Posts from Venture capital

When a blockbuster deal happens, a lot of people get excited. The press is all over it, money comes pouring into startups in search of the next one, people quit jobs and school to get in the game. It's a gold rush.

But there's another reaction that I have heard a lot in the past few weeks that is quite different. It is "why not me?" The title of this post is from an email between me and an entrepreneur I know who will go nameless.

It sums up the emotion so well for me.

Startups are hard. They require great sacrifice from everyone. They are stressful and fail more often than they succeed.

And when you've been toiling away month after month, year after year, with no pot of gold in sight, it can be hard to watch that billion dollar deal go down. It's a punch to the gut. It hurts.

I'd love to say to all of you who are feeling that pain that your time will come. But most likely it will not. That's the way this game is played.

Over the history of the institutional VC business (the past 40 years) the number of companies started every year that turn out to be worth billions sustainably is in the tens not the hundreds. If you are looking for a billion dollar check in the startup game, you are playing for lottery odds.

So if you are doing the startup game for money, and lots of it, you are in for a plate full of frustration. It must be for more than that. It must be for the love of the game, a passion for what you are bringing to market, and for the chance that you will hit paydirt. But it is a lot more likely that you will watch someone else hit the big payday than hitting it yourself. And that sucks.

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’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

I've written 5,680 posts according to Typepad. There are a lot of gems in the back catalog here at AVC. So I'm occasionally going to feature old and possibly forgotten posts under the tagline From The Archives.

I've been playing a lot of poker while on our ski vacation. The youngsters think they've got game and in fact they do. But I've been holding my own and am up nicely on the week.

Which brings me to a post I wrote in November 2004 called The Poker Analogy. Here it is without the intro and with a few edits.

—————————-

Poker is an incredible game.  It is about risk management and knowing when to go for it and when not to.  So is the VC business.

Early stage venture capital is a lot like poker.  The first round is the ante.  I think keeping the ante as low as possible is a good thing.  I like to think of it as an opportunity to play in the next round and to see the cards.  Clearly, we don't ante up to just any deal, but it is very useful to think of the first round as the ante.

For the first year or 18 months, however long the first round lasts, you get to "see your cards".  You learn a lot about the management team.  You learn a lot about the market you've chosen to go after.  You learn about the competition and a whole lot more.

Then you have to decide whether to you want to see "the flop", that is the next year to 18 months.  The price to see that is usually higher.  If you don't like your cards (ie the management team, the market, the competitive dynamic, etc) then you fold.  Cut your losses.  Preserve your capital.  Wait for the next deal. 

In poker folding is simple.  In the VC business, it's not that simple.  Sometimes you can fold by selling the company or the assets.  Other times, you need to shut the business down.  It's not easy and many inexperienced VCs make the mistake of playing the hand out because they don't want to face the pain of folding.  That's a bad move.

If you structure your deals appopriately, you can often get three or four rounds (three or four flops).  As your hand strengthens, the cards get better, you increase the betting, putting more money at risk in each subsequent round.  That's how smart poker players win and its also how smart VCs win.

The poker analogy only works so far.  Bluffing doesn't work in the VC business.  If you've got a bad hand, you really can't bluff your way out of it.  But on the other hand, you can impact the cards you've got.  You can work with management, beef it up, switch markets, buy some businesses, etc.  You can significantly improve your hand if you work at it, something that's not really possible in poker.

This is why I think VC is mistakenly seen as risky.  Sure the ante is very risky.  But if you play your hands right, the subseqent rounds are much less so, and the fact that you can put most of your capital to work in the later rounds makes the total portfolio a much less risky proposition than the upfront ante.

I absolutely love Paul Graham's story of how Y Combinator started. It has all the makings of a great startup story. Paul and Jessica came up with the idea on the way home from dinner walking through Cambridge. The sand in the oyster was the fact that Jessica hated her job.

It made me think we should share startup creation stories today on fun friday. I will start with mine.

It was 1996, I was restless in my job as a Partner at Euclid (do all startup stories start with a job thing?). My friend Mark Pincus said "you should start a venture capital firm." I said, "I'd like to do that but who would be my partner?" Mark said "Jerry Colonna of course."

So I reached out to Jerry. We arranged a dinner for us and our wives. I left the Gotham Gal inside with Jerry and Barbara while I was on the phone helping with the negotiation of the sale of Mark and Sunil's first company Freeloader. It was rude, but what was I going to do? That was a big deal for me. Fortunately the Gotham Gal closed the deal with Jerry for me.

On the way home across the Throgs Neck Bridge, I asked the Gotham Gal what I should do. She said "go for it." And so we did.

That's the creation story of Flatiron Partners.

Do you have a fun startup creation story? If so, please share it with us in the comments.

Every company should have a Board Of Directors. At the start it can simply be a one person board consisting of the founder. But it should not stay that way for long. Because if you are your own board, you won't get any of the benefits that come with having a board. These benefits include, but are not limited to, advice, counsel, relationships, experience, and accountability.

The shareholders elect the Board of Directors. But there is usually a nominating entity that puts directors up for election by the shareholders. If the founder controls the company, then he/she is usually that nominating entity.

I am a fan of a three person Board early on in a company's life. I generally recommend that a founder put himself/herself on the board along with two other people they trust and respect. The election of directors in this scenario is simply a matter of the controlling shareholder voting them in.

This situation changes a bit when investors get involved. If the founder retains control, then the situation does not have to change. The founder can still nominate and elect the directors they want on the board. However, investors can and will negotiate for a Board seat in some situations. This is less common for angel investors and more common for venture capital investors.

The way investors negotiate for a board seat is usually via something called a Shareholders Agreement. This is an agreement between all the shareholders of the company. It contains a bunch of provisions, but one of the provisions can be an agreement that the shareholders of the company will vote for a representative of a certain investor in the election of the Board of Directors. The representative can even be named specifically. For many of the Boards I am on, this is how my seat is elected. For venture capital investments, this is a very typical provision.

Adding an investor Director does not mean that the founder loses control of the Board. It can remain a three person Board with one investor director and two founder directors. Or the Board can be expanded to five and the investors can take one or two seats and the founder can control the rest. These two situations are common scenarios when the founders control the company.

As a company moves from founder control to investor control, the notion of an independent director crops up. And independent director is a director who does not represent either the founder or the investors. I am a big fan of independent directors and like to see them on the Boards I am on. Boards that are full of vested interests are not good boards. The more independent minded the Board becomes, the better it usually is.

When the founder loses control of the company (usually by selling a majority of the stock to investors), it does not mean the investors should control the Board. In fact, I would argue that an investor controlled Board is the worst possible situation. Investors usually have a narrow set of interests that involve how much money they are going to make (or lose) on their investment. It is the rare investor who takes a broader and more holistic view of the company. So while investor directors are a neccessary evil in many companies, they should not dominate or control the board. The founder should control the board in a company he or she controls and independent directors should control a board where the founder does not control the company.

When and if a company goes public, the Shareholders Agreement will terminate and public company governance standards will dictate how a board is selected and elected. There will most likely be a comittee of the Board that is called the Nominating Committee. That committee will select a slate of directors that will be put up for election by all the shareholders of the company at the annual meeting. Most public company Boards have staggered Board terms such that a subset of the Board is elected every year. Three year and four year terms are most common.

It is possible for the shareholders to put up an alternative slate. In theory, this approach could be used in both private and public companies, but in reality it is almost entirely limited to public companies. This will be percieved as a hostile move by most companies and they will fight the alternative slate of directors. This "aternative slate" approach is most commonly taken by "activist investors" who take a meaningful minority stake in a public company and agitate for changes in the Baord, Management, and strategic direction of the company. But it can also be used in a hostile takeover effort.  It is very very rare for an alternative slate to take control of a company, but it is fairly common for a new director or two to get elected in this way.

Boards should evolve. Boards should recruit new members on a regular basis. Board members should have term limits. I like the four year term. But I've been on Boards for much longer. I'm in my thirteenth year on one board and my eleventh on another. These are not ideal situations but they involve companies I invested in while I was with my prior venture capital firm and I have a responsibility to my partners and the founders to see these situations through.

A much better example is Twitter, where I was the first outside Director, taking a board seat when Twitter was formed in the spinout from Obvious and USV made its initial investment. Over time Twitter added several investor directors and then started adding independent directors. By last fall, Twitter had the opportunity to create a board with two founders, a CEO, three independent directors, and one investor director. As a shareholder, that sounded like the right mix to me and I voluntarily stepped down along with my friend Bijan who had led the second round of investment.

The point of the Twitter story is that Boards evolve. In the first year it was me and two founders and a founding team member. In the second year it was me and Bijan, two founders and a founding team member. In the third year it was three investors, two founders, and two senior team members. In the fourth year, it was three investors, two founders, a CEO, and three independents. And now it is one investor, two founders, a CEO, and three independents. Many of these changes in the Twitter board happened at the time of financings. That is typical of a venture backed company.

In summary, the shareholders elect the Board. That is the essential truth in every company. But how they elect the directors can be very different from company to company. For public companies, it is largely the same for all. In private companies, as JLM would say "you get what you negotiate for" so negotiate the Board provisions carefully. They are important.

Most importantly, build a great board. They are not that common. But you owe it to your company to do that for it.

I met with a group of very experienced and sophisticated investors yesterday who make up the investment committee of a large charitable foundation that is an investor in USV. I gave them a two minute brief on our macro investment thesis (large networks of engaged users that can disrupt big markets) and then took them on a tour of some of these large networks (Lending Club, Kickstarter, Etsy, Twitter, and Codecademy).  Then I took questions.

This group doesn't spend a ton of time on AVC, Techmeme, Hacker News, or the tech industry in general. And yet the questions they asked me were as good as I ever get. I guess four decades of investing teaches you a lot.

One of the best questions I got was "when do you decide to sell?". Such a great question and such a hard one to answer. I've got scars from this one.

I explained that first and foremost, we generally don't make that call. The entrepreneur and her management team generally makes that call and the board is asked to ratify it.

But when and if we get to weigh in on the timing of the exit, my view is that you look to exit your weakest investments as soon as you can and you let your winners run as long as you can.

USV 2004 is instructive. Between 2004 and 2008, we made investments in 21 companies. So the youngest portfolio company in that portfolio is four years old now. Most are five to six years old. And a few, like Meetup and Return Path, are ten years old or more. We've exited six of the 21 investments, you can see them here, under past investments at the bottom.

We still have fifteen investments active in that portfolio including Zynga and Twitter and we own large blocks of stock in both of those companies. We own stakes in thirteen other portfolio companies most of which we believe are super strong companies that are building large and sustainable businesses. We will likely exit a few weaker investments in that portfolio over this year and next. But there are at least ten companies in the USV 2004 portfolio that we would be happy to own for the rest of this decade.

This does create a bit of an issue in that we raise ten year venture capital funds. So we are supposed to wind things up in the 2004 fund in another two years. But I am fairly sure that my partners and I and our limited partners will be happy to let this fund play itself out over a longer period of time.

I've made the mistake of exiting investments too quickly. Back in the middle of 2007, my previous firm Flatiron exited our investment in Mercado Libre at the IPO selling our entire position for about a 10x gain. In the almost five years that MELI has been public, it has gone up 5x. So had we held our position for another five years, we'd have made 50x instead of 10x. That stings. Lesson learned.

When you have portfolio companies that are category creators, category leaders, who are well managed, and growing 50% per year or more and delivering 20-30% pre-tax margins (or more), and who have no existential threats to their market leadership, you might want to hang on to them for a bit. They may be just getting going on the valuation creation thing.

I've always seen the work that my colleauges and I do as more than venture capital investing. That is our main job and we need to do it very well. But we also need to work to make sure the macro environment for our investing activities remains attractive.

There are two primary activities that Union Square Ventures focuses on in addition to our core venture capital activities of backing and then working closely with entrepreneurs and their teams. They are policy advocacy around protecting the freedom to innovate and efforts to build the ecosystem for startups and entrepreneurship. Longtime readers of this blog understand this from the many many blog posts on these two topics.

I'd like to talk a little about building the ecosystem this morning. We view "the ecosystem" both globally and locally. We want to work to build a world where entrepreneurship is available everywhere. But we also want to do everything we can to grow and nurture the entrepreneurial community in New York City. And we believe that the things we support in NYC can and will be copied throughout the world so that our local ecosystem efforts support our global ecosystem efforts.

I've talked at length about many of our local ecosystem efforts and I don't want this post to be a laundry list of the things we are working on. Many of you are quite familiar with them. I would like to talk about a specific thing that two of my colleagues are doing that inspires me.

Last week, Gary and Christina asked me to stop by our event space late one afternoon and spend 45 minutes talking to a group of a dozen or so interaction designers. I talked to them about writing, the importance of taking the time every day to put words down "on paper" and how that forces you to think crisply and clearly. It was a great discussion.

This was part of a three hour class that Gary and Christina teach master students at the School Of Visual Arts (SVA) here in NYC. The class is a requirement for the Interaction Design program and it is called Entrepreneurial Design. Gary blogged about the class here and Christina blogged about it too.

The idea to teach this class came out of Gary's observation that almost all of our portfolio companies are suffering from a dearth of talent in interaction design and that we needed to do something to help produce more talent in this area. Gary and Christina didn't ask for permission to teach this class from anyone in our firm. They just did it. Freedom to innovate in action. I love it.

Things like this make a difference. They add up and build on each other. USV is not alone in this effort. Our colleagues in the startup and venture community in NYC and our colleagues around the world are actively doing things just like this. And the result is a thriving global startup movement that is getting stronger every day.

Related articles

• New Course: Entrepreneurship, Innovation, and Public Policy (feld.com)
• Startup Communities: Creating A Great Entrepreneurial Ecosystem In Your City (feld.com)
• Seeding Entrepreneurship: How to Build a Venture-Finance Ecosystem (xconomy.com)
• Innovation Hubs with a Local Touch (growvc.com)