Posts from VC & Technology

My partner Albert wrote this a few weeks ago. Since then I have met with a number of founders who are most certainly headed for this problem. As valuations are extended and it feels very late in this cycle, I feel that the risk of this happening to entrepreneurs is quite high now.

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In the current valuation environment many entrepreneurs seem to believe that only two numbers matter in a financing: the amount of the raise and the dilution. This leads them to buy into the idea that more money for the same dilution is always strictly better. Combined with a lot of money being available from investors this is resulting in Series A rounds of $10 million and more.

What could possibly go wrong? The number everyone seems to be forgetting about is the post-money valuation. It is a crucial number though as long as a company is not yet financed to profitability. It determines how far the company needs to come to be able to raise money again. It needs to build enough value so that the next round of fundraising can be at or ideally above the current post money valuation.

If you do a Series A with a $50 million post-money, it means you have to build something that people will consider to be worth $50 million when you next raise money. Now if your company hits a great growth trajectory and the financing environment stays as it is then great. But if either of those two conditions are not met you will find yourself in the post money trap.

Again, you can get caught in this trap in two different scenarios. The first one is that you hit a bump in the road. Users or revenues or whatever the most relevant metric for your business wind up not growing as fast as you think or worse yet hitting a temporary plateau, possibly even a small setback just as you need to raise more money. The second one is that the external financing environment adjusts for instance because the stock market drops 20%. Then even if you hit all your milestones, suddenly that may no longer let you clear the hurdle you set for yourself.

Some founders seem to ignore this logic entirely. Others come back and say “but we will have that much more money to and hence time to clear the hurdle.” That too, however, is faulty logic. It reminds me a lot of the problem of getting rockets into space. The simplistic answer would seem to be: just add more fuel. The problem though is that fuel too weighs something which now needs to be lifted into space. Your burn rate is pretty much the same thing. Unless you are super disciplined on how you spend the money you will have a higher burn rate the more you raise which makes subsequent funding harder (instead of easier).

Another, less common, founder objection is: well, if necessary we will just do a down round. This ignores that down rounds are incredibly hard to do. For reasons of founder, employee and investor psychology they rarely happen. And if they do they are often damaging to the company. So when you are in the post-money trap you have largely made your company non-financeable entirely.

Finally, this situation is highly asymmetric from the point of view of funds versus companies. First, funds have portfolios, so some deals with dangerously high post money valuations can be offset — if one is disciplined — with others that are more attractive. Second, when investing in preferred there is a lot of downside protection built in that’s not available to the common shares. Hence a simple test to see just how far you are stretching into is to ask investors (and better yet yourself) how much common they (you) would buy right now and at what price.

I said something on stage at Launch yesterday that I’d like to elaborate on:

“Great VCs care more about the company than their investment.” –@fredwilson @Launch #launch2015

— Red Clay (@redclayco) March 4, 2015

I do not mean that your investment isn’t important and I do not mean that making money isn’t the focus of a venture capital firm and a venture capital investor. Both are absolutely true.

However, I believe if you are invested in a startup at an early stage that goes on to become a “great company”, that your investment is going to work out fabulously well.

So I think that putting all of your energy into helping the entrepreneur and the team around them build a great company is the best way to accomplish generating great returns on investment.

Venture capital is one of those asset classes where you can impact your investment. And the best VCs do that very well. I’ve studied the great VCs and how they conduct themselves. And what I have seen is that this focus on the company first and everything else second is what separates the best ones from the rest.

Most people that are in the VC and startup sector know that USV likes to invest in networks. And most of the networks we invest in are consumer facing networks of people. Peer to peer services, if you will. The list is long and full of brand name consumer networks. So it would be understandable if people assumed that we do not invest in the enterprise sector. That, however, would be a wrong assumption.

We’ve been looking for enterprise networks to invest in since we got started and we are finding more and more in recent years. There is a particular type of enterprise network that we particularly like and I want to talk about that today.

Businesses, particularly large ones, build up large groups of suppliers. These suppliers can be other businesses or in some cases individuals. And these suppliers also supply other businesses. The totally of this ecosystem of businesses and their suppliers is a large network and there are many businesses that are built up around making these networks work more efficiently. And these businesses benefit from network effects.

I am going to talk about three of our portfolio companies that do this as a way to demonstrate how this model works.

C2FO is a network of businesses and their suppliers that solves a working capital problem for the suppliers and provides a better return on capital to large enterprises. Here is how it works: C2FO has a sales force that calls on large enterprises and shows them how they can use their capital to earn a better return while solving a working capital problem for their suppliers. They bring these large enterprises onto their platform and, using C2FO, they recruit their supplier base onto the platform. They also bring all the accounts payable for the large enterprise onto the platform. Once the network and the payables are on the platform, the suppliers can bid for accelerated payment of their receivables. When these bids are accepted by the large enterprise, the suppliers get their cash more quickly and the large enterprise earns a return on the form of a discount on their accounts payable. C2FO takes a small transaction fee for facilitating this market.

Work Market is a network of businesses and their freelance workforce. Work Market’s salesforce calls on these large enterprises and explains how they can manage their freelance workforce directly and more efficiently. These enterprises come onto the Work Market platform and then, using Work Market, invite all of their freelance workers onto the platform. They then issue all of their freelance work orders on the Work Market system, manage the work, and pay for the work, all on Work Market. Work Market takes a transaction fee for facilitating this and many of Work Market’s customers convert to a monthly SAAS subscription once they have all of their freelance work on the platform.

Crowdrise is a network of non-profits, the events they participate in, and the people who fundraise for them. Crowdrise’s salesforce calls on these events and the large non-profits who participate in them. When a large event, like the Boston Marathon, comes onto Crowdrise, they invite all the non-profits that participate in their event onto the platform. These non-profits then invite all the individuals who raise money for them onto the platform. These events and non-profits run campaigns on Crowdrise, often tied to the big events, and Crowdrise takes a small fee for facilitating this market.

I hope you all see the similarities between these three very different companies. There are several but the one I’d like to focus on is the “they invite all the ….. onto the platform”. This recruiting function is a very powerful way to build a network from the top down. And once these networks are built, they are hard to unwind.

We don’t see many consumer networks built top down, but we do see a lot of enterprise networks built top down. And we are seeing more and more of them. It is also possible to build enterprise networks bottoms up (Dropbox is a good example of that). That’s the interesting thing about enterprise networks. You can build them top down or bottoms up. And we invest in both kinds of enterprise networks.

The top down enterprise network is a growing part of the USV portfolio. We like this approach to building an enterprise software business and it does not suffer from the “dentist office software” problem. Which is a very good thing.

Back in the early days of this blog I had a series called VC Cliche Of The Week. I’m not sure how long I ran it but I did eventually run out of material and phased it out. In continuation of yesterday’s good vibes and with yet another shoutout to Bliss, here’s a reblog of one from March 2006:

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The father of this weekly series, the guy who taught me at least half of the cliches I know, is a guy named Bliss McCrum. He and his partner Milt Pappas taught me the venture capital business from 1986 to 1996 when I worked with them at their firm, Euclid Partners.

One of my favorite cliches from Bliss is a rising tide lifts all boats.

Whenever things seemed too good at a portfolio company, in the stock market, the economy, or somewhere else, Bliss would quip, “well you know that a rising tide lifts all boats“.

It was his way of saying “don’t mistake a good market for a good business”.  The insinuation was always that the tide would come back in and so would the boats.  And you had to be prepared to make things work in tough times as well as good times.

And we are in good times in the venture business, the internet business, and for the most part, the US economy.  Consumer confidence hasn’t been this strong since before the Iraq war.  The Fed has raised rates 15 times and may not be done, signalling that the economy remains stronger than they’d like it. Venture money is flowing freely in Silicon Valley and China and in many parts of the developed or developing world.  Advertising dollars continue to move from offline media to online media and that is one rising tide that is certainly lifting all boats.

But we know these good times will come to an end at some point.  Are we in 1998 as Caterina suggests and have another year or two before the good times end?  Who knows?  I don’t expect this run of good times to play out like the last one anyway.

The best we can do is prepare our companies to withstand a business environment that is less friendly.  Companies need a business model, they need a seasoned and well constructed team, and they need patient and experienced financial partners.  With these ingredients, hard work, and some luck, you can survive a downturn.

Some of the best companies I’ve ever worked with were funded at the height of the last bubble and they are doing great now.  So it doesn’t really matter when you start a company, but it does matter that you can make it through tough times.  Because right now we have a rising tide that is lifting all boats and that won’t last forever.

I was catching up on Brad Feld’s blog this morning and saw that he had posted about the “40% rule” for SAAS companies.

I was at the same board meeting as Brad and came away similarly impressed by the simplicity of the rule and the logic behind it.

Here’s the 40% rule and it is aimed at SAAS companies:

Your annual revenue growth rate + your operating margin should equal 40%

So, if you are growing 100% year over year, you can lose money at a rate of 60% of your revenues

If you are growing 40% year over year, you should be breaking even

If you are growing 20% year over year, you should have 20% operating margins

If you are not growing, you should have 40% operating margins

If your business is declining 10% year over year, you should have 50% operating margins

I have never seen growth and profitability so nicely tied together in a simple rule like this. I’ve always felt intuitively that it’s OK to lose money if you are growing fast, and you must make money and increasing amounts of it as your growth slows. Now there’s a formula for that instinct. And I like that very much.

Thanks Brad for posting it.

I was reading William’s post on the potential crash in the Bitcoin sector this morning and I thought of Carlota Perez. Longtime readers of this blog will know that I am a huge fan of Carlota’s work, her research around technology revolutions and financial capital, and her book about all of that.

In 2011, I got to interview her on stage at the Web 2.0 expo, which was one of the highlights of my career.

For those that are not familiar with Carlota’s work, she studied all of the major technological revolutions since the industrial revolution and how they were impacted by and how they impacted the capital markets. What she found was that there are two phases of every technological revolution, the installation phase when the technology comes into the market and the infrastructure is built (rails for the railroads, assembly lines for the cars, server and network infrastructure for the internet) and the deployment phase when the technology is broadly adopted by society (the development of the western part of the US in the railroad era, the creation of suburbs, shopping malls, and fast food in the auto era, and the adoption of iPhones, Facebook, and ridesharing in the internet/mobile era).

And the “turning point” between the two phases is almost always marked by a financial crash and recovery. See the chart below from Carlota’s book:

I’m not going to guess if we’ve seen the “collapse phase” of the Bitcoin technological revolution, or if we are in it, or if it is coming. But if Bitcoin and Blockchain is going to be a meaningful technological revolution, and I think it will be, then we are going to move from the installation phase to the deployment phase at some point and there will be a major financial break point that happens along the way.

What is less clear to me is whether this “collapse” will be seen in the price of Bitcoin, the health of the overall Bitcoin and Blockchain sector and the companies in it, or possibly the broader capital markets (VC, public equity, etc). It seems to me that the first is very likely, the second is also likely, and the third is less likely.

In any case, as my friend Tom Evslin like to say “nothing great has ever been accomplished without irrational exuberance”. And the Carlota Perez corollary to that is “nothing important happens without crashes”.

And the lesson I’ve learned in my career is to invest into the post crash cycle. When you do that, and do it intelligently, you are rewarded greatly.

I kicked off the second topic of the week discussion on usv.com today with a post about community ownership of Internet applications and services.

If you want to read the post and/or join the discussion, go here and do that.

Here’s a teaser to get you interested in doing that:

With more and more web and mobile applications deriving their value mostly or completely from their user base (Facebook, Twitter, eBay, Etsy, Reddit, Kickstarter, Uber, etc, etc), there is a growing sense that the community could or should have some real ownership in these businesses.

I go on to explain a bit about why this has not happened except in very rare cases and what needs to get figured out to make it happen more frequently.

There’s a lot going on, including approaches unleashed by blockchain technology, to make this easier to do and we think this is a trend worth watching and discussing. That’s why we made it the topic of the week.

There was a good discussion in the comment threads to yesterday’s post. This comment from Rick made me think a follow-up post would be helpful.

Seed, Later Stage, etc. all mean different things to different people. That’s where the confusion comes from.

I wrote a post explaining how we think about seed last June. Here’s the important part from that:

The first step you need to climb is building a product, getting it into the market, and finding product market fit. I think that’s what seed financing should be used for.

The second step you need to climb is to hire a small team that can help you operate and grow the business you have now birthed by virtue of finding product market fit. That is what Series A money is for.

The third step you need to climb is to scale that team and ramp revenues and take the market. That is what Series B money is for.

The fourth step you need to climb is to get to profitability so that your cash flow after all expenses can sustain and grow the business. That is what Series C is for.

The fifth step is generating liquidity for you, your team, and your investors. That is what the IPO or the Secondary is for.

At USV, we like to invest in a company once they have launched a product and we think that they have either found product market fit or they are well on their way. If you think about the “five steps” that leads us most often to invest in the Series A stage.

But occasionally one or two people, working nights or weekends, or working in an accelerator, or working for themselves and bootstrapping, are able to get a product into the market, get adoption, and get to or close to product market fit. They don’t need $3mm or $5mm, they need $500k to $1.5mm to finish off the search for product market fit, allow them to work full time on their project, and hire a few people to help them improve the product. That is the kind of seeds we like to do at USV.

Here are some examples:

Delicious – Joshua Schachter had built Delicious working nights and weekends, launched it, got traction, and needed $1mm to leave his day job, start a company, hire some people, and scale the product.

Tumblr – David Karp and Marco Arment built Tumblr while doing consulting to others. Tumblr took off and they needed to stop doing consulting work so the two of them could focus 100% of their time on Tumblr. Spark and USV each invested $300k to help them do that.

Etsy – Rob, Haim, and Chris built Etsy themselves, launched it, and were scaling the business. They had raised a little money from two local entrepreneurs but they needed more to keep Etsy growing. We participated in a $600k seed round to help them do that.

MongoDB – Dwight, Eliot, and Kevin had invested their own money and time getting the 10gen “stack” into the market. They wanted a financial partner to help them continue to fund the effort to find product market fit. USV provided seed capital so they could do that. They ended up finding product market fit for the database, MongoDB, but not the rest of the 10gen stack and they refocused the business entirely on the database and then were able to demonstrate product market fit and get to a Series A.

Foursquare – Dennis and Naveen built the initial version of Foursquare themselves. They launched the product and started to get users who liked the product, including a bunch of folks at USV. We liked what they were up to and thought they were close to nailing product market fit. We led a seed round that allowed them to hire a bunch more engineers who essentially rebuilt the product so it could scale.

Kickstarter – Perry, Yancey, Charles, Luke and maybe a couple others got the initial Kickstarter service launched and struck a chord with it. They had raised some capital from friends who helped them get the product into the market. USV led a seed round so they could hire a team and scale into the market.

Amino – Ben and Yin built Amino, went through Techstars, got their iOS product into the market, and proved that there was a market for native mobile communities. We led a seed round to enable them to hire a few more people, get an android app into the market, and nail product market fit.

OneName – Ryan and Muneeb built and launched OneName while they were in Y Combinator. We saw what they were doing and liked it a lot. We led a seed round to enable them to flesh out the product and build out the initial use cases.

Those are not the only seed investments we’ve made at USV. We’ve made over twenty seed investments over the life of USV. But these are good examples and I think they do a good job of explaining what it is we like to fund at the seed stage at USV.

We (USV) raised a new venture fund at the start of last year and started investing it in the spring of 2014. It is called USV 2014. We have made six investments in it so far and five of them are seed investments. That’s a very high ratio for USV and we do not expect that ratio to continue over the life of the fund. In fact our next investment will be a classic Series A so we are already lowering the ratio. But it is a bit of a return to form for USV as half of the initial investments in our first fund (USV 2004) were made at the seed stage.

In our core early stage funds (as opposed to our Opportunity Funds), we make initial investments at the seed, Series A, and Series B stages. In an ideal world for USV, there would be a normal distribution of these entry points with the highest percentage in the Series A stage. Over the entire history of USV, that is very much true. But on a fund by fund (or year by year basis) it varies a lot. It is mostly us reacting to the market. When the later stage rounds are too expensive on a risk/reward basis, we tend to move earlier. And when we can get good risk/reward opportunities in the Series A and Series B stages, we tend to move later. The downturn of 2008/2009, for example, led us to move a bit later in our 2008 fund because we could invest in more mature (and therefore less risky) opportunities at attractive prices.

The current market environment has pushed us to invest earlier. Some of it is that the Series A and particularly the Series B valuation environment has gotten very expensive relative to the risk as we see it. And some of it is that we are in a period of flux, where it is not entirely obvious to us where the next big things are going to happen. We have some ideas, of course, and I have been exploring them here at AVC and we have been exploring them as a team on usv.com. We think that in times of flux it is attractive to make a bunch of smaller seed investments in areas we think are going to emerge as important in a few years.

So that explains the move to seed as our primary entry point last year. I think it will continue this year but maybe moderate a bit as some of these developing markets mature and become more investable at scale.

Ok. Now that I’ve explained why I’m thinking about seed investing a lot these days, I’d like to talk about how we do seed at USV. Here are the important points:

1) We do not take a shotgun approach. We do not view seed investments as “options”. We only make a seed investment if we have as much conviction on the team and the opportunity as we would at the Series A round. We are as committed to our seed investments, both in terms of the time we spend with them and the willingness to follow-on in them. They are core investments with as much stature in our portfolio and in our firm as any other early stage investment. This is critical to understand. And it is not true of many (most??) VC firms who make seed investments.

2) We like seed investments in teams and opportunities where they have built and launched a product already. We don’t like investing in a concept or participating in a round where the uses of the capital will be to build and launch a product. This means the vast majority of seed rounds are not a fit for us. We pass on a lot of seed stage opportunities because it is “too early” for us. That is a comment on the specific opportunity however, and not seed stage investing as a whole. This confuses a lot of people. They tend not to think of USV as a seed investor when in fact we do make a lot of seeds (over 80% of last year’s investments, for example).

3) We will often lead the Series A (and sometimes Series B) in companies where we did the seed investment. We led both the Series A and Series B in Etsy and we co-led (with Spark) the Series A and Series B in Tumblr. We were seed investors in both companies. We continue to do that where it makes sense for the founders and USV. That is not a requirement or an expectation, but it does happen and I believe it is a very good thing in the right circumstances.

4) We like to participate in syndicates in our seed investments. We don’t focus too much on ownership at the seed stage. We do focus on the investors coming together around a project. We like partnering with smart angels, seed funds, and even other VCs, if the other VCs are aligned with us on how they are thinking about the particular seed investment. Our investment with Spark in the seed round at Tumblr is a good example of two VC firms partnering up at the seed round and doing a good job working together and scaling into the opportunity.

USV will never be confused with a seed fund, but we sometimes act very much like one, except that we can and will invest 20-30x our initial investment over the life of the company. That combination (a committed and active seed investor + deep pockets) is unusual. You can get one of those two a lot. But rarely both. So if you are working in an area that is interesting to USV, and if you have launched something into the market already, and if you are doing a seed round, please do reach out to us. We are in the business of making seed investments and doing a lot of it these days.