I posted a couple of weeks ago on convertible notes and how I thought Angels were better off using them (Angel Valuations in Seed Rounds). I’ve realized that there were some inherent assumptions in that posting that I want to clarify. I’m prompted by a talk I saw yesterday where an experienced angel was discussing some bad outcomes he had had with bridge loans.
So I want to clarify. My posting was advocating the use of convertible notes in early stage deals, i.e. where the angel group (or individual angel) is providing seed funds or bridging to a first venture round. In those cases, I definitely think the convertible loan route is usually the way to go. There may be specialized exceptions, but that is a general rule.
The bad loans I was hearing about were much later stage loans. In one case, the loan was to a struggling company that already had taken in three rounds of money (i.e. had almost exhausted a Series C). They were running out of cash, and went to angels for a bridge. Presumably, their earlier investors were tapped out or disenchanted, but either way, the earlier investments were completely exposed. This is a “distressed company” bridge loan. Sometimes it is called a “pier” loan, i.e. a bridge to an uncertain destination.
I frankly believe this is an area where angels simply should not fly. Almost by definition, if the company can interest a Series D investor, there will be a major devaluation coming, and when that happens everybody is going to get a haircut. That kind of situation will even tend to select for a VC who is “bottom feeding”, and they are even more likely to not respect shallow-pocketed angels, even if the angel money is the most recent money in the deal.
It is a given that a seed-stage startup is distressed --- they have little beside an idea and sweat equity. But there is little to lose --- the valuation is hypothetical and somewhat arbitrary at first. The seed investors are in the same boat as the entrepreneurs, when facing the first institutional investors in a Series A. The Series A money doesn’t want to disincentivize the entrepreneurs, and the seed angels can shelter somewhat under that umbrella.
But later stage deals are cases where valuations have already been made, money invested, and positions have to be defended. These are circumstances where angels are ill-equipped to fight. This kind of defensive battle favors deep pockets and additional firepower. Most angels or angel groups are not good at deals that require repeated reinvestment. VCs know this and the knives will come out.
So I believe that in most seed and early stage deals, angels are well-advised to use a time-limited, escalating-return, convertible note instrument in their investing. And I further believe that angels should avoid getting involved in later stage bridge or “pier” loans in companies that have already been valued and are now likely to be revalued. In that case, I think angels should try to make any investment as a piggy-back on the new VC money, if they can get it, and not get out in front of that VC money. They will get run over.
Thursday, November 15, 2007
Friday, November 2, 2007
An Alternate Investment Philosophy, Finding the Disruptive Deals
As I have mentioned in an earlier posting, I believe the nature and scale of many startup deals is changing. While VC funds are generally getting larger and the amount they need to invest in every deal is also getting larger, startup deals are generally requiring less capital to get off the ground. There is a disconnect here. I’ve noted that this is opening a window for angels. And I’ve just blogged that it may not all be good for entrepreneurs.
The Holy Grail for VCs is the big, hairy, disruptive deal --- an idea that completely upsets the playing field in a market area and allows for huge scaling and a big win for the investor. Think Skype, or Google (the ad company). How do you find “disruptive” deals, i.e. ones that can create 100x returns?
I am inspired by comments made by Nassim Nicholas Taleb in his most recent book, The Black Swan, The Impact of the Highly Improbable. He describes an investment philosophy where 80% of your capital is in lower risk, more conventional investments, and 20% is in smaller high risk investments --- trying to expose yourself to lots of possible positive Black Swans.
Now admittedly, he is talking about an overall investment philosophy from the perspective of a fund manager in NYC. But there is the kernel of a good advice here, I believe.
I’m suggesting that a VC fund should consider such an investment philosophy. The VC fund should set aside a specific seed-fund that is used explicitly to look for positive Black Swans. This seed-fund should invest in earlier stage or riskier investments, or to simply play hunches. The partner group should loosen their normal criteria when evaluating these deals. They should focus more on how disruptive the idea is. There may even be an opportunity to allow an individual partner to play a personal hunch. The decision can be made by just that partner, subject only to the outright veto by one of the other partners. I am proposing that that partner does not necessarily have to convince everyone to agree with their vision. And critically, in all cases, such a seed investment would have to be made with the expressed provision, at the fund’s option, to subsequently invest more, up to some limit.
Some Justification and Comments:
It is increasingly apparent that IT deals often need less capital to get off the ground. Also entrepreneurs are growing wiser about delaying a traditionally-scaled venture round until they have more traction. And angels are increasingly filling that gap. Early stage VC funds are prone to being "jumped" by deals that go from an angel round to a larger VC round.
Setting aside an explicit subsidiary seed fund and committing to try to invest it in more, smaller, more speculative deals will focus a VC’s attention on playing some educated hunches. I believe that the rational consensus-oriented approach VC funds currently rely on almost exclusively, leads to a more mundane set of moderate return deals and misses on the individual investment hunches of each investment professional.
One can assume the fund will see a larger attrition in these smaller seed deals, but even if they all fail the total amount lost would collectively only be equal to one or two failed conventional deals. On the up side, the fund may get a large piece of a more disruptive deal by grabbing a piece earlier. The result would likely more than offset these speculative losses, and maybe even “make the fund”.
Such deals would require some time commitment to mentor. Such mentoring and early support will build the fund’s reputation in the entrepreneurial community. More early deals may also come the fund’s way. It can be synergistic to their investment goals. And they learn by immersing themselves in some leading (bleeding?) edge deals that they otherwise would miss. The selection criteria for these deals might include a requirement that the team is clearly identified as “coachable”.
To put it simply, making seed investments from an explicit seed fund allows the fund to bet on more horses than they otherwise would and increases the chance that they’ll get a big winner.
This does not necessarily represent a relaxation of the fund’s investment decision standards. I believe that some of the best returning, most disruptive deals a VC may see do not lend themselves to classical due diligence and risk minimization. Sometimes it is a matter of connecting the right idea to the right people that unlocks big value. Doing more seed deals will allow the fund to possibly unlock more of these big opportunities.
Some deals are execution deals while some deals are big idea deals. I believe the current VC process tends to favor the former, but the big, hairy, disruptive deals with >10x return potential are more likely in the later category. Big idea deals don’t lend themselves to classical diligence.
Finally I want to acknowledge that Charles River Ventures has prominently taken a position that is similar to this idea. I’ve seen it stated that they are addressing the smaller deal demand issue with this plan. My point here is there may also be a greater yield in big idea, disruptive deals by making more smaller investments.
Tuesday, October 30, 2007
“Worth What You Pay For It?” Musings on Entrepreneurism without a clear economic goal…
A couple of postings back, I noted on how web startups could get going on much less invested capital, and how startup investing had to adapt. Well here’s another way of looking at it, that isn’t so sanguine.
I’m stimulated by a posting I read recently by Paul Graham of y-Combinator fame (http://www.paulgraham.com/webstartups.html). He is hitting on many of the same points, i.e. that startups can be launched much more efficiently now, that capital needs are lower and time to market is shorter. I couldn’t agree more. He also makes a number of sweeping generalizations that my 7th grade teacher would have nailed me for. I don’t buy the whole message.
But my point here is to say it isn’t all good. Along with a blossoming of inexpensive web startups, there are also a lot of cool apps with hopelessly non-existent business models … if we build it they will come. There seems to be a growing divide between things you can do that will have a big impact on the world, and things you can do that will have a large economic return on investment. I often find myself in a presentation on a new startup idea, where I could definitely use the product, but can’t figure out how they will make a business out of it. I can see clear value in it, but no way to extract that value.
It feels like we are in an Oklahoma Land Rush world. A couple of major paradigm-shifting changes have occurred (the Internet, the cellphone, ubiquitous computers, mapping the Human Genome…), and now we have this whole generation of bright people rushing across the newly opened landscape, seeking homesteading sites to stake a claim on. Some people are doing a good job finding economically valuable homestead sites. Others are just trying to sell wagons and provisions to the incoming flood of homesteaders. Yet others are trying to stake out beautiful view lots that won’t be economically valuable but give a great view (and someday may therefore become valuable). And others are simply enjoying the run in the countryside, and are admiring their beautiful running form.
Many startups I see today are simply not venture investible. That doesn’t make them bad, just not good vehicles for VCs to invest in and get a return from. VCs have to return money to their investors. Hence they can only invest in a subset of the new ideas brewing out there, i.e. the ones that have the potential for a steep increase in economic value over a short period of time. And not likely to help the entrepreneur put food on the table.
But what happens if you can start a company with practically no money and no hassle pitching angels. My fear is that entrepreneurs will expend an enormous amount of effort launching a startup that can never become self sustaining. They have become enamored with their own idea and it’s novelty, and haven’t tested it outside of their narrow circle. And because they haven’t had to go out there and convince others that it’s a good idea --- and pitch the idea over and over again to investors --- adapt the idea to what seems to stick to the wall --- they will ultimately be wasting their time. It may be very worthwhile meaningful work, which makes a difference and draws huge traffic and changes the flow of homesteaders across the prairie, but doesn’t end up making the entrepreneur or their investors any return. In the end, it’s possible the entrepreneur will look back on these years as wasted --- benefiting others but not themselves.
What’s happening on the web is frequently cultural, and not necessarily economic. Great revolutionary businesses are being created, and great cultural changes are happening, but they don’t always overlap. And the test of a good idea is not that it is neat, or that it can be implemented simply and elegantly, or that it can draw many other’s curiosity and interest. The test of a good idea is the value others will place on it, and a good proxy for that value is the money they will pay for it. A good predictor of that value is whether others find it investible, be they angels or VCs.
So I think it is a good thing for entrepreneurs to have to pitch their ideas and convince others to put a value on it. I found in my own entrepreneurial career that my business models and even my technical ideas benefited from being pitched and explained to others. They became more focused and distinct. I recall A-HA moments that happened in front of prospective investors.
I worry about a world where doing things, making a big impact, affecting our culture in a big way, has such a very low cost of implementation. And even pitching some small investors isn’t necessary. I think it is bad even for the entrepreneurs who might seemingly benefit from it.
I’m stimulated by a posting I read recently by Paul Graham of y-Combinator fame (http://www.paulgraham.com/webstartups.html). He is hitting on many of the same points, i.e. that startups can be launched much more efficiently now, that capital needs are lower and time to market is shorter. I couldn’t agree more. He also makes a number of sweeping generalizations that my 7th grade teacher would have nailed me for. I don’t buy the whole message.
But my point here is to say it isn’t all good. Along with a blossoming of inexpensive web startups, there are also a lot of cool apps with hopelessly non-existent business models … if we build it they will come. There seems to be a growing divide between things you can do that will have a big impact on the world, and things you can do that will have a large economic return on investment. I often find myself in a presentation on a new startup idea, where I could definitely use the product, but can’t figure out how they will make a business out of it. I can see clear value in it, but no way to extract that value.
It feels like we are in an Oklahoma Land Rush world. A couple of major paradigm-shifting changes have occurred (the Internet, the cellphone, ubiquitous computers, mapping the Human Genome…), and now we have this whole generation of bright people rushing across the newly opened landscape, seeking homesteading sites to stake a claim on. Some people are doing a good job finding economically valuable homestead sites. Others are just trying to sell wagons and provisions to the incoming flood of homesteaders. Yet others are trying to stake out beautiful view lots that won’t be economically valuable but give a great view (and someday may therefore become valuable). And others are simply enjoying the run in the countryside, and are admiring their beautiful running form.
Many startups I see today are simply not venture investible. That doesn’t make them bad, just not good vehicles for VCs to invest in and get a return from. VCs have to return money to their investors. Hence they can only invest in a subset of the new ideas brewing out there, i.e. the ones that have the potential for a steep increase in economic value over a short period of time. And not likely to help the entrepreneur put food on the table.
But what happens if you can start a company with practically no money and no hassle pitching angels. My fear is that entrepreneurs will expend an enormous amount of effort launching a startup that can never become self sustaining. They have become enamored with their own idea and it’s novelty, and haven’t tested it outside of their narrow circle. And because they haven’t had to go out there and convince others that it’s a good idea --- and pitch the idea over and over again to investors --- adapt the idea to what seems to stick to the wall --- they will ultimately be wasting their time. It may be very worthwhile meaningful work, which makes a difference and draws huge traffic and changes the flow of homesteaders across the prairie, but doesn’t end up making the entrepreneur or their investors any return. In the end, it’s possible the entrepreneur will look back on these years as wasted --- benefiting others but not themselves.
What’s happening on the web is frequently cultural, and not necessarily economic. Great revolutionary businesses are being created, and great cultural changes are happening, but they don’t always overlap. And the test of a good idea is not that it is neat, or that it can be implemented simply and elegantly, or that it can draw many other’s curiosity and interest. The test of a good idea is the value others will place on it, and a good proxy for that value is the money they will pay for it. A good predictor of that value is whether others find it investible, be they angels or VCs.
So I think it is a good thing for entrepreneurs to have to pitch their ideas and convince others to put a value on it. I found in my own entrepreneurial career that my business models and even my technical ideas benefited from being pitched and explained to others. They became more focused and distinct. I recall A-HA moments that happened in front of prospective investors.
I worry about a world where doing things, making a big impact, affecting our culture in a big way, has such a very low cost of implementation. And even pitching some small investors isn’t necessary. I think it is bad even for the entrepreneurs who might seemingly benefit from it.
Sunday, October 14, 2007
Angel Valuations on Seed Rounds
In a recent IBF Panel on the topic of Angel and VC cooperation, I made the observation that I believe Angels should avoid valuing startups in priced rounds, and rather should invest using a convertible note. I said that nothing could screw up a follow-on VC investment more than an unrealistic early angel valuation.
I want to elaborate on that observation. First, I want to divide the startup world into two general categories: 1) startups that can reach their goals with a small infusion of seed capital within the reach of angel financing (i.e. less than $1M), and 2) startups that will ultimately require VC scale financing and are raising angel capital to eliminate some risk factor and improve their ultimate VC valuation. Frankly, this is an easy way to divide startups coming to angels. Is this deal a nearly self-sufficient business, or is it seeking seed capital before later going to the venture capital community.
In the first category, angels setting valuations are probably taking a defendable position. But frequently it isn’t clear at the outset whether the angel raise will be all the money the startup raises. So I think the convertible debt approach is still a good way to go. The note should have an automatic conversion privilege after a reasonable period of time, at a clear valuation.
However, more often it is better to assume the seed angel round is a precursor to a later VC round. In this case I strongly suggest that a convertible debt approach is the right way to go. Let me explain why, by showing the pitfalls of angels valuing a deal. Again there are two possible cases: A) setting the valuation too low, or B) setting the valuation too high.
Suppose the angel (or angel group) succeeds in convincing the entrepreneur to accept a lower valuation than a VC would demand, i.e. case A. Frankly, in my experience over the past few decades, this is very rare. Valuations tend to be set by the golden rule --- whoever has the gold sets the rules. VCs have more money in play, with the potential for multiple subsequent rounds, and will therefore be most likely to get a lower valuation. But for the sake of argument, assume that a low initial valuation is successfully negotiated by the angels. In that case, a follow-on VC round will likely see this as an invitation to lower their valuation proposal below what they might have otherwise offered. This will hurt the entrepreneur and the angel prorata. Even if the follow-on VC chooses a more “fair market” valuation, the entrepreneur will still be getting a worse deal. Either way you end up with a less happy entrepreneur, and maybe the angel is unhappy as well.
Now suppose the opposite happens, i.e. the entrepreneur manages to convince the angels to give him a high valuation, higher than he might get from a VC. In my experience, this is actually a fairly common experience. Seed rounds are often made by Friends and Family, and they are emotionally involved with the entrepreneur. They will accept a valuation set by their friend or “son” because “he knows more about this”. But again, for the sake of this analysis, assume the entrepreneur gets a higher than “fair market” valuation. When the follow-on VC comes to see the deal, they will quickly come to understand the valuations previously set and the expectations of the entrepreneur to up that valuation. They know to get this outon the table early. I can say that my VC fund sees this case a lot and it often stops a deal cold. Frequently, the entrepreneur has taken the high seed valuation to heart, and is insulted by a VC opinion that it is excessive. For the VC to proceed, they will have to offer a down round deal. Remember that VCs often are investing to a formula promised to their LPs, that mandates their seeking a certain percentage of ownership. An overly optimistic valuation in the seed round directly hurts both the entrepreneur and the seed angels.
So in summary, if there is even a chance that follow-on VC money will need to be raised, in my opinion, an angel-priced seed round is a lose-lose situation. The best outcome is the angels set a valuation very close to what the VC expects --- and that is exactly what a properly constructed convertible debt deal will deliver automatically.
In essence, a convertible debt deal is saying that the angels want to be in the same boat as follow-on investors, rather than starting out in opposition to, or second guessing them. I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.
But a priced angel seed round is at best a breakeven exercise. Much of the time it will be to the disadvantage of the angel and it will almost always be to the disadvantage of the entrepreneur.
Convertible debt seed financing can be done with a timeout conversion at the angel’s option, with a time matched escalation of reward, and with interest and dividend privileges. In the end, the seed round is very exposed, and angels are investing monies they should never expect to get back. The lack of security for the loan is therefore relatively unimportant. And the conversion will be to a preferred round with all its carefully constructed advantages crafted by the VCs. In contrast, I often see priced seed rounds where the angels bought common stock. That opens the door to the VC constructing preferred terms that put the common stock class at a major disadvantage.
I will acknowledge that this advice is Bay Area centric, where there are many many venture capital funds. When the angel investment is coming in geographic areas with limited local VC financing, the value of this advice is lower.
As a general rule, ANY investment in a startup should be made so that follow-on financing is not inhibited. Valuation can be a big inhibitor to venture capitalists. And VCs will usually craft the best terms to protect their investment. It is better for angels to try to be under that same umbrella.
I want to elaborate on that observation. First, I want to divide the startup world into two general categories: 1) startups that can reach their goals with a small infusion of seed capital within the reach of angel financing (i.e. less than $1M), and 2) startups that will ultimately require VC scale financing and are raising angel capital to eliminate some risk factor and improve their ultimate VC valuation. Frankly, this is an easy way to divide startups coming to angels. Is this deal a nearly self-sufficient business, or is it seeking seed capital before later going to the venture capital community.
In the first category, angels setting valuations are probably taking a defendable position. But frequently it isn’t clear at the outset whether the angel raise will be all the money the startup raises. So I think the convertible debt approach is still a good way to go. The note should have an automatic conversion privilege after a reasonable period of time, at a clear valuation.
However, more often it is better to assume the seed angel round is a precursor to a later VC round. In this case I strongly suggest that a convertible debt approach is the right way to go. Let me explain why, by showing the pitfalls of angels valuing a deal. Again there are two possible cases: A) setting the valuation too low, or B) setting the valuation too high.
Suppose the angel (or angel group) succeeds in convincing the entrepreneur to accept a lower valuation than a VC would demand, i.e. case A. Frankly, in my experience over the past few decades, this is very rare. Valuations tend to be set by the golden rule --- whoever has the gold sets the rules. VCs have more money in play, with the potential for multiple subsequent rounds, and will therefore be most likely to get a lower valuation. But for the sake of argument, assume that a low initial valuation is successfully negotiated by the angels. In that case, a follow-on VC round will likely see this as an invitation to lower their valuation proposal below what they might have otherwise offered. This will hurt the entrepreneur and the angel prorata. Even if the follow-on VC chooses a more “fair market” valuation, the entrepreneur will still be getting a worse deal. Either way you end up with a less happy entrepreneur, and maybe the angel is unhappy as well.
Now suppose the opposite happens, i.e. the entrepreneur manages to convince the angels to give him a high valuation, higher than he might get from a VC. In my experience, this is actually a fairly common experience. Seed rounds are often made by Friends and Family, and they are emotionally involved with the entrepreneur. They will accept a valuation set by their friend or “son” because “he knows more about this”. But again, for the sake of this analysis, assume the entrepreneur gets a higher than “fair market” valuation. When the follow-on VC comes to see the deal, they will quickly come to understand the valuations previously set and the expectations of the entrepreneur to up that valuation. They know to get this outon the table early. I can say that my VC fund sees this case a lot and it often stops a deal cold. Frequently, the entrepreneur has taken the high seed valuation to heart, and is insulted by a VC opinion that it is excessive. For the VC to proceed, they will have to offer a down round deal. Remember that VCs often are investing to a formula promised to their LPs, that mandates their seeking a certain percentage of ownership. An overly optimistic valuation in the seed round directly hurts both the entrepreneur and the seed angels.
So in summary, if there is even a chance that follow-on VC money will need to be raised, in my opinion, an angel-priced seed round is a lose-lose situation. The best outcome is the angels set a valuation very close to what the VC expects --- and that is exactly what a properly constructed convertible debt deal will deliver automatically.
In essence, a convertible debt deal is saying that the angels want to be in the same boat as follow-on investors, rather than starting out in opposition to, or second guessing them. I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.
But a priced angel seed round is at best a breakeven exercise. Much of the time it will be to the disadvantage of the angel and it will almost always be to the disadvantage of the entrepreneur.
Convertible debt seed financing can be done with a timeout conversion at the angel’s option, with a time matched escalation of reward, and with interest and dividend privileges. In the end, the seed round is very exposed, and angels are investing monies they should never expect to get back. The lack of security for the loan is therefore relatively unimportant. And the conversion will be to a preferred round with all its carefully constructed advantages crafted by the VCs. In contrast, I often see priced seed rounds where the angels bought common stock. That opens the door to the VC constructing preferred terms that put the common stock class at a major disadvantage.
I will acknowledge that this advice is Bay Area centric, where there are many many venture capital funds. When the angel investment is coming in geographic areas with limited local VC financing, the value of this advice is lower.
As a general rule, ANY investment in a startup should be made so that follow-on financing is not inhibited. Valuation can be a big inhibitor to venture capitalists. And VCs will usually craft the best terms to protect their investment. It is better for angels to try to be under that same umbrella.
Tuesday, October 2, 2007
How close is Too Close?
A common axiom is “Invest in what you know.” I want to amend it. “Invest in what you know enough about… but not too much about.”
I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.
You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.
In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.
So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.
The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.
I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.
You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.
In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.
So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.
The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.
Monday, September 24, 2007
Startups Then and Now
A few years ago, I remarked to a friend that Microsoft Word took longer to start up on my 3GHz Pentium laptop than my DEC EDT word processor took in 1980 on a PDP-11/34 running RSX-11M. My modern laptop was hundreds of times more powerful, but I was still waiting 10 seconds. True, MS Word is much more powerful, but for the basic stuff, I was still waiting…
Nevertheless, when you read about productivity nowadays, it is apparent that in this decade we are reaping the benefits of the digital age --- all those computers and Internet linkages mean that the average information worker is much more productive today than he was just 20 years ago. In fact, according to the U.S. Department of Commerce Bureau of Labor Statistics, productivity in software publishing is up by a factor of 17x in the past 20 years. In Computer and Electronic Manufacturing, it is a factor of 9x.
So what does this mean to Venture Capital and startup financing? I submit that it simply takes less money to start a high tech company nowadays. Particularly in software development, the costs of developing a product are far lower compared to 20 years ago. And the reach of the Internet and the ease of leveraging viral marketing and messaging, means the costs of customer cultivation and product marketing and deployment are far lower as well.
I frequently see startup teams who have launched their company on less than $100K of total capital in, and only need $200-300K to get to breakeven. They can almost bootstrap it, if they use all the tools available to them, play the blogosphere right, leverage the buzz… Now it’s debatable whether trying to do it that cheap is always the best way to go, but it is certainly a viable option.
So one clear trend in my mind in seed venture capital is that deals are going to get smaller and VC funds are going to have to adjust to that. Six digit seed checks will become more common in the coming years, even with the effects of inflation. ($100K isn’t what it used to be…)
I actually believe that is healthy for the VC funds. As I’ve mentioned in my first post, I’m a big fan of Nassim Nicholas Taleb’s writings, particularly his most recent Black Swan book. He persuasively argues that a good way to invest in our inherently unpredictable world is, among other things, to expose yourself to as many positive Black Swan opportunities as possible, with a portion of your money. I think all VC funds would benefit from setting aside a portion of their funds, say 20%, and taking “fliers”, betting “hunches”, but most importantly making more, smaller bets. Yes, they can take up time, but I think it is manageable. And as Taleb says, your downside is limited to 1x, but your upside is largely unbounded.
The irony is most VC funds are going the opposite direction. They were so successful in the last decade that they have had little trouble raising gigantic new funds. When a partner group has to invest $1B, they are discouraged from making $250K investments. So they set a policy of investing no less than $5M in a first round investment, and reject deals that don’t “put that much money to work.” They say “your deal is very interesting, but it isn’t big enough for us”. In my humble opinion, this is a big mistake, and heading in the wrong direction.
VC funds, particularly those than do Early Stage investing, will necessarily have to evolve in the coming decade. This is a particular focus for me in this blog. More on this topic to come…
Nevertheless, when you read about productivity nowadays, it is apparent that in this decade we are reaping the benefits of the digital age --- all those computers and Internet linkages mean that the average information worker is much more productive today than he was just 20 years ago. In fact, according to the U.S. Department of Commerce Bureau of Labor Statistics, productivity in software publishing is up by a factor of 17x in the past 20 years. In Computer and Electronic Manufacturing, it is a factor of 9x.
So what does this mean to Venture Capital and startup financing? I submit that it simply takes less money to start a high tech company nowadays. Particularly in software development, the costs of developing a product are far lower compared to 20 years ago. And the reach of the Internet and the ease of leveraging viral marketing and messaging, means the costs of customer cultivation and product marketing and deployment are far lower as well.
I frequently see startup teams who have launched their company on less than $100K of total capital in, and only need $200-300K to get to breakeven. They can almost bootstrap it, if they use all the tools available to them, play the blogosphere right, leverage the buzz… Now it’s debatable whether trying to do it that cheap is always the best way to go, but it is certainly a viable option.
So one clear trend in my mind in seed venture capital is that deals are going to get smaller and VC funds are going to have to adjust to that. Six digit seed checks will become more common in the coming years, even with the effects of inflation. ($100K isn’t what it used to be…)
I actually believe that is healthy for the VC funds. As I’ve mentioned in my first post, I’m a big fan of Nassim Nicholas Taleb’s writings, particularly his most recent Black Swan book. He persuasively argues that a good way to invest in our inherently unpredictable world is, among other things, to expose yourself to as many positive Black Swan opportunities as possible, with a portion of your money. I think all VC funds would benefit from setting aside a portion of their funds, say 20%, and taking “fliers”, betting “hunches”, but most importantly making more, smaller bets. Yes, they can take up time, but I think it is manageable. And as Taleb says, your downside is limited to 1x, but your upside is largely unbounded.
The irony is most VC funds are going the opposite direction. They were so successful in the last decade that they have had little trouble raising gigantic new funds. When a partner group has to invest $1B, they are discouraged from making $250K investments. So they set a policy of investing no less than $5M in a first round investment, and reject deals that don’t “put that much money to work.” They say “your deal is very interesting, but it isn’t big enough for us”. In my humble opinion, this is a big mistake, and heading in the wrong direction.
VC funds, particularly those than do Early Stage investing, will necessarily have to evolve in the coming decade. This is a particular focus for me in this blog. More on this topic to come…
Sunday, September 9, 2007
Dangers From Friends&Family Money
There is one truism in the startup business. The more an entrepreneur can reduce the technical and market risk in their startup before seeking outside money, the better valuation they will get, and therefore the more ownership they will retain. VCs and angels will value a startup by the size of the opportunity and the inherent risks in that opportunity. An entrepreneur can only clearly describe the size of the opportunity --- it is what it is, but he/she can definitely reduce the technology risk by building a proof of concept demonstration, or reduce the market acceptance risk by signing up pilot customers.
These early risk reduction efforts typically require some seed capital. Entrepreneurs often self-finance this seed stage, or they turn to “Friends & Family” angel investment. In general, this is a good idea, and it helps a startup get later financing if the idea has been better validated, and if the entrepreneur seems to have some “skin in the game”. However, I want to discuss some aspects of F&F seed financing that may be under-recognized and hurtful to the entrepreneur’s efforts.
Here is a great saying that I have always respected for its wisdom:
“Reasonable people adapt themselves to the world. Unreasonable people attempt to adapt the world to themselves. All progress, therefore, depends on unreasonable people." -George Bernard Shaw
Entrepreneurs almost have to be unreasonable, even irrational, to try to start a business around a new idea. They have to visualize something that doesn’t exist, create it out of thin air, and sell it to others, particularly VCs and early adopter customers. If it was obvious, everybody would be doing it. Instead, it is usually obscure and often seemingly crazy. Who will invest in such a raw idea?
Mom and Dad, ... your best friend… that’s who. They trust you for reasons unrelated to the idea you are promoting. In fact, in the case of parents, biology drives them to support their offspring, even irrationally. In the case of friends, it can be payback for that time you bailed them out of a DUI in college, or any number of pre-existing debts, or irrational friendship.
I’m going to ignore the argument that parents investing in their kids is an unwise concentration of assets. I’m concerned with the hazier issue of irrational seed investors not giving the entrepreneur unbiased feedback. There is danger in F&F seed funding.
If for no other reason, subsequent investors will be looking to see who has invested before them. They will be looking for previous validation. Mom’s money is weak validation.
It’s a tough balance to strike --- you want some seed money to validate the idea, but you also want unbiased input on whether you are drinking too much of your own KoolAid. And believe me, after an unreasonable, irrational entrepreneur fixes on an idea and throws their weight behind it, it is hard to be convinced otherwise. The danger is that calling on the easy money, may delay getting a cool, rational dose of reality.
So I guess my advice is to validate that idea before seeking VC money, but test it both with F&F money and with unbiased, “tell you the honest to God truth” advice that a family member or close friend cannot give you. Don’t just labor away in stealth mode, eating up your parent’s money. Find “seed advisors” you can trust who know the space and the technology, and continually test your idea and fine-tune your pitch on them.
VCs have a phrase for Friends and Family money. Sometimes it’s just called Friends, Family and Fool’s money. Don’t trust the F's to validate your idea, and definitely don’t trust them to Value your idea. They love you and love is blind.
These early risk reduction efforts typically require some seed capital. Entrepreneurs often self-finance this seed stage, or they turn to “Friends & Family” angel investment. In general, this is a good idea, and it helps a startup get later financing if the idea has been better validated, and if the entrepreneur seems to have some “skin in the game”. However, I want to discuss some aspects of F&F seed financing that may be under-recognized and hurtful to the entrepreneur’s efforts.
Here is a great saying that I have always respected for its wisdom:
“Reasonable people adapt themselves to the world. Unreasonable people attempt to adapt the world to themselves. All progress, therefore, depends on unreasonable people." -George Bernard Shaw
Entrepreneurs almost have to be unreasonable, even irrational, to try to start a business around a new idea. They have to visualize something that doesn’t exist, create it out of thin air, and sell it to others, particularly VCs and early adopter customers. If it was obvious, everybody would be doing it. Instead, it is usually obscure and often seemingly crazy. Who will invest in such a raw idea?
Mom and Dad, ... your best friend… that’s who. They trust you for reasons unrelated to the idea you are promoting. In fact, in the case of parents, biology drives them to support their offspring, even irrationally. In the case of friends, it can be payback for that time you bailed them out of a DUI in college, or any number of pre-existing debts, or irrational friendship.
I’m going to ignore the argument that parents investing in their kids is an unwise concentration of assets. I’m concerned with the hazier issue of irrational seed investors not giving the entrepreneur unbiased feedback. There is danger in F&F seed funding.
If for no other reason, subsequent investors will be looking to see who has invested before them. They will be looking for previous validation. Mom’s money is weak validation.
It’s a tough balance to strike --- you want some seed money to validate the idea, but you also want unbiased input on whether you are drinking too much of your own KoolAid. And believe me, after an unreasonable, irrational entrepreneur fixes on an idea and throws their weight behind it, it is hard to be convinced otherwise. The danger is that calling on the easy money, may delay getting a cool, rational dose of reality.
So I guess my advice is to validate that idea before seeking VC money, but test it both with F&F money and with unbiased, “tell you the honest to God truth” advice that a family member or close friend cannot give you. Don’t just labor away in stealth mode, eating up your parent’s money. Find “seed advisors” you can trust who know the space and the technology, and continually test your idea and fine-tune your pitch on them.
VCs have a phrase for Friends and Family money. Sometimes it’s just called Friends, Family and Fool’s money. Don’t trust the F's to validate your idea, and definitely don’t trust them to Value your idea. They love you and love is blind.
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