Posts from VC & Technology

The Great Public Market Reckoning

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.

#stocks#VC & Technology

Hair On A Deal

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.

#entrepreneurship#VC & Technology

The Hit Rate

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.

#VC & Technology

Returning The Fund

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.

#VC & Technology

Hypothetical Value To Real Value

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.

#VC & Technology

The Long Engagement

The Gotham Gal and I met when we were 19 and got married when we were 25. We lived together for most of those six years before we got married. By the time we tied the knot, we knew each other very well.

While venture capital investing and marriage are two different things, I think there are some things one can take from love and marriage into the world of startups and venture capital investing.

One of them is the value of long engagements.

I have never understood why founders want to run a lightning fast process to select business partners who they may have to “live with” for the next seven to ten years.

And yet we see this behavior all of the time. Often it is driven by other VCs who toss in “preemptive term sheets” thus turning a fundraising process into a sprint.

What I would prefer to see, and do see in many cases, is a founder who takes the time while they are not raising money to build a number of relationships with potential investors and then engages those investors in a process when it is time to raise capital. I like to call this process the “long engagement”.

It might sound like a lot more work than the fast and furious fundraising process that many founders are running these days.

But I don’t think it is a lot more work. Building relationships over a six to twelve month period can take the form of an occasional face to face meeting, emails back and forth, and even a few visits to the office by the investor. And none of that has to have the pressure of a pitch, an ask, and a price.

For the investor, this is a much better process. It allows them to see the founder and the business execute over time. It allows everyone to develop comfort with each other.

I would argue that it is a much better process for the founder too. It let’s them see which investors are truly interested in their business, their team, their product, and their success. It also reveals which investors are “here today, gone tomorrow.” You want the former on your cap table, not the latter.

It is easy to get caught up in the game of startups and investing in them. A fundraising process is at its heart a competition. And everyone wants to win. But you don’t get a trophy for winning this game. You get into a relationship. Often a very long one. So I think stepping back from the game theory and stepping into the relationships is the way to win long term. Which is the only form of winning that really matters.

#entrepreneurship#VC & Technology

Reserves

One of the unique things about early stage investing is the ability (and in my view, the need) to continue to invest in the companies for multiple rounds of investment.

Late stage, public market, private equity, real estate, and most other popular forms of investing typically involve a single or a time limited series of investments.

But at USV, we typically will make four to six investments in a “name” over five to seven years.

And we do this style of investing with a fixed pool of capital.

So we have gotten very analytical about modeling out our reserves for our follow on investments.

What we do is maintain a spreadsheet of every investment in a given fund and the likely amount and timing of future follow on investments as well as the probability of us having the opportunity to make those investments.

We then run a Monte Carlo simulation 1000 times and draw a distribution curve of outcomes and then manage our funds against that.

We have a “cushion” for error which is our ability to recycle roughly 20% of our funds and that has come in handy on every fund we have managed at USV.

I think the proper allocation of follow on capital into the portfolio and making sure you can follow your winners and defend your position in certain situations is absolutely critical to producing top tier returns.

It is not as important as portfolio selection (which comes from our thesis) or our work on the boards of our portfolio. Those two things are the most critical factors in our performance.

But I think capital allocation/fund management is third on the list and is a missed opportunity for many early stage investors.

#VC & Technology

Certainty Of Close

On Friday, I had two separate conversations with founders about fundraising strategies.

Both had an easier path that would likely get them to a closing quickly but might cost them some economics and a harder/longer path that would allow them to maximize economics.

I gave them both the same advice which is that certainty of close is super important, particularly early on in a venture when you see an opportunity and want to capture it before someone else does.

Most decisions are not black and white. There is usually a lot of grey in between. Fundraising is always like that. There is rarely an obvious right answer.

Many founders are advised to run a competitive process, get as many quality offers as you can, and use that competitive dynamic to maximize economics.

While that is a great strategy if you have the luxury of time on your side and the ability to spend several months focused on raising capital, there is often merit to the quick close that maximizes certainty over other things.

Both conversations on Friday ended in a discussion about people and how important they are in all of this. The answer to that is that they are the most important factor of all when raising capital.

If you are comfortable with the people involved and have a high degree of confidence that they will be great partners, then everything else is secondary. That is true for at least the first five years of a venture. At some point, in very late stage or public financings, the people issues lessen and you can optimize for other things.

But early on, if you optimize for anything, optimize for the people you work with. Otherwise you are taking on risks that can and will blow up in your face.

After that, I might put certainty of close next on the list, as long as the economics of the “bird in the hand” are ones you can live with and the people are known quantities. You can rarely go wrong with that combination.

#entrepreneurship#VC & Technology

Whales Not Unicorns

I have been vocal here that I do not like the term Unicorn to describe highly valued venture-backed startups. Unicorns are mythical creatures that don’t really exist and highly valued venture-backed startups do exist. They might be rare, but they are not fictional.

A better word would be Whales. And it turns out that the Whaling industry in the United States in the 18th and 19th centuries looked remarkably similar to today’s venture capital business.

Some of my friends and colleagues have been texting and tweeting about a book called VC: An American History by Tom Nicholas. So I got it on my Kindle and the first chapter is all about the Whaling industry and its similarities to the VC business.

Here are some photos I took of the first chapter on my phone.

This is a chart that plots the distribution of returns by whaling voyage vs venture capital fund.

This is a diagram that compares the structure of the whaling industry to the venture capital industry.

And this is a chart that shows the performance of the top 29 whaling agents. This is very similar to charts I have seen that compares the performance of the top venture capital firms.

So while Unicorns are made up creatures, Whales are not. And given the similarities between a highly successful venture capital investment and a highly successful whaling voyage, I am going to start calling the big winners in the venture industry Whales. I hope it catches on.

#VC & Technology