Tag Archives: Venture Capital

THE ANGEL EDGE


PB&J T-JAJAdapted from the Journal of the Heartland Angels

Part 1 – by John Jonelis

Is an Angel a fool?

In the world of private equity investing, the order of funding is supposed to go like this:

  • Seed Round—that’s friends, family, and fools.
  • Angel Round—that’s funding the big initial spurt of growth.
  • Venture Round—that’s big funding for massive scaling.

Compare that stack-of-three (above) to a peanut butter and jelly sandwich. Notice that Angels make up the good stuff in the middle. And yes—according to studies by the Kauffman Foundation—Angels make the best money. Continue reading THE ANGEL EDGE

Why Facebook is Killing Silicon Valley


We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win…

— John F. Kennedy, September 1962

Innovation
I teach entrepreneurship for ~50 student teams a year from engineering schools at Stanford, Berkeley, and Columbia. For the National Science Foundation Innovation Corps this year I’ll also teach ~150 teams led by professors who want to commercialize their inventions. Our extended teaching team includes venture capitalists with decades of experience.

The irony is that as good as some of these nascent startups are in material science, sensors, robotics, medical devices, life sciences, etc., more and more frequently VCs whose firms would have looked at these deals or invested in these sectors, are now only interested in whether it runs on a smart phone or tablet. And who can blame them.

Facebook and Social Media
Facebook has adroitly capitalized on market forces on a scale never seen in the history of commerce. For the first time, startups can today think about a Total Available Market in the billions of users (smart phones, tablets, PC’s, etc.) and aim for hundreds of millions of customers. Second, social needs previously done face-to-face, (friends, entertainment, communication, dating, gambling, etc.) are now moving to a computing device. And those customers may be using their devices/apps continuously. This intersection of a customer base of billions of people with applications that are used/needed 24/7 never existed before.

The potential revenue and profits from these users (or advertisers who want to reach them) and the speed of scale of the winning companies can be breathtaking. The Facebook IPO has reinforced the new calculus for investors. In the past, if you were a great VC, you could make $100 million on an investment in 5-7 years. Today, social media startups can return 100’s of millions or even billions in less than 3 years. Software is truly eating the world.

If investors have a choice of investing in a blockbuster cancer drug that will pay them nothing for fifteen years or a social media application that can go big in a few years, which do you think they’re going to pick? If you’re a VC firm, you’re phasing out your life science division. As investors funding clean tech watch the Chinese dump cheap solar cells in the U.S. and put U.S. startups out of business, do you think they’re going to continue to fund solar? And as Clean Tech VC’s have painfully learned, trying to scale Clean Tech past demonstration plants to industrial scale takes capital and time past the resources of venture capital. A new car company? It takes at least a decade and needs at least a billion dollars. Compared to IOS/Android apps, all that other stuff is hard and the returns take forever.

Instead, the investor money is moving to social media. Because of the size of the market and the nature of the applications, the returns are quick – and huge. New VC’s, focused on both the early and late stage of social media have transformed the VC landscape. (I’m an investor in many of these venture firms.) But what’s great for making tons of money may not be the same as what’s great for innovation or for our country. Entrepreneurial clusters like Silicon Valley (or NY, Boston, Austin, Beijing, etc.) are not just smart people and smart universities working on interesting things. If that were true we’d all still be in our parents garage or lab. Centers of innovation require investors funding smart people working on interesting things — and they invest in those they believe will make their funds the most money. And for Silicon Valley the investor flight to social media marks the beginning of the end of the era of venture capital-backed big ideas in science and technology.

Don’t Worry We Always Bounce Back
The common wisdom is that Silicon Valley has always gone through waves of innovation and each time it bounces back by reinventing itself.

[Each of these waves of having a clean beginning and end is a simplification. But it makes the point that each wave was a new investment thesis with a new class of investors as well as startups.] The reality is that it took venture capital almost a decade to recover from the dot-com bubble. And when it did Super Angels and new late stage investors whose focus was social media had remade the landscape, and the investing thesis of the winners had changed. This time the pot of gold of social media may permanently change that story.

What Next
It’s sobering to realize that the disruptive startups in the last few years not in social media – Tesla Motors, SpaceX, Google driverless cars, Google Glasses – were the efforts of two individuals, Elon Musk, and Sebastian Thrun (with the backing of Google.) (The smartphone and tablet computer, the other two revolutionary products were created by one visionary in one extraordinary company.) We can hope that as the Social Media wave runs its course a new wave of innovation will follow. We can hope that some VC’s remain contrarian investors and avoid the herd. And that some of the newly monied social media entrepreneurs invest in their dreams. But if not, the long-term consequences for our national interests will be less than optimum.

For decades the unwritten manifesto for Silicon Valley VC’s has been: We choose to invest in ideas, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win.

Here’s hoping that one day they will do it again.

Read more Steve Blank posts at www.steveblank.com.

The 3 bad habits VCs can’t afford anymore


Disclosure: I’ve conducted a thousand meetings with venture capitalists in Europe and thousands of calls with investors worldwide for the past 5 years. There are many good investors in France and Europe, don’t get me wrong. But i’m not here to pin medals ☺

I have heard too many stories and have witnessed too often venture capitalists misbehaving with entrepreneurs, especially and including some of the best ranked in Europe. It’s really sad for the entrepreneurs but mostly for the venture capital industry itself. Probably because (fortunately!) most of the time, it’s unintentional.

The mere fact that a venture capitalist tried to go towards a VC code of conduct is actually pretty alarming. I won’t go through all the details -education and good habits come from a consistent practice. But let’s be specific on three basic facts:

  • #ON-TIME > Some investors are late, always or often, and let’s face it, this is unprofessional, especially when the entrepreneurs are coming to you. At A16Z, partners are fined $10 for every min late to a meeting.
  • #EMPATHY > Entrepreneurs are on a mission and they deserve respect. The best investors are pretty straight-forward but they also show a lot of empathy while others are almost despising during the meetings, which is incredibly rude.
  • #FOLLOW-UP > The dealflow at venture capital firms is pretty huge, from 100 to 1,000 new opportunities per month popping-up. Not replying to unsolicited email is fine I guess, the rules are pretty clear for anyone looking to raise funds. But when you have been introduced to an entrepreneur by someone you trust or have met up with someone, you should absolutely get back to them, whatever the consistency of the answer.

I’ve been surprised in the US by the conciseness among the top venture capitalists, the straightness and the empathy in their answers. They’re full of humility and respect and we should learn from those practices in Europe. Some of them are even sending satisfactory forms after having met with entrepreneurs to make sure they were well received.

Good practices are not only good for the entrepreneurs but also for the investors themselves and the ecosystem. Please consider.

A bon entendeur ☺


Tips: Gmail for to-do, email & calendar(stop using outlook, NSA does not care about your dealflow), aText for templates, Doodle for meetings, Rapportive for people checking and finally Good habits but practice and organisation are actually the best tools.

Start-Up Drugs


ADVENTURE-JOURNAL.COM

ADVENTURE-JOURNAL.COM

Start-ups can be a vice grip of stress. At first you don’t have money, and so when you finally do, it’s feels like a victory. You are funded at last. So much effort goes into fundraising that it feels psychologically like you’ve made it.

You haven’t.

Within six months of raising venture capital, something goes wrong. It always does. You quickly realize you’ve added a huge new source of stress: getting a return for major shareholders who define winning as building a huge business. That goes on top of the formidable baseline stress of building a great product, delighting your customers, and providing stable and meaningful jobs to your team.

The new capital is different than the angels who invested previously. They came in for the love of the game and owned a tiny stake. The venture capital is a different ballgame. These folks are fiduciaries whose own jobs are on the line, and they probably own at least 10% of your business, and on frequently more.

You don’t want to let them down. So why did you feel a sense of accomplishment when the capital came in, when you really were just getting started?

It’s a paradox that because the process of raising venture capital is hard, it feels like an ending when it’s really a new beginning. The goal was never the fundraising, it was the innovation that fundraising enables.

So now what? The core business isn’t producing. The thesis of the investment isn’t panning out. You’ve got capital. But you’re not deploying that capital into growing your business effectively.

The narrative is gonna be you raised money against something that showed promise and could have been great, you took dilution and raised the stakes with pricey valuation, and now you’ve screwed the whole thing up because you couldn’t translate that capital into growth.

The pressure to grow increases as you miss numbers. You know it, your board knows it, your team knows it: growth is the lifeblood of a start-up. Your current investors can’t put more money in if there aren’t new investors who want in. Fresh blood is required. And the romance phase with your VCs moves into the marriage phase. Will it end in divorce?

You thought not having money was more stressful than having it. Now you’ve got it, and you realize you are even more stressed than you were before when it was just you in the garage.

What do you do when you have cash but no productive use of it? Drugs.

Crack

Advertising, or paid marketing, is one way out. You spend money, you make money. You spend more money, you make more money. The only problem is the money you are “making” is showing up on the top-line and not the bottom-line.

Once the dust settles, as you look more closely, you will find you are acquiring worse and worse cohorts of customers. In many cases, to make the advertising really sing, you are running promotions and deals that erode your margin and your brand.

Now everyone is hooked on the top-line growth. The revenue expansion is driving a (private market) valuation that you need to keep “up and to the right” to raise capital. You must avoid the dreaded down round at all costs.

With supreme intellectual dishonesty, everyone marches on, temporarily intoxicated by the envisioned share price appreciation that comes from growing your top-line. Founders are usually the most guilty of this delusion. If you don’t have honest investors around you to tell you the truth, god help you.

What does advertising have to do with this? It’s the crack. It becomes more and more addictive as you use it. As one of my lead investors — the Oracle — once told me:

Spending a lot of money on paid marketing is a great way to scale a bad business.

Once you start, it’s like building a time bomb into your P&L which pushes out your break-even. It cannot be shut off without shutting off growth. Your investors may get liquid along the way, but if you really care about this company, you as the entrepreneur are screwed because your company’s never going to win.

How does this happen? Everyone wants to see that the advertising works, so they look for the confirmation bias of good news: more advertising equals more growth. What they don’t do is the more nuanced (hard) work of looking at how the marginal cohorts are declining in value. What they don’t look at is the detailed impact on the quality of that growth, aka the margins and repeat transactions attached to it.

Why don’t they do this?

Part of it is the systems to look at the data are rarely very good in a start-up. Part of it is you’ll need really talented analysts, a precious resource and often a luxury at the early stage where most people are zapped just keeping the trains running on time. Part of it is even if the systems are pristine and the data is rapidly returned by ready analysts to business (which I’ve not seen three for three at any start-up), it can take twelve to eighteen to twenty-four months to have confidence in where the cohorts are going.

In startup lifetime, that’s an eternity, and you’ve already burned through cash for a business which might be cash flow negative even pre-marketing dollars. You’re ready to raise your next round, because you need to, and you don’t even know if your growth is good.

Something stinks, but no one has an incentive to look under the hood because the bad news could preclude the next round.

A paradox is that it can be worse if you actually get the money raised without addressing the problem. You may have your conviction furthered in using crack to scale by the new capital coming in. Worse still is when founders get liquidity as part of these “hit the crack-pipe” rounds. Founders take huge sums of money off the table before employees or other investors have made a penny. The stomach turning part is that non-founder shareholders may never become liquid due to this top-line expansion/death spiral valuation fallacy.

So what to do now? Your whole company is hooked on crack. You are, your board is, even your internal team culture and organizational structure is architected to it. The very people you have in chairs is structured to deliver that shot in the arm.

What are you going to do? I don’t know exactly. What I do know it is likely to involve emotional turmoil and that ultimately nobody cares.

Speaking of which, can we get Ben Horowitz posting up in here?

What I can do is tell you what I did. When I do, the word did will become a link.

What I can do is tell you is that if you’re not going to pivot, you’ll need lead bullets and little bets.

Ecstasy

Founders have a gift for imagining a future that might be and then endeavoring to make it so.

By definition if you make it past the first few years, you have a track record of envisioning the future, attracting resources to that envisioned future, and in fact creating it.

This track record of success in achieving something likely thought contrarian when you began — otherwise everyone would be doing it — is both the reason for the company’s being and a threat to its existence.

The former we all get. Why the latter?

Mostly because the act of scaling a company once created is very different from the act of creation itself.

Scaling a company requires focus and execution. Starting a company requires imagination and being driven to distraction by life so much so that your imagination becomes your reality.

When the time comes for imagination vs. execution to do battle within your own company, it won’t be clear who is right. As the founder you will have history on your side (we made it here by following me, didn’t we), persuasive ability on your side (you wouldn’t be in the chair if you couldn’t attract talent and capital), and one of the most powerful home court advantages in humanity going for you (everyone is there because of you).

This doesn’t mean you will be right about what to do, which will be tricky for you, internally. Deep down you know you don’t know the future, and so you may end embodying a quote from Reinhold Niebuhr:

Frantic orthodoxy is most often rooted in doubt.

According to a little Harvard Business Review ditty called The Founder’s Dilemma, 30% of founders are gone in three years, 50% in five years, and 90% in ten years. I believe the fundamental reason is because creating something and scaling something are different jobs.

Yet the paradox is that the biggest companies are created by founders who can grow into becoming CEOs. I don’t have much to add on why this is, as Andreessen Horowitz pretty much wrote the book on it.

What I can say is that start-ups which become big companies are a survivorship bias of rocketships. Rocketships are start-ups which grow so fast that the founder has the luxury of learning on the job because they’re viewed as geniuses, or are indispensable in the early innings. That genius attracts a lot of capital, and capital plus indispensability plus strong growth equals plenty of founder time to evolve from founder to CEO, and to over time hire a leadership team that can cover for their weaknesses. As time heals all wounds in life, growth solves all problems in start-ups.

Perhaps I spare too much credit though for the rocketship founders, which leads me to this: most founding CEO are better at focus and saying no than I have been over the past six years. Particularly under duress, I find myself coming up with new ideas and getting excited about shiny new objects. The really good founding CEOs I’ve seen are much, much better at saying no.

Hope is not a strategy.

Prior to a lobotomy I just underwent which removed shiny new object syndrome (SNOS) from my brain, I was both an asset and a threat to my own company.

The company is trying to do one thing, and I would come up with another. I can’t tell you how dangerous this is. If the founder doesn’t know what the company is doing, the company won’t either.

In some cases the shiny new object you come up with saves the company. In other cases it sinks it. If it’s the former, they will call it a pivot and hail you as brilliant. If it’s ends up being a distraction or taking the company off course, they will call you delusional and un-focussed.

So which will it be? The evolution of the company that creates an awesome core business? Or a hope-fueled delusional fantasy of what the future might bring that creates the accurate narrative that the founder screwed the whole thing up?

I’ve attempted both. One thing has worked so well it might change retail forever. The other thing went so poorly I literally can’t understand the self that thought it possible.


When something isn’t working, there are two strategies. One is do more of what isn’t working. That’s crack. The other is do something totally different. That’s ecstasy.

If you have to make a radical pivot, do it. It’s the equivalent of leaving South America on a man-made raft to sail to Africa. You might make it, you probably won’t, but if it’s more hopeful than staying the course, then go for it.

In all other cases, there is a third path which I have come to believe is better: let’s call it LB squared, which stands for lead bullets and little bets.

Little Bets + Lead Bullets = LB Squared

There are no silver bullets for this, only lead bullets.

First, you just have to do the hard work of fixing what’s broken about what you began in the first place. A lead bullet is this: just fix it. Do whatever you have to do, but fix it.The godfather lays it all out here.

Once you’re on the lead bullets track to fix the core, it’s time to make some boundarized little bets to expand the horizon for what the company might become, and this is critical — without de-railing the core endeavor which is in the lead bullet itself.

In the words of the author of the man who wrote the book on it, Peter Sims:

We all want to make big bets. That’s a Silicon Valley mantra. Be bold. Go big. But I think ingenious ideas are over-rated and that people routinely bet big on ideas that aren’t solving the right problems.

A little bet is this: you take your pivot idea or an aspect of it, and treat it not as a game change but as an experiment. You might even be able to run a couple little bets in a year while you focus on fixing the core, the lead bullet. Remember: don’t make any little bets which are too big to fail.

If they’re too big to fail, you’re actually attempting a pivot.

It’s critical that the company understands whether the experiment is a pivot or a little bet. They need to know where the lion share of the company’s energy is going. They need to know if what they’re doing is fixing the existing business or moving into a new business.

Sound like fun? This job largely isn’t. It’s one of the great myths of starting a company that it’s fun. It’s like being with an infant. It’s really hard work, it’s often miserable, it’s frequently stressful, it’s incredibly meaningful, and it’s sometimes fun.


Start-ups are my favorite thing in the world because they are the direct collision of fantasy and reality.

Charisma will get you capital. It won’t get you a business. Imagination will attract people. But it won’t give your employees the lasting sense of purpose that winning will.

Getting to a real business from something that is a twinkle in your eye is a long journey. If you really want to build a P&L vs. just sell your top-line user or revenue growth story to an acquirer, be prepared to buckle in for ten years at least.

When it gets hard, and it will, avoid drugs. They’re temporary relief but as they do in real life for addicts — they only make the recovery harder, the lead heavier, the stakes of the little bets higher.

The stakes are high enough already.

The magic of a founder in times of duress is that you have the imagination and the moral authority to lead people through the scary parts of the journey. The scary part is that the very personality traits that enabled you to start the company could ruin the company if you can’t rein yourself in and become a CEO.

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What Is This Palo Alto VC Smoking?


Chamath Palihapitiya, a venture capitalist and former AOL manager, went to the Harvard Business School last weekend to deliver an interesting message:

It’s really unfair to you guys, but I think you’re discriminated against now. (…) I would bet a large amount of money that the overwhelming majority of us would not look favorably on a company started by one of you.”

Seriously? Of course, the news media picked up this quote and ran with it. First it was The New York Times and then Fortune and finally it went viral. After all, there’s an endless passion for MBA bashing.

Palihapitiya, founder of the venture capital fund Social+Capital Partnership and who graduated from the University of Waterloo with an undergraduate degree in electrical engineering, must have loved making those comments in front of MBAs at a private equity and venture capital conference at HBS.

As for me, I love people who make provocative statements for the sake of being provocative. But I have to call out this character on what he said because he is dead wrong.

First off, it’s important to point out that many of the venture capital firms in the Bay Area, in New York, Boston, and Austin actually employ MBAs to decide where to put their money. It’s highly unlikely for them to look unfavorably on startups founded by people who like them see the incredible value in an MBA degree.

Secondly, there is no evidence whatsoever to suggest that what Chamath said is even remotely true. I have no doubt that he brings this bias into pitch meetings (which should basically tell every MBA to avoid his firm, The Social+ Capital Partnership in Palo Alto, like the plague.

But the truth is that some of the most prominent VCs in the world love MBA-founded companies. In fact, we did a thorough analysis of MBA startups only a few months ago that showed the exact opposite of what Palihapitiya claims. Out of the most successful MBA startups in the past five years, Harvard leads the pack with founders at 34 of the top 100 startups, even though fewer than 7% of HBS grads founded companies. Those 34 startups alone received $575.8 million in funding from VC firms, angel investors and others.

Truth is, many of the Harvard Business School alumni chapters throughout the world have now organized angel investors to pour money into startups founded by current students and HBS alumni. It may well be the biggest and most organized campaign by any university alumni network ever to back innovative ideas and concepts. Who needs Palihapitiya’s money?

And Harvard’s success is not an anomaly when it comes to MBAs. When we identified the top 100 startups founded by MBA grads, Stanford followed close behind Harvard with 32. MIT Sloan is next with 11, followed by Wharton (3), the University of Chicago’s Booth School (3), and Columbia Business School (3). In all, venture capital firms and angel investors plunked down more than $2 billion in cash to back MBA students and graduates. So much for Chamath’s view that an MBA is a disadvantage to raising money.

In fact, the VCs pouring money into these startups are among the leading venture capitalists in the U.S.: SV Angel, First Round Capital, Bessemer Venture Partners, Founder Collective, Felicis Ventures, Red Swan Ventures, New Enterprise Associates, Lerer Ventures, Andreessen Horowitz, Google Ventures, Greylock Partners, and Accel Partners–all highly prominent VC firms.

What is this guy smoking?

For the full list of the biggest VC investors in the most successful MBA startups, check out PoetsandQuants.com:

The Top Investors In MBA Startups

Reducing friction in VC fundraising


The concept of ‘reducing friction’ is now an important part of any tech startup.

You want to maximize the chances of your user performing a certain action: signing up, purchasing your product etc. You have given your user a good motivation. You then need to minimize the barriers to them taking action.

This might be the time required, confusion on the proposition, addressing them at the wrong time, social stigma. Whether the user gives up completely, or just pauses, you will have been cast back into the pool of other companies seeking a fragment of their attention.

A good rule of thumb is to reduce the number of steps to take an action to the absolute minimum, and make the expected next step very clear at every stage

There is masses of further reading on this topic e.g. Bryan Eisenburg, Hooked by Nir Eyal, and the Qubit blog

What I have not seen is this concept applied to startup fundraising.

As a founder, you want to minimize the friction for an investor as he moves through the funnel from awareness, through interest, to decision. You want to maximise your chances of a yes, and you want a quick decision (even if it is a no).

Of course, the most important thing in getting funded is the quality of your business. A great business will get funded even with lots of friction in the funnel. However, achieving a 10% better business is hard, whereas it can be easy to eliminate 10% of friction in your interactions with investors.

I have taken a first cut at what might cause friction through the funnel of investor interactions below, broken down by stage

Friction in getting to first meeting:

  • Emailing the VC’s generic email address (information@balderton.com or similar). It will get read, but usually by the most junior member of the team on a Friday night
  • Emailing a partner cold. 95% of the time will end up in generic email box — see above. If you can get a genuine warm intro to a partner great. Otherwise go for an associate or principal.
  • Emailing a list of investors, or an obvious mail merge (instant delete)
  • Not providing enough info, e.g. “Please can we meet for a coffee” emails with no info on the business, or insisting you can only speak about the business in person, or giving only vague details
  • Asking for an NDA (see Mark Suster post on the topic here )
  • Complex/unclear descriptions of what the business does, or providing so much info that it becomes confusing
  • Not giving any context for the business: “We have no competitors”; ”Our market is entirely new”
  • Not having a social context: not having an Angellist profile; not saying how you connected with the VC (you can always find something, even if it is a second degree linkedin connection or blog post)
  • Not having a clear ask (almost always this should be a meeting)

Friction in first meeting (see also my post ‘What VCs listen to in meetings’):

  • Speaking by phone. Sometimes this can’t be helped, but it’s far from ideal. Couple of tips:
  • Avoid skype, poor mobile signal, free conference call numbers — anything that harms sound quality or call reliabilityThe only objective of the call is to get one of you to travel to make a meeting in person
  • Too many people in the room. Having someone in the room who is completely silent, or (even worse) tapping away on their laptop, is a distraction. Equally, having several people talking a lot, embellishing each other’s points, makes it hard to really connect with the VC.
  • Too much jargon or buzz words. Any VC will then be using their mental energy working out what you are actually talking about rather than engaging on it .
  • Over-selling. At best this is irritating. At worse it can create suspicion: “If it’s so good why is he selling it so hard?”
  • Exaggerating, over-promising (especially for current month metrics) or downright lies. Credibility, once lost, is very hard to regain.
  • Not managing time well. Trying to get through final 10 slides in 5 minutes.
  • Not sharing data.
  • Not agreeing next steps.

Fiction in getting to decision:

  • Not following up. If there any next steps from your side, aim to get them done next day (or a quick email to say when they will be ready). If next steps are on the VC’s side, send them a reminder. VCs see a lot of companies, are generally poor at prioritising, and so it is hard to stay top of their mind. Not following up doesn’t say much for an entrepreneur’s hustle and/or organizational skills.
  • Negotiating too early. You should absolutely negotiate with a VC on valuation and terms. But only after you know that they want to invest in you. Making demands too early in the process, when they don’t know if they want to invest yet, is just friction.
  • Setting false deadlines. Certainly you should create a sense of urgency by giving the VC the impression that other investors are moving forward quickly. But false deadlines (“I need a termsheet by next week”) usually backfire.

I hope these thoughts are somewhat helpful. Please comment/challenge.

There is of course a lot that VCs need to do to eliminate friction on their side (Gil Dibner has a good post covering some of these here). I also believe that Angellist & similar platforms should make the whole VC investing process smoother and less expensive.

There is plenty of potential here on both sides — a long way to go before securing VC investment is as frictionless as Tinder or Amazon…

Written by

  • Principal at Balderton Capital in London. Formerly Google & Bain. Statistician by education

    Updated January 29, 2014

Published in

Overseeding Will Be Key To Strong Venture Returns


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Editor’s note: Mike Jones, formerly CEO of Myspace, is the CEO of Science, Inc., a Los Angeles-based technology studio that nurtures successful digital businesses by bringing together the best ideas, talent, resources and financing through a centralized platform. Follow him on Twitter @mjones.

The story is one we’ve heard before: plucky startup sails through seed fundraising, unfurls its wings, then runs into the brick wall of not enough venture and shatters into pieces. The numbers speak for themselves. There were 65 percent more seed-stage deals in 2013 than in 2012 while venture funding stayed relatively flat – 7.5 percent fewer dollars, 7 percent more deals.

But the forgotten winners behind this equation – the ones we’re not really talking about because we’re busy lamenting the hardships of fledging entrepreneurs – are venture capitalists. That venture as an asset class has struggled is not a surprise given its lackluster performance following the bubble years of the late nineties. But all that is about to change.

Supply-Side: Too Much Seed Money?

There are several structural factors that have increased the supply of seed funding in the short-term and contributed to the perception of a supply-demand imbalance. One is that the Silicon Valley has become a victim of its own success: every successful IPO yields newly liquid and wealthy early-stage employees/investors.

Facebook’s IPO alone was expected to create over 1,000 new millionaires by some estimates. Perhaps most importantly, these individuals/firms are more likely to invest in highly speculative assets/seed stage companies due to the “house-money effect.” They are already winners, so why not roll the dice again?

Secondly, the number of crowd-sourcing platforms and startup incubators has exploded, giving early-stage startups access to more money and increasingly inexperienced investors.

Finally, one can even take a stab at making a quantitative easing argument (when in doubt, blame the Fed!). The Federal Reserve purchases $75 billion in treasuries and mortgage-backed securities every month. As the risk-free rate is forced down, investors rotate out of treasuries and into high-yield and equity markets, causing risk premia across the board to fall.

Active/non-indexed investors are then increasingly forced to look at non-traditional asset classes for market-beating returns. Hence the increase in hedge funds, asset managers, and Middle Eastern royalty investing in pre-IPO companies like LinkedIn and Twitter. As traditional VC returns come under pressure from the influx of capital (it’s hard to compete on valuation with a Saudi prince), they too are forced to swim upstream, increasing the amount of capital deployed in early-stage/seed rounds. In a world awash with liquidity, “next best alternative” style investing eventually becomes…well, Bieber’s selfie app.

However, while important as catalysts, in the long-run none of these drivers should persist. More seed funding without a corresponding increase in Series A should theoretically lead to higher failure rates and lower returns for seed investors, and an ensuing drop in capital allocation to seed rounds.

Demand-Side: Not Enough Series A?

Of course, the flipside to this narrative is that more, better, companies are being created today compared to five years ago, and the problem lies with Series A VCs who have failed to adjust accordingly. For example, starting a business is becoming far less capital-intensive, leading to efficiency gains and increased competition among early-stage companies.

VCs can also be overly myopic and short-sighted. As noted by David Freedman, VCs might be missing out on great businesses that, while not the next Facebook, could have niche markets or longer development timelines.

In any case, if Series A investors have access to a surplus of high-quality deals and are currently only cherry-picking the very best, returns for VC funds should be increasing. Following our previous logic, this should theoretically lead to a market correction and an increase in capital allocation to Series A rounds.

Historical LP Returns Tell The Real Story

According to the Kauffman Foundation, VC LP returns have drastically underperformed the public market since the tech bubble. In fact, the average VC fund has failed to even return 100% of their invested capital back to LPs (a negative IRR!). When analyzing their own portfolio of investments in 99 VC funds from 1989-2011, the Kauffman Foundation reported a slightly higher, but still modest average net return multiple of 1.31x.

In contrast, an academic study backed by the Kauffman Foundation reported that earlier stage angel investors achieve on average a 27 percent IRR, with an average net return multiple of 2.6x. Seed/angel investing is a bit riskier than VC investing, and as a result, should achieve somewhat higher returns. However, this does not explain the unexpectedly large gap between basically similar asset classes, nor does it explain the underperformance of VCs relative to public equity markets.

This disconnect implies that historically, there has been a glut of VC funding and a dearth of earlier-stage seed/angel investors. Therefore, what we perceive as a “Series A Crunch” actually represents a long-overdue market correction. A portion of the correction is manifested by a shift in VC capital allocation, away from later-stage companies and towards earlier stage seed rounds.

However, there is also simply more seed capital available due to lower startup capital requirements, lower transaction costs, and innovative financing platforms. These structural developments should deliver more and better companies to Series A investors, helping boost returns in what has historically been an under-performing asset class.

Analyzing it from this perspective, the Series A Crunch becomes not so much an imbalance of supply/demand as it is a long-awaited rebalance. If the past is any indication, the process of correction will be slow, but will produce years of outsized returns for recently struggling venture capital funds.

http://techcrunch.com/2014/01/25/overseeding-will-be-key-to-strong-venture-returns/