Posts from Investment

Ron Lieber has a column in today's New York Times called "A Financial Plan For The Truly Fed Up" where he lists some alternatives to investing your savings with the banks and brokerages that make up Wall Street.

His roadmap is basically what the Gotham Gal and I have been doing since the aftermath of the financial market meltdown in 2008. We invested pretty heavily in the stock market as the market was melting down in 2008 and I blogged actively about that here at AVC. But we took our gains early, in the first half of 2009, and then have more or less stayed out of the stock and bond markets since then (we do use our portfolio company Covestor's service).

We are in cash, real estate, venture capital, and private investments centered around our neighborhood and city (retail, restaurants, etc). Other than cash, we are invested in things we can touch and/or impact and understand.

As Ron talks about at the start of his piece, the never ending blowups on wall street are eroding confidence in that system. It certainly has eroded our confidence in that system. So we are staying out of it for the most part.

We do have our cash at a large money center bank. Ron advises credit unions instead. We haven't made that move and I am not sure we will.

Ron also advises people to check out peer to peer lending markets and mentions our portfolio company Lending Club. I was very happy to see that Ron has come around on peer to peer lending. Our firm is a big fan of these markets, having invested in two of them and looking at others.

And he describes a movement he calls Slow Money described in this way:

“Let’s just take some of our money and invest it near where we live in things we understand, starting with food,” as the movement’s founder, Woody Tasch, puts it. He describes returns as being in the “lowish single digits,” ranging from roughly 3 percent to a few percentage points higher.

The Gotham Gal and I are big fans of this approach. We have invested in a number of busineses in our neighborhood and city with expectations properly set for the occasional loss and in general low returns on the portfolio. But we are helping folks start their own businesses and create establishments we can use and that we want to see in our neighborhood. It feels good and I think it will turn out to be as good an investment as cash in the bank. At least I hope so.

As one system seems to be failing on a regular basis, it makes sense that there are new systems that operate differently that are emerging. We are seeking to invest in the ones that can scale at USV and the Gotham Gal and I are also looking to support these efforts in our personal investing. I am optimistic about this emerging movement and I am pleased to see mainstream media starting to talk about it.

I have written about this topic before but it's important and I want to say it again.

Investing in startups is risky. If you make just one investment, you are likely going to lose everything. If you make two, you are still likely to lose money. If you make five, you might get all your money back across all five investments. If you make ten, you might start making money on the aggregate set of investments.

The math behind this is pretty simple. If you assume that the average startup has a 33% chance of making money for the investors, a 33% chance of returning capital, and a 33% chance of losing everything and that only 10% will make a big return (>10x), then you can model this out.

All the profit in that ten investment portfolio comes from the big winner. If you don't make that investment, you would have made nine investments for a total of $450,000 and you would have gotten back $450,000. You would have been better keeping the money in the bank.

So you need to make enough investments to be confident that you will get at least one big winner. And so that means making enough bets.

There's another important aspect of this. You should invest roughly the same amount in every investment. Don't try to pick the winners at the time of investment by putting more in the ones that are "sure things" and less in the ones you are less sure about. The only sure thing about startup investing is that there are no "sure things."

Let's look at the same portfolio with a set of random initial investment amounts.

You can see that even with the same set of outcomes for each investment, the amount invested in each one has a big impact on the total return of the portfolio. It really all comes down to how much you have invested in your big winner. And since I do not believe you can predict which one will be your big winner, my view is you want to be as consistent as possible with your investment amounts.

When you are an investor, there are days when some of your investments are doing great and some are doing badly. If you are broadly diversified, those days are easier to take. If you are all in on one investment, then those days are brutal. Entrepreneurs go all in and are rewarded accordingly when they hit it. Investors should not go all in. They should be diversified.

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.

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.

Related articles

• Now Samwer brothers look set to clone Square (gigaom.com)
• A Samwer Clone Caught Misleading Users Again. This Time It's Fab-Clone Bamarang. (pandodaily.com)
• Singapore's very own Pinterest clone, Singterest, is an exact carbon copy (sgentrepreneurs.com)
• Pinspire, The Hottest New Startup To Completely Rip Off The Hottest New Startup (readwriteweb.com)
• Guess What? Tencent Clones Zynga's Draw Something [LEAKED PICTURES] (techinasia.com)
• Have The Samwers Gone Too Far With Their Blatant Amazon Clone Lazada? (techcrunch.com)

I guess this will be online learning weekend. Yesterday I talked about MBA Mondays Live and the fact that it will be available via livestream and via archive.

Today, I'd like to tell you about an online conference being put on by our portfolio company Covestor. It is called the Next Invest Conference and it takes place this tuesday and wednesday (3/20 and 3/21). The conference partners include Motley Fool, Stocktwits, Seeking Alpha, Benzinga, TedX Wall Street and many of the biggest names in online investing.

Best of all, it is free to attend. If you are into online investing, either personally or via your startup, you should check this conference out. Details are here.

The WSJ says some venture funds hit pause on big deals. The Journal describes

a group of venture capitalists dialing back on certain deals after a breathless year of venture investing that had some comparing 2011 to the late 1990s dot-com bubble. Many venture capitalists said they now are increasingly passing on companies seeking frothy valuations, and some are trying to get off the beaten path to find cheaper deals.

I am not a fan of this start and stop style of investing. Nobody can time markets. You can't deliver great returns to your investors by being a momentum investor during some periods and a value investor in others.

I believe the only way to be a top performing investor in any asset class is to have a disciplined investment strategy and approach and apply it consistently and actively in all markets all the time.

I am proud that our firm has been investing at about the same rate of new investments per year for almost eight years now. It hasn't gone up much but it also has not gone down much. We will never be the most active venture capital firm. But we will never be inactive either. We are open for business as much today as any other day in the past eight years. If you are building a large network of engaged users that has the potential to disrupt a big market, please talk to us about what you are doing.

Mark Suster has a great post on this topic. In typical Mark fashion, it is long, with a lot of detail and substance. I highly recommend all entrepreneurs take the time to read it end to end.

For those who won't take the time to read it end to end, I'll summarize it.

Many high growth companies can be profitable. They have enough revenue to cover their essential costs and could easily decide to show a profitable income statement. But they don't make that choice. Instead they invest heavily in the business with the expectations that those investments will produce more revenue (by hiring salespeople), or additional products (by hiring engineers and product managers), or additional geographies (by hiring an international team), or any number of other value enhancing aspects of the business. The result of that decision is that the business loses money or simply breaks even (I prefer the latter approach).

There was a discussion of profits (or the lack of them) in the comments to the IPO Market blog post I wrote last week. A number of commenters pointed out that many web companies lack profits. I don't think that is actually true (certainly not for many that have gone public), but it is true that most, if not all, web companies are not optimizing for profits this year or next year. They are optimizing for the ultimate size of their businesss and the total amount of cash flow they can ultimately expect to generate when the business gets to maturity.

This is tricky stuff. If you are going to take all of your potential profits and reinvest them in the businesss in search of higher growth and greater profits in the future, you had better be right about those investments. And it is often hard for investors to see how those investments are going to pay off, so at times you can be penalized for making those choices. Right now the public markets seem to be paying companies more for long term growth than for near term profits, so it seems that public market investors (and VCs) are aligned in this respect. But that is not always the case. Markets are fickle. But the best entrepreneurs are focused on the long term vision and will invest in their businesses without paying too much mind to what investors want at any point in time.

Today on MBA Mondays, I am going to walk you through some math that our team does when looking at a venture investment in a company that is starting to scale its business.

Let's assume we have a portfolio company. I will call it fit.sy. It is a marketplace for fitness experiences. We invested in it last year as it was getting ready to launch. A year later the business is scaling nicely and needs more expansion capital. The founders don't really want to go out and do a fundraising process. So they have asked the existing investors to make them an offer for an internal round. They believe they need $3mm of expansion capital to get them to cash flow breakeven.

So now the VC firm (us) needs to figure out what is a fair price. So we pull out Google Docs and run some numbers. For those who didn't click on the link and see the spreadsheet, here are the numbers:

– fit.sy is on track to generate $10mm in gross transactions in 2011

– they operate on an all-in "take rate" of 9% so their net revenue in 2011 will be $900k

– they will have operating costs in 2011 of $1.5mm and they will lose $600k this year

– they plan to triple gross transactions in 2012 to $30mm and grow to $150mm in gross transactions by 2014

– they plan to do this while ramping operating costs to $3mm in 2012 and to $7mm in 2014

We lay all of those number out in a spreadsheet and then look for some multiples to apply to them to get to a sense of value. The two multiples I like to use for marketplace businesses are enterprise value/gross marketplace transactions and enterprise value/EBITDA. And the multiples I like to use are 1x gross marketplace transactions and 20x EBTIDA. These are for internet marketplaces that are growing fast and are category leaders.

I've observed these multiples over a long time, going back to eBay and Mercado Libre a decade or more ago. We keep a spreadsheet of all Internet marketplace financing transactions in our portfolio and also include transactions we are very familiar with. That spreadsheet validates these multiples again and again.

When using multiples, one question that comes up is "do we apply these multiples to the current year results (which are almost in the bag), the current run rate (current month X 12), or next year's forecast. My answer to this quesion is "yes." I like to apply these multiples to all three and then triangulate from there. The reason being that when markets are frothy, investors will often give a company valuation credit for the next year's forecast (meaning a forward multiple). But when markets are tough, the multiple will be on the last twelve months (meaning a trailing multiple). You don't know what kind of market you will find yourself in so you should look at the multiples in a number of ways and triangulate to get to a comfort zone.

We did this in our spreadsheet (just for the current year and the next year) for our two multiples (1xGross and 20xEBITDA) and we got to a range of valuations for 2011, 2012, 2013, and 2014. They are:

2011: $10mm to $30mm (midpoint $20mm)

2012: $30mm to $75mm(midpoint $52.5mm)

2013: $35mm to $150mm (midpoint $92.5mm)

2014: $130mm to $150mm (midpoint $140mm)

So that's how we think about valuation. The spreadsheet says that if the Company hits plan, it will grow from a valuation of $20mm now to a valuation of $140mm in three years. And if we invest at that valuation of $20mm, we stand to make 7x on our investment in three years if the Company hits plan. If we pay at the top of the valuation range right now ($30mm) and get out at the top of the valuation range in 2014 ($150mm), we stand to make 5x.

I believe 5x to 7x is a good return objective on a follow-on investment in a venture stage company that is scaling nicely. We look to make 10x on our initial investment but cut our return objectives back as the risk comes out of the investment. There is still a tremendous amount of risk in a follow-on investment of this stage (mostly related to executing, hitting plan, etc) and a big multiple is still appropriate.

So that's pretty much all that is involved. We talk this over with our entire team and decide what to offer and what our walk away price is. Based on this analysis, I believe our offer would be around $25mm pre-money, $28mm post-money. We might go up a couple million to get the round done but I think $30mm post-money would be as high as we would go. At that point, we would encourage the founders to go out and find new investors to price and lead the round.

This is the first in a series of posts about financing options for startups. By "financing" I mean obtaining cash to fund your business. There are all sorts of strategies to avoid needing funding, but this series is not about them.

Many entrepreneurs turn to friends and family for their first funding needs. In fact, it is common for non-tech startups to raise all the capital they need from friends and family. I don't know for sure, but I would suspect that friends and family make up the largest source of funding for entrepreneurs and startups.

Friends and family financing is popular because it is easy to get a hearing from the people who know you best and they are positively inclined to say yes. But there are some negatives as well. It's tough to know how to price and structure an investment where the investors are close friends or family. You don't want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.

And friends and family often cannot come up with a lot of capital so unless your business doesn't need much funding, this will not be the only round you do. But friends and family can get you into business and give you some time to create value that other investors will recognize and value.

Probably the most tricky part of friends and family financing is that you really don't want to lose money that friends and family have invested with you. And most startups fail so the chances that will happen are high. I would encourage entrepreneurs who take funding from friends and family to be very clear about the risks and downside. I would also suggest only taking capital from friends and family members who can afford to lose the investment. That way, if the investment does turn out to be bad, at least you won't lose valuable relationships. Even so, it is easier on the mind to be doing a startup when your capital comes from professional investors than your loved ones.

I would recommend doing friends and family financings as convertible notes with a discount and a cap on the valuation. That way you don't have to worry about how to price the investment. A 20-25% discount from the next round is appropriate. The valuation cap is going to vary depending on the size of the raise and the size of the opportunity. I'd suggest a cap that gives the friends and family around 10% of the business if things work out. But that is just a suggestion. A 10% interest will not be appropriate for every friends and family investment.

Friends and family funding is the most common form of startup financing but also the most tricky in many ways. Be careful to do it right because there's a reason why these people will back you when nobody else will.