Posts from VC & Technology

One of the most noticeable changes to the VC business over the past decade is the movement of investment allocation from capital and time intensive sectors like biotech and clean tech to capital efficient and fast moving sectors like internet and mobile.

This makes total sense if you think about it. VCs are professional money managers. We are provided capital to invest as long as we can return it to our investors with a strong return in a reasonable amount of time. A strong return is 3x cash on cash. A reasonable amount of time is ten years max.

Internet and mobile product development cycles are measured in months not years. And the capital required to get a product built and into the market is less than $1mm. And the returns, when things work out, can be enormous.

Contrast that with biotech. A new drug takes $100mm in capital investment to get to market. And that process can take a decade or more.

If you were a professional money manager, where would you invest? Where has USV invested our investors' capital for the past eight years? It's not even a contest. Internet and mobile wins hands down.

But internet and mobile will not and can not solve all of society's problems. We need new medical approaches to preventing and/or curing disease. We need new scientific approaches to generating, storing, and being more efficient with energy. Maybe we need more space exploration. Maybe we need more undersea exploration.

Enter the crowd.

When the Gotham Gal and I allocate our personal capital, we do it broadly. We give it away to good causes. We invest in things we want to see in the world regardless of whether there is a good return on it. We are driven by the outcome as much as the return.

I suspect that many people approach the allocation of their personal capital similarly. And that is very different than a professional money manager behaves.

So the advent of crowdfunding, for equity, for philanthropy, and for patronage, seems like a great fit with these capital and time intensive projects that the VC business has largely abandoned.

If we saw a promising technology that could prevent or cure cancer, we would be inclined to help fund that, regardless of the timing and magnitude of the financial returns it could produce. If we saw a promising technology that could store and move energy more efficiently, we would be inclined to fund that as well.

I can feel the crowdfunding movement coming. It's in the air. And I think it will be impactful and helpful in many way. And I hope that its impact will be most felt in the sectors that have been starved for capital, not the sectors that are awash in capital.

I read a post by my friend Brad Feld this morning that struck me as great advice. Brad says:

I’ve been noticing an increasing amount of what I consider to be noise in the system – lots of drama that has nothing to do with innovation, creating great companies, or doing things that matter. I expect this noise will increase for a while as it always does whenever enthusiasm for startups and entrepreneurship increases. When that happens, I’ve learned that I need to go even deeper into the things I care about.

I've been noticing the same nonsense and I've been trying to put up blinders myself. Brad's advice is to make a list of the thing that interest you and then dig deeper on them. His is at the end of his post.

I am interested in extending the internet/web/mobile disruption we've seen in media to big industries like finance, education, healthcare, energy, etc in order to address the challenging economic and social issues of our time. I'm going to take Brad's advice and dig deeper on these areas. And I want to write more about this stuff and discuss it with all of you here.

I was up at Columbia University on thursday speaking to Steve Blank's students. Steve did a weeklong version his Lean LaunchPad class at Columbia last week. During the Q&A, a student asked me how I engaged with the startups we invest in. I answered that I planned to play paintball with two of our portfolio companies on the coming weekend. That got a chuckle from the class but it wasn't a joke. I don't think VCs should be meddling with the companies they invest in but I do think they should be engaged. And playing paintball is a good way to do that.

I like to stop by the offices of the companies we invest in and have lunch with the team. Over one of those lunches at Canv.as a few months ago, I told the team that I had been in ROTC in college and that I still had decent skills. I described a paintball game I had played with my son and his friends a few years ago. The next thing I know, Chris Poole, the founder of Canv.as emails me and tells me that he wants me on his team for a paintball throwdown with Codecademy, another USV portfolio company. How could I say no to that after bragging about my skills to the Canvas team at lunch?

So we trucked out to Staten Island yesterday morning to Cousins Paintball and spent three hours running around the woods shooting each other with paintballs. It was a blast. There are a couple photos of the event here.

I got to know everyone on both teams a lot better and got shot by most of them at least once. Chris and Zach trash talked and beefed a fair bit at the start but by the end it was all hugs.

Great day, great bonding. That's what I call engaging wtih the companies we invest in.

I was having lunch with a veteran of the entertainment and the video game business this past week. It was an interesting and wide ranging chat. One of the things we discussed that stuck in my mind was the thought that web and mobile apps might behave more like TV shows than traditional software applications.

I've watched my kids go from myspace to facebook to instagram over the past seven years. And who knows what social app will be their "go to app" in five years. This has always been the case in videogames. Farmville to Cityville to something else. Words With Friends to Draw Something to something else.

This round trip from nothing to everything to nothing again is also true at some level with many tech companies. Digtal Equipment Corporation was founded in 1957 and shuttered in 1998. RIM was founded in 1984 and in all liklihood will be gone before the end of this decade. Same with Sun Microsystems, Silicon Graphics, and many more iconic tech companies.

This concern or observation depending on where you sit has wide ranging implications for valuations, returns, and many other aspects of the startup economy. Companies are worth the net present value of their future cash flows. Said another way, if you knew that a company was going to earn $1mm a year for the next ten years and then be shut down, there is no way you'd pay more than $10mm for that company and certainly you'd pay something a bit less than that.

There are web and mobile applications that seem more immune to the "here today gone tomorrow" concern. Utilities like search, email, calendar, document store, etc feel less likely to be subject to this issue. YouTube also feels fairly secure. But purely social apps, the ones that depend on having your friends on them, seem quite vulnerable to a mass exodus. RIM's demise among my kids' generation had more to do wtih everyone leaving BBM than anything else. For as long as all of their friends were on BBM, they all wanted to be on it too.

Network effects are powerful in both directions. They can help you grow exponentially. But when they are going against you, they work just as fast. Myspace's decline was mind blowingly quick. RIM's has been as well. Who is next?

I am not writing this post to pour cold water on the internet sector. There are so many amazing things happenning right now. We are investing actively and agressively and are not the least bit bearish.

But it is important to understand the entire life cycle of what you are investing in. If you are playing a game of musical chairs, you have to know that's what you are playing. Or you will be the one left standing with nowhere to sit. And that sucks.

Yesterday Twitter announced that they plan to amend the assignments agreements that they sign with their employees. They call this proposed amendment the Innovator's Patent Agreement. I've been aware of this effort inside of Twitter for a while and I like to call this move the "Twitter Patent Hack" because I think what they have done is very clever and is likely to have a material change in the way patents are used to foster and/or hinder innovation, as the case may be.

Specifically Twitter has said that they will only used these assigned patent rights defensively to protect themselves against hostile actions. And further that any company that acquires these patent rights from Twitter will need the inventor's consent to use them in an offensive action. Twitter has also provided the inventor with certain rights to license the patent to others for defensive purposes. You can read the entire set of provisions on GitHub.

The other day I talked about Insurgents vs Incumbents. This is the framework we use at USV to think about a lot of things. And in the world of patents, the advantage goes to the Incumbents who can hoard patents and use them to their advantage. The insurgent, three engineers in a walk up in Bushwick, can't even afford the lawyer or the time to file a patent. So it is very encouraging to see an emerging incumbent, Twitter, do something like this. They are saying to the world that they do not intend to compete on the basis of patents and instead they will compete on the basis of product, feature set, user experience, etc, etc.

USV is committed to support this initiative. We are instructing the startup lawyers we work with to insert the patent hack language in our standard forms. We are reaching out to our friends in the startup world including other VCs, accelerator programs, and the startup lawyer universe to suggest that they to insert the patent hack into their standard forms. And we will recommend to our existing portfolio companies that they adopt it as well. Of course, entrepreneurs and their companies will have to be the ultimate determinator of whether they want this provision in their inventions assignments agreement. If an entrepreneur we invest in does not want this provision, we will certainly support that decision. But we will want to have a conversation about why they would want to do that.

I will end this post with a story. Many years ago now, my prior venture capital firm, Flatiron Partners, invested in a company called Thinking Media. It was an early Internet company. They developed some browser based javascript tracking technology. The company ulimately failed but was sold in a fire sale including the patents. Those patents eventually made their way to an incumbent, the big marketing research company Nielsen. Fast forward ten years or so and Nielsen sued two of my portfolio companies, comScore and TACODA, and a bunch of other companies too, on the basis of the Thinking Media patents. So IP that was partially funded by our firm was used to sue other portfolio companies. It is so galling to have this kind of thing happen and it is one of the many reasons why I have come to believe that software and business method patents are an enemy of innovation in the tech sector.

If Thinking Media had the patent hack in their documents, the story I just told would not have happened. And thanks to Twitter's leadership, I hope that all future USV portfolio companies will have the patent hack in their documents and stories like that one will be a thing of the past. I'd like to thank Twitter's leadership team, especially the legal and engineering teams, for coming up with such an elegant and simple solution to this thorny problem. The startup world is a better place today than it was yesterday as a result of their work.

Possibly the most interesting running conversation I've been having with entrepreneurs lately is how they can keep their companies independent without having to go public and turn their cap table into a casino. There are a bunch of entrepreneurs thinking seriously about this issue and I've been thinking seriously about it too.

Of course if you bootstrap your business and never take outside investors then this is not an issue. You control the timing and the choice of exit and there are no investors to concern yourself with. But there are plenty of entrepreneurs who have built interesting businesses using outside capital – angel, seed, VC, or some other form – and they have a portion of their cap table that is seeking a return on their capital on some reasonable timetable.

The emergence of a vibrant secondary market may point to a solution. If one set of investors eventually cashes out to another set of investors who eventually cash out to another set of investors then you have a formula for staying independent while giving your investors liquidity over time.

To some extent this has already been happening in the buyout and private equity world. One financial buyer trades the asset to another financial buyer and so on and so forth. The venture capital industry could potentially adopt some of these practices while leaving the entrepreneur and their management team intact and in control.

Angels and early stage investors who have portfolios with high loss ratios might hold on to their strongest performers for five to ten times their money. Later stage investors who have much less downside risk might hold on for three to four times their investments. Companies could build enterprise value over time generating returns to their various stakeholders who might change over time.

Another possibility is leveraged recaps and possibly dividends. If you build a business with excellent cash flow, there will be cash that can be used to pay out dividends or used to service and pay down debt. Dividends are not tax efficient under US tax law. The Company will pay income taxes on its earnings and then the investors will pay taxes again on the dividends. That is why leveraged recaps are more attractive in the US. Instead of paying dividends, the Company borrows funds it can easily service and pay down over time and uses those funds to repurchase stock from its investors.

Both of these approaches (dividends and leveraged recaps) require that the Company have strong recurring cash flow that when multiplied by a cash flow multiple will provide a meaningful gain to the investors.

Let's look at a model of how this might happen. Let's say a company required $10mm of startup capital to get to breakeven. Let's say $3mm of it came in for 20% of the business and another $7mm came in for another 20% of the business. The investors would then own 36% of the business. If over time, that business could earn $20mm per year of pre-tax cash flow, then it would have roughly $12mm of after tax cash flow to pay out. The investors could be paid out $4.3mm per year in dividends (36% of $12mm). Over the course of five to ten years, those dividends could deliver a 2.2x to 4.4x return to the investors. The issue with this approach is the tax inefficiency resulting from double taxation and the long time frame it would take to earn a decent but not amazing return.

On the other hand, $20mm of cash flow could be used to borrow $100mm (5x coverage) and that $100mm could be used to repurchase the 36% from the investors. The investors would get a 10x return on their investment and the founders would get all of that equity back. It would take 7 or more years to pay off the debt including interest and that would be a large debt balance for a company to carry.

Clearly the leveraged recap is preferential to paying dividends as a way to take out investors with cash flow. Some variation of the leveraged recap will be the way to go for as long as dividends are tax disadvantaged to leverage.

None of these approaches is likely to result in returns that are as good as what could be obtained in a strategic sale at a big premium or an IPO in a strong market environment. A company with $20mm of pre-tax cash flow is likely to have close to or greater than $100mm in revenue and could possibly exit or IPO for between $300mm to $500mm in a strategic sale or IPO in a good market environment. If the investors own 36% of the Company, their proceeds in that kind of an exit would be $110mm to $180mm, higher than what could be obtained in any cash flow based exit scenario.

But none of this says to me that new approaches to liquidity for venture investors should not be on the table. If the entry price is right (rare these days) and the investor is patient and if the entrepreneur and company is willing to get creative, there are ways to get early investors liquidity at acceptable rates of return that compensate for the risk of the early investment that do not require selling the company or taking it public.

I am working on this on a few fronts. Nothing urgent or imminent. But I am confident we will see our firm utilize some of these different approaches in the coming years. I think we have to if we want to continue to serve the interests of entrepreneurs and the companies they create.

Jeff Leventhal, the CEO of our portfolio company WorkMarket, emailed me yesterday. He said:

i would love to see an avc post about copycats like samwer bros. what do u think of this form of entrepreneurs, etc?

I looked back over my archives and I guess I've never addressed this topic here at AVC. So here goes.

It's a free market out there. People can do what they want. That's even more true globally. If you are successful, you will be cloned. That's life. In fact, it's a sign that you've made it when clones of your website, mobile app, and business start cropping up.

That said, I am not a fan of this behavior and approach to making money. It is devoid of any creativity. It doesn't inspire me. And we avoid doing it and investing in those who do it. As Jeff said to me in an email reply, "the problem is that people make money doing it……..these people should just internally understand that they are not entrepreneurs and not creating true value." I agree with Jeff on that.

Some will say "but you are an investor in Zynga and they copy others' games." I accept that critique but we committed to invest in Zynga when it was just poker on Facebook and that was an entirely new idea. They grown by adapting other games to their social model for sure. That's the history of the games business by the way. Even so, I'm not attracted to or inspired by this approach to making money.

Our approach at USV is to invest in the category creator, the innovator, the market leader. That's what attracts us to startups. And when the category creator executes well, we have found that it can win the market by a long shot and produce fantastic returns.

There are a few examples of USV portfolio companies that were not the category creator. Lending Club is a good example of that. We invested in Lending Club because they innovated around the peer to peer consumer lending model and came up with the winning approach and they are now the clear market leader. That was a late stage investment made out of the Opportunity Fund. I suspect that we will do that kind of thing more frequently in our Opportunity Fund investments.

But in the early stage sector, we are drawn to entrepreneurs who have new ideas, novel approaches, and big visions with long roadmaps. We are not drawn to those who seek to knock off another company and execute it better or in a different geographic market. If that is what you are doing, I am certain you can find investors and I am not looking down on your approach. But we are not the best investor for you and your project.

It's really easy to appear intelligent when you are surrounded by smart people. I've written a fair bit about how my partner Brad is responsible for much of USV's investment thesis and the deep thinking we do as a firm.

But USV is also extremely fortunate to have had the benefit of Albert Wenger's big brain for the past five years, since he helped Joshua build and sell Delicious to Yahoo!

Since I don't have anything particularly interesting to say this morning, I thought I'd feature this interview with Albert that Rocky Agrawal did in our office recently. It's 45 minutes so it's a long listen, but there are a lot of good insights in here.

One more thing while we are talking about Albert – He's been doing this great weekly column called Tech Tuesdays where he essentially explains how this technology we are all using works. He's got a survey up on his blog looking for some feedback about where to take Tech Tuesdays next.

I’m out here slingin bringin the drama,
tryin to come up in the game
and add a couple of dollar signs to my name
– Memphis Bleek Coming Of Age by Jay-Z

I'm not going all Ben Horowitz on you. But imitation is the finest form of flattery and I do like how Ben rolls on his blog and in the venture capital business.

I'd like to talk this morning about how hard it is the come up in the venture capital game. I work with a bunch of VCs who are in their early 30s and have less than five years in the business. They work hard, put in ridiculous hours, are on top of all the latest trends, companies, technologies, etc. They meet with tons of companies every week, work hard for their portfolio companies, and are on planes flying around to the important confereneces and demo days. I can assure you they are working harder than I am.

But when it comes to winning deals, they have a distinct disadvantage. They can be working on a deal for a year or more, and then when the entrepreneur decides to raise funds, a more experienced VC such as myself can swoop in, spend a week or two building a relationship with an entrepreneur, and take the deal away from them. I've seen it happen. I've done it myself.

They make rookie mistakes. They let a reporter hang out with them for a week thinking they can trust them. They talk when they should be listening. They overpay for deals thinking that will win the deal for them. They use their phones in board meetings. They fight with entrepreneurs over meaningless things.

When I see these things I cringe. Because I've been there and done that. I spent the first ten years (maybe 15) of my time in the venture business as a young VC trying to make it in the game and not really knowing how. I've made all of these rookie mistakes and more. I feel for them, I often mentor them, and I really enjoy working with young VCs.

When a young person asked me about getting in the venture capital business, I advise them not to. I think VC is an experienced person's game. Startups are not so much. Startups are a great place to be in your 20s and 30s. VC is a great place to be in your 40s and 50s.

I look at Ben and his partner Marc and think "they did it right." They got into the venture capital business when they had all the experience one could ever want working with startups. They don't lose deals to more experienced VCs. They win deals over more experienced VCs.

But of course many young VCs made the decision to get in the game at an early age and are committed to making it work. They are going to have to take their lumps. Make the mistakes. Learn from them. Continue to work harder for less results to show for it. And lose deals they should win.

One of the things I did not do very well that many of these young VCs are doing much better is building relationships with more experienced VCs. As I said, I work with a bunch of them. Teaming up with a more experienced VC can help you win a deal, you can learn from them in the board room, and you can ask them for advice when you screw up.

Going back to where we started this post to end it, I like how Jay-Z and Memphis Bleek partner up in Coming Of Age. That's the way to do it.

[JZ] Hahahh I like your style
[MB] Nah, I like YO’ style
[JZ] Let’s drive around awhile