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Tag: Venture capital

What Happens After the Tech Bubble Pops

In recent years, it’s been the opposite of controversial to say that the tech industry is in a bubble. The terrible recent stock market performance of once high-flying startups across virtually every industry (see table below) and the turmoil in the stock market stemming from low oil prices and concerns about the economies of countries like China and Brazil have raised fears that the bubble is beginning to pop.

Company Ticker Industry Stock Price Change Since IPO (Feb 5)
GoPro NASDAQ:GPRO Consumer Hardware -72%
FitBit NYSE:FIT Wearable -47%
Hortonworks NASDAQ:HDP Big Data -68%
Teladoc NYSE:TDOC Telemedicine -50%
Evolent Health NYSE:EVH Healthcare -46%
Square NYSE:SQ Payment & POS -34%
Box NYSE:BOX Cloud Storage -42%
Etsy NASDAQ:ETSY eCommerce -77%
Lending Club NYSE:LC Lending Platform -72%

While history will judge when this bubble “officially” bursts, the purpose of this post is to try to make some predictions about what will happen during/after this “correction” and pull together some advice for people in / wanting to get into the tech industry. Starting with the immediate consequences, one can reasonably expect that:

  • Exit pipeline will dry up: When startup valuations are higher than what the company could reasonably get in the stock market, management teams (who need to keep their investors and employees happy) become less willing to go public. And, if public markets are less excited about startups, the price acquirers need to pay to convince a management team to sell goes down. The result is fewer exits and less cash back to investors and employees for the exits that do happen.
  • VCs become less willing to invest: VCs invest in startups on the promise that future IPOs and acquisitions will make them even more money. When the exit pipeline dries up, VCs get cold feet because the ability to get a nice exit seems to fade away. The result is that VCs become a lot more price-sensitive when it comes to investing in later stage companies (where the dried up exit pipeline hurts the most).
  • Later stage companies start cutting costs: Companies in an environment where they can’t sell themselves or easily raise money have no choice but to cut costs. Since the vast majority of later-stage startups run at a loss to increase growth, they will find themselves in the uncomfortable position of slowing down hiring and potentially laying employees off, cutting back on perks, and focusing a lot more on getting their financials in order.

The result of all of this will be interesting for folks used to a tech industry (and a Bay Area) flush with cash and boundlessly optimistic:

  1. Job hopping should slow: “Easy money” to help companies figure out what works or to get an “acquihire” as a soft landing will be harder to get in a challenged financing and exit environment. The result is that the rapid job hopping endemic in the tech industry should slow as potential founders find it harder to raise money for their ideas and as it becomes harder for new startups to get the capital they need to pay top dollar.
  2. Strong companies are here to stay: While there is broad agreement that there are too many startups with higher valuations than reasonable, what’s also become clear is there are a number of mature tech companies that are doing exceptionally well (i.e. Facebook, Amazon, Netflix, and Google) and a number of “hotshots” which have demonstrated enough growth and strong enough unit economics and market position to survive a challenged environment (i.e. Uber, Airbnb). This will let them continue to hire and invest in ways that weaker peers will be unable to match.
  3. Tech “luxury money” will slow but not disappear: Anyone who lives in the Bay Area has a story of the ridiculousness of “tech money” (sky-high rents, gourmet toast, “its like Uber but for X”, etc). This has been fueled by cash from the startup world as well as free flowing VC money subsidizing many of these new services . However, in a world where companies need to cut costs, where exits are harder to come by, and where VCs are less willing to subsidize random on-demand services, a lot of this will diminish. That some of these services are fundamentally better than what came before (i.e. Uber) and that stronger companies will continue to pay top dollar for top talent will prevent all of this from collapsing (and lets not forget San Francisco’s irrational housing supply policies). As a result, people expecting a reversal of gentrification and the excesses of tech wealth will likely be disappointed, but its reasonable to expect a dramatic rationalization of the price and quantity of many “luxuries” that Bay Area inhabitants have become accustomed to soon.

So, what to do if you’re in / trying to get in to / wanting to invest in the tech industry?

  • Understand the business before you get in: Its a shame that market sentiment drives fundraising and exits, because good financial performance is generally a pretty good indicator of the long-term prospects of a business. In an environment where its harder to exit and raise cash, its absolutely critical to make sure there is a solid business footing so the company can keep going or raise money / exit on good terms.
  • Be concerned about companies which have a lot of startup exposure: Even if a company has solid financial performance, if much of that comes from selling to startups (especially services around accounting, recruiting, or sales), then they’re dependent on VCs opening up their own wallets to make money.
  • Have a much higher bar for large, later-stage companies: The companies that will feel the most “pain” the earliest will be those with with high valuations and high costs. Raising money at unicorn valuations can make a sexy press release but it doesn’t amount to anything if you can’t exit or raise money at an even higher valuation.
  • Rationalize exposure to “luxury”: Don’t expect that “Uber but for X” service that you love to stick around (at least not at current prices)…
  • Early stage companies can still be attractive: Companies that are several years from an exit & raising large amounts of cash will be insulated in the near-term from the pain in the later stage, especially if they are committed to staying frugal and building a disruptive business. Since they are already relatively low in valuation and since investors know they are discounting off a valuation in the future (potentially after any current market softness), the downward pressures on valuation are potentially lighter as well.
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Tesla in Energy Market

One of the most fascinating things about the technology industry is how the lines between markets and competitors can shift all of a sudden. One day, Nokia is mainly thinking about competing with phone makers like RIM and Motorola on getting influence with carriers and upselling text messaging services / ring tones and, the next, they need to deal with players like Apple and Google, fostering a strong app ecosystem, creating intuitive user experiences, and building a brand that resonates with users.

One interesting case that has emerged in the past couple of days is the electric car company Tesla entering the Home and Industrial energy market. In much the same way that software let Apple and Google build operating systems that could double up as phones, the manufacturing prowess and battery technology which let Tesla take on the electric car market also gives them the ability to offer energy storage solutions for the utility market.

When I was a VC looking at energy storage opportunities, there was a fair amount of discussion in the industry about the future potential for electric cars connected to the grid to themselves to operate as energy storage / load balancing. I never expected this to amount to much for at least a decade — when the penetration of electric vehicles would be high enough to make sense for utilities to invest in this capability. Never would I have imagined the path to anything even remotely like this would be through an electric car company directly making and offering electric batteries to supply the market. While history will judge whether or not Tesla is successful at this (a lot of unanswered questions around the durability of their Li-ion batteries for utility purposes and how they will be serviced / maintained), you can’t fault Tesla for lack of boldness!

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How Often Does a $3 Billion Valuation Come Along?

Snapchat-reportedly-said-no-to-3-billion-in-cash-from-Facebook

I blogged recently about why companies like Facebook are willing to pay large amounts for barely-in-revenue-if-at-all companies like Snapchat – but that’s a question about the buyer. The question dozens of entrepreneurs and venture investors are asking themselves is: should Snapchat have taken Facebook’s rumored bid?

While the right answer to that is a combination of personal (what does the team want to do) and business (what do we see as the likely path forward for the company), one question we can answer objectively is how often does such an exit happen?

As part of an exercise to try to better understand when and where big venture-backed opportunities lie, I pulled together data from Dow Jone’s Venturesource service and cross-matched it with companies from S&P’s Capital IQ to try to identify the home runs that venture capitalists pat themselves on the back for since 2002 (the end of the 2000’s dot-com bubble and burst).

My dataset showed 23 venture-backed outcomes that exceeded $3 billion in valuation (factoring in a 180-day lockup period that accompanies most IPOs where investors and key employees cannot sell stock, except for companies listed which haven’t had that 180-days of history then which I added the most recent market cap). Five of these (Yandex, Hibu, Biosensor Applications, Carmat SAS, and CTC Media) are not U.S. companies and an additional three (MetroPCS, Antero Resources, and First Republic Bank) are what I would call “unconventional” (i.e., an organization which does VC investments was involved in a pre-exit financing but they don’t fit the usual profile). So, more practically, since 2002, only 15 U.S.-based venture-backed companies have achieved exits in excess of $3 billion.

Company Valuation ($M) Exit Date Type Sector

Google

$53B

Aug 2004

IPO

Search

Facebook

$48B

May 2012

IPO

Social

Twitter

$22B

Nov 2013

IPO

Social

Workday

$9.8B

Oct 2012

IPO

Business Software

LinkedIn

$7.2B

May 2011

IPO

Social

Groupon

$6.9B

Nov 2011

IPO

Coupon

Veeva

$4.8B

Oct 2013

IPO

Business Software

FireEye

$4.5B

Sep 2013

IPO

Security

Tableau

$3.9B

May 2013

IPO

Business Software

Palo Alto Networks

$3.7B

Jul 2012

IPO

Security

Service Now

$3.7B

Jun 2012

IPO

Business Software

Zynga

$3.7B

Dec 2011

IPO

Gaming

Hyperion

$3.3B

Mar 2007

M&A

Business Software

Doubleclick

$3.1B

Mar 2008

M&A

Adtech

Splunk

$3.1B

Apr 2012

IPO

Business Software

Of those 15, only two are acquisitions — Hyperion Solutions (a business intelligence software company bought by Oracle) and DoubleClick (a leading ad exchange bought by Google) – the remainder are IPOs, and only 5 or 6 (depending on if you count LinkedIn) are direct-to-consumer in the same way that Snapchat is.

In short, Snapchat supposedly walked away from an outcome which is extremely rare and so the Snapchat founders/board, if they’re being “rational”, are clearly focused on building a standalone, IPO-able company of the size of a Google/Facebook/Twitter/Groupon/Zynga.

They have had remarkable traction to date and it will be interesting to see if they look back on this as a big mistake or the beginning of when the rest of the world understood just how big of a company they could become.

(Image source – PhoneArena.com)

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Crowdfunding: Hardware Startups Beware

Hardware startups are one area I spend a fair amount of time with in my life as a VC, and while I love working with hardware companies, it should go without saying that hardware startups are incredibly difficult to do. They require knowhow across multiple disciplines — software, electrical engineering, industrial design, manufacturing, channel, etc. – and, as a result, have challenges and upfront capital needs that most software/web companies lack. This has led many angels and VCs to be wary of investments involving building hardware so its no small wonder, then, that many hardware entrepreneurs have turned to crowdfunding websites like Kickstarter and Indiegogo to try to raise funds for development.

While crowdfunding can be a great fit for certain projects, I think early stage hardware startups should beware. Yes, crowdfunding sites can generate upfront capital that can fund development, but unlike traditional equity/debt investments (like the kind an angel or VC or bank will give you), “crowdfunding capital” has a particularly onerous type of “string attached”: it’s a presale.

Obviously, the entrepreneurs trying to raise crowdfunding capital want to push their projects towards real sales – so why might a presale be a bad thing? For hardware companies:

  • Raw production costs are a major percentage of sales – so even if you raised $1 million, you probably are going to be able to keep max $500,000 after the cost of materials/manufacturing
  • These pre-sales are oftentimes discounted – so you are generating lower margins on each unit making these particularly painful sales to make
  • Except in a few instances, the number of presales tends to not be high enough to meaningfully change the cost of manufacturing (i.e. upfront tooling costs or supply procurement) – which further eats into the amount of capital you have left to deploy on development since you probably have to pay the low volume price
  • It means you need to keep to some level of deadline. There is a risk that you won’t make your own deadline and there’s also risk that the time pressure might lead to tradeoffs (leave out a certain feature or asset, run fewer tests, etc.) which could hurt your reputation since the public will be getting its first impressions of your company based on that initial launch.
  • It publicly commits you to a particular product even if you learn that your initial idea is wrong or needs tweaking.
  • It tips off the market and potential competition earlier since you likely are doing this at a point before your product is ready and need to provide a fair amount of detail to get supporters.

In the end this “capital” ends up being a very real “liability”, and is a big part of why serious hardware startups that do crowdfunding almost all go back to the traditional VC/Angel community – it is simply not practical to scale up a meaningful hardware business on crowdfunded capital alone.

That said, there are definitely cases where it makes sense for hardware companies to use crowdfunding – and they are cases where the above problems are irrelevant:

  • If your cost of production is tiny relative to the price (think pharmaceuticals, software, music, movie, etc. – trivial cost of production per unit sold)
  • If you’ve already completed the vast majority of development or managed to get capital from another source and are simply using crowdfunding to either gauge customer interest or raise publicity
  • If your intention is to raise money from a VC/angel using a crowdfunding success story (that you’re positive you will get) to show that a large market exists for your product
  • You couldn’t raise money from VCs period and have no other choice

In the first case, a very low cost of production means that more dollars raised can actually go into development, irrespective of volume of production and discounts. In the second case, the pre-sale becomes a good thing: a market signal or a heavily publicized pre-sale for a product which is/is almost done. The third is very risky – because I would maintain its nigh impossible to know if a crowdfunding attempt will “go viral” and even if it does, you are still left with the liability of these presales that you need to fulfill. The last is self-explanatory :-).

If you are an aspiring hardware entrepreneur, in almost all cases your best bet will be to go with traditional equity/debt financing first. Obviously, I am in part biased by my current choice of profession but while VCs and angels can be annoying to deal with and raise money from, the lack of the pre-sale liability and their potential for connecting you with potential hires and partners makes them a much better fit.

Got any questions? Disagree? I want to hear from you!

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Tomorrow’s Pets.com

petscomToday, it seems perfectly obvious that building an internet business to sell pet food to customers where shipping and logistic costs (let alone advertising costs, etc.) wiped out any chance of profitability was an idea doomed to fail.

But, was it obvious at the time? While some folks will claim they knew all along, the market evidence suggests that most people had no clue: after all, the company raised over $110M in capital from Hummer Winblad, Comcast, Amazon.com, and others. It went on to successfully IPO in 2000 and at one point employed over 300 people. If it was such a terrible idea, it seems that it took quite a while for people to catch on.

This isn’t to specifically pick on Pets.com – quite the opposite: when you work in technology, there is oftentimes so much change and uncertainty around the future that its not obvious that the “emperor has no clothes” until its too late, oftentimes driven by entrepreneurs, career-seekers, and investors willing to pile on to make sure that they “get in on the action before its too late.”

And therein lies a very interesting question: what are the ideas/companies that have generated a ton of traction today which will become “duh, stupid” Pets.com ideas of tomorrow?

Examples of companies that flew high once and “obviously” crashed afterwards (most of the Dot Com bubble companies, many of the Cleantech bubble companies, some prominent consumer internet companies, etc) suggest that ignoring economic realities is a common refrain. Many of the failed Dot Com bubble companies and many of the challenged consumer internet companies relied primarily on drawing eyeballs to their websites/apps without figuring out how to make money enough on them to recoup their costs of marketing & advertising. The cleantech companies, similarly, gambled wrongly on government support and on their ability to make their technologies competitive with conventional systems.

But, the danger of generalizing from this type of thinking is that are plenty of examples of huge companies which succeeded despite bleak economic pictures in the early days. Amazon.com is a particularly noteworthy company that aimed to grow first before worrying about profitability (something it continues to do in a number of new businesses), not generating profit until late 2001, 7 years after founding, and over 4 years after it went public. Considering the company is worth over $100B today, compared with roughly $400M when it went public, it would seem blindly paying attention to the immediate economic picture would’ve cheated you out of a very impressive investment.

The truth is that I don’t have a good answer to this question. Studying what led to the failure of past startup models can be very informative in terms of how to think about other businesses, but the truth is that we aren’t likely to know until it hits us. Who knows, maybe in a few years “Big Data” or “Mobile advertising’ might all be revealed to have been terrible businesses…?

I would love to hear any thoughts on the subject in the comments below.

(image credit – Pets.com sock puppet – RightStartups)

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The Margin Question

While I’ve never been told this directly, I’m sure that a lot of startups I meet are a little put off as to why I oftentimes ask so many questions about their margins. As a brief refresher, margins are the % of sales that a company gets to pocket, after accounting for the cost of production. So, if it costs Acme Co. $5 to make a shirt that it sells for $10, their (in this case gross) margin is 50%.

Generally, the entrepreneurs are miffed at me because – well, they’re working in startups. They’re too busy trying to build out their product to work on financial forecasts which are likely inaccurate. The savvier entrepreneurs will sometimes throw back some variant of the point I made a while back about how the goal (for a venture-backed startup) is not profitability, but growth. The numbers themselves are also kind of a trap: if they are too high, it makes the entrepreneur seem naïve. If they are too low, it makes the business seem uninteresting.

But, the real reason I ask about margins is not necessarily to get at the precise number, but so that I understand how the management team thinks about their business and how it will grow. I’ve been in many meetings where management teams present a fantastic revenue growth story which relies on expanding product lines with lower margins. The idea here is two-fold: first, products with lower margins are easier to sell (since you’re marking them up less) and, second, as long as you are making money on each incremental sale, why not push lower margin products when venture-backed acquisitions and IPOs are oftentimes mainly evaluated on sales growth?

I tend to view that type of reasoning as a poor rationalization of opportunity costs. Whereas an entrepreneur might see “profitable growth opportunity,” my first instinct is that if a business is forced to turn to lower margin products to grow the business, then they should spend more time building a better product (to get those margins back up) or trying to find markets where the company’s innovations are more highly valued. As is oftentimes said, the most important assets that any startup has are time and money – and every second and every dollar spent chasing a lower-margin sale is a second and a dollar that is not being spent improving one’s products or chasing a higher-margin sale. When you combine that with the fact that lower margin businesses tend to be that way because there is more competition, the idea of pursuing lower margin growth opportunities becomes a lot less appealing.

Now, this isn’t to say that pursuing a lower-margin market is fundamentally a bad thing. Companies like Amazon and Samsung have built impressive businesses going after barely profitable markets (i.e., many types of online retail for Amazon and memory chips & TVs for Samsung). But, its only after a careful consideration of opportunity costs and strategy that such a choice should be made.

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What Accel Thinks About Big Data

Capitalizing on widespread interest in companies built around “Big Data”, VC firm Accel yesterday unveiled its “Big Data Fund 2”, a $100M fund aiming to make investments in technology companies which help their customers make sense of the massive volumes of data that they are now able to gather and generate.

While I personally have gotten a little sick of the “Big Data” moniker (its become like “cloud computing” – just one of many buzzwords that companies slap on their websites and press releases), what jumped out to me in reading the press release and the tech blog coverage was the emphasis of the fund away from companies commercializing Big Data infrastructure technology and towards companies building “data driven software”.

Now, no VC’s “rules” about a fund are ever absolute – they will find ways to put money into (what they perceive as) good investments, regardless of what they’ve said in press releases – but the message shift jumped out to me as potentially a very bold statement by Accel on how they perceive the state of the “Big Data” industry.

All industries go through phases – in the early days, the focus is around laying the infrastructure and foundation, and the best tech investments tend to be companies working on infrastructure which ultimately serves as a platform for others (for example: Intel [computing] and Cisco [internet] and Qualcomm [mobile]). Eventually, the industry moves on to the next phase – where the infrastructure layer becomes extremely difficult for small companies to compete in and the best tech investments tend to be in companies which take advantage of the platform to build new and interesting applications (for example: Adobe or VMWare [computing] and Amazon.com [internet] and Rovio [mobile]).

Of course, its hard to know when that transition happens and, as often happens with tech, the “applications” phase of one industry (e.g., Facebook, Salesforce.com, etc.) can oftentimes serve as the infrastructure phase for another (e.g., social applications, CRM-driven applications, etc.). But, what Accel’s “Big Data Fund 2”’s mission suggests is that Accel believes the “Big Data industry” has moved beyond infrastructure and is on towards the second phase where the most promising early-stage investments are no longer in infrastructure to help companies manage/make use of Big Data, but in applications that generate the value directly.

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My Weekend with 20 Under 20

I got the opportunity to spend this past weekend attending the Thiel “20 Under 20” Fellowship 2012 Mentor Match and Exhibition at the beautiful San Francisco Palace of Fine Arts. For those of you who aren’t familiar with the program, the fellowship was the brainchild of ex-PayPal CEO Peter Thiel and gives $100K to 20 individuals under 20 years old every year to drop out of school and work on their own projects/companies for 2 years.

While I had met a couple of the fellows last year, I formally became a mentor for the program earlier this year, and one of the few formal obligations that come with that include attending the event and providing some of my opinions on the incoming batch of finalists.

It was a fascinating couple of days, with the first day being predominantly about meeting and learning about the talented set of 41 finalists vying for the fellowship and the second day being a chance for the finalists and the mentors to hear about what the current batch of fellows were up to and what they had learned after a year in the program.

While it’d be impossible to capture the entire experience down in a blog post, three things jumped out at me that I wanted to share:

  • This is the stuff great entrepreneurs are made of. While there are many market and business model factors that venture capitalists look for and analyze when thinking about investing, one of the most important things that we look for are character traits in the founders/executives that seem predisposed to “win big.” While different investors will have different (and oftentimes irrational sounding and contradictory) opinions on what that actually means, there tends to be general agreement that wildly successful entrepreneurs are very smart, extremely energetic, and somewhat-irrationally ambitious. Suffice to say, the vast majority of the finalists and the fellows had all three. It doesn’t guarantee they’ll be successful now or even in the future, but I can say that if these guys keep trying and keep thinking big, a reasonable number of them will find meaningful ways to impact the world around them, and it’s a great pleasure and an honor for me to be a witness and potentially play a part.
  • Related to my last point, many of the project proposals were refreshingly bold. While I can point to a number of cool projects (one oriented around using algae to extract carbon dioxide from car exhaust and one around creating a new way of producing medical radioisotopes jump immediately to mind), what I am really referring to is a lot more philosophical. The simple truth is that while experience (and, in my case, “borrowed” experience from colleagues and mentors older and wiser than me) can impart many lessons, it has a cynicism-inducing effect – it teaches you that certain things are “extremely difficult”, “impractical”, and other euphemisms for “you’d be crazy to try to do that.” Yet, therein lies the paradox – while experience is probably right the vast majority of the time, it is occasionally wrong – and you need people who are too inexperienced – read: young and ambitious — to appreciate that conventional wisdom that “it won’t work”. Its the potential of providing support for super-smart and “naively optimistic” young people that, to me, is the real potential of the fellowship program, and that’s why I find many of the project proposals refreshingly bold. It doesn’t mean I think many of them will succeed – after all, my experience tells me otherwise 🙂 — but gosh darn it, its people like these finalists and fellows who will prove experience wrong and make meaningful impact on the world.
  • It was also fascinating to see the differences between last year’s fellows and this year’s finalists. A very common theme from the fellows’ updates on how their past year have gone were around experience: mainly that raw smarts and ambition oftentimes need to be coupled with experience and understanding and open-mindedness to make a meaningful difference. Several of the fellows admitted to not achieving everything they thought they would, and quite a few even changed their projects (some several times!). Several of the fellows spoke about the great advice they received in talking with their mentors (both affiliated and unaffiliated with the program). If there was one thing that seemed universal for the fellows, it was that they all got a little taste of how challenging and complex it is to make a big impact and learned a great deal in the process, and I think it bodes well for what they will be able to do in the year to come.

In any event, I had a great time this weekend and definitely felt inspired. I look forward to more of these in the future and the chance to help some really cool people hopefully change the world for the better!

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The Best Video on Entrepreneurship I’ve Seen

A few months ago, I attended Morgenthaler Venture’s DC-to-VC conference on health IT startups. Now, at some point, everyone who works in venture capital attends enough events that they kind of all blur together. But, there was something very special about this event that set itself apart from all the others.

Ryan Howard, the CEO of Practice Fusion — itself a very impressive Electronic Medical Record startup – gave a very memorable keynote about what it takes to succeed as an entrepreneur. While many conferences have inspirational keynote speakers who point out, in generalities, the potential for startups and entrepreneurs to “change the world”, Ryan gave a fabulous presentation – both realistic and very moving — about what it takes to be an entrepreneur: the type of drive, support, unreasonableness, sacrifice, and mentality it takes to succeed. For anyone who is an entrepreneur or even a venture investor who’s never spent time on “the other side of the table”, it’s a must-see:

(just watch the first 17 minutes of this video – the rest wraps up the Morgenthaler event):

Great job, Ryan!

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Pitching a VC is a Romantic Affair

processI swear the title has nothing to do with Valentine’s Day :-).

One question that comes up often when people find out that I work at a venture capital firm is “how do venture capital firms decide what they invest in?” How is it that the same firms that pick wildly successful companies like Google and Facebook can also pick the “what were they thinking” duds?

People are oftentimes surprised to hear my answer. The truth is that while there is a general perception that there is some kind of a secret formula with objective criteria and analysis, the idea that the VC decision process is a purely objective and analytical affair is plain wrong.

The analogy I like to give is that getting an investment from a venture capital firm is a lot like marriage. Yes, there are obviously objective criteria which inform the decision – is the potential spouse/founding team trustworthy? Do we share the same goals in life (i.e. kids vs no-kids or size of outcome/industry)? Are we at the right stage (i.e. ready for commitment or point in lifecycle of the startup)? What do friends/industry experts/customers say? Can both parties add meaningful value to both sides?

But, like with marriage, there is a significant emotional component to the decision as well which can’t be ignored. Things like personal chemistry or whether or not the investors involved are enchanted/charmed by the founding team and the business idea play an enormous role. An investor who doesn’t have a specific qualm about a startup but who just isn’t feeling “the love” will not push a deal forward, no matter how great of a business case is being made. Why? The business model of most venture capital firms forces individual investors to only commit to a handful of companies that they truly can commit to and stick with through thick and through thin (and, rest assured, all companies have bad times they have to survive through).

Of course, let it be clear: any decent investor who “falls in love” with a startup and later uncovers objective reasons to not go forward will fall rapidly out of love with a company – lest someone reading this gets the idea that its all about the emotions. But the lesson to take away here for entrepreneurs is that while its absolutely critical to nail the objective criteria (things like business model, team composition, market size, go-to-market strategy, product/service quality, technology, etc) – that is, after all, the bread and butter of any good startup – don’t forget that, just as with most sales/business deals, the VC process has a huge emotional piece. So:

  • Have high EQ when you approach a conversation with a VC you are interested in: fit the message to the person and if you see the interest/reaction start to go the wrong way, shift gears and adapt the message (although I should remind people to not lie – that never ends well for either party)
  • Know the VCs you are presenting to: its impossible to precisely predict what combination of things will really click with a person, but you can get hints of that by doing your research. At the minimum, it means reading the backgrounds/profiles of the individuals you will be meeting with to understand what they are interested in and what sorts of themes they tend to look for. But, keep in mind to also pay attention to what things might turn them off (i.e. if they were involved with a bad eCommerce deal and you are trying to pitch a eCommerce company, make sure your story/pitch is *very* different).
  • Talk with a lot of VCs and expect to do this for every round of financing: as with romance, you can’t expect to click with everyone, not to mention, as with romance, things can always change the second or third time around. There are definitely cases where entrepreneurs have had very successful relationships with investors they never expected in their first set of pitches as well as VCs who have passed on earlier rounds of investment (no chemistry the first time) only to eagerly participate in follow-on investments.

(Image credit – 3Forward)

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That’s Fab!

Companies rarely change successfully. I’ve blogged before about some of the cultural reasons this is true for larger companies – but much of the same holds true for smaller ones as well. But, every now and then, you do get a change which does seem to work for the better.

Take the rapidly growing flash sales site Fab.com. They started as a social networking service focused on the gay population. But, when that did not work as well as they had hoped, they then attempted to reposition themselves as a review/check-in service also focused on the gay population.

Actually, it would be far more illustrative to use their words (see slide from Fab.com presentation below): they started as “Gay Facebook”, then tried to become a “Gay Yelp”, then shifted businesses to become a “Gay Foursquare” (after the popular social and location-based check-in service), and then tried to pivot again towards being a “Gay Groupon”.

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But before they could try (and potentially falter again at) becoming the gay versions of the other major internet companies out there (Quora, Zynga, LinkedIn, Google, Pandora maybe?), they stumbled on something which really fit with their passions and interests – and that is the birth of the Fab.com that we see today.

So, successful changes can happen. Ideally, they wouldn’t need to take as many steps as Fab.com did, and we’re still a long way from ultimately calling Fab.com a success, but under the right reasons and with the right strategic thinking and operational chops, they can happen.

(Slideshare link)

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Solyndra and the Role of VCs and Government in Cleantech

Because of the subject matter here, I’ll re-emphasize the disclaimer that you can read on my About page: The views expressed in this blog are mine and mine alone and do not necessarily reflect the views of my current (or past) employers, their employees, partners, clients, and portfolio companies.

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If you’ve been following either the cleantech world or politics, you’ll have heard about the recent collapse of Solyndra, the solar company the Obama administration touted as a shining example of cleantech innovation in America. Solyndra, like a few other “lucky” cleantech companies, received loan guarantees from the Department of Energy (like having Uncle Sam co-sign its loans), and is now embroiled in a political controversy over whether or not the administration acted improperly and whether or not the government should be involved in providing such support for cleantech companies.

Given my vantage point from the venture capital space evaluating cleantech companies, I thought I would weigh in with a few thoughts:

  • The failure of one solar company is hardly a reason to doubt cleantech as an enterprise. In every entrepreneurial industry where lots of bold, unproven ideas are being tested, you will see high failure rates. And, therein lies one of the beauties of a market economy – what the famous economist Joseph Schumpeter called “creative destruction.” That a large solar company like Solyndra failed is not a failing of the industry – if anything it’s a good thing. It means that one unproven idea/business model (Solyndra’s) was pushed out in favor of something better (in this case, more advanced crystalline silicon technologies and new thin film solar technologies) which means the employees/customers of Solyndra can now move on to more productive pastures (possibly another cleantech company which has a better shot at success).
  • The failure of Solyndra is hardly a reason to doubt the importance of government support for the cleantech industry. I believe that a strong “cleantech” industry is a good thing for the world and for the United States. Its good for the world in that it represents new, more efficient methods of harnessing, moving, and using energy and is a non-political (and, so, less controversial to implement) approach to addressing the problems of man-made climate change. Its good for the United States in that it represents a major new driver of market demand that the US is particularly well-suited to addressing because of its leadership in technology & innovation at a time when the US is struggling with job loss/economic decline/competition abroad. Or, to put it in a more economic way, what makes cleantech a worthy sector for government support is its strategic importance in the future growth of the global economy (potentially like a new semiconductor/software industry which drove much of the technology sector over the past two decades), the likelihood that the private sector will underinvest due to not correctly valuing the positive externalities (social good), and the fact that…
  • Private sector investors cannot do it all when it comes to supporting cleantech. One of the criticisms I’ve heard following the Solyndra debacle is that the government should not leave the support of industries like cleantech to the private sector. While I’m sympathetic to that argument, my experience in the venture investing world is that many private investors are not well equipped to providing all the levels of support that the industry would need. Private investors, for instance, are very bad at (and tend to shy away from) providing basic sciences R&D support – that’s research which is not directly linked to the bottom line (and so is outside of what a private company is good at managing) and, in fact, should be conducted by academics who collaborate openly across the research community. Venture capital investors are also not that well-suited to supporting cleantech pilots/deployments – those checks are very large and difficult to finance. These are two large examples of areas where private investors are unlikely to be able to provide all the support that the industry will need to advance and areas where there is a strong role for the government to play.
  • With all that said, I think there are far better ways for the government to go about supporting its domestic cleantech industry. Knowing a certain industry is strategic and difficult for the private sector to support completely is one thing – effectively supporting it is another. In this case, I have major qualms about how the Department of Energy is choosing to spend its time. The loan guarantee program not only puts taxpayer dollars at risk directly, it also picks winners and losers– something that industrial policy should try very hard not to do. Anytime you have the ability to pick winners and losers, you will create situations where the selection of winners and losers could be motivated by cronyism/favoritism. It also exposes the government to a very real criticism: shouldn’t a private sector investor like a venture capitalist do the picking? Its one thing when these are small prize grants for projects – its another when its large sums of taxpayer dollars at risk. Better, in my humble opinion, to find other ways to support the industry like:
    • Sponsoring basic R&D to help the industry with the research it needs to break past the next hurdles
    • Facilitating more dialogue between research and industry: the government is in a unique position to encourage more collaboration between researchers, between industry, between researchers AND industry, and across borders. Helping to set up more “meetings of the minds” is a great, relatively low-cost way of helping push an industry forward.
    • Issuing H1B visas for smart immigrants who want to stay and create/work for the next cleantech startup: I remain flabbergasted that there are countless intelligent individuals who want to do research/work/start companies in the US that we don’t let in.
    • Subsidizing cleantech project/manufacturing line finance: It may be possible for the government to use tax law or direct subsidies to help companies lower their effective interest payments on financing pilot line/project buildouts. Obviously, doing this would be difficult as we would want to avoid supporting the financing of companies which could fail, but it strikes me that this would be easier to “get right” than putting large swaths of taxpayer money at risk in loan guarantees.
    • Taxing carbon/water/pollution:  If there’s one thing the government can do to drive research and demand for “green products” is to issue a tax which makes the consequences of inefficiency obvious. Economists call this a Pigovian tax and the idea is that there is no better way to get people to save energy/water and embrace cleaner energy than by making them. (Note: for those of you worried about higher taxes, the tax can be balanced out by tax cuts/rebates so as to not raise the total tax burden on the US, only shift that burden towards things like pollution/excess energy consumption)

    This is not a complete list (nor is it intended to be one), but its definitely a set of options which are supportive of the cleantech industry, avoid the pitfall of picking winners and losers in a situation where the market should be doing that, and, except for the last, should not be super-controversial to implement.

Sadly, despite the abundance of interesting ideas and the steady pace of innovation/business model innovation, Solyndra seems to have turned investors and the public more sour towards solar and cleantech more broadly. Hopefully, we get past this rough patch soon and find a way to more effectively channel the government’s energies and funds to bolstering the cleantech industry in its quest for clean energy and greater efficiency.

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The Goal is Not Profitability

I’ve blogged before about how the economics of the venture industry affect how venture capitalists evaluate potential investments, the main conclusion of which is that VCs are really only interested in companies that could potentially IPO or sell for at least several hundred million dollars.

One variation on that line of logic which I think startups/entrepreneurs oftentimes fail to grasp is that profitability is not the number one goal.

Now, don’t get me wrong. The reason for any business to exist is to ultimately make profit. And, all things being equal, investors certainly prefer more profitable companies to less/unprofitable ones. But, the truth of the matter is that things are rarely all equal and, at the end of the day, your venture capital investors aren’t necessarily looking for profit, they are looking for a large outcome.

businessgrowthBefore I get accused of being supportive of bubble companies (I’m not), let me explain what this seemingly crazy concept means in practice. First of all, short-term profitability can conflict with rapid growth. This will sound counter-intuitive, but its the very premise for venture capital investment. Think about it: Facebook could’ve tried much harder to make a profit in its early years by cutting salaries and not investing in R&D, but that would’ve killed Facebook’s ability to grow quickly. Instead, they raised venture capital and ignored short-term profitability to build out the product and aggressively market. This might seem simplistic, but I oftentimes receive pitches/plans from entrepreneurs who boast that they can achieve profitability quickly or that they don’t need to raise another round of investment because they will be making a profit soon, never giving any thought to what might happen with their growth rate if they ignored profitability for another quarter or year.

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Secondly, the promise of growth and future profitability can drive large outcomes. Pandora, Groupon, Enphase, Tesla, A123, and Solazyme are among some of the hottest venture-backed IPOs in recent memory and do you know what they all also happen to share? They are very unprofitable and, to the best of my knowledge, have not yet had a single profitable year. However, the investment community has strong faith in the ability of these businesses to continue to grow rapidly and, eventually, deliver profitability. Whether or not that faith is well-placed is another question (and I have my doubts on some of the companies on that list), but as these examples illustrate, you don’t necessarily need to be profitable to be able to get a large venture-sized outcome.

Of course, it’d be a mistake to take this logic and assume that you never need to achieve or think about profitability. After all, a company that is bleeding cash unnecessarily is not a good company by any definition, regardless of whether or not the person evaluating it is in venture capital. Furthermore, while the public market may forgive Pandora and Groupon’s money-losing, there’s also no guarantee that they will be so forgiving of another company’s or even of Pandora/Groupons a few months from now.

But what I am saying is that entrepreneurs need to be more thoughtful when approaching a venture investor with a plan to achieve profitability/stop raising money more quickly, because the goal of that investor is not necessarily short-term profits.

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DCM Raises $100M Android Fund: Looking for Great Ideas

Full disclaimer: While I work for DCM, the views expressed in this blog are mine and mine alone and do not necessarily reflect the views of my current (or past) employer, their employees, partners, clients, and portfolio companies.

If you follow the tech trades about Android as much as this “fandroid” does :-), you’ll have seen an announcement from leading venture capital fund DCM which I found extremely exciting:

MENLO PARK, Calif. – TOKYO, Japan – April 21, 2011

Today, leading Pacific Rim technology venture capital firm DCM announced the launch of the world’s first Android-focused fund (“AFund”). The A-Fund is a $100 million strategic investment initiative that will focus on startups developing compelling solutions taking advantage of Android’s rapid growth.
The A-Fund will be managed by DCM, an investor in early stage technology companies based in Silicon Valley, Beijing and Tokyo. Anchor investors include GREE Inc., Japan’s largest mobile gaming social network, and KDDI Corporation, Japan’s second largest mobile operator. Funding and support will also come from strategic partner Tencent, one of China’s largest integrated Internet services companies. DCM plans to announce additional partners in the A-Fund, including a leading US based semiconductor company, in the coming weeks.

“The rise of Android is a rare and massive opportunity – one that comes only once in a major tech cycle,” said David Chao, co-founder and general partner, DCM. “The A-Fund will seek out the most promising companies enhancing and extending the rich open Android ecosystem—in mobile and beyond – including applications, services, and enabling technologies.”

The A-Fund will create a strong network of top-tier startups and provide access to resources, relationships and business opportunities catered to the needs of Android related companies.  DCM and its corporate partners will provide the capital, global business expertise, business development support, and other value-add services needed to succeed in a rapidly evolving market.

Suffice to say, given my prior blog coverage on Android, it should come as no surprise that I think Android represents potentially one of the largest opportunities ever for entrepreneurs, consumers, and investors, particularly in three categories:

  • Because Android is open source and available for a wide range of device manufacturers, it is becoming one of the fastest growing and most prolific platform plays ever, especially overseas where cash-strapped consumers and hardware guys are turning to Android devices. In the same way that iPhone enabled guys like Evernote, Rovio, and Ngmoco to build sizable businesses, Android’s wide and international reach will create large opportunities for entrepreneurial mobile software and service companies.
  • Android’s greater openness relative to other platforms provides the opportunity for new types of software and services to be deployed that more closed platforms will not be able to enjoy, at least not in the short-term. That translates into my belief that the next BMC/VMWare/Oracle/Symantec/Adobe of mobile will most likely first build on a more open platform like Android.
  • Android is not just a software play – its more open nature lets it function as a hardware enabler too: manufacturers of tablets, TVs, set-top boxes, printers, appliances, cars, medical devices, and even more can benefit from Android as a way to reduce costs/time-to-market or as a way to add application functionality/a consumer-friendly user interface to their design. In the same way that Android helped build HTC into a giant, Android will enable a new generation of hardware and software/applications to run on that new hardware, helping to build “the next HTC.”

So, if you or someone you know has a great Android-related project or idea that fits into any of the categories above, feel free to shoot an email to <first initial-last name (no hyphen in between)>-at-dcm-dot-com. 🙂

For more coverage on DCM’s Android Fund, check out:

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Our Job is Not to Make Money

Let’s say you pitch a VC and you’ve managed to avoid the classic VC pitch pitfalls I outlined before and have demonstrated thoughtfulness regarding the scalability illusion. Does that mean you get the venture capital investment that you so desire?

Not necessarily. Now, there could be many reasons for a rejection, but one that crops up a great deal, at least in my experience, is not anything intrinsically wrong with a particular idea or team, but something which is an intrinsic issue with the venture capital model.

One of our partners put it best when he pointed out, “Our job is not to make money, its to make a lot of money.”

What that means is that venture capitalists are not just looking for a business that can make money. They are really looking for businesses which have the potential to sell for or go public (sell stock on NYSE/NASDAQ/etc) and yield hundreds of millions, if not billions of dollars.

Why? It has to do with the way that venture capital funds work.

  • Venture capitalists raise large $100M+ funds. This is a lot of money to work with, but its also a burden in that the venture capital firm also has to deliver a large return on that large initial amount. If you start with a $100M fund, its not unheard of for investors in that fund to expect $300-400M back – and you just can’t get to those kinds of returns unless you bet on companies that sell for/list on a public market for a lot of money.
  • Although most investments fail, big outcomes can be *really* big. For every Facebook, there are dozens of wannabe copycats that fall flat – so there is a very high risk that a venture investment will not pan out as one hopes. But, the flip side to this is that Facebook will likely be an outcome dozens upon dozens of times larger than its copycats. The combination of the very high risk but very high reward drive venture capitalists to chase only those which have a shot at becoming a *really* big outcome – doing anything else basically guarantees that the firm will not be able to deliver a large enough return to its investors.
  • Partners are busy people. A typical venture capital fund is a partnership, consisting of a number of general partners who operate the fund. A typical general partner will, in addition to look for new deals, be responsible for/advise several companies at once. This is a fair amount of work for each company as it involves helping companies recruit, develop their strategy, connect with key customers/partners/influencers, deal with operational/legal issues, and raise money. As a result, while the amount of work can vary quite a bit, this basically limits the number of companies that a partner can commit to (and, hence, invest in). This limit encourages partners to favor companies which could end up with a larger outcome than a smaller, because below a certain size, the firm’s return profile and the limits on a partner’s time just don’t justify having a partner get too involved.

The result? Venture capitalists have to turn down many pitches, not because they don’t like the idea or the team and not even necessarily because they don’t think the company will make money in a reasonably short time, but because they didn’t think the idea had a good shot at being something as big and game-changing as Google, Genentech, and VMWare were. And, in fact, the not often heard truth is that a lot of the endings which entrepreneurs think of as great and which are frequently featured on tech blogs like VentureBeat and TechCrunch (i.e. selling your company to Google for $10M) are actually quite small (and possibly even a failure) when it comes to how a large venture capital firm views it.

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The Scalability Illusion

Even if an entrepreneur avoids all the pitfalls of how not to pitch a venture capitalist, there are still quite a few common mistakes that happen. One of the most common is something I call the scalability illusion.

It goes something like this:

Entrepreneur: I have got a great idea. I’ve built a [blog/game/social network/eCommerce site/product/etc] that has really taken off. Without any advertising, it has [100,000 users/articles/purchases/customers/etc]. All I need are a few million dollars and I can really blow this baby out of the water!

kcsw-t-front-expStop me if you’ve heard this one before…

The fundamental mistake that many new entrepreneurs make is that they assume that their ability to do well on a small scale with very little money necessarily translates into being able to do as well on a large scale … if only they had some money.

Occasionally, they are right. But, 9 times out of 10, they’re not. I have a theory of how these sorts of businesses grow:

  • Phase 1: Building something that works at all to get a small amount of recurring users/customers/etc.
  • Phase 2: Growing to a fairly large number of users/customers/etc.
  • Phase 3: billion dollar business.

Phase 1 tends to be extremely difficult. It takes a lot of work and skill and luck to build a product/service that is good enough to get people to actually use and stick with it. Phase 2, in my book, tends to be relatively easy (each step is hard, but this one is relatively easy compared to the other two phases) – because once you have a good product in place that a few people will use, it’s natural for there to be a few thousand or tens of thousands of users who are looking for a similar product or service.

Phase 3, however, is always the hardest part of the growth story. Once you get past your first few thousand/tens of thousands of users, you’ve gotten all the “low hanging fruit” – all the people who would naturally flock to your business have already jumped on board. To grow further, you need to:

  • develop a product team, not only because you’ll need new products and features to attract new customers and ward off competition, but because other companies will try to hire your best people
  • expand sales & marketing to win new customers and hold on to existing ones
  • build out a business development team to land the partnerships and deals you’ll need to stay ahead of the curve
  • invest in support/logistics to manage all the new people you need to hire and all the new customers you need to bring on
  • bring on a strong finance team and retain a good legal counsel, because the cost of success is taxes, red tape, lawsuits, and cash management
  • a general rule of thumb I’ve observed is that good strategies to bring in new customers always get copied, making the cost of getting a new customer go up over time (all other things held constant)

Or, in a nutshell: you are chasing an illusion if you think early stage successes easily scale to big home runs. If it were that easy, it’d happen a lot more often.

So, what does this mean if you’re a budding entrepreneur trying to raise money?

  • Be mature enough to accept that the toughest part of building your business is not the product, but getting it to scale. One of the biggest red flags on the quality of a management team, in my mind, is when they say “the tough part – building the technology/product — is over, now is the easy part – signing deals/landing customers.”
  • Expect one of the biggest questions on a potential investor’s mind to be how costly/difficult it will be to scale your business, and have a thoughtful, well-researched answer to it. This should include looking at how much other companies needed to spend to grow and the next bullet point…
  • Actively track the scalability of your business: have numbers like customer lifetime value and capital intensity readily available
  • Avoid business models/products which are obviously very hard to scale. On some level, all business models are hard to scale. But there are definitely some ideas which are notably harder to scale. For instance, selling a service where you have a complicated sales and development process that varies significantly for every customer? Probably not easily scalable (i.e. selling to K-12 schools; management consulting). Building a product which requires you to build an expensive factory every few years to achieve your growth goals? Probably not easily scalable (i.e. IDM semiconductor manufacturers). Selling a product that is extremely hit-driven and very long tail? Probably not easily scalable (i.e. movie studio, games, etc.) These aren’t the only ones — but they give you a flavor. The exception to this rule is if you have some underlying formula/secret which allows you to scale more easily — but rest assured, it is extremely rare for a startup to find this legendary holy grail

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Goodbye consulting, hello venture capital

image A little over three years ago, I entered the world of management consulting. Yesterday was my last day. In true consultant fashion, I sent the office a slide-as-farewell-email and enjoyed a few glasses of wine and a few bottles of beer with my “war-buddy” colleagues and other well-wishers at a local bar in the early evening. It was a great way to go.

What’s next? I now move from the world of advising large companies on big business issues to advising and, now also, investing in small, early-stage startups as someone in the venture capital space. This move won’t surprise many of my friends who have, for years, known me as someone with a lot of interest in startups and new technologies and who has dabbled on and off with my own little projects like Xhibitr. For me, a stint in VC was a great opportunity to get a chance to do many things, including:

  • Learn more about what makes new business ideas/technologies succeed: Working at a VC gives you a unique chance to truly take in numerous business plans and ideas at all stages in the startup lifecycle and see what helps drive success and failure.
  • Build an interesting network of thinkers and do-ers: While Dilbert is probably an over-exaggeration of corporate life, there is something to be said about large companies being less able to respond to disruptive innovations and business models. By immersing myself in a world of startups, I’m hoping to get to meet and converse with some of the thinkers behind the big ideas which will change the world.
  • See a different side of the business world: Consulting is a great introduction to understanding how businesses think and work, but it operates mainly at the big business level, where gameboarding and strategy matter a great deal more than boldness and execution. I didn’t feel comfortable making a commitment to a particular industry or specialty (or to a MBA/masters/PhD/other degree) without seeing this other side as well.

I’m very excited and am looking forward to the next chapter of my professional life!

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