Posts from April 2009

The Venture Capital Math Problem (continued)

My post yesterday is still generating comments. We've got about 180 comments so far and will certainly pass 200. It's an important topic so I'm thrilled that so many people feel compelled to engage in the discussion.

I've also received a number of private emails on the topic and several of them have included data which I did not have access to when I wrote the post. So I am going to do some follow up posts as I drill down in the data.

First up is the number of exits per year. The debate in my post was between 200 exits per year and 1000 exits per year. As you might expect, the answer is in between.

A friend sent me Thomson VentureXpert data going back to 1990. Here's the raw numbers:

Total Reported Exits Since 1990: 7,373
Total M&A Exits Since 1990: 4,392
Total IPO Exits Since 1990: 2,981

Whenever I look at venture capital data, I like to back out 1999 and 2000 because those years were not normal by any measure.

Total Reported Exits (less '99/'00): 6,204
Total M&A Exits (less '99/'00): 3,812
Total IPO Exits (less '99/'00): 2,392

If you take the data, after backing out 1999 and 2000, and calculate the annual numbers, they are:

Annual Average Reported Exits: 365
Annual Average M&A Exits: 224
Annual Average IPO Exits: 141

We know that these do not include all the exits as many funds who do poorly do not report and surely Thomson misses some of the exits from the funds that do report. But we also know that the 1000 exits per year number is way too optimistic. It's probably in the 400 to 500 range.

The next step is to figure out two important data points; the value of the biggest exit each year and the shape of the distribution curve of exits (is it power law, gaussian, poisson, etc). Now that I have the data and have access to the right kind of mathematicians (the readers of this blog), we can get somewhere.

The Venture Capital Math Problem

Yesterday Albert and I visited one of the investors in our fund. The good news is they are happy with the job we are doing. The bad news is they are frustrated with the venture capital asset class.

We got to talking about the venture capital asset class and it wasn't long before we got to the "math problem". The venture capital math problem is pretty basic, maybe something you'd do in high school calculus or even pre-calculus. Here's how it works.

The venture industry has been raising between \$20bn and \$30bn per year for the past few years. Here's recent data from the NVCA's web site.

Let's be generous and say that the average is \$25bn per year (it's actually more). The math problem is to figure out how much in proceeds every year need to be generated to deliver a reasonable return to the investors.

Here's how I go about solving it. My math is not perfect and I'd like to hear from all of you how you'd solve it in the comments.

First, the money needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns. So \$25bn needs to turn into \$75bn per year in proceeds to the venture funds.

Then you need to figure out how much of the companies the VCs normally own. The number bandied about by most VCs is 20%. That means that each VC investor owns, on average 20% of each portfolio company. We'll use that number but to be honest I think it's lower, like 15% which makes the math even tougher.

Using the 20% number, that \$75bn per year must come from exits producing \$375bn in total value.

But it is also true that many of these exits have multiple VC investors in them, sometimes three or four. So you really need to look at the percent ownership by VC funds in the average deal at the time of exit. That number is likely to be over 50% and maybe as high as 60%. If we use 50%, then to get \$75bn per year in distributions, we need to get \$150bn per year in exits.

Here's where my math starts to get a little fuzzy and where I'd love some other approaches. I assume that the distributions of exits each year is distributed on a power law curve like this one:

I've heard from investors in venture funds, including the one we visited with yesterday, that about 200 exits per year produce all the returns in the business. I think that number is too low because that is about the number of venture funds raised each year. That would suggest each fund has only one meaningful exit and that's just not right. I think each fund has at least five or six meaningful exits. So I would use a number like 1000 exits per year.

And I assume that the biggest exit each year is \$5bn. Yes, it is true that some venture investments turn into businesses like Apple, Google, Microsoft that are worth \$100bn and more. But it is also true that most VCs are long gone from those deals before the valuations get to that level. So for the sake of solving this problem, I'd assume the largest exit each year is \$5bn and then you have a power law distribution of another 999 deals.

These assumptions are important to the results you get from this math problem and I'd love to hear everyone's thoughts on them in the comments.

I tweeted this power law math problem yesterday hoping to get some answers. Most of the replies said that I need a "scaling exponent" or a "power number" to get the answer I wanted. So my attempt to use twitter as a math crutch didn't work out very well.

So in order to finish this post and get to a discussion, I'll assume that the biggest deal, \$5bn, represents 5% of the total value of all 1000 exits and that the total value of all exits is \$100bn per year. If others come up with different numbers I will update this post with them here.

So here's the venture capital math problem. We need \$150bn per year in exits and we are getting about \$100bn. That \$100bn produces roughly \$50bn in proceeds for venture firms per year. After fees and carry, that \$50bn is around \$40bn. Which is only 1.6x on the investor's capital if \$25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.

Here are the most recent NVCA numbers which I got from Anthony Ha's Venturebeat piece a few days ago:

I tend to look at 5 year and 10 year numbers since 20 year numbers include a period when there was a lot less money in the venture business. Those numbers suggest that the 10% per year returns are about right, or are at least in the ballpark.

So here's my conclusions from all of this math (some good, some not so good). The venture capital asset class does not scale. You cannot invest \$25bn per year and generate the kinds of returns investors seek from the asset class. If \$100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage.

If you use my 3x gross and on average 50% ownership by VCs, then the number that the asset class can take on each year is around \$15bn to \$17bn. It's interesting to note that the industry raised \$4.3bn in the first quarter of 2009. That's a good thing. If we can keep it to that level, or less for a while, then we may be able to downsize and get returns back on track.

I'm optimistic that it will happen. In an open and free market, capital will flow to the places where it can earn an appropriate return. I suspect we'll see some of the large public pension funds who have been drawn to venture capital over the past decade decide to leave the asset class because it does not scale to the levels they need to efficiently invest capital. That will leave the asset class to family offices, endowments, and other smaller institutions who made up the largest part of the asset class in the 1980s and early 1990s.

I think "back to the future" is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits. The math works as long as you don't put too many zeros on the end of the numbers you are working with.

The Face To Face Reference Check

Regular readers of this blog know that I was fortunate to learn the venture business via an old school apprenticeship at the feet of two late 50s/early 60s venture capitalists named Milton and Bliss. I learned a ton from those guys over ten years from 1986 to 1996.

I was reminded of that yesterday morning when I took another VC out for coffee to do a reference on a person we are thinking of hiring to run one of our companies. After we spent fifteen minutes talking about a person that had run one of his companies, the other VC said to me "I'm impressed that you took the time to meet me face to face. This is not an easy reference."

That's exactly the point. Milton taught me to do all the important references face to face. He said "people will lie or hide the truth from you over the phone but they can't do that when you are looking them in the eye."

But it's not just about lies versus the truth. The phone is all about expediency. Both people on the call have a job to do and each of them is looking to get through the call and move on to something else.

A cup of coffee is an opportunity to meet someone, talk about a few other things, make a friend or a business acquaintance. Done right, the face to face reference check is a lot more than a reference check. It's a way to grow your network and your business. And it's also the best way to find out exactly what you need to know about a person you want to hire, invest in, or otherwise go into business with.

Let The Students Teach

Last night I read An Unschooling Manifesto by Dave Pollard. It's a very inspiration post and well worth reading. I don't know enough about the unschooling movement to know if I should get behind it or not. But so much of what Dave says rings true to me. I particularly like this part:

Then in Grade 12, something remarkable happened: My school decided to
pilot a program called "independent study", that allowed any student
maintaining at least an 80% average on term tests in any subject (that
was an achievement in those days, when a C — 60% — really was the
average grade given) to skip classes in that subject until/unless their
grades fell below that threshold. There was a core group of 'brainy'
students who enrolled immediately. Half of them were the usual boring
group (the 'keeners') who did nothing but study to maintain high grades
(usually at their parents' behest); but the other half were creative,
curious, independent thinkers with a natural talent for learning. The
chance to spend my days with this latter group, unrestricted by school
walls and school schedules, was what I dreamed of, so I poured my
energies into self-study.

To the astonishment of everyone, including myself, I did very well at
this. By the end of the first month of school my average was almost
90%, and I was exempted from attending classes in all my subjects. I'd
become friends with some members of the 'clique' I had aspired to join,
and discovered that, together, we could easily cover the curriculum in
less than an hour a day, leaving the rest of the day to discuss
philosophy, politics, anthropology, history and geography of the third
world, contemporary European literature, art, the philosophy of
science, and other subjects not on the school curriculum at all. We
went to museums, attended seminars, wrote stories and poetry together
(and critiqued each others' work).

As the year progressed, the 'keeners', to my amazement, found they were
struggling with this independence and opted back into the regular
structured classroom program. Now our independent study group was a
remarkable group of non-conformists, whose marks — on tests we didn't
attend classes for or study for — were so high that some wondered
aloud if we were somehow cheating. My grades had climbed into the low
90% range, and this included English where such marks were rare —
especially for someone whose grades had soared almost 30 points in a
few months of 'independent' study. The fact is that my peers had done
what no English teacher had been able to do — inspire me to read and
write voraciously, and show me how my writing could be improved. My
writing, at best marginal six months earlier, was being published in
the school literary journal. On one occasion, a poem of mine I read
aloud in class (one of the few occasions I actually attended a class
that year) produced a spontaneous ovation from my classmates.

The Grade 12 final examinations in those days were set and marked by a
province-wide board, so universities could judge who the best students
were without having to consider differences between schools. Our
independent study group, a handful of students from just one high
school, won most of the province-wide scholarships that year.
I received the award for the highest combined score in English and
Mathematics in the province — an almost unheard-of 94%.

Russell Ackoff, who I took a class from at Wharton twenty plus years ago, says in his book, Turning Learning RIght Side Up, that he has learned more from teaching than anything else. Of course that makes sense. I learn way more blogging, giving talks, and teaching than I do listening to others. When you are required to explain something to others, you have to figure it out yourself first.

I love the idea of turning students into teachers and I would do that going all the way down to elementary school. But in high school and college, it ought to be a primary way we educate students.

I am going to dig deeper into the unschooling movement and look at other models, like the Montessori schools, to figure out who is doing this well and why. It's a bit late for my own kids, who have largely been educated in the traditional school system (albeit a progressive one).

But if we are going to fund people who are hacking education, I think its best to figure out what is working and what is not. Then we know what to hack and why.

Blogrollr Two Months Later - My Top Ten

Back in February, I wrote a post asking for a new kind of blogroll. I wanted a blogroll that implicitly determines what I read and shows that. Two days later, I had my request answered and launched Blogrollr on this blog.

Blogrollr is exactly what I asked for. I put their Firefox extension on the computers I use to access the Internet (in my case my laptop and my desktop at work). It records all the blogs I am reading and creates the blogroll.

It took a couple months to get enough data to make the blogroll statistically accurate and I suspect it will get even better over time. I love that if it start reading a blog or stop reading a blog, the blogroll figures that out and I don’t have to do anything.

Here are the top thirty blogs I read:

You’ll see that my wife, The Gotham Gal, is at the very top of the list as it should be. I’ve visited her blog 103 times in the past couple months.

TechCrunch is next. I am not particularly excited about that as I know there are better blogs out there. As I said yesterday, I use aggregators to get to most of the content I consume and TechCrunch does a great job at getting top placement in many of the tech aggregators I use.

My friend Bijan’s blog is next. He posts a song every day as I do. And I tend to comment on many of them. So that activity alone will lead to a lot of daily visits. But his interests are very similar to mine so I’m always finding great stuff on bijansabet.com

Business Insider is next. Like TechCrunch, they do a great job of getting picked up by my favorite tech blog aggregators. But also, they cover the NYC internet scene which is near and dear to my heart.

My brother in law’s blog and my daughter’s blog are tied for fith place with 41 visits each. I read both of them because they are family. But they are also awesome blogs in their own right. Jerry writes about the challenges of running a commercial production company in the age of digital media. If you are in the advertising or film business, you should be reading Jerry too. And Jessica’s basically a photo blogger combining her own fantastic images with great stuff she finds on the web. I sure wish she was on tumblr but she’s figured out how to turn blogger into a tumblog.

Continuing the family thing (family’s first always), my brother’s blog comes in sixth. Jackson (that’s his handle and he’s known to this community that way) is always an entertaining read. If blogrollr had been capturing my visits for the past five years, his blog would probably be in second after Gotham Gal. Jackson’s tagline, “A home for unfinished dreams, delusions of grandeur, and musings on a planet gone wild” is my all time favorite blog tagline.

Venturebeat comes in seventh. They cover the tech beat with a venture capital perspective. And I think they do a great job with their posts. However the loss of MG Seigler to TechCrunch is a big loss for them. I always click over to his posts without even thinking about it.

Kara Swisher comes in eighth. Maybe it’s her obsession with Twitter. Maybe it’s her obsession with finding out the truth before writing a post. Or maybe it’s just that I like her sense of humor. Like MG, I click over to every Kara link I find on the web.

Howard Lindzon comes in ninth. Howard is a mad genius and the single best networker I know in the world of social media. His ruminations on stocks, the market, and the social web are required reading, at least by me.

My partner Albert’s blog comes in tenth. Albert’s a recent convert to blogging but he’s been on a tear lately. If you read Albert’s blog, my blog, the Union Square Ventures blog, Andrew’s blog, and Eric’s blog, you’ll come pretty damn close to hanging out in our office all week.

The rest of the top thirty include some very familiar names, like Brad Feld, Seth Godin, Dave Winer, Steven Johnson, John Battelle, Mo Koyfman, Umair Haque, Peter Kafka, and Roger Ehrenberg. It also includes tech blogs like Mashable, Read Write Web, GigaOm. And the blogs of my portfolio companies like Twitter, Boxee, and Disqus. And some gems you might not know about like Alan Patrick’s blog that he calls Broadstuff.

So that’s what I read the most. Not surprising. Family is at the top, followed by the big tech blogs, the blogs of the people I work with and collaborate with and the blogs of my portfolio companies. I always thought it would look like that, but there is nothing like scrobbling your life and looking at it.

Speaking of scrobbling, over 800 bloggers have put up the Blogrollr widget and started scrobbling their favorite blogs. To date Blogrollr has scrobbled over 500,000 blog visits. If you want to join the party, go visit Blogrollr and get started.

I’ve enjoyed working with the small team behind Blogrollr and they are now building their next project called This Is Feedback, a suggestion box for web services. Check it out.

Celebrating Aggregation

Lately, it's been all the rage to bash the services on the Internet that aggregate content. Robert Thompson, editor of the Wall Street Journal, said this about aggregators a few weeks ago:

[they are] parasites or tech tapeworms in the intestines of the internet

Since I read that, I've been calling every one of my favorite services on the web "tapeworms." It's a compliment of the highest order. Because I love aggregators and they are the only way I get to content anymore. I don't read the NY Times directly, I don't read the Wall Street Journal directly, I don't read any blogs directly, and I don't watch videos or listen to music directly. I've got dozens of aggregators that I use daily and they take me to the content I want to consume.

The Internet and digital media broadly has produced a glut of content. There is no way that anyone can consume all of the content that is available and relevant to them. And no media property, be it the Wall Street Journal or any other content creator, can produce even 5% of the best content I want to consume daily. These media companies used to be the distributors and creators of content. But now they are just the creators and they will never get back to a position of being a distributor unless they become "tapeworms" too. Watching them insult the best services on the Internet tells me that they aren't headed in that direction.

One of my favorite examples of aggregators is Tastespotting, one of the Gotham Gal's favorite web services. Here is the front page of Tastespotting right now:

Tastespotting is like Techmeme or the Hype Machine or Digg, but it is for recipes and the photos that accompany the recipes. If you click thru to Tastespotting, and you should, you'll see that these images all link out to blog posts by regular people. There are millions of people who cook, love recipes, love food, and many of them have taken to photographing their work and blogging about it. The Gotham Gal is one of them.

The food magazines and even the food sections of newspapers could have done what Tastespotting did, and they still can, and they should. Because there is a ton of great food content out there on the web and aggregating it up is more valuable to readers than trying to do it all yourself with your editorial team.

Aggregation is the central element of distributing content on the web. It's not going to get shut down by calling these services names, suing them, or even worse taking your content out of them. The best and only thing media companies can do is join the aggregation parade, celebrate it, and get good at it.

Geocities

Yesterday, TechCrunch reported the news that Yahoo! is planning to shut down Geocities. That is sad news on many levels. Geocities was the web's first community and it was my first "mega deal" when it was sold to Yahoo! in 1999 for \$3.5bn (including the value of the options Yahoo! assumed). I learned a lot from that investment and I thought I'd share some of the lessons with you all this morning.

My partner at Flatiron, Jerry Colonna, who led the Geocities investment, will read this post and will surely correct all the things I get a little wrong so make sure to read the comments. I do have the benefit of having all the cap tables and investment memos still on my laptop so most of this is based on more than memory.

In the summer of 1996, Jerry and I formed Flatiron Partners. We wanted to focus exclusively on Internet investments. We quickly rounded up two \$75mm commitments from SOFTBANK and Chase and by the fall we were off to the races.

Our first investment was Seth Godin's company Yoyodyne which we had both been looking at while we were at our prior firms (Jerry was at CMGI and I was at Euclid). As we were considering what next investments to make, I suggested that we each pick a company from the portfolios of our prior firms to make an investment in. I felt that we could use a couple "sure winners" and there is nothing like cherry picking a venture fund you know well to produce a sure winner.

Jerry liked that idea. I picked Multex (which went on to go public and then sell to Reuters for \$250mm). Jerry picked Geocities.

Image of David Bohnett via Wikipedia

Jerry flew out to Los Angeles where Geocities was headquartered (it was initially called Beverly Hills Internet) and talked to David Bohnett, the founder of the company. Jerry knew that the initial \$2mm that David had raised from CMGI was going to run out shortly and so he proposed that Flatiron invest \$8mm at a \$10mm pre-money valuation.

David immediately liked the idea of having Jerry as an investor. He knew Jerry from CMGI and they had a great relationship. But he hated the idea of selling 45% of the company when he had already sold 50% of it to CMGI earlier for \$2mm.

When we showed up, CMGI owned half the company and David owned less than 35%. The rest was in the hand of friends and family and options. David felt that he had made a bad deal with CMGI and wanted to fix that in the next round.

So Jerry invited David and his brother Bill out to NYC to meet with the two of us and figure it out. We went out to dinner at a place in the lobby of the Met Life Building (which I still think of as the Pan Am Building) and discussed the issue at length.

At that dinner, I proposed that we issue David 500,000 options as part of the financing which would be 10% of the company post financing. He and Bill went outside to talk it over and they came back and told us we had a deal.

So we drafted up a term sheet and sent it to David. Flatiron and our partners SOFTBANK and Chase would lead an \$8mm financing at a \$10mm valuation. CMGI would invest \$2mm of the \$8mm and we'd issue 500,000 options to David. We'd add to the employee pool as well. After the financing, Flatiron and our partners would own about 30% for our \$6mm, CMGI would own about 33%, and David would own north of 20%.

David liked the proposal and he sent it to CMGI for their approval. They hated it. To this day, I'm not sure if it was the fact that a former partner, Jerry, was showing up and attempting to invest in their little secret or if it was just the financial terms. But whatever the case, they fought the idea for a while. I don't recall exactly what the delay was all about. I assume they were looking around for a better option. But finally they came to the table.

They demanded that we split the 500,000 options and give half of them to CMGI and half to David. They saw them as a sweetener for David, which they were, and wanted to participate. After a lot of back and forth, none of it pleasant, David conceded. And in the late fall of 1996, the financing closed.

Three years later, when Geocities was sold to Yahoo!, those 500,000 options I came up with over dinner in the old Pan Am Building lobby were worth \$234mm. By then they had split 2 for 1 twice and David had given a bunch of them to his co-founders. CMGI still had all of theirs.

We decided to invite a couple of other VCs into the deal. I was concerned that Geocities was in LA and we were in NYC and CMGI was in Boston. I felt that we needed a local VC to "watch over the deal". The only VC I knew in LA was Harry Lambert of Innocal, who had previously been at Innoven in New Jersey. So I called up Harry and asked him to go see David. They hit it off and so we allocated \$1.75mm of the deal (which we increased to \$9mm) to Innocal. We also invited Intel into the deal, also allocating them \$.175mm. Between Intel, Innocal, SOFTBANK's Charley Lax, and Bob Greene from Chase, we had quite a few VCs involved in that first round.

I've always felt that syndicating a deal to other VCs who can be helpful is a good idea. In the case of Geocities, we cut ourselves back by \$3.5mm, which ultimately became worth \$500mm, and I'd do it all over again. Intel wasn't particularly helpful as investors, but their brand was helpful to the company who used it actively. But Harry was a big help. Less than six months after we made our investment, the company was burning through cash and there were no financial controls in place. Harry showed up with his team and got things under control, fixed the financial management, and bought enough time to get another round raised.

As we were getting ready to close our initial round of financing, the November 1996 Media Metrix numbers came out. Geocites, which was growing like crazy, had made it into the top ten. I turned to Jerry (we shared an office back then) and said to him with a big smile "we are about to invest in one of the top ten internet companies in the world at a \$10mm valuation." Not many people understood how big a deal that was back then, but we did.

We did not have an investment analyst on our team at that time and we needed to do a lot of work on the market and what the other home page services were and what their tools were like. Jerry called up Jason Calacanis, who I had not met at the time, and we brought him in and hired him as a consultant. He was young and smart and a wiseass. Some things don't change. Jason did all of our deep analysis on the Geocities deal. He didn't get any Geocities stock out of it, but he did get Flatiron as the advertising sponsor for the first issue of Silicon Alley Reporter out of that gig.

After Harry and his team got the finances under control, Geocities started to prepare for another round of financing. It was the summer of 1997 and the Internet investing climate was not great. We did an insider round at 4x the last round price and raised another \$5mm.

But by the end of 1997 and into early 1998, things were heating up and SOFTBANK and Yahoo! had their eyes on Geocities. The two companies proposed to invest \$25mm into the company at a \$225mm valuation and also do a \$50mm secondary purchase from the investors. All of the investors in the initial round other than CMGI and SOFTBANK participated and Flatiron and Chase sold a third of our position to SOFTBANK and Yahoo! at \$15/share (post a 2/1 split so actually \$30/share pre split). That was almost 10x on our purchase price in less than two years. By selling a third of our position for 10x what we paid, we locked in a 3x on the deal and still had 2/3 of our investment working for us.

When the company went public a year later and eventually sold for \$120/share to Yahoo!, Jerry and Bob Greene (our partner at Chase and eventually our partner at Flatiron) asked ourselves if we had made a mistake selling a third of our position in December 1997 and January 1998. I didn't think so and I still don't. Yes, the shares we sold for \$15/share would have split 2/1 once more and would have been worth \$120/share in the Yahoo! sale, but I don't think you ever should regret taking a 10x gain and taking some money off the table. We did that and I don't regret it one bit.

The rest of the story is pretty well known. Around the time of the Yahoo!/SOFTBANK investment, David recruited Tom Evans to join the company as CEO. Tom took the company public in 1998 and sold it to Yahoo! in 1999. Tom did not join Yahoo! and went on to build and run several very successful public companies. David made a bundle in the sale of Geocities, turned his energies to other interests for a number of years, but is now back in the saddle as the founder of another internet startup in LA.

And Jerry, Bob, and I went on to exit from dozens of internet deals in 1998, 1999, and 2000 before the market blew up and Flatiron stopped making investments in the summer of 2000. Between all the big exits we had in Flatiron and a number I've had since, you might think that Geocities is just another deal. But for me, it was the first rocket ship ride I had in the venture business and it will always have a special place in my head and heart because of that.

I learned a lot from that deal. I learned that the Internet is all about people expressing themselves on pages they own and control. I learned that a business deal made over dinner and a handshake can turn into hundreds of millions of dollars, I learned that good partners are worth every penny of returns you give up to get them, and I learned that selling too soon is not too painful as long as you don't sell too much. And most of all I learned that you can make 100 times your investment every once in a while. And when you do, it's something special.

A Second Market Is Emerging

Claire Cain Miller has a story in today's NY Times about Second Market, a NYC based company that makes markets in illiquid securities. She reports that they will shortly be launching a marketplace for private company stock.

I've written about this idea in the past and I think it is badly needed. Not everyone can wait until the exit comes or the IPO market comes back. We are seeing a lot of founders selling portions of their stock privately, mostly to the other investors in their companies. But that is not a transparent or particularly liquid market and it is not clear that the founders or the investors buying their shares are getting a fair deal.

A better idea is to create a marketplace where sellers and buyers can meet and where both sides can get price discovery. When you know the latest prices and can get a price history, you can be more confident of your purchases.

Last week Mike Arrington wrote a post on Facebook turning down an offer to invest at a \$2bn valuation. I left a comment on that post saying that I thought that \$2bn price was low given the prices being paid in the Facebook secondary market. Later that day, I got a private email with a price chart for Facebook common since January 2008. I was asked not to publish that chart so I won't. That chart showed that Facebook common has traded as low as \$6/share earlier this year but is now trading around \$8/share. That translates into \$3bn to \$3.5bn, lower than I had suggested in my Techcrunch comment.

Seeing that chart was a real "aha moment" for me. There is enough activity in Facebook common that we can tell at any time what the market price is and we can also see how that price has changed over time. Like I said in a post last week, it's like Facebook is a public company without really being public.

I understand that there are issues with this development. It will be harder to strike options at low prices when the company's stock has a price history. It will be harder to control who the shareholders are and it will be harder to keep employees motivated to stick around if they can cash out early. These are all problems companies usually don't face until they go public. Now they will have to face them earlier.

But I still think this is a really good idea. Claire talked to me about this story and I told her:

Entrepreneurs won’t start companies and investors won’t invest in them
if there is no path to liquidity on the company stock. A secondary market for private company stock can
fill the gap that the lack of an I.P.O. market has created.

I don't believe that the secondary market will replace the public markets and M&A as the primary liquidity options for venture backed startups. I think it's a third choice that we need. And I think it represents a tier in the market that is missing between venture capital and the public equity markets. There are about a half dozen other startups working on creating markets of this kind and I expect we'll see all of them launching in the next six months. I hope that one or more of them makes it and that we'll develop a robust, liquid, and transparent secondary market in the next few years. I know we need it.

When A Key Man Leaves The Firm

There’s a front page story in the NY Times today about Quadrangle Group. It’s two stories in one. The first story is about Quadrangle’s use of fundraising agents with political connections to assist them in raising capital from state pension funds. I don’t know anything about that issue other than what I read in the paper so I can’t really comment on that story.

The other story is about Steve Rattner‘s departure to join the Obama administration and help with the restructuring of the US auto industry. Steve is a founder of Quadrangle and is clearly what is known as a “key man”.

In our firm, my partner Brad and I are “key men”. If either of us were to leave our firm for any reason, our investors would have the option of causing an early termination of the “investment period”. Basically, our investors could decide to halt all new investments and put the firm into maintenance mode.

That is exactly what the investors in Quadrangle are now debating. Apparently they have until this friday to make that decision.

This happened to me and my partners in late 2000 when the sole investor in Flatiron Partners, JP Morgan Chase, decided it didn’t want to be doing early stage Internet investing via the Flatiron partnership anymore. We went into maintenance mode and remain in it today. We still have a portfolio of five investments we are managing. It doesn’t take much time anymore but for the first three years after that decision was made, it was a full time job just managing the portfolio.

I talked a bit about this during my InSITE talk a few weeks ago. Here’s a short one minute clip from that talk where I addresses this issue. The clip keeps going but the relevant part ends at 8:10.

It’s not often that a key man, like Steve Rattner, leaves a firm in the middle of a fund cycle. It is more common for the departure to happen at the start of a new fund cycle. One of the great venture capitalists of all time is Vinod Khosla, who now has his own venture firm, Khosla Ventures, but he is also still affiliated with his prior firm, Kleiner Perkins. At some point, I don’t know the exact details, Vinod decided he did not want to be part of the team raising a new fund at Kleiner Perkins. But because he has obligations to his partners, investors, and portfolio companies, he will be involved with Kleiner Perkins for some time to come. That’s typically how this kind of thing happens.

The biggest and best known venture firms may not have key man provisions in their fund documents. They may have gotten beyond the point when any one partner is critical to the firm’s ability to manage a fund. But most smaller funds and newer funds are going to have these provisions and if a key man departs, for any reason, it can mean the end of the firm as an ongoing entity.

So if you are a VC or an entrepreneur, pick your partners wisely and make sure they are in it for the long haul. As I said in the InSITE talk, venture capital is a long term business and requires people who are patient and committed investors.