Posts from VC & Technology

Power Law And The Long Tail

If you look at the distribution of outcomes in a venture fund, you will see that it is a classic power law curve, with the best investment in each fund towering over the rest, followed by a few other strong investments, followed by a few other decent ones, and then a long tail of investments that don’t move the needle for the VC fund.

But that long tail is comprised of entrepreneurs and their teams. People who have given years of their lives to a dream that was ultimately not realized.

And as I have written many times over the years on this blog, I spent the majority of my time on that long tail. This is irrational behavior if you think about fund economics, but I believe it is rational behavior if you think about firm reputation.

The best thing you can do for this long tail is find a good home for the portfolio company. That could be everything from a modest acquisition to an acqui-hire. If you have to do a shutdown, then I like to see it done on terms the entrepreneur can live with.

All of these actions require irrational economic behavior from the investor(s). The goal is to get an exit that everyone can feel good about. The goal is not to maximize the VC’s returns from a failed investment. Because it doesn’t matter to the fund economics one bit but it can matter a lot to the entrepreneur and his or her team.

The Blurring Of The Public And Private Markets

Five or six years ago, as the USV team was discussing the evolution of late stage financings and secondaries on the venture landscape, our partner Albert described something to us that was, in hindsight, very prescient. He said “there is no reason why there is such a bright line between public and private markets, we should have one market where the more a company discloses, the more liquid their security becomes” (or something like that). His point was that the only thing that really matters is how much information a company is willing to disclose.

We are increasingly seeing what Albert described to us come to pass. The ability to raise large sums of capital from public market investors has been available to privately held companies for a number of years now. There is no real difference between the public markets and the late stage growth markets in terms of availability of capital. That was not true a decade ago.

With the recent SEC adoption of Title III of the Jobs Act, non-accredited investors can start investing in private companies. There are limitations and reporting requirements which will certainly limit the adoption of Title III fundraising, but even so, we have crossed a threshold here that should lead to more individuals investing in privately held businesses over time.

Privately held companies are increasingly using electronic stock ledgers (like the one our portfolio company eShares offers) which allow them to easily manage a large and rapidly changing cap table, much like the function that brokers and transfer agents provide in the public markets.

So, as you can see, we are slowly witnessing the blurring of the lines between the public and private markets.

But maybe the biggest “tell” is the recent brouhaha over Fidelity’s public markdowns on its holdings of well known startups. One of the many reasons companies don’t want to go public is they don’t want to have to deal with a valuation that moves around all the time without their ability to manage it. Well guess what? If you raise from certain investors in the late stage growth market, you are doing that, even if you didn’t realize it.

I don’t think we will see less of these public markdowns. I think we will see more of them. And we VCs are now facing the choice of whether to markdown our portfolios in reaction to Fidelity’s markdowns or explain to our investors and auditors why we did not do that. Since our quarterly holding values don’t really matter to us (cash on cash returns are what matters), it’s easier to markdown than discuss why we didn’t do that.

It’s interesting and noteworthy that when the private capital markets got the benefit of large pools of capital coming in, that came with increasing transparency. Of course it did. We just didn’t realize that was going to happen. Staying private won’t shield you from the pains of going public. Because the lines are blurring between the private and public markets and we are in for more blurring and it will come faster in the coming years. Be careful for what you wish for, you may just get it.

Startup Physics

I have used the word “physics” to describe a few things here at AVC over the years. I am tempted to write a “textbook” on this topic as I have observed many “formulas” over the years that seem to repeat themselves again and again.

A few examples are this post on the relationship between monthly actives, daily actives, and concurrent users, or this one on the elasticity of paid vs free services. I also wrote one about the numeric relationship between creators, curators, and consumers on a platform but I’m having trouble finding it and linking to it right now.

Yesterday I suggested another to William Mougayar via Kik when he observed to me that valuation mania has emerged in the blockchain for financial institution space.

I told him that when you are looking at financial manias, the amplitude of the mania is inversely correlated to its duration.

I like to think of these manias as waveforms. When they build slowly they last longer. When they develop overnight, they dissipate quickly as well.

This rule also works pretty well for consumer internet services.

Software Is The New Oil

I was with some friends this weekend and one of them was talking about an investment committee meeting he attended and there was a discussion at that meeting about some of the threats out there in the macro investment landscape. One of them was “vanishing liquidity” and the significant change in net cash flows from the global oil sector. Oil producing regions have gone from being a massive cash generator to a relatively small one in the past few years. Now this could well be a temporary thing as the oil market adjusts to some new realities. This post is not really about oil, even though that word is in the title of this post.

As I pondered that, I thought about oil’s role as the thing that captured the economic surplus of the industrial revolution. You can’t run factories, railroads, trucks, etc without carbon-based products and in particular oil. So oil has been a cash/capital magnet for the wealth that the industrial revolution produced. Those that owned oil producing assets (or better yet, oil producing regions) sat back and collected the economic surplus of the industrial revolution and that has been a path to vast wealth and economic power.

What is that same thing in the information revolution? And where is cash piling up around the world? On tech company balance sheets, of course. Apple has $200bn of cash on its balance sheet and produced $53bn of cash in the six months ending March 2015. Microsoft has $110bn of cash on its balance sheet and produced $30bn of cash in the year ended June 2015. Google/Alphabet has $70bn of cash on its balance sheet and produced $14bn of cash in the six months ended June 2015. Facebook could have $20bn of cash in the next year and could be producing $20bn of cash a year soon. Amazon, the company that “will never make money” surprised Wall Street last week with strong profits and it seems to me that they are going to start producing cash like these other big tech companies now.

It makes sense to me that software is the oil of the information revolution. Companies that control the software infrastructure of the information revolution will sit back and collect the economic surplus of the information revolution and that will be a path to vast wealth and economic power. It has already happened but I think we are just beginning to see the operating leverage of these software based business models. The capex spending necessary to be a software infrastructure provider at scale has shielded the cash producing power of these companies (and many others) and may continue to do that for a time, but I suspect at some point the profits are going to overtake the capex at a rate that the cash will be flowing out of software companies the way that oil flows out of wells.

Full Disclosure: The Gotham Gal and I own a lot of Alphabet stock and also shares in several hundred other software based businesses. We are long software.

Outsider vs Disruptor

Mark Suster wrote an interesting post on the state of the VC business this weekend.

In it, he makes this comment and puts the blame on the current rabid environment on “outsiders”:

If “the market” is driving up prices beyond intrinsic value the main new entrants to the market that have taken a less rational view of historical prices are a series of “non VCs” including corporate investors, hedge funds, mutual funds and crowdsourcing. Note that I’m not absolving my industry, venture capital, from bad behavior. I’m merely pointing out that price drivers are more strongly correlated with outsiders.

The question I always try to ask myself about new entrants in a market is “are they stupid or do they actually know something we don’t?”

Or said another way, are they outsiders or are they disruptors?

Combine that with Jerry Neumann’s recent post observing this:

Where are we in the cycle? Perez, in a 2013 paper10, says we are now in the deployment period. This has big consequences for how you run your business.

This quote makes a shocking claim I didn’t think the Transition audience would be interested in: financial capital’s job is done.

“Financial Capital” is VCs (and mutual funds and hedge funds). Production capital is corporations investing their capital in the innovation cycle now that it is well understood. Think Alphabet.

So I’m not sure I would go there with Mark. It’s tempting but might be the wrong place.

Negative Gross Margins

There’s been a lot of talk coming out of silicon valley lately about fast growing companies with high valuations that are going to face problems in the coming year(s).

Bill Gurley said this recently:

“I do think you’ll see some dead unicorns this year”

Mike Moritz said this recently:

“There are a considerable number of unicorns that will become extinct.”

But how is this going to happen?

The most likely scenario is the thing that has been driving growth (and valuations) for these companies ultimately comes home  to roost. And that is negative gross margins.

We have seen a tremendous number of high growth companies raising money this year with negative gross margins. Which means they sell something for less than it costs them to make it.

It can be an “on-demand” service provider that subsidizes the cost of the workers on its platform so that the service seems like it costs less than it actually does. Why would an on-demand startup take this approach? To build demand for the service, of course. The idea is get users hooked on a home cleaning service, a ridesharing service, a food delivery service, or a gym roaming service by bringing it to market at a price point that is highly attractive and then, once the users are truly hooked, take the price up.

It can be a service provided to startups, like the ability to ship via an API, or the ability to process payments via an API, or the ability to pay your employees or give them benefits. All of these examples have a real cost component to them. They are not pure software. And there are providers in the market who are not passing through the true cost, in effect subsidizing the cost of the service, to gain market share. This results in fast growth but negative gross margins. Again, the companies that are doing this are hoping that once they get to scale and users are “locked in”, they can raise prices.

There are other examples out there of companies with negative gross margins, but these two categories are where we’ve seen a lot of this kind of behavior.

The thing that is wrong with this strategy is that taking prices up, or using your volume to drive costs down, in order to get to positive gross margins is a lot harder than most people think. If there are other startups competing with you and offering a similar service, you aren’t going to be able to take prices up without losing customers to a similar competitor, unless your service truly has “lock in.” And most don’t. Using volume to drive costs down can work, but if there are similar services out there, the provider who is being asked to take a cut by you might just move their supply over to another competitor offering a higher price.

The bottom line is the primary way this strategy works is if you obtain a monopoly position in your market and you are the only game in town for your customers and suppliers. But given the massive amount of startup capital that is out there and the endless number of entrepreneurs starting businesses similar to each other these days, I think it will be hard for most companies to achieve monopoly position (which is somewhat in conflict with what I wrote here the other day).

Yes, there will be a few that succeed with this strategy. Getting a huge lead on your competitors, raising a ton of money to operate a scorched earth strategy and force your competitors out of the market, will work for some. But not nearly as many as the capital markets seem to think.

And so most of the companies out there who are growing like weeds using a negative gross margin strategy are going to find that the capital markets will ultimately lose patience with this strategy and force them to get to positive gross margins, which will in turn cut into growth and what we will be left with is a ton of flatlined zero gross margin businesses carrying billion dollar plus valuations. And that is what Gurley and Moritz see when they look out into next year and the year beyond. They aren’t alone.

Video Of The Week: Kim-Mai Cutler and Sam Altman

This past week YC announced a $700mm Continuity Fund to allow YC to continue to invest in its portfolio companies. YC has become one of the most important investors in the startup sector and it’s leader, Sam Altman, is driving it to do more faster. This interview he did with Kim-Mai Cutler recently reveals a side of Sam that many may not see that often.

The European Startup Market

At USV, we’ve been investing in European startups since 2008. Currently 22% of our active portfolio is in Europe. Since 2010, we’ve invested in 47 companies (roughly 8 per year) and 11 of them have been in Europe (roughly 2 per year). So over the past six years, roughly 25% of our investments have been in Europe. In 2015, we have made nine investments to date (a few have not yet been announced) and four of them have been in Europe (45%).

So what’s happening here?

Well first, we have developed an investment presence in Europe. While we don’t have an office in Europe we do have fourteen portfolio companies and every USV partner has at least two European portfolio companies. So we all travel to Europe regularly and we look at new investments when we are over here.

Second, we have developed a number of strong relationships with European venture capital firms. Serving on boards with other VCs is the number one way you build relationships in the VC business and we’ve done a lot of that with European VCs.

Third, European entrepreneurs have, for the most part, abandoned the approach of building domestic businesses in their home markets and are now targeting global customer bases from day one. That means the potential scale of European startups is as large as US startups.

Fourth, there has been a wave of new European VC firms started in the past couple years. Most of these VCs got their start in older legacy VC firms and they are now opening up shop on their own and operating in a more entrepreneurial “silicon valley” style. This reminds me very much of the period ten years ago in the US when USV, Emergence, Foundry, Spark, First Round, and a number of other high quality VC firms opened their doors in the US. This post by a leading venture fund investor in the US talking about the new European VC funds is right on the mark.

Fifth, European entrepreneurs have made money for VCs. There have been 24 billion dollar plus exits in Europe in the last five years.

When you take all of that and combine the fact that there is probably a hundredth of the VC dollars at work in Europe vs the US, you get a great market to invest in.

The Gotham Gal and I are here for the next few weeks of mostly vacation but we will get to see a few of our portfolio companies. Yet another reason to invest in Europe!

A Different Approach To VC

I wrote this to my partner the other day. I’m not going to provide the context. It doesn’t matter. It could have been about almost anything in the startup sector right now.

“the biggest thing that is wrong with the startup sector right now is entrepreneurs and their teams are too focused on valuation and not enough focused on business fundamentals”

There are a bunch of reasons why we’ve ended up in this place and my friend Bryce talked about some of them in his talk at XOXO. He posted the transcript of his talk this week. It’s a good read.

But in case you aren’t going to click through and read it, here are a few choice quotes from it:

  • I think there’s something that comes with being an outsider in an insider’s game.
  • Once you start taking other people’s money, it becomes very difficult to stop taking other people’s money.
  • they are building for investors and not necessarily building for customers
  • So we can’t talk about venture capital without talking about Unicorns, right?
  • 99.93 percent of companies are using a product, venture capital, that really doesn’t work for them.
  • you have entrepreneurs building companies, building customer bases, designing interactions with their users in order to make themselves appealing to venture capital
  • Turns out when you invest in things that VCs won’t, you end up with a bunch of companies that VCs don’t want to invest in.
  • what if we surrounded our founders with other people who weren’t focused on fundraising and valuation, but focused on revenue and customers?
  • Rather than make people move, we decided to let people bloom where they are planted.
  • The reality is we tried and weren’t able to pull it off.
  • Just last week, our largest investor passed.

Bryce is not having an easy time raising a dedicated fund. Neither did Brad and I when we raised the first USV fund in 2004. We got 20 passes for every yes.

I’m a contrarian and that tells me that Bryce is on to something. As you might imagine, the Gotham Gal and I said yes when Bryce asked us.

A Critique of VC, Founders, and Tech

This talk by Maciej Ceglowski (the founder of Pinboard among other things) is mostly a discussion of ad:tech and privacy issues. It raises a number of interesting points and echoes a view of ad blockers that my partner Albert has convinced me is correct (that they are a logical extension of the user agent concept embedded in web browsers).

But the most biting critique is saved for the end of the talk and aimed at the VC and founder communities and the tech sector more broadly.

Our venture capitalists have an easy answer: let the markets do the work. We’ll try crazy ideas, most of them will fail, but those few that succeed will eventually change the world.

But there’s something very fishy about California capitalism.

Investing has become the genteel occupation of our gentry, like having a country estate used to be in England. It’s a class marker and a socially acceptable way for rich techies to pass their time. Gentlemen investors decide what ideas are worth pursuing, and the people pitching to them tailor their proposals accordingly.

The companies that come out of this are no longer pursuing profit, or even revenue. Instead, the measure of their success is valuation—how much money they’ve convinced people to tell them they’re worth.

There’s an element of fantasy to the whole enterprise that even the tech elite is starting to find unsettling.

We had people like this back in Poland, except instead of venture capitalists we called them central planners. They too were in charge of allocating vast amounts of money that didn’t belong to them.

They too honestly believed they were changing the world, and offered the same kinds of excuses about why our day-to-day life bore no relation to the shiny, beautiful world that was supposed to lie just around the corner.

Even those crusty, old-fashioned companies that still believe in profit are not really behaving like capitalists. Microsoft, Cisco and Apple are making a fortune that just sits offshore. Apple alone has nearly $200 billion in cash that is doing nothing .

We’d be better off if Apple bought every employee a fur coat and Bentley, or even just burned the money in a bonfire. At least that would create some jobs for money shovelers and security guards.

Everywhere I look there is this failure to capture the benefits of technological change.

So what kinds of ideas do California central planners think are going to change the world?

Well, right now, they want to build space rockets and make themselves immortal. I wish I was kidding.

I don’t agree with all of Maciej’s critiques, but he is directionally correct, particularly the bit about profits, revenues, and valuations. He nailed that. There is more truth to his critique than many would like to admit. That’s why I am copying and pasting it here. It’s important to look at yourself sometimes and think you could use some work.