Posts from October 2015

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.

We’ve been in Europe since Oct 2nd. We are on a cross Atlantic flight returning to NYC today. In those 18 days we spent a week in Paris with our oldest daughter who was installing a show there for two artists she works for, a long weekend in Berlin with two other couples, two days in London, and wrapped with a long weekend in Paris and a board meeting yesterday before coming back.

The passport control agent in CDG today asked us if we were in Europe for business or vacation. The Gotham Gal answered “both, of course.”

If there’s anything we’ve mastered since our kids left home and headed to college and on to adult life it is the art of mixing work and time off.

Last night we had dinner with a friend in the VC business in Europe. The Gotham Gal had drinks with him and then I joined for dinner. They had a seed/angel discussion over drinks and we had a wider ranging discussion at dinner.

It is also great to do business travel, particularly long range business travel, with your spouse. I find being half way around the world in a hotel jet lagged to be a disorienting experience (Lost In Translation captured it well) and having my spouse along for the trip makes it much better for me.

I am happy to get home. I’ve missed my routine, my yoga, my local coffee shops, the Mets and Jets and Knicks games, my colleagues at works, our friends, and the creature comforts of home.

But being away makes you appreciate those things so much. There’s a world full of business opportunities and culture and things to enjoyed that you have to get on a plane and fly overseas to enjoy. We do that three or four times a year and it’s a great thing to do.

Last night we took a walk along the Seine with some old friends who we’ve been hanging out in Paris with this past week. There was a boat in the river that people were partying on and they started setting off fireworks. I took about six or eight photos of the fireworks along with a bunch of other photos on my phone.

This morning when I woke up, there was a notification from Google Photos that there was an “animation” available for me. When I clicked on that notification, I got this GIF. If you click on it, you can see the animation. I’m not sure why it doesn’t animate here in the WordPress post.

I think that’s pretty cool. Google figured out that those six or eight photos were all connected and stitched them into a GIF. Well done Google. This is not the first time Google Photos has delighted me with a notification like that.

We are wrapping up our time in Europe. I’ve got a board meeting and dinner tonight and we fly back tomorrow. It’s been a great trip but I’m eager to get back and start watching the Mets in real time.

The history of the Internet and mobile is that in many categories the winner takes most of the market:

• Search – Google
• ecommerce – Amazon
• Social – Facebook
• Ridesharing – Uber

We can go on and on with making a list like that and I have left off many many markets, but I think this short list I made at least gets the point across.

The reasons are many, but at the core are network effects and the fact that the more users and data a service has, the more value it can create for its customers and users.

We strongly believe in network effects at USV and look for them as the primary form of defensibility in the investments we make. We don’t always get things right and we certainly don’t always end up investing in the company that wins the market. But we understand how these things work and invest with the mindset that winning a market can result in a very large return on investment.

Lately, we’ve been wondering if there is an end to this pattern on the Internet and mobile. We think it is possible that an open data platform, in which users ultimately control their data and the networks they choose to participate in, could be the thing that undoes this pattern of winner takes most. The blockchain is the closest thing to emerge that looks something like that. But the blockchain hasn’t (yet?) shown that it can produce something important like Google’s search or Facebook’s social graph and until it does, we are just waiting.

This is an issue for society to ponder. As I have spent time in Europe this past month, it’s easy to see that the search engine they use here is Google, the social graph they use is Facebook, and so on and so forth. If the US produces the networks that win most of the market, that’s an issue for the rest of the world. The Chinese have dealt with that issue by protecting their market. The rest of the world (mostly) has not.

Will that always be the case? Will the countries with the most sophisticated tech startup communities end up winning the global economic race as we transition from an analog to a digital world in which the winners take most of the market?

It’s unclear to me how all of this plays out, but it’s been on our minds at USV and we are talking a lot about it. So I figured I’d talk a bit about it here too.

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.

So I woke up in Paris at 8am this morning and checked my phone. The Mets beat the Dodgers last night in Los Angeles and now go to the National League Championship Series to play the Chicago Cubs.

I know there are a few Cubs fans who are AVC regulars.

So fun friday is going to be about the wager I will make with the AVC Cubs fans.

Jeff Carter suggested that if the Cubs win, I need to buy a Cubs jersey and post a picture here of me wearing it. If we go in this direction and the Cubs win, I will buy some Cubs gear on Etsy and post a photo of me wearing it on AVC. If the Mets win, the AVC folks from Chicago will buy Mets gear on Etsy and send me selfies which I will post on AVC.

And, of course, we know that William is salivating over the potential fun we can have if the Mets and the Blue Jays get to the World Series.

So, let’s discuss. Do we like the wager Jeff suggested and I modified? And who would like to get in on this bet?

I was looking at comScore’s list of the top mobile apps in the US for “time spent” recently.

Here’s the list (#14 was apparently an error so I left it off):

It’s all about messengers, movies, and music. I am being somewhat inaccurate in the choice of the word movies. I should use the word video. But I like the alliteration of the M words so I’ll stick with the word movies for this post.

Movies and music make a lot of sense. I often hit the play button in the SoundCloud app and two hours later I’m still listening. And I know my kids can binge on Netflix shows for hours at a time.

But messengers is interesting. Sending a message in Kik or Whatsapp or iMessage takes almost no time. Replying to one is the same. So for messaging apps to be so well represented in this list means that we are going in and out of them so frequently that these little bits of time add up to a lot of time. Google search is in there for the same reason.

The category I’m a bit surprised to see pulling up the rear is games. I would think games would be right up near the top with messengers, movies, and music. This list is for the month of August 2015 so its not the volatility of games (a hit business if there ever were one) that causes them to be poorly represented. It’s the fact that on mobile devices in the US, we seem to like talking, listening, and watching more than playing.

I find that interesting.

Last week, our newest portfolio company Clue announced that it had raised a Series A round from USV and Mosaic. Co-Founder and CEO Ida Tin‘s blog post is here. My partner Albert’s post on why we invested in Clue is here.

There’s an interesting backstory here and I thought it might be useful to tell it.

A few years ago our oldest daughter told the Gotham Gal that she was using this mobile app called Clue to track her cycle and related health data and she loved it. She recommended it to her.  So the Gotham Gal took notice and ended up participating in Clue’s angel round. So our family has been a user (first) and then an investor in Clue for a few years now.

I got wind of this sometime later and asked the Gotham Gal why she picked Clue in a field with a number of strong competitors. She responded “in this market I’m backing a woman and Ida is exactly they kind of person who should be running a company like this.” That shut me up and ever since then I’ve been rooting for Clue.

Earlier this year USV did a roundup of all the interesting things we’ve seen in health care apps and Clue was on the list. I was mindful of my conflict of interest but did mention that I thought Clue would be raising a Series A this summer. Albert jumped on that and the result was our investment in Clue’s Series A.

If you believe, as I do and as USV does, that the mobile phone is the new EMR, then I can’t think of any better example of that than Clue. Women use it to track their cycle and their fertility and a whole lot more. I have not yet met a woman who uses Clue that doesn’t love it.

Ida says it best in her post:

Millions of people across all cultures are using Clue. With every single data point a user enters, we are moving the world toward an educated, informed and empowered future – for our users and their partners and families, for mothers and daughters and sisters, for doctors and patients.

I am super excited that USV and that our family are investors in (and users of) Clue. It’s a great app and a great company.

A few weeks ago, the Gotham Gal said to me “considering how much time and money you are investing in K-12 education efforts, you should read this book.” The book she recommended is called The Prize by Dale Russakoff and it tells the story of the Newark, NJ public school system reform effort over the past five years.

I’m almost done with the book and I’m very glad she suggested it to me. I’ve long been a fan of the education reform movement, in particular the rise of charter schools, but I’ve also been troubled by the knowledge that charters don’t solve all the problems and some students are beyond the reach of even the best teachers.

The Prize tells two stories at the same time. It tells the story of the “top down” Newark reform effort driven by Cory Booker and Chris Christie and funded with Mark Zuckerberg’s incredibly generous $100mm gift. It also tells the story of real teachers and real students and the challenges they face every day in a few of the charter and district schools in Newark. By telling the story this way, Russakoff gets to the fundamental challenges facing the education reform movement and the entire K-12 system, at least the K-12 system in inner city schools.

In Newark, and in the New York City school system where I’ve spent time the past five years, you have both charters and “district” schools. The charters benefit from flexibility due to having non-union teachers, they benefit from not having the overhead burden of the “district bureaucracy”, they benefit from often having wealthy donors (like us) who cover startup costs and other needs, and they benefit from the self selection that comes from parents who care enough to get their kids into a charter school. The results that the best charter operators have produced with this formula in Newark and New York City is undeniable. They have created some amazing schools that are getting fantastic results. I know many of the leaders of these charter schools and I continue to be impressed by the quality of their work, their schools, and their commitment to the students and we have supported them financially and in other ways.

But not every child gets into a charter and there is a growing number of people, in and out of the education reform movement, who understand that district schools aren’t going away and we need answers for these schools and the children that attend them. And it is also important to understand that, by their nature, charters tend to siphon the best families in a community out of the district school and those that are left in the district schools need more social and remedial support than they are getting and that the district schools have resources to provide.

A few years ago a friend of mine said to me “if you are interested in K-12 inner city education you need to go see this person. The person he sent me to meet with has been providing mental health services to children who are struggling in inner city schools. She explained to me that you can’t teach a student who is in trauma. It doesn’t work. So she has taken on the effort to try to provide mental health resources to the most challenged schools and the most challenged students. That is an example of the “social and remedial support” that district schools need more of.

If there is any lesson that I took away from The Prize it is that we can talk until we are blue in the face about bureaucracies, and unions, and bad teachers, and fraud, and corruption, and the need to reform all of that. And we do. But where the rubber meets the road is the student and its the inner city students who are failing in kindergarten, first grade, and second grade who we need to focus on. Because once they fail at that level, it is so hard to get them back on track and most don’t make it.

I sat next to NYC Schools Chancellor Carmen Farina at Mayor de Blasio’s recent speech on his education efforts. When the Mayor mentioned the big investment they are making in second grade reading performance, Carmen turned to me and said “this is critical. these kids need to read in second grade”. She’s right.

If you are interested in this stuff, as I am, I would strongly recommend reading The Prize. It didn’t tell me anything I didn’t already know. But I helped me think about this stuff and that’s super helpful.