Posts from Venture capital

This post is for everyone who thinks venture capital is an easy business. I'd like to dispel that notion.

Here are short term and long term returns for the venture capital business over the past ten years compared to the public equity markets in the US.

These numbers don't include the internet bubble of the late 90s, so they are just for the past ten years.

What jumps out at me is there are no venture capital returns in this set of numbers that break double digits. When I got into the business in the mid 80s, I was schooled that you needed to produce at least 20% annual returns net to the limited partners to stay in business.

The ten year comparisons to the public markets are also challenging. The NASDAQ Composite beats later and expansion stage funds and all the public indexes beat early and multi-stage funds.

The performance of early stage funds is particularly disappointing. You would expect early stage funds to underperform in the early years. But ten years out, you would expect to see early stage outperform multi and late stage. More risk should produce more return.

This is Cambridge Associates data so it is based on many of the leading venture capital firms and it spans tech, biotech, cleantech and other areas. I believe this is a good representation of the overall performance of the VC business in the US.

Early stage investing is hard. You lose more than you win. And when you win, you need to win big. Later stage investing is a bit easier. You can pick winners in that business more easily. But so can everyone else. Each deal is an auction and the winner pays the highest price.

So the next time you are bidding one VC against another, maybe you can feel just a bit of empathy for us. We are in a tough business, trying to make a buck to live to fight another day. Just like everyone else.

Last October, I skyped into an entrepreneur meetup in Milan and talked for 30 minutes. This was arranged by AVC community member David Semeria.

The main topics were building a tech community outside of the main startup hubs, raising angel and venture capital in a market where there isn't much of that, and the differences between US and european investors.

When I watched this video this morning, the audio and video were out of sync which made it hard for me to watch. I ended up listening more than watching. I hope you all don't have that same problem.

In a comment on the latest tally of VC fundraising, NVCA President Mark Heesen said:

“The venture capital fundraising environment has settled into a ‘new normal’ which is characterized by a barbell structure of larger funds which are stage and industry agnostic on one end, and smaller, early stage, industry or region specific funds on the other.

This is certainly true and has been for a long time. The two successful models seem to be the large megafund and the small early stage fund. It's hard to be anything else in VC.

Entrepreneurs need to understand this. There are a ton of options out there for early stage funding. And if you get to the stage where you need a growth round from a big fund, there are plenty of options for that too. But if you are looking for a Series B round to help you grow from early revenue status to true growth status, you are going to find that challenging.

To put it another way, there are plenty of us who fund hopes and dreams. And plenty of us willing to fund true success. At the stage where you are past hopes and dreams, where you have customers, revenue, and a real business, but have not yet reached "true success", there just aren't many investors to choose from.

The truth is early stage investors are often asked to be the funders of last resort for the "in between" stage. We do that all the time at USV. We will lead or do an inside round for the Series B and Series C rounds if we have to. So choose your early stage investors well. Make sure they are willing to see you through the in between phase if need be. Because they will probably need to.

As I read this post in the WSJ about the changing nature of VC funding of consumer web companies, I thought that we may be looking at the symptoms and not the disease. As the WSJ notes, VC funding of consumer web and mobile companies is down 42% in this first nine months of 2012 (vs the first nine months of 2011). And the big falloff is not in seed rounds, which are still getting done, but in follow-on rounds, which are not.

So what has changed in the past couple years? A lot, actually.

1) the consumer web has matured. we are almost 20 years into the consumer web and we have large platforms that are starting to suck up a lot of the oxygen. google, facebook/instagram, amazon, microsoft, apple, twitter, ebay, yahoo, AOL, craigslist, wordpress, linkedin together make up a huge amount of the time spent online, particularly in the english speaking world. there are still occasional new entrants into this list and departures too. tumblr and pinterest have risen a lot in the past couple years while myspace has declined. but consumer behaviors are starting to ossify on the web and it is harder than ever to build a large audience from a standing start.

2) the consumer is moving from desktop/web to mobile/app. we've talked about this transition ad nauseam on this blog. it is the single biggest megatrend in the consumer internet space right now. most new consumer internet startups need to build for iOS, Android, and web at the same time. it is making the startup more expensive and time consuming. distribution is much harder on mobile than web and we see a lot of mobile first startups getting stuck in the transition from successful product to large user base. strong product market fit is no longer enough to get to a large user base. you need to master the "download app, use app, keep using app, put it on your home screen" flow and that is a hard one to master.

3) the momentum/late stage investors have moved from consumer to enterprise. there is a large pool of money in the venture capital asset class that is opportunistic, momentum driven, and thesis agnostic. this pool is driven largely by the public markets. this pool of capital was "all in" on consumer web/social web in the 2009-2011 time frame. it drove a lot of activity throughout the venture capital markets because each layer of the VC stack (angel, seed, Srs A, Srs B, Srs C, etc) needs to be aware of what the next layer up wants to fund. when the momentum/late stage wanted web/social, the layers below gave them web/social. now that the momentum/late stage wants enterprise, we should expect the layers below to give them enterprise.

The combination of these three factors is making it harder for consumer internet companies (web and mobile) to get funding. But the first two factors are also making it harder for consumer internet companies (web and mobile) to breakout which is more and more a prerequisite for funding. As venture portfolios fill up with promising companies with solid products that are struggling to breakout, the VCs will naturally be drawn ever more to the companies that are in fact breaking out. It is a pernicious cycle and we see it playing out very clearly in the consumer internet space these days.

What does that mean for USV? Well not that much actually. We are thesis driven to the core. We believe in what we believe in, for good or bad. And that is large networks of engaged users that have the power to disrupt big markets. We are investing at the fastest rate right now in the history of our firm. We are doing a lot of Srs A and Srs B rounds right now because that is where we see the biggest vaccum in the market. We have not done a real seed or angel round in quite a while. But that doesn't mean we wouldn't and our next investment could well be a seed or angel round.

But we are a small firm. We put out maybe $40mm to $50mm per year across all of our core funds, across initial investments and follow-ons. That is a tiny fraction of the venture capital market. We are small on purpose. We don't want to be the market. We want to invest in a tiny slice of the early stage ecosystem where our thesis collides with great teams and unique and differentiated products.

All that said, these three trends are impacting our portfolio. We have fifty portfolio companies, with the vast majority in the consumer internet space. We encouraged our portfolio companies to raise a lot of capital in 2011 and many did. But even so, we are seeing fundraising challenges everywhere, even in our very best portfolio companies. We are also seeing many of the youngest companies in the portoflio, those started after the summer of 2010, struggling with the breakout challeneges I mentioned earlier in this post. We are patient investors and believe in our portfolio companies and the teams we have funded. We are seeing patience being rewarded, particularly in the mobile market. But it is a tougher time for early stage consumer internet companies than I have seen since the 2001-2004 time frame. And I think we are still in the early innings of this more challenging environment.

So things have changed. As they always do in tech. Those who adapt to the changing dynamics, who see the openings that were not there before and slice through them, will succeed. But the wind that has been at our back for 7-8 years in consumer internet is no longer there. It's tougher sledding and will likely continue so for some time to come.

There is a lot of sturm und drang out there in the worlds of social media, finacial media, and just plain media about all the lockups coming off and all the insider selling going on in some big internet stocks. As someone who has played this game a few times, I tought I'd post some thoughts about this.

First and foremost, this post has nothing to do with what USV has done, might do, or is thinking about doing with specific stocks we might own or not. That's a disclaimer for those who aren't familiar with one.

When a venture backed company goes public and is worth billions (or even hundreds of millions), the investors who provided the early capital to that company are going to be sitting on a lot of stock. They can easily own 15-20% or more of these companies. But even if they own less than 10% (as Accel Partners does in Facebook), they can be looking at billions of dollars of value.

It is an investors job to return capital. I will say that again. It is an investors job to return capital. That is how we are measured. Paper gains are fine. But at the end of the day, an investor will be measured by the amount of cash or liquid stock they return divided by the amount of cash that was invested in their fund. A multiple of three is good for a venture capital fund. A multiple of five is great. A multiple of ten is once a decade.

When an investor is looking at a single holding being worth three, five, or possibly ten times their entire fund, you can be sure they are looking to lock in that gain. That's a recipe for fantastic performance and the downside of not locking that in is a lot bigger than the upside of another one or two times their fund size.

And then there's the question of whether venture capital firms are good public market investors and whether they should be managing/holding public stocks. I don't have any hard data here, but my anecdotal data says that we are terrible public market investors. That is why many VC firms have a policy of moving the public stocks out of their portfolios as quickly as they can.

I think that is a good policy. Venture capital is about capturing the value between the startup phase and the public company phase. Others should be focused on capturing the value post the public offering.

So let's go back to the expiration of lockups and the waves of insider selling that result. This is to be expected and in fact is expected by the public markets. Look at all of the short positions that get built up in the locked up newly minted public companies in the weeks before the lockups come off. Investors know that a ton of stock is going to hit the markets and they make bets that it will impact the stock price and in most cases it does impact the stock price. As JLM likes to say "this generation did not invent sex." This has been going on since I got into the venture capital business in the mid 80s and I expect its been going on for a lot longer than that.

So to all the folks out there who are shocked and outraged at all the insider selling going on, I would suggest they park their outrage at the door of capitalism. Those who took the risk of losing all the capital they bet on 20 year old Mark Zuckerberg are entitled to their return. And they will get it. And anyone who thinks otherwise has their head in the sand.

I did an interview yesterday in Buffalo, NY where I was the past couple days for the launch of the Z80 incubator. Grove Potter, the Business Editor for the Buffalo News, interviewed me for something like an hour. It was a fun talk.

At one point he asked me about the issue of entrepreneurs giving up control of their companies to VCs. It's an interesting issue and one that I think is not well understood.

In theory, control of a company rests with the ownership split between the founder and the investors and how the Board of the Company is set up. If the founder/entrepreneur owns more than 50% of the company and controls more than half of the board seats, then he or she has "control" of the Company.

But in reality I have found things are very different than that. And it all comes down to two things:

1) How well the Company is performing

2) Whether the Company needs more investment capital and where it is coming from

I like to think about it this way.

An entrepreneur or hired CEO can own as little as 5-10% of a Company but they can control it like a dictator if they are doing a great job running the business and the company is making a lot of cash flow and has no need for additional capital.

An entrepreneur can control 95% of a company and all the seats on the board but they can easily lose control of the business if they company is floundering and they need more money and the only investors who would consider putting up money are the existing investors.

This extends to the idea of who sells companies. My friend Dave Winer put up an interesting discussion thread a few days ago talking about the sustainability of social media platforms. It is an interesting discussion and one very much worth having. In the post that kicks off the thread, Dave suggests that VCs are behind the decisions to sell/exit companies.

I left a comment on that thread and at the end of my comment I made this point:

I would be remiss if i did not take a minute to point out that you are missing the person who is the most important part of this discussion and that is the founder. In big successful companies, the founder, founders, and the teams they hire to help them run their businesses, are really the ones in control. The VCs are often "along for the ride".

VCs have control when things don't work. Entrepreneurs have control when they do.

That last line sums up my point of view on control and that is why I used it to headline this post. If you want to maintain control of your company, focus on running it well or find a team to run it well, and make sure you have plenty of cash to operate your business and that you never find yourself in a position where you are running out of cash and have nowhere to go but your exisiting investors. Do those two things well and you will be in control for as long as you want to be in control.

Mitt Romney is taking some flack for continuing to have ongoing involvement in Bain Capital well after he supposedly left the firm for good in 1999. I am not supporting Romney for President as I can't get comfortable with his party's views on social issues that matter a lot to me. But I have a fair bit of empathy for him on this specific issue.

I am still technically a partner in a venture capital firm (Euclid Partners) that I left in early 1996. I still get K1s from them as there remain a few illiquid investments in the last fund I was a partner in.

We stopped investing at Flatiron Partners in the summer of 2000, twelve years ago. I still sit on several boards from that portfolio. One of my partners sits on another board. We have three funds that remain active. We send out annual reports and K1s on all of them. I sign things all the time for Flatiron. And I haven't been "active" in that business for a decade.

Venture Capital and Private Equity are "long latency" businesses. You can leave a firm, you can start a new career, a new business, or go into politics. But you aren't going to be completely done with the investments you made and the partnerships you set up or were partners in for a long time.

I suppose there are ways to have a clean break, but they would not be simple to accomplish. You would need to be bought out and who is going to establish fair value for highly illiquid investments? Who is going to put up the money to buy you out? And getting all the investors to sign off on these changes is another hurdle. And allocating your equity to others is another challenge. That's why I am still a partner in two businesses that I have not been active in for a long time. It's a lot easier to just let things run off and have a departed partner be a "silent partner" with no operating role or responsibility. But even if you are a silent partner, you still need to sign stuff from time to time.

I think the Obama team is beating up Romney for something that makes great headlines and might look bad to an unsophisticated voter. But to me this looks petty and cheap. I don't like petty and cheap. I wish the Obama team would talk about important stuff instead of beating up a guy over nonsense.

Like many of my friends and colleagues, I was touched by this heartfelt post by Dave McClure yesterday. This part really rings true to me:

and so here I am: still standing in the arena, in hand-to-hand combat with demons mostly of my own making, aiming to make a small dent in the universe. nowhere near a great success story, yet fighting the good fight and perhaps helping others to achieve greatness as I attempt a bit of my own. I’ll be 46 in a month, well past the age when most folks have already shown what they’re made of. but I’m still grasping for that brass ring.

That one paragraph packs a lot of emotion and pattern recognition for me in it.

Going hand to hand with demons of your own making. Check.

Nowhere near a success story. Check.

Well past the age when most folks have already shown what they are made of. Check.

Still grasping for that brass ring. Check.

I could have written this exact post five years ago. When I was Dave's age.

Venture capital doesn't create 20 something millionaires. The prime of your career in VC is the late 40s. Right where Dave is.

I am not exactly sure when I stopped feeling all these things that Dave is feeling. But I did. It happened sometime in the past few years. And I am happier for it. But also worried that I don't have that big chip on my shoulder anymore. We will see.

But the best line of all is the one that I ganked for the headline of this post. Helping others to achieve greatness is what VC is all about. If you do it well, you achieve a bit of it yourself along the way. But you have to do the first to get the second. Dave understands that. And so I think he'll get his brass ring soon enough.

Hunter Walk has a post up suggesting that "social proof" is not as helpful of an indicator of startup quality as it once was.

I have always hated the idea of social proof. It's just the herd instinct at work. It's nonsense.

If you can't figure out why you like an investment and why it will be successful, don't make it.

Yesterday my partner Andy and I met with a company that has had a hard time raising capital. I talked to a bunch of big name investors about it and they all hated it. I told Andy "that makes me like it even more."

We may or may not make this investment. We have to do our work, figure out the market, make the calls on the management team, and figure out how big of a business it can be and whether we can make a good return on it. But we don't care who else wants to invest. In fact, I'd prefer if nobody else wants to invest in it. That would be great.

Make up your own mind. Don't follow the herd. Don't chase.