Fundraising is not just limited to companies.  Venture Capital firms have to do this as well.  It is an interesting process and you get to meet fascinating people.  Potential limited partners (or LP’s as we call them) come to the table with a set of beliefs that are, well, sometimes peculiar and rarely challenged – after all, the VC that is raising capital does not want to upset their potential investor.  The net result is that certain “truths” often have to be addressed and given consideration, such as:

1. You will be shut out of the hot deals if you’re not one of the best-known funds
2. You need to have a broad, deep team of senior investment professionals
3. Specialization is the best way to generate the best returns

The underlying issue is that many LPs feel they know the fundamental requirements of a successful VC firm, have boiled it down to a few precepts, and anything that does not meet those precepts cannot work.  This is the same logic as reportedly used in the argument that bumblebees cannot fly.  Supposedly during dinner a biologist asked an aerodynamics expert about insect flight. The aerodynamicist did a few calculations and found that, according to the accepted theory of the day, bumblebees didn’t generate enough lift to fly. Once he sobered up, however, the aerodynamicist realized what the problem was: a faulty analogy between bees and conventional fixed-wing aircraft. Bees’ wings are small relative to their bodies. If an airplane were built the same way, it’d never get off the ground. But bees are not like airplanes, they are like helicopters.

We believe that the only way to measure success in venture capital is via returns, not firm structure: flight and not ones assumptions about flight.  Now success can also be due to simple luck, but a long consistent track record would indicate process has something to do with it.  In fact, a continually refined process.  For us returns are a function of process which breaks down into finding great companies, selecting those you want to work with, and then determining the amount of capital to deploy each time there is an opportunity to invest, or simply:

Success = returns = deal-flow + selection + deal negotiation + portfolio management

Far too much discussion is based on deal flow, and in particular the notion, or belief, that hot deals lead to successful companies.  As a firm, we are wary of hot deals and far prefer ones that are ‘cold’.  Why?  Well, as we invest at an early stage, we want to invest ahead of an opportunity, preferably 3-5 years ahead.  As such if a deal is hot, then the idea is likely of the now and not the future, and the company will not have the time to grow to the right size and heft to dominate that opportunity.  Successful companies, like successful people, often have tough childhoods and adolescent periods – there is no silver spoon.  Deal selection is simply tougher that latching onto the next hot idea, the theme-du-jour, the company with the cool kids or the cool co-investors.  We love cold deals with no ‘social proof”, just amazing CEO’s and management teams.

Larger funds are at a triple disadvantage vs. smaller funds:

(A) No professional active money manager should be too diversified, and so focusing on investments below 0.5% of their capital base is asinine. No fund manager can seriously do so as fund management is a matter of balancing time on a portfolio position vs. the potential return.  The capital that is most scare is intellectual capital.

(B) The people working at the fund focused on seed investments tend to be the most junior.  They will feel they have been given the short-stick opportunity, as whatever they do they feel that they cannot move returns for the whole fund.  The fund will also feel conflicted out of putting larger amounts of capital to work in competitors when the early stage company almost inevitably pivots in a space that is just emerging.

(C) The tool-set for early stage investing is simply different.  The toolset that makes for a typical partner at a $500mm VC fund is different than the toolset needed for early-stage deals.   The early stage toolset is way more qualitative than quantitative.

The bar of having  ”a broad deep team of senior investment professionals” is interesting – after all who can argue that more talent is better.   After having worked at Goldman Sachs and some other very large companies, I fully understand the value of a large team, but the downside of a large team is that it leads to groupthink and a consequent conservatism – remember the quote about a camel having been designed by a committee.  In addition, a large team creates a higher cost structure that requires a larger fund, which is counter to our approach.

So many people manage money so that they can manage more money.  The management fee that is insignificant for a small fund becomes a raison d’être for a large fund.  Their objective is to manage the maximum possible so that they can have significant asset based fees and be less reliant on performance fees.  They become asset gatherers.  One of the most successful asset gathering strategies is to specialize. After all, a specialist will know much more about something than a generalist.  That leads to higher returns, right?

As a firm we respectfully disagree, especially with regard to the world of early-stage investing. This is despite some academic research on later-stage investing that has indicated some advantages to specialization for later-stage funds; see “The Performance of Private Equity Funds: Does Diversification Matter?”  Specialists focus on areas they think that investors want to invest in today, and so are always proposing the theme-du-jour.  In early stage investing, this is a bit like fighting the last battle.  Early stage investing is a long-haul game, and not one that should be tied down to a tantalizing theme during the capital raising period.  Technology moves too fast to tie a successful fund down like that.  Specialist investors have to turn down investments that they think are going to be successful if outside of their theme.  Specialist investors that are hands-on cannot invest in the best companies in the space; as they might compete.  If they are not hands-on then they cannot help their companies succeed and have to watch from the sidelines.  Specialist investors have one hand tied behind their backs.

When my partner, David Teten, wrote his research study on best practices in deal origination, one of the people he spoke with was Bill Morrow, formerly COO, Mid Europa Partners, a European private equity fund, which is comprised of a team of 30 people from 19 different countries.  Bill observed, “We have deliberately not chosen a country-specific origination model, because we’re afraid of adverse selection.  If you pay someone to eat what he kills in Romania, he may bring something not palatable back from Romania because that is all that was available.”

Bill went on to say: “Similarly, we’re debating the extent to which we should be sector-focused.  We’re wondering to what extent a well-defined sector focus is good or bad.  It comes with some logistical issues.  If your focus is retail, and nothing is going on in retail, then you’re either a wasted talent or again face adverse selection.  We want our people to be fungible.   We don’t hire the Czech investment professional just to originate Czech deals, although we recognize he or she will be more likely to source deals in that geography.”

Similarly, in Robert Finkel’s excellent book, The Masters of Private Equity and Venture Capital, there’s an interview with John Canning, chairman of Chicago private equity firm Madison Dearborn Partners LLC.  He observed that during the telecom bubble, his team thought of creating a dedicated telecom fund, because they had made so much money from telecom investments.  Madison Dearborn did not, and were very glad about that decision with the advantage of hindsight.

We are unapologetic generalists and invest for returns.  We think that limited partners actually want returns and we work to deliver them.  Specialization is a sub-optimal strategy for early stage venture capital.

So, how do you measure success in the space?  What are the best proxies for future returns?  We maintain it is having a philosophy of investing for returns in a fund with aligned interests and a proven track record that is way above the median for the space.  Returns are all about looking at a ton of deals and finding the few management teams you want to work with, then working with them and giving them more capital as they succeed.  It is a long game, it is an unconventional game, and it is tremendous fun.

Look out for the bumble bees.

Bumblebee takeoff by Manechka

A few days ago Dave McClure posed this:

This was the consummation of a heated debate on Twitter regarding a blog posting by Niki Scevak entitled Angel Index Funding Bullshit.  Niki argues that Ron Conway and Dave McClure by investing in a large number of startups leads to them being more passively involved than if they focused on a smaller number of companies.  He goes on to argue that “handsome returns” will not be forthcoming due to high fees, the increasing number of startups, that if you invest in the market then you get market level of returns (i.e. median returns), and that if involvement leads to higher returns you ultimately will not get them as you are spread too thin.

This is an interesting discussion as it ties in closely with an increasing amount of capital being deployed in the early stage VC space, be it by funds like ff Asset Management and  even some larger traditional VC funds.  Entrepreneurs that have oversubscribed rounds are then forced to allocate, and when the allocate they then should carefully examine what is the motivation for the investor to invest in their company, as well as what is the quality of the money?  Many startups will not face this dilemma, but as the capital drought of early 2009 has been replaced by the glut of late 2010 more and more startups are having this “problem”.  This is despite the withdrawal of funds by angels themselves.  In 2007 $26bn or so was invested by angels.  In 2009 this fell to, perhaps $12bn.  This has recovered in 2010, but not to the 2007 levels.  VC’s, on the other hand, because of the long-term nature of their funds still have plenty of capital to deploy.

All funds are managed for return (or should be!), and return is a function of the size of investment and time devoted to the investment for any actively managed VC portfolio.  I personally think that if the fund is investing well less than 1% of the total fund’s size in an investment then there is a risk of misalignment of interests between the investor and the entrepreneur.  Remember, the investor is buying an option to participate if the company is successful, and walk away if not.  That is generally fine, but it can pose a risk for the startup if it is a large traditional well known VC where people will care if they do not re-up.  If the investor’s fund will end up with well north of 50 investments in the fund at maturity, then there is the question of whether the startup will get sufficient attention from the fund’s principal(s) for the money to be treated as “smart” money and not “dumb” money.  Finally, if the fund is spread too thin, then the fund will not have the capital for follow on investments, and new relationships will need to be developed at the next round – not a real problem, but something to understand.

Bottom lime, if you have an oversubscribed round then understand the motivation of each investor and their fund:  If there is alignment, great; if not, then think carefully if you expect your investor to invest not only money but also time.

If you are not oversubscribed then consider this article (which like most “news” overstates the situation):

One person we know who has a startup trying to raise money was floored at how easy it was to get a small slug of cash. It was basically a short phone call with a potential investor who said, “I’ve heard good things about you from people I trust. When you’re ready for me to invest, just call me back.”

]]> http://www.any.biz/2010/09/raising-money-easy-investing-easy-why-not/feed/ 0 http://www.any.biz/2010/09/the-internet-of-people/ http://www.any.biz/2010/09/the-internet-of-people/#comments Sat, 04 Sep 2010 00:57:38 +0000 admin http://www.any.biz/?p=125

Since the mass adoption of services such as LinkedIn and Facebook people have increasingly come online using their real names.  There has been a shift from representing yourself as angrybear101@aol.com to using your actual identity.  This phenomenon is culturally more important.  I like to refer to it as the Internet of People, compared to the the original Internet of Data or The Internet of Things.  It is significant: it involves people that have rights, emotions, intentions, and other attributes that toasters, phones, and databases do not.  It will lead to a changed understanding of information rights, privacy, and what is creepy and what is acceptable.

At its core I see four fundamental pillars: Identity, Trust, Reputation and Influence.   Yes, social networking is part of this, but this perspective gives a different, and I would say more informative, way to look at the space.  Here are a few thoughts:

• These four pillars will become increasingly important to two different constituencies: advertisers that want to reach consumers, and individuals themselves;
• Game dynamics can be applied to “manipulate” or “guide” people into certain behaviors that can then be measured in real-time – shopping and flash-deals come to mind;
• Regulation will have to play catch up – this is not longer cookie tracking it is stalking;
• People will be rewarded for the data  they surrender: a better table at a restaurant, front row seats, free goods, if they can influence others to follow their lead.

Companies will grow up over the next few years to address these needs.  Watch this space as it is going to be very, very interesting.

My run-rate for looking at businesses is over one a day, and rapidly approaching two.  I enjoy almost every meeting, and in fact cannot think of one that I have not found useful.  As a firm we end up investing in a very small proportion of what we see, perhaps one percent or so.  Of late, I have been meeting with a number of companies that in effect are features, and not businesses and a number that would work great if everyone would adopt their product.  Both of these are red flags to me.

So, what is a “feature”?  It is a business that is not a business, it is something that in itself is neat or cool that improves fun or efficiency.  It has no revenue model, and if successful can be copied by existing players or new entrants in the space.  It probably can’t be patented effectively and if could you would not have the resources to defend yourself.  It is the stuff dreams are made of, but often not businesses.  It is narrow in its application, or something that could be wide if everyone changed what they do today and do it differently using this new wizbang feature.  Businesses that start as features often spend a lot of energy looking to back into a business model.  A few make it.  Twitter?

This brings me to adoption.  The biggest area I have difficulty with, and where I am likely to disagree with an entrepreneur,  is with user adoption.  Start-ups want to change the world, and to do that effectively they often need to change behavior from “I would never Tweet” to “Twitter is where I get all my cool news” or from “the iPad will never take off” to “I watched two movies on my last trip and read 5 books, all on my iPad”.  The question is when you try to change the world will it change with you?  This comes down to user adoption curves and entrepreneurs’ vision as to the ease of take-up/deployment of their product.  Often they simply underestimate the difficulty of gaining customers.  The key question that they do not have a perspective.  Is this a problem?  Yes and no.  On the one hand they have to have an unreasonable belief and passion for their idea, because if they do not it will never happen.  On the other hand this can border on the delusional.  What is most essential is that the entrepreneur tries to understand why others question their adoption assumptions and then communicate effectively their perspective.  If you are raising money this can be the most difficult idea to get across.

I do not have a checklist when I meet with investors, but if I did these would be top of the list.

]]> http://www.any.biz/2010/07/is-it-a-business/feed/ 0 http://www.any.biz/2010/05/the-fed-is-to-blame/ http://www.any.biz/2010/05/the-fed-is-to-blame/#comments Mon, 10 May 2010 14:36:55 +0000 admin http://www.any.biz/?p=128

For what, you might ask?   For the mess the current financial system is in, and the wealth destruction that has ensued.

Well, in fact, we all are to blame in some interconnected way, but it is clear to me that actions taken by the Fed a decade ago have been the prime determinant for the path we are on.  They never should have cut rates to such low levels and allowed them to stay there for so long.  They never should have indicated stability in rates and “measured” changes.  They never should have reached for quantitive easing.

Low rates have led to misallocation of capital on a scale never before seen.  This has “forced” savers to reach for yield and make poor investments.  This has allowed people and peoples to borrow money hand-over-fist and spend it unwisely.  There is a fantastic quote from Michael Lewis’ article in Vanity Fair:

When you borrow a lot of money to create a false prosperity, you import the future into the present. It isn’t the actual future so much as some grotesque silicon version of it. Leverage buys you a glimpse of a prosperity you haven’t really earned.

Leverage buys you a glimpse of a prosperity you haven’t really earned.  This encapsulates the problem we have.  A decade of easy money not only allowed people to become over-leveraged but also gave politicians the tools to go out and make promises that can’t be met; whether they are in Greece, California, or my local town school system.  A bailout will only kick the can down the road for someone else to face.  Borrowing more to solve a debt problem is not a solution that can work for the long term, as the debt is not borrowed to supercharge growth.  We are now entering the Decade of Defaults as it becomes clear that there is no other solution.

Why are the authorities so wary of defaults?  Because it will wreck the banks, pension funds, insurance companies that own this debt and want to treat it as money good.  I suspect it would have been better to take the losses and re-cap the banks and start to explain to people that their pensions and other “entitlements” are not entitlements rather than continue the charade.  Politicians do not have the stomach for this – they, like investors, are increasingly myopic.

I am in a small minority, and it is increasingly clear that banks, politicians and regulators have interests that are mis-aligned to what is best for the rest of society – they will continue on with their make-believe asset valuations and hold onto power beyond any reasonable expectation.

Ultimately, there will be a reconciliation and such a reconciliation will be political as much (or more so) than economic.  Political reconciliation can sometime be peaceful and through the system, but often than not it is neither.  Don’t blame me when it happens, blame the Fed.

Postscript: The ECB is just as bad, given their capitulation this weekend.

[Okay, this post refers to a portfolio company, and hopefully is not seen as a shameless plug]

During the due diligence for a recent investment in Klout by my fund, ff Asset Management, we have been thinking about  online identity and reputation and trying to understand what is changing here.  Recent posts by Fred Wilson and other are scratching at the surface.  It is clear to me that something changed with the mass adoption of Facebook, LinkedIn and other real-name social networks.  Facebook Connect has further extended it to the non-social web.  People moved from being anonymous to leaving real footprints on the web.  People are no longer hiding behind “anonymous” or “cutiebear107@aol.com” but are leaving traceable marks as to what they think, who they know, who thinks what they have to say is important.

This real-name web will lead to a host of services that connect-the-dots and help manage their identity, reputation and influence.  We are moving from the Internet of idea to the Internet of things to the Internet of people.  Clearly privacy, gossip, reputation, influence, trust, all are relevant here.

We invested in Klout as they are working on the influence aspect of the influence of people.  They people-rank tweets real-time and give people, for the first time, a measure of their influence on the web.  Fred Wilson has a Klout Score of 70, I have one of 12 - so you can clearly see who carries more weight on the web!

Over time we think that people will want to know who they are dealing with on the web in a simple manner, knowing their influence and their reputation.  In the same manner there will be companies that will work to help people manage them.  This is an evolving space and one which will be of increasing interest to venture capitalists and the media at large.  Thank you Facebook.  Thank you LinkedIn.

On Change: Everything is in flux.  Everything is a “fad”.  Nothing is constant.  Change comes, so accept it and embrace it.

On Capitalism: Capitalism is about efficient allocation of capital.  Regulations that get in the way distort capitalism and lead to inefficient allocations, often to the financial supporters of government.

On Social Democracy: You cannot borrow and tax your way into growth.  Pushing public debts onto Sovereign balance sheets for good reasons, ends up staying there for bad reasons.  Sovereign defaults is the expected outcome as politicians avoid hard solutions.

On Bureaucracy: The Fed has 20,000 employees.  20,000!

On American Democracy: Taxpayers want small government, as they pay for it.  Non-taxpayers want large government programs.  Only time will tell who will win out in the “grand experiment” of American democracy.

On Contrarian Investing: To make money you want to be where others are not or fear to be.  Be illiquid when others are not, own loss making ventures when others want dividends, be contrarian.

On China: China’s growth is amazing.  If only their government was driven to generate economic growth.  It is not, it is driven to stay in power and growth gets them there, for the time being.

On The Next Big Thing: China’s growth saved the world economy post the dot-com bubble.  Who/what will save us when the China ceases to?

On Investing Long-Term: There are two ways to invest; one involves constantly picking the right asset, and moving to the next one as soon as the money has been made in the first.  It is frenetic and involves thousand of investment decisions in a short period of time.  Another one is boring and patient and simply requires investments that fit a longer time-frame.

On Investment Horizon: In the investing game, time is your friend.  Invest so that your wealth can compound at the highest rates over the cycle, and remember that the gains in the out years are where the money is really made.

No.  They never should, and if they do then it indicates a lack of drive, verve and creativity in reaching angels and VC’s.

Here is how I see it:  VC’s make money by investing in successful companies, and like to believe that their input along the way with regard to ideas, best practices, contacts and reputation bias the outcome – I certainly do.  To ensure that they get to see good ideas they meet a lot of people, and will invest in a single digit percentage of those they initially meet with – the funnel.  Every VC tells me that the best ideas they get are vetted by people the trust and not the result of receiving a presentation in the (e)mail.  I can personally attest to that.  If someone smart that you trust says “look at this”, you will.  I think in the past year I have had over 300 hour-plus conversations with entrepreneurs pitching their ideas – and this is just the initial meeting or call.  Some subset have led to multiple meetings, calls, research hours and the end result has been less than a handful of investments in the fund this year ~ about a 1% pitch-to-investment ratio.  Time will tell how many great ideas were passed on.

Why do we reject 99% of ideas presented to us?:  There are many reasons, some can be articulated and some not.  There are probably a handful of common reasons that account for the majority of the non-invest decisions; portfolio fit, people fit, management, size, terms, and addressable market.  A random selection of some of the questions we think about are (in no particular order):  Does this fit our investing criteria?; Is the idea big enough, yet the execution focused?; Does management listen?; Is this a team and an idea that we want to spend then next 5-7 years being around and thinking about?; Is the investment at a reasonable valuation?; Are the terms reasonable?; Does the capital raise get them to profitability and if not then do we care for the risk?; What is the operating leverage in the model?

What entrepreneurs should do to increase success?: In fact there is quite a lot here.  In fact how a management pitches an idea and manages the fund raising process is telling of itself, and something we listen to.  In simplest terms know who you are talking to and what you want out of the conversation.  Your objective should be to find the VC that has the best fit for you.  To do that start by leveraging your contacts and the web to identify potential VC’s.  If you have direct contacts use them to get a personal referral to a VC.  Before your first conversation with a VC review their website and see if they describe their investment philosophy, list their portfolio and describe their ideal investment.  If they do, then are you a fit?  If not then ask the VC if they know of another VC that might be a good fit.  It is a job in itself, and so paying to pitch seems to be a good shortcut, but in reality there are no good shortcuts here.

After Google I/O, my wife and I visited my eldest, Rich, who is a graduate student at Stanford, and he suggested that we sit in on one of his lectures.  It was a treat, and not just because Professor Mehran Sahami throws candy to his students.  The class was on probability theory.  So here I was sitting at the back of a lecture hall, which I have not done for 27 years, being taught about “Modeling Uncertainty and Utility” – so, why was it such a treat?

Well, first of all, Sahami is a great teacher.  He keeps his students involved and awake, and not just from a sugar high.  He tied the subject back to the real world, talking about betting games, and micromorts, an idea core to life insurance.  It was his discussion of the behavioral aspects of utility that grabbed my attention.  Why would one person make a bet (or an investment) where the long-term average outcome (the “certain equivalent”)  makes it a “bad” bet.  Part of the answer lies in the relative amount of the bet vs. the person’s net worth and well being.  Sizing up/down the size of the bet changes the attractiveness of the bet in a way not immediately apparent from the numbers.  A billionaire is more willing than a multi-millionaire to bet $1mm for the fun of it, even if the odds do not make sense.  Psychology and Maslow’s Hierarchy need to be factored in.

The lecture made me think about the outcome of an investment in a private company.  Say that you invested $1mm 10 years ago at $1 per share and the company just had a successful IPO.  You also believe that it is capable of growing 50%  a year for next few years.  For sake of argument assume that there was no dilution and the company went public at $10 per share and traded to $15.  Assuming the market is rational (Okay, bad assumption) the stock could rise 75% a year for the next few years, if multiples do not contract.  You $1mm investment is worth $15mm today, $26mm in one year, $46mm in two year and $80mm in three years.  What is the utility value of profit?  When do you take money off the table?  Situations like this are are the subject of bar discussion by angel investors.

Sahami’s lecture helped me solve this problem.  It all depends how rich you are.  If you are just getting by, then $15mm today is very valuable to you, you can’t risk losing it (the market being irrational and all that) and so you probably sell a lot of it so that you can have money to live on.  If you are worth $100mm, you probably let it ride, not because you need it, but because of what a great story turning $1mm into $80mm would be.

This perspective helps solve another question I have been pondering as well.  If early stage venture capital and angel investor returns CAGR north of 15% (and there are a number of studies that support this view, but let’s just take it as a given) then why do more people not invest in this space?  Well, part of the answer is that if they did then the returns would not be as strong – which I wholly agree with, but part of the answer is that there is a small group of people to draw from that both have enough money to make such an investment and tie up their money for 3-8 years, but do not have so much money that the investment is too small to be worth their time.  Thus the space is left to a subset of rich angels and the handful of early stage venture capital firms such as ff Asset Management.

I was attentive throughout the class, and gained a lot from it.  We had a great weekend touring Alcatraz and walking amongst the sequoias at Muir Wood National Monument – some of these trees predate Christianity.  Both worthy uses of time, and good places to clear one’s head.  But the 50 minutes I spent listening to Professor Sahami and dodging candy was just as special.  Thanks, Rich.