I was in the venture capital business. I think it would be a better thing for everyone. But if we can’t put the genie back in the bottle, we can at least bottle it up a bit better. Because it is causing a lot of problems for everyone.

The Bloomberg Startup Barometer

I came across this index from Bloomberg that tracks the health of the US startup ecosystem.

This index “incorporates both the money flowing into VC-backed startups, as well as the exits that are making money for investors. To smooth out some of the volatility, we calculated the average value for the last 12 weeks.”

I like that they are tracking both inflows (investments) and outflows (exits). What’s interesting is that over the past year, the exit chart is looking better than the investment chart:

If exits continue to outpace investments, that’s a very bullish thing for the startup sector, particularly for investors. But what is good for investors is ultimately good for founders because strong performance will lead to more capital flowing into the sector.

This chart is investments since 2007:

You can see that the VC sector ramped its investing activity significantly in 2010 & 2011 and has maintained it at roughly those levels (with some tailoff recently) since then.

This chart is exits since 2007:

You can see that exits did not start increasing until 2014, roughly three to four years after the significant pickup in investment pace. That makes sense because of the “gestation period” of startups is at least four years and in most cases longer.

I will be keeping my eye on this new index from time to time. And I will be most interested in the shape of the exit chart because it is the strongest predictor of the long term health of the startup ecosystem.

Video Of The Week: Mark Cuban At Upfront Summit

I posted the discussion my partner Andy and I did at the Upfront Summit last week.

There were other great conversations at the Upfront Summit.

This discussion with Mark Cuban was great. I totally agree with Mark that we need more tech companies to go public and have been saying that publicly for several years.

The End Of The Level Playing Field

I am old enough to remember the gogo days of cable TV when entrepreneurs who wanted to launch a new cable channel would go, hat in hand and cap table in tow, to the big cable companies and beg to get distribution on their networks. 

When the Internet came along in the early 90s, we saw something completely different. Here was a level playing field where anyone could launch a business without permission from anyone. 

We had a great run over the last 25 years but I fear it’s coming to an end, brought on by the growing consolidation of market power in the big consumer facing tech companies like Google, Apple, Facebook, Amazon, etc, by the constricted distribution mechanisms on mobile devices, and by new leadership at the FCC that is going to tear down the notion that mobile carriers can’t play the same game cable companies played.

Here is a quote from the incoming FCC Chair:

“Today, the Wireless Telecommunications Bureau is closing its investigation into wireless carriers’ free-data offerings,” FCC Chairman Ajit Pai said in a statement. “These free-data plans have proven to be popular among consumers, particularly low-income Americans, and have enhanced competition in the wireless marketplace. Going forward, the Federal Communications Commission will not focus on denying Americans free data. Instead, we will concentrate on expanding broadband deployment and encouraging innovative service offerings.”

It is certainly true that consumers, particularly low-income consumers, like getting free or subsidized data plans. There is no doubt about that. But when the subsidies are coming from the big tech companies, who can easily pay them, to buy competitive advantage over that nimble startup that is scaring them, well we know how that movie ends.

It is sad to see this era ending. It was a lot of fun and quite profitable too. I am hopeful that some new competitive vector, like the Internet, will come along and make all of this moot and we are spending a lot of our time looking for it. Because backing startups on a field tilted in the favor of the incumbents is not fun and not particularly profitable either.

Generational Transition In VC Firms

Today, sometime around 5:30/6pm PT at the Upfront Summit, my partner Andy and I are going to talk about generational change in VC firms, in a talk moderated by Lindel Eakman, who has been our lead limited partner investor at USV since we started the firm in 2003.

The subject is timely with the news that the leadership of Sequoia, surely one of the greatest VC firms in the business, is transitioning a third time, from Jim Goetz to Roelof Botha and Alfred Lin.

I don’t want to steal our thunder for what is going to be a lively conversation with Lindel this afternoon, but I think this is a very important topic. When my partner Brad Burnham and I started USV in 2003, we told prospective investors, including Lindel, that we had no intention of building an institution. We said we just wanted to create a place we could do great work and when we were done, the firm would be done as well.

That was naive. Whether we like it or not, we did create an institution at USV and the key stakeholders in that institution are not the partners of USV, or the team at USV, or the limited partners at USV. The key stakeholders are the founders, leaders, and team members of the 80ish portfolio companies of USV. They have attached their companies to our brand and we owe it to them to sustain it and build it over time.

I didn’t understand that in 2003, but I do now. And so did Don Valentine in 1996 when he passed the baton to Mike and Doug. That is an act of courage and respect for what is special about a venture capital firm and I think it is something to emulate. Which we are doing at USV now and which Andy and I will talk more about later today.

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.