Posts from VC & Technology

Pacing in a VC fund context is how much capital the firm is investing in a given period and tracking that over time.

I don’t think a VC firm should manage to a pacing number. It should manage to the opportunity set that it sees.

But I think pacing is a great thing to track in the rearview mirror.

I like to look at investment pace by quarter and year. And by dollars and deals. And by new names and follow-ons.

If you keep track of that, chart it, and review it, you will be mindful of whether the firm is getting too far out over its skis or heels.

And that is a super useful thing to be aware of.

We get feedback from the leaders of our portfolio companies on an annual basis. It helps me get better at what I do and I love it.

One area that I am constantly challenged to improve on is accessibility.

The common refrain is “I know you are busy and I hate to bother you.”

To which I reply “It is your job to bother me and my job to be responsive when you do.”

But even so, getting portfolio company leaders to feel that they can reach out, even on small things, is a challenge.

An approach that I have taken and many other VCs also take is to schedule weekly or bi-weekly catch ups with the portfolio leaders.

That works but sometimes what is needed can’t wait for that or is a “in the moment thing” like “today sucked.”

And sometimes helping someone deal with “today sucked” gets you to a level of comfort with a leader that allows you to help on many other things too.

My point is simple. Being there for portfolio leaders is job number one for venture capitalists. If we can’t do that, what can we do?

So working on that is a big part of my personal development and I work on it every day.

The post I wrote yesterday generated a lot of discussion. I followed it on Twitter and engaged with much of it there.

One of the best things about writing is all of the feedback you get. It helps to sharpen your arguments and also makes you rethink them too.

Here are some of the takeaways:

• Some readers interpreted the post as arguing for only investing in high gross margin businesses. I don’t believe that is the right takeaway. The better takeaway is that high margin businesses are often less dependent on capital markets because they can internally generate cash more easily. That is not the case with low margin businesses. So how you value and how you finance low margin businesses becomes very important. They can’t be valued too highly or you risk a financing crisis.
• Bill Gurley tweeted his blog post from 2011 that “all revenue is not created equal.” That is a great way of saying what I was trying to say.
• Apple and Amazon were put forth as great lower margin businesses. Amazon is a roughly 25% gross margin business and trades at a little over 3x revenues. Apple is a roughly 40% gross margin business and trades closer to 4x revenues. I think that emphasizes the point that revenue multiples ought to reflect gross margins.
• Many people argued that operating margins and growth rates should be the two numbers that matter most in valuing a business. I totally agree. But it is hard to have 40% operating margins if you have 40% gross margins. The truth is that operating margins will be highly dependent on gross margins. But there will be edge cases where that is less true.
• I got a lot of people saying “isn’t this totally obvious?”. To which I say “it should be but clearly it is not.”

The most important takeaway for me is that the public markets are showing us in tech/startup/VC land that the economic fundamentals of a business, even those that are driving massive disruption in their markets, really does matter and that we need to pay attention to them when we finance these companies.

Dan Primack wrote in his friday newsletter:

Public market investors have become less willing to leave their comfort zones, and it’s manifesting most obviously in the IPO market.
Novel disruption has fallen out of favor, with many preferring more time-tested models like enterprise SaaS and biotech.
Peloton yesterday raised over $1.1 billion in its IPO, pricing at the top of its $26-$29 range, but its shares then got crushed (although still valued well above the last private mark). Its CEO talked to Axios yesterday about the falling stock price.
Endeavor, the live events and artist representation firm led by Ari Emanuel, last night canceled an IPO that originally was to raise over $600 million, before it was later downsized.
WeWork… well, you know the story there.
Yes, all three companies have dual-class shares. Yes, all three were highly valued by venture capital or private equity investors. Yes, all three were unprofitable for the first half of 2019.
Those characteristics are also true of Datadog and Ping Identity, both of which had successful IPOs this month and continue to trade above offering.
The trio’s real similarity was that each had a very complicated story.
Peloton is a high-end hardware and SaaS business that produces original media content, sells apparel, and runs its own delivery logistics.
Endeavor began life representing movie stars and Donald Trump, but later expanded into a massive live events business that includes the UFC and Professional Bull Riders. Plus, it’s got a streaming platform.
WeWork… again, it’s different.
All of this comes against the backdrop of Uber, which also had a very complicated story and an IPO that emboldened short-sellers.
Up next: A lot of biotech startup IPOs, but no high-growth, complicated tech unicorns.
“We’re about to get a bit of a break from those sorts of deals, which I think is good for everyone,” a top Wall Street banker told me this morning.
Private markets follow public markets, so don’t be surprised to see some valuation and/or deal size pullback for these “hard to comp” companies.
Particularly if SoftBank fails to raise Vision Fund 2.
Goodbye to egregious governance terms. Dual-class will survive, but WeWork laid a third rail for others to avoid.
U.S. IPOs have still outperformed the S&P 500 in 2019, although the gap has shrunk significantly this month.
Or, put another way: The sky isn’t falling, but it’s gotten a lot darker. And, for some, downright stormy.

While all of this is true, I think it is a lot simpler than that.

The public markets are a lot different than the private markets.

Financial transactions in the private markets are controlled by the issuers, happen when the issuers want them to happen, and are generally auctions, particularly in the late stage markets.

Public market investors can buy and sell stocks every day based on what is attractive to them and what is not. If they feel like they missed out on something, they can get into it immediately.

For this reason, valuations in the private markets, particularly the late-stage private markets, can sometimes be irrational. Public market valuations, certainly after a stock has traded for a material amount of time and lockups have come off, are much more rational.

For the last five or six years, I have been writing here that I very much want to see the wave of highly valued and highly heralded companies that were started in the last decade come public. I have wanted to see how these companies trade because it will help us in the private markets better understand how to finance and value businesses.

And now we are seeing that.

And what we are seeing, for the most part, is that margins matter. Both gross margins and operating margins.

If you look at the class of companies that have come public in the last twelve months, many of the stocks that have performed the best are software companies with software margins. One notable exception to that is Beyond Meat.

• Zoom – 81% gross margin
• Cloudflare (a USV portfolio company) – 77% gross margin
• Datadog – 75% gross margin

If you look at the same list, many of the stocks that have struggled are companies that have low gross margins.

• Uber – 46% gross margin
• Lyft – 39% gross margin
• Peloton – 42% gross margin

Some other notable numbers:

• WeWork gross margins – 20%
• Spotify (down almost 30% in the last two months) gross margins – 26%

I believe that we have seen a narrative in the late stage private markets that as software is eating the world (real estate, music, exercise, transportation), every company should be valued as a software company at 10x revenues or more.

And that narrative is now falling apart.

If the product is software and thus can produce software gross margins (75% or greater), then it should be valued as a software company.

If the product is something else and cannot produce software gross margins then it needs to be valued like other similar businesses with similar margins, but maybe at some premium to recognize the leverage it can get through software.

But we have not been doing it that way in the late-stage private markets for the last five years.

I think we may start now that the public markets are showing us how.

My partner Nick did this podcast recently. In it he talks about how we think about and make investments at USV, our thesis on crypto, and a number of our crypto investments.

If you want to bypass all of the intros and sponsor messages, fast forward to 3mins.

In a perfect world, everything about a potential investment will be confidence inducing. The team will be great and reference well. The market will be huge. The technology will be well developed. The price and terms will be attractive.

But the world is not perfect. There will always be things about a potential investment that create heartburn. A term that I have heard used over the years to describe these imperfections is “hair on a deal” as in “there is a lot of hair on that deal.”

A little hair is OK if everything else lines up. A lot of hair is not OK and can be a deal killer.

The news that WeWork has postponed their IPO plans for now is an example of when too much hair gets in the way of a deal.

There are a lot of things to like about WeWork. They have popularized a new form of work space, a new business model for it, and have they have built a global brand around shared workspaces.

I expect the company will eventually get public.

But right now there is too much hair on that deal and all the work they did over the last few weeks to clean it up was not enough, at least for now.

So the lesson for entrepreneurs is that you really need to have your house in order when you go out and raise capital. The more eyebrows you raise with investors, the worse it gets. And hair can get in the way of an otherwise financeable opportunity.

This simple and short blog post by the folks at Correlation Ventures contains the key to venture capital returns – the hit rate.

In the Correlation post, they define “hit rate” as:

the percent of invested dollars generating a 10X or greater return

But “hit rate” could be something else. It could be the number of investments in your portfolio that return the fund. It could be the number of seed investments you make that turn into billion-dollar valued businesses. It could be the number of your seed and Series A investments that go public.

My point is that it doesn’t really matter than much how you define hit rate.

What is important is this chart from the Correlation post:

I guess they have a keen eye for correlation at Correlation Ventures. They certainly found it here.

Venture capital returns are highly correlated to a fund’s hit rate.

Or said differently, a fund’s hit rate determines their returns.

I think that is a pretty well-known fact these days with all of the obsession with billion-dollar valued companies, or “whales” as I like to call them.

We know that venture investments result in a power-law distribution of outcomes.

And so one or two companies will determine the returns in a given fund.

Sometimes that is not the case. In our 2004 fund it was five companies, but that is why that fund was so good.

The other interesting thing about that chart is why the hit rates and returns in the venture capital industry have not returned to pre-2000 levels.

I think that is all about the amount of capital in the business now. More capital means more businesses get funded. So even if you have more winners, you don’t see the hit rates move up. The numerator and the denominator have both grown in the hit rate calculations.

Before 2000, the venture capital business was a bit of a cottage industry.

In the last 15 years, VC has become an institutional asset class with the permanence and stature that brings seemingly endless amounts of capital to it.

And so the returns have stabilized in or around the 2-2.5x over ten years number, which produces high teens/low 20s IRRs, which is enough to sustain the sector.

The only thing that I think would take us back to mean multiples of 4x or better would be some sort of massive reduction in the amount of capital coming into the venture capital business. And I don’t see that happening any time soon.

But one thing about the VC business has not changed in all of the years in that chart, which is roughly how long I have been a partner in a venture firm, and that is that your big winners will determine your returns.

Same as it always was.

I have always felt that every investment in a venture fund should be able to return the fund.

That doesn’t mean that they all will.

In fact, for many funds I have worked on, only one or two investments work out well enough that each of them can return the fund.

So if you have a $100mm fund, you need to look at each and every investment and ask yourself if the company delivers on everything they are seeking to do will that return $100mm to your fund.

It’s a tall order and doesn’t happen that frequently.

But if it never happens, you won’t be in the venture capital business for long.

I remember when my son came home one day in high school and told me he wanted to “day trade” along with some friends who were doing it. We opened a TD Ameritrade account and staked him with a small amount of money, enough to trade but not enough that if he lost it all it would be an issue. And off he went.

A few weeks later he asked me “Dad, what is a PE ratio?” So I said to him “you know that deli that you stop in every morning and get a bacon egg and cheese on the way to school?” He said “yes”. I said “let’s say tomorrow the owner says to you, I’m selling the business, do you want to buy it? We make $1mm a year in profits and have for the last thirty years.” Then I said, “how much would you pay him for it?” My son thought about it and said “Four to five million dollars.” I asked him why. He said, “Because I would get my money back in four to five years and then make a million dollars a year after that.” I said, “you offered to pay a PE of 4 to 5.” And he said, “Oh, I get it.”

I like to call that kind of valuation “real value”. You pay $4-5mm for a business and you get your money back after a few years and then cash flow after that. While nothing in life is guaranteed, real value is tangible. You can see your way to realizing it. It’s right there in front of you.

Then there is what happens in early-stage investing. We offer $1mm for 20-25% of a company and value it at the same $4-5mm. But there is no cash flow. There is no revenue. There are no customers. There is no product. Just a few people and an idea. That is hypothetical value. We think “if this becomes worth a billion dollars, we might hold onto half of our initial ownership and end up with $100 million or more”. And we plunk down the money and go.

Here is the thing. A startup becomes a company and eventually, that company gets valued on real value metrics. Someday it will have customers, and revenue, and profits. And investors will think “how many years of profits will I be willing to pay for that company?” A PE ratio will be applied and it will be valued on the business fundamentals and not what can or could be.

Venture capitalists and seed funds and angel investors make or lose money on the journey from hypothetical value to real value. And when the spread between the two narrows, the money we make is less. When the spread increases, the money we make is more.

It is easier to drink your own Kool-Aid in the world of hypothetical values. You handicap the odds of winning more aggressively. You trade ownership for capital at work. You accept the new normal.

Real value doesn’t move so fast. Because it is right in front of you. You can see it. So it is not prone to flights of fancy.

I try to keep this framework front and center in my brain as we meet with founders and work to find transactions that work for everyone. I find it to be a stabilizing force in an unstable market.