Information Arbitrage

What I've learned from Little League

Tue, 30 Apr 2013 14:15:12 PDT

As my friends know all to well, mine is a life immersed in baseball. Yes, there’s that venture investment stuff, but in between board meetings, team meetings, meeting new companies, staying in touch with my networks and breaking down the barriers to data entrepreneurship at Michigan and Columbia there is baseball. Both my kids are intense baseball players. My wife is a Little League executive (and holds a Ph.D in psychology, which helps) and division coordinator. And I am a long-time manager and coach of teams with kids ranging from ages 7-17, from Junior Minors all the way to Seniors. It has almost become a third career of mine (Wall Street, venture capital, baseball coach). Along the way I have learned a ton about strategy, human psychology - and life.

Newly-minted baseball teams and start-ups have a tremendous amount in common. Every Spring there is a Little League draft and the managers sit around and pick their teams, not dissimilar from kicking off a new start-up. Those of us who have been around Little League a long time know most of the kids, their playing histories, their personalities and their families. But this anecdotal knowledge is augmented with objective data that are generated in a common League-wide tryout the morning of Super Bowl Sunday. Players are scored on their batting, fielding, pitching and catching (if they pitch and catch), and there are various sub-categories in each of these areas. Think of these scores as their resumes and conversations with prior coaches as being reference checks. Drafting players, like hiring team members, is an inexact science but the goal is to get as much quantitative and qualitative data as possible to make the most informed decision you can. Assuming all the mangers work reasonably hard in the data collection process, there is a somewhat common view of how players rank by position based upon skill. But somehow, people’s draft boards look very different post facto. The reason: managers draft for different things.

Year after year, in my experience newer managers tend to underperform more experienced managers. Why is this? My hypothesis is that the newer managers tend to draft based on the theory of “best athlete available that meets my position requirements,” while the old timers tend to draft with a particular team construction in mind. This means taking into account factors such as “Is the kid a team player? Does the player show up for practice on time? Are they humble and do they work hard? Are their parents over-involved and stressing out the kid (and the coaches and other team members in the process)? Is the player a potential leader? Has the player previously been on teams with other kids where they’ve been successful?” In short, the objective function is building the best team, not assembling the most talented group of individual players. And in Little League, as in life, teams win when they function as a single unit and not as an amalgam of autonomous parts. So I have consistently passed up more skilled players in order to draft players who are good, but even more importantly, are good kids and fit within the team concept.

This is a movie I’ve seen many times before in start-ups I’ve backed. There is the seduction of hiring the “rock star, 10x performer, force of nature” contributor, even if they are a prima donna and most assuredly not a team player. I’ve witnessed this from the perspective of whether or not to hire these people as well as whether or not to fire these people who are already in the company. It is a very painful decision to make, but in my experience these people almost never work out in a start-up environment, where every person is so crucial to getting the business off the ground. Positive team chemistry and culture is critical at all times, but especially when a team needs to be working in perfect synchrony, backing each other up and focused as a single unit on the task at hand. Selfish but talented people mess up this dynamic, even if they can write beautiful code but piss off their team members or treat them in a disrespectful way. Fortunately there are talented people who aren’t destructive to a firm’s culture, and these are the people start-ups need to find. Optimizing for team, not simply talent, is the message.

When building a high-performance team the question you should be asking yourself is: what is the goal and what are the resources I need to get there? Because the goal invariably requires multiple skill sets spread across several individuals, ensuring that you build the connective tissue among these people who are receptive to this “team first” notion is Job #1. It’s not about finding the brightest stars in the sky, it’s about finding those stars that make the constellation you want to call your own.

Breaking through

Thu, 18 Apr 2013 12:43:06 PDT

I spend a bunch of time speaking at events, guest lecturing at friends’ classes and mentoring young people. It is something I feel passionately about and enjoy a great deal. I always try to be blunt, honest and unambiguous with my input, hoping that at least some of the take-aways will be employed by those hearing my words. But I continue to be surprised by the number of common mistakes made by start-up founders, and wanted to provide a short list of some of my hot buttons.

Post-presentation behavior: When I (or someone like me, be they an investor, a well-know start-up founder, etc.) speak at a conference, it is commonplace for a group of people to line up to say hi and chat for a minute. All good. Except what often happens is that a (most often young) founder will try to pitch me their idea. I hate this and it generally leaves a bad taste in my mouth. There are too many people and too little time for this to be successful. You do not have my undivided attention. However, the goal should be to be brief, on point and to either say something smart or ask a good question that relates to discussion. This way, you can send me an email at roger@iaventures.com and you might have seeded a dialogue. But if you force a pitch on me at this moment, forget it.

Getting in touch with a VC: The number of blind emails we get with a pitch and a meeting request is extreme. This exercise is a complete waste of time as far as I’m concerned. The signal/noise ratio is simply too high to do all the calls and take all the meetings people want. But there is one way people short-circuit a meaningful part of the deal funnel - getting referred into us by a trusted person. This person can be another investor with whom we’re close and done business. It can be one of our founders. The common thread is someone whom we trust and whose judgement we value. While we don’t take every meeting requested from referrals, the likelihood of getting a close look is infinitely higher than sending in your stuff and hoping that a meeting will take place. So use that entrepreneurial intensity, passion and ingenuity to network to someone who knows me or one of my colleagues and impress them sufficiently such that they’re comfortable making the introduction.

Networking: Even with all that has been written about the importance of networking, I see way too many aspiring entrepreneurs looking for a silver bullet for how to meet domain relevant people for collaboration, recruitment and support. Have you checked out relevant Meetup groups? General Assembly? Do you have specific experience where you might mentor other founders at TechStars or another accelerator program? Have you spent time doing research around events taking place at local colleges and universities? How about starting your own community around your particular area of interest? With even a little effort it is impossible not to find abundant opportunities to network, learn and grow. You’ve just got to do it. I have no simple answer. It just takes time and hard work. Kinda of like what it takes to be a startup founder.

Building your brand: If you are in the start-up world, either as an employee, founder, investor or aspiring to do any of the three, it is important to thoughtfully build your online and offline identity. The beauty is that these efforts are valuable for anything you might want to do, and, in fact, is great practice for what you’ll do when you land your dream role. Develop a thesis and take a stand. How can you add value to the community discussion? Start writing, but with a purpose. It forces clarity of thought, opens up your mind and lets people get to know you better. Create opportunities for speaking in public and sharing your ideas with others. This will help bridge the online/offline gap and build a more personal identity, as well as providing a forum for feedback and debate instead of living inside your head. And of course actively maintain a Twitter account and an up-to-date LinkedIn profile. These are table stakes for people wanting to get a quick snapshot of who you are and what you’re about.

Be passionate, be strong but be deliberate. The fact is that no matter how smart or hungry you are, it just takes time to network, acquire knowledge and experience and to feel comfortable in your own skin as a member of the start-up community. And this is a good thing. Life is a marathon, not a sprint, so be purposeful and focused without feeling like you’re behind where you should be. The worst thing you can do is be unfocused and reactive, letting the environment dictate your roadmap instead of the converse. This doesn’t mean be insular and block out external influences; it means remaining true to your mission. It’s just like my idol W. Edwards Deming used to say (paraphrasing): It’s about understanding the process. If you develop the best processes, positive results will follow.

It’s all there within your grasp. Just be thoughtful. Listen a lot. And by all means, follow your passions.

"Dear Friends, We are, no doubt, shocked by yesterday’s events at the Boston marathon. Many of..."

Tue, 16 Apr 2013 12:14:28 PDT

“

Dear Friends,

We are, no doubt, shocked by yesterday’s events at the Boston marathon. Many of us have friends or family who live there or were there for the event. All of us, as New Yorkers, know what it is like to have our city overturned by terror, or more recently, by a devastating event of nature. Our hearts are with those affected by the violence and its ripples of destruction and disruption.

Today is Yom Ha’atzmaut, Israel’s Independence Day. Yesterday was Yom HaZikaron, the Memorial Day for Israel’s war dead. The juxtaposition is intentional: a reminder of the relationship between sacrifice and suffering, and the presence of the miraculous. So too after every shocking public tragedy we confront the sharp contrast between the worst and best in human nature. Some are capable of mass violence. And so many more are capable of acts of heroism, service, and love in response. And we know from our own lives too that our darkest moments — however unwanted — offer a window into all that is most important, most wonderful and most connecting in our lives. And this is how some of us, sometimes, can feel God is still with us, even in our hardest times.

We pray for all those affected by the awful events in Boston. And we pray for all of us that our despair over tragedy is far exceeded by our inspiration at the way so many of us respond to it.

In hope,
David

”

- Rabbi David Adelson, East End Temple, April 16th, 2013

The response to the terror in Boston: Channeling for good

Tue, 16 Apr 2013 05:20:14 PDT

Yesterday’s horrific and senseless tragedy in Boston stirred up many of the same feelings I had on a beautiful September morning almost 12 years ago. Sadness. Anger. Rage. Confusion. And simply Why? Why did this happen? How could it happen at a time of celebration, peace and personal and community achievement? Words simply don’t do the feelings justice. I went to Twitter to get more facts about what had happened, and then looked for the Tweets of my many Boston-based friends to see that they and their families were ok. Finally, my feelings washed towards empathy, understanding how such a tragic event can both shock and ultimately cause a city, a community to come together in ways previously unimaginable.

As I’ve watched the many responses to the event pop up on blogs, Facebook, Tumblr and Twitter I’ve been both amazed and blown away by the stark message sent by all: We will not stop. We will not be scared. We will get busy helping, contributing - and running. I wouldn’t be surprised to see 2x the applications to the 2014 Boston Marathon given the vibe I’ve seen across the social nets. Many of my running friends across the start-up and investment communities have already stated their intention to run next year’s Boston Marathon, to simply say no to fear and to move forward in a constructive way. Props to all.

But perhaps the most surprising aspect of the responses I’ve seen is that rather than focusing on anger and thoughts of revenge, they’ve largely centered on feelings of sadness followed by calls to action. Donating blood, money and time. Running in next year’s race. Positive stuff. I don’t know if we as a society are getting better at reacting to crises or if violating something as pure and sacred as the Boston Marathon caused a specific outpouring of emotion, but I’m truly blown away by the tone of the messaging. To me it is a life lesson in how to handle crises being demonstrated on a mass scale.

#respect

Reflections on IA Ventures, 3.5 years in

Mon, 15 Apr 2013 19:13:22 PDT

I periodically write about my learnings as the leader of IA Ventures, principally to unlock what is in my head and in my heart. As an operating partner with people who are giving their lives to building their businesses and a financial partner with those who have entrusted us with their capital, this is a very serious undertaking. Sometimes I find it necessary to call a “time out” in order to reflect, assess and share. That time is now.

As I’ve written before, our most valuable resource is time, not money. Given this realization, we’ve continued to emphasize lead-managed investments or relationships where we are co-lead with a partner and firm whom we like and respect a lot. This necessarily means writing somewhat larger checks and working to own more of companies driven by compelling teams possessing great chemistry, rich skill sets and bold visions. The result of this strategy is to take somewhat longer to close an investment, but to have established an even deeper relationship with our founders, their customers and other key players in their ecosystem. I can’t tell you how many times I’ve referenced my friend and co-investor Mark Suster’s memorable post Invest in Lines, Not Dots. His advice cuts both ways - not only is it important for we as investors to get to know our potential founders well, but for founders to get to know us as people and potential partners, too.

This also works to cement one of my absolute bottom lines as an investor: our founders need to want to work with us as much as we want to work with them, and if there is a “fire drill” to consider an investment or a sense that founders are optimizing for round price and not for who-is-the-best-partner-to-build-the-best-business, we’ll simply agree to disagree and bow out. No hard feelings, but these are simply not the situations that comport with our notion of deep partnership. I’ve also been amazed and impressed at the due diligence our potential founder/partners are doing on us, and value and appreciate the thoughtfulness and the time they take to make sure we’re the right fit for them.

It is important to note that the above in no way has impacted the stage at which we invest in companies, which continues to be seed stage/first money in (or first institutional money in) or early Series A. Our fundamental philosophy is that we are best-suited to help build companies from Seed through Series B stages, and this is closely tied to our belief that we are building a portfolio that sits at the optimal point of the risk-reward continuum. We’ve always believed that “small is beautiful,” and continue to cultivate deep relationships with larger firms to partner with us at later stages of a company’s development. It is very hard to be good at everything, and we’ve deliberately chosen to focus on the early stages of a start-up’s life.

This approach also has also worked to shape our reserve policy. While we have always created significant reserves for follow-ons, we are now firmly settled into a “life cycle” approach: we are positioned to lead Seed and Series A rounds, with sufficient reserves to do our full pro rata in Series B rounds. We have done and will do select Series C participations, but only where we expect the marginal return on our capital to be in the 7-10x range or higher. But as companies experience rapid growth and begin to scale beyond our early-stage competency and capital base, we allow ourselves to get diluted down from the early high ownership levels to still significant but lesser levels as fresh capital is better deployed against new opportunities. This is a natural and comfortable hand-off that takes place from early stage to growth stage, and we are not in the growth stage business. And that is fine with us.

Likely the hardest thing about building a business for the next 50 years is team construction and company culture. While I work hard to create a particular culture that I hope is retained well beyond my leadership of IA Ventures, team construction is a delicate balance that needs to evolve as the business grows and develops. Venture capital is a people-powered business and one which doesn’t scale particularly well (at least in the way we interact with our partner companies). Therefore growth requires more people, each new person adds to and changes the culture to a certain degree. Core principles are retained but style and chemistry dynamically adjust to new people who have entered the system.

So as culture and vibe are shifting and incorporating new inputs, the nature of communication necessarily changes in response to more specialized roles and responsibilities. New analyst? That changes things. New principals and partners? I can only imagine the shock to the system. It’s not that shocks, jolts and new dynamics aren’t good; in fact, they’re mostly great! But getting the balance of skills and styles right that all fit within the culture is not an easy task. This is why we’ve been super deliberate when bringing on new team members, and our approach has worked thus far. But the stakes continue to grow as the firm grows, and as we are all so busy traveling and spending time with our companies it is challenging remaining centered, strong, focused, synchronized. Mindfulness is one thing: successful execution is something else entirely.

In the time I’ve spent building the IA Ventures business, it has become abundantly clear that I am facing exactly the same issues as those founders whom we back every day. Articulating and selling the mission and the vision of the firm. Clearly communicating the value and benefits of our product. Closing business. Staying close to and getting feedback from customers. Recruiting. Understanding the competitive landscape. Proactive strategy development and planning. Marketing and PR. To say that I have empathy for the startup founder is the understatement of the century. I get it. Believe me, I get it. Few things are as exciting or rewarding as building a business, but it is also among the hardest things I’ve ever done. But 3.5 years in, there is nothing I’d rather be doing. Thanks to Brad, Ben, Jesse, Julie, Joey, Adrian, Drew, and all of our founders. You’ve pushed me hard, yo! The best is yet to come…

VC funding vs. Crowdfunding - let's get real

Tue, 02 Apr 2013 22:39:00 PDT

Crowdfunding is all the rage. Even the SEC recently blessed one type of crowdfunding for which there was risk of an enforcement action. Several in the early-stage ecosystem have called for VCs to “up their game,” as alternative paths to financing create competitive threats to both incumbent firms and the venture model itself. I think drawing parallels between crowdfunding and VC investment is both silly and inappropriate and conflates several important factors, most of which have to do with whether a founder is dealing with a good VC partner or a lousy VC partner. There will always be good VCs and shitty VCs from a founder perspective, and the presence of crowdfunding is unlikely to impact this phenomenon. That said, here is the compare/contrast as I see it between crowdfunding and VC funding (assuming one is dealing with a quality VC who acts as a true partner with management). Please note that I am not looking to specifically address of whether crowdfunding may or may not be a good vehicle for accessing early-stage investment opportunities. I will say, however, that if one’s investment thesis generally revolves around the notion of “social proof” than I don’t hold high hopes for this corner of the asset class.

1. Mentoring and assistance

VC: High
Crowdfunding: Low

With younger first-time founders, I personally believe money is not at all fungible and that there is significant value to partnering with a great individual at a great firm. I have personally witnessed this as a founder, as an angel and most recently as a VC. Whoever says that “all money is green” and that the source doesn’t matter isn’t giving the inexperienced yet visionary founder very good advice. I believe this talk is a function more of ego and bravado than really trying to give a founder the best advice for building a sustainable, long term, profitable business. Cynics will say “Oh, you’re just talking your book.” My response: come back with a thoughtful argument and save the platitudes. I also acknowledge that many founders successfully build a suite of mentors and advisors both inside and outside of their funding syndicates, but I don’t see these relationships as a replacement for a VC operator that has interests and exposures closely aligned with those of the founders.

2. Stability

VC: High
Crowdfunding: Low

Most seed stage businesses with which I’ve been involved have not been “up and to the right” propositions from the get go. It has taken a bunch of time - invariably more time than expected - to achieve product/market fit and, more importantly, to figure out a scalable and replicable way to sell the product. And with this extra time comes extra financing requirements, often more than the start-up has on hand. Because of this, in purely angel-funded situations (and, by extension, crowdfunded situations where there is no ostensible deal lead with the responsibility and resources to bridge the gap), it is frequently either brutally painful and time consuming or impossible to secure this incremental capital prior to Series A-type metrics being hit. This is only one of the ways where a supportive VC partner can help keep the team focused on execution by injecting enough capital to hit the key operating milestones Series A investors are looking for. And this can generally be done quite quickly and painlessly, but has to be done in an environment of trust and support. It is important that both founders and the VC feel a bridge investment was done fairly and thoughtfully, but this is something that strong VC partners do every day. It’s part of life.

3. Friction

VC: High
Crowdfunding: Low

As crowdfunding platforms become increasingly turn-key and the information provided becomes better, it will become easier and easier to tap a broad array of accredited investors for start-up funds. VCs, regardless of how streamlined their process might be, will always represent more friction and require more effort in order to close a round. They will ask more questions. Spend more time. Likely distract to a greater extent. But in my experience this process is often healthy for the start-up founder and forces a level of self-awareness, insight, professionalism and transparency that did not exist previously. For more seasoned founders this might not be seen as valuable, and the more streamlined crowdfunding process might be more appealing. In fact, as I see it crowdfunding appears most appropriate in two distinct circumstances:

Where the money raised is to hack together a prototype, and the focus is purely technical and not on business-building; or
Where the money is raised from a seasoned founder who doesn’t value the tangibles and intangibles offered by a VC, and really does view dollars as fungible.

Focus, focus, focus: Understanding your value stack

Sat, 16 Mar 2013 09:14:07 PDT

Distraction and diffuse efforts are killers, especially in nascent businesses. Trying to do too much sucks valuable resources from accomplishing the core mission, but is often viewed as being important for “keeping options open” or “controlling one’s destiny.” The goal of a seed stage company shouldn’t be optionality preservation but laser-focused customer engagement, and to let the market help drive the iterative product development process rather than engineering in a vacuum and trying to solve everyone’s problem. This is the big issue of developing a general platform versus solving an important pain-point through a vertical application. Platforms can have great capabilities, but it is hard to prove the value without specific use cases. This is why UI is so important even in data-driven API-based start-ups, as potential customers need to actually SEE the value, not merely have it depicted in a spreadsheet or on a series of charts. Being able to demonstrate value is no easy task and involves several key steps. Ignore them at your peril.

Know your customer. This is especially difficult in two-sided markets, where seeding growth on both sides is often a necessary element of demonstrating value. But many B2B2C companies have similar issues. Do you need to get widespread consumer adoption before showing a clear value proposition to the enterprise? Can you be laser focused on building the consumer application and solidifying usage and deep engagement while seeding a small number of strategic enterprise relationships to illustrate the enterprise use case and prove the ability to monetize? Spend too much time with the enterprise and you risk losing focus on your user. Ignore the enterprise and you might not develop a consumer experience that benefits from enterprise engagement. It’s not easy. You simply can’t serve two masters early in the company’s life. Complexity can distract, drain resources and impact culture.

Know your source of competitive advantage. Another crushing drain on the early-stage company is trying to do too many things: not simply trying to sell to multiple constituencies, but engineering more than you need to beyond what’s truly core to the customer experience. For instance, if you’re parsing text together with numerical data to generate a “score” (for creditworthiness, influence, purchase intent and 1000 other use cases), is the value in the database where the information is stored? Perhaps it resides in the harvesting and cleansing architecture to bring in the data and put it in a usable format? Or is the value in the algorithms used to develop the signal? Or might the value be in the application that creates the engagement necessary to monetize the signal? I think it’s safe to say that the algos together with the application are where the real differentiation resides, while the database and data ingestion layers are better done by and purchased from companies whose sole mission is to be the best at these things. While there are companies that ultimately require a “full stack” solution to deliver the best customer experience and to create the deepest competitive moat, most companies can go a long way towards demonstrating and creating value by focusing on the areas where they are truly differentiated and not worrying about the less essential elements of the value stack.

Know where you are in your evolution. As mentioned above, the answers to your questions potentially vary with time. While ruthless focus on a single goal has to dominate in the earliest days, this will necessarily evolve as the business grows. When does it make sense to approach a new set of customers with a different use case? Should we built our own proprietary [key part of your stack currently subbed out goes here] because it will enable us to [more rapidly/better] serve our customers and create a turn-key solution for potential acquirers? Managing growth while managing culture (and finances, for that matter) is very challenging, and only something that should be taken on after you’ve nailed that first use case. And by all means, don’t mistake revenues for a scalable and replicable sales process. The road is littered with start-ups that confused revenue growth with product/market fit, funding rapid expansion before the repeatable machine had truly been built.

I have seen too many potentially great teams and companies make these mistakes by trying to do too much, too soon. Please do not let this be you.

Taking the long view (when building the business)

Mon, 11 Mar 2013 15:22:09 PDT

In the wake of my SXSW chat with Lauren Lyster of Yahoo! Finance, I once again began to think about the relationship between equity valuation and business decisions. In my perfect world, a business is financed in a manner that optimizes financial outcomes by creating a set of decision points along its growth trajectory.

This “optionality” is created by raising capital at times, in amounts and from investors that fund and support the business to the next series of key operating milestones, at which point an assessment can be made: is this working how we’d like? Are we doing a good job tackling our execution challenges? Has the competitive landscape changed? Is our company of particular interest to one or more buyers who are willing to pay for the next several years of growth? This necessarily implies that different kinds of investors can help at different phases of a company’s growth, and that long-term founder goals are essential inputs to the decision-making process.

This also encompasses the concept of founder liquidity, which at appropriate times can be used to re-align motives between founders and investors. As a business becomes increasingly successful, is scaling rapidly and third-party acquisition offers are an ever-present option, it is important to re-visit the goals of both founders and investors. When a business is first seeded, founder/investor alignment is generally tight because both parties want to prove out the business, achieve product/market fit and secure happy customers. But once this happens and the company moves from “proving” mode to “scaling” mode, this alignment can often diverge, especially with first-time founders who haven’t made much money and have gone all-in on their start-up. It may be that both founders and investors believe the business can grow into a multi-hundreds of millions or even billion-dollar exit, but that an M&A offer for $80 million that puts $20-$30 million into the founders’ pockets is just too compelling to pass up. This is the time when a new growth financing coupled with a secondary purchase of founder stock could reduce the founders’ risk profiles, still preserve that vast majority of their ownership and give them the peace-of-mind to redouble their efforts to build a huge company. This closes the yawning mis-alignment bred by success but can only emerge from an environment of partnership, trust and long-term vision.

This is a completely different mind-set than founders saying: “I want to maximize valuation, minimize dilution and treat investors as fungible sources of capital.” In my opinion, this is a dangerous game for founders to play as it sharply reduces the margin for error in executing the plan. In my experience the business-building process is anything but linear and the unexpected and unplanned is the norm. Achieving product/market fit at scale is, as you well know, insanely difficult, and no seed stage company, by definition, has achieved this or they wouldn’t be a seed stage company: they would either shun investor money altogether or jump from a bootstrapped rocket ship to raise a later stage growth round. So just to be clear this isn’t what I’m talking about; I’m referring to the 99.9% of start-ups that have an early product, have engaged with some early customers and are looking for money to continue to prove out the market and achieve a measure of product/market fit. These companies in the best of cases are fraught with risk and will not be fundamentally de-risked for quite some time. This is when having strong investors who are aligned with you is particularly valuable, as they can help provide interested and knowledgeable third-party perspective, serve as a healthy counterweight to the unbridled optimism of early-stage teams and work with management to devise a set of KPIs and metrics for the business. Should additional financial runway be needed because of a delayed product launch, difficult in recruiting the go-to-market team, etc., the strong and committed investor can help provide the resources necessary to achieve the critical operational milestones essential for raising the next round. Either a group of angels without a distinct lead or a firm that is pissed off because they overpaid for a seed stage deal will not be awesome to work with during this challenging time.

Angels are terrific, and we work with them in almost all of our companies. Really good ones have great domain knowledge, expertise and contacts and are super helpful. They are, however, not a substitute for a strong deal lead with reserves held against the investment position who can help drive a round extension or a bridge to the next financing. And inexperienced angels can freak out at times of trouble and be a significant drain on management bandwidth. Also, venture investors who were induced to pay a high price to get a deal may use a hiccup in execution to extract a pound of flesh from the founders in exchange for bridge capital, as they feel a measure of “buyer’s remorse” and are likely unhappy by perceiving they were oversold at the outset. One might say “caveat emptor,” but let’s remember who holds the cards at times of stress: those with the money. The honeymoon is over. The slick fund-raising presentation is long since forgotten. All that’s being looked at is the business and the price paid for the business – and the investor isn’t happy. This is a lousy situation for founders to find themselves in, but is exactly what they’re singing up for by treating the investor selection process as a game of “Who’s the highest bidder?” instead of “Who’s my best long-term partner?”

I know some might say, “You’re talking your book” or “That’s not the way YC does it” and my response to those naysayers is as follows: you’re wrong. Building a company is far more art than science, especially in the earliest days, and having the right support systems around the table – both knowledge and financial resources – is essential for managing the risks and opportunities of a nascent business. If you have complete conviction that you can and will achieve product/market fit and scale to the moon without hitting bumps in the road, then by all means raise a bunch of uncapped or high-cap convertible notes from a dispersed group of investors, none of whom has enough skin in the game or commitment to impact the outcome of the business. Just know that you are betting the entire company on Day 1 by pursuing this strategy. Eyes wide open and acknowledgement of the risks is all I ask. Alternatively, if: (a) you feel you’ve got something hugely exciting where you’ve proven some stuff but have a long way to go before feeling confident that you’ve achieved product/market fit, and; (b) you believe that you’d benefit from the mentoring, experience, commitment and financial resources of a top-quality institutional investor, then perhaps you could re-think the wisdom of the prior approach. Put a more stable capital plan in place through partnership with the right investor for your business with whom you cement aligned motives. This may mean not taking the highest-priced offer on the table, but I believe it will provide the greatest opportunity for maximizing equity value over time. If you are playing a long game, as I am, you need to adopt a long-term mind-set. It’s not about winning the tactical battle of getting the highest price for your seed round: it’s about winning the war. Don’t let ego and crappy advice get in the way.

Come join the IA Ventures Family

Tue, 05 Feb 2013 18:53:20 PST

I started IA Ventures a little over three years ago with Brad and Ben. The original thesis: build an early-stage venture firm designed for the long-term that focused on companies seeking competitive advantage through data. Infrastructure. Platforms. Applications. All of it. We’d take a life-cycle approach to investing, building our positions early, working hard in partnership with our founders to achieve “escape velocity” and providing additional capital to support growth over time. This was the playbook I articulated to investors in 2009 and the same holds true to this day. We remain convinced that our approach is well-suited to building valuable, long-lasting relationships with great business-builders and generating superior cash-on-cash returns for our Limited Partners.

While our thesis and approach has remained largely unchanged since our founding, much has happened in the meantime. We have raised two funds, our first fund of $50 million which is now fully deployed, and a second fund of $105 million which has more than two years to be invested and over 2/3 of its capital untapped. We have 31 portfolio companies across the two funds, and have averaged approximately 10 investments per year. This has all been accomplished with an investment team that has remained essentially the same - the original three partners plus an analyst (initially the highly skilled Justin Singer who left to work for a portfolio company, and now the incomparable polymath Jesse Beyroutey). The good news is that we’ve created a very tight-knit team with a strong culture that is working well with and for our companies. The bad news is that given our strong deal flow and hands-on approach to working with our companies, we feel that our investment team is bandwidth constrained. Further, we are interested in getting some new perspectives in the Firm to help us look at opportunities through a different lens. We believe this is a positive and healthy development for our companies, our Limited Partners and the Firm. The time has come to grow the investment team.

We are already well on our way to bringing on a new analyst to work with us. The candidates have been spectacular and we are excited to announce a new member of the team in the next few weeks. But this is only one piece of the puzzle.

Now for the big news: We are committed to bringing on a new Partner at IA Ventures. This will be someone who shares our passion for early-stage investing in the mode of partnership with our portfolio companies. The person may have been an entrepreneur before becoming an investor or may have been investing all their life. We don’t have a pre-conceived notion of the “just right” background. We expect that every likely candidate will be passionate, articulate, interested in engaging in constructive debate and strong. While we all have a technical bent, we can see a wide range of people “clicking” with us. As with our founders, most of whom we backed at the seed stage (almost always pre-revenue and sometimes even pre-product!), so much is based upon chemistry and how we see a long-term partnership evolving. What we aren’t looking for is someone exactly like us.

We fully expect this process to take some time and we’re signed up to make the investment in our future. We are easy to check out. Speak to our founders. Speak to other venture firms and angels that have worked with us. We’re proud of what we’ve achieved thus far, but we’re playing a very long game. And we’re looking for that right someone to come and play with us. If you’re interested please send me a note and whatever else you want to send to roger@iaventures.com. I look forward to hearing from you.

Founders: Eyes wide open

Sat, 15 Dec 2012 13:00:24 PST

Raising money is a hard and sometimes scary thing. Friends & family money might be relatively easy to raise but often comes with lots of emotional strings attached. “What if I lose their money? Might this adversely impact our relationship? Will I feel horrible and guilty?” Raising angel money is somewhat harder, but with less drama and entanglement. “These people believe in me and are trusting me, which is a huge obligation. But will any of these investors actually be able to help me to build my business?” And finally, securing venture investment is generally challenging for all but the brand-name and heavily pedigreed entrepreneurs, but hard work on both sides leads to a more balanced relationship: there are certainly clear expectations coming for the VC and often symmetrical wants and desires from the entrepreneur. And this is a good thing.

Early stage VCs and founders are bound together by a spiritual relationship around the founders’ mission. This is made more complicated by the financial and legal dynamics introduced by a financing. Taking VC money is like getting married: when it’s good it’s great and both productive and fulfilling. When it’s bad, however, splitting up is hard to do, both emotionally and logistically. So bringing a VC into the mix is not something that should be taken lightly.

However, if you do decide to take venture money, there are few things I’d recommend founders do to get the most out of the relationship:

Trust your new partners

I have heard way too many times from people who are ostensibly “founder friendly” that founders shouldn’t trust their investors but keep them at arms-length: they are simply not to be trusted. I have one word for this advice: bullshit. It is incumbent upon founders to do their homework and to pick their investors as carefully as they pick their co-founders and early employees. Each of these key relationships can and generally does have a material impact on the culture and future success of the company. The relationship with a lead investor is no different. But once you choose an investor, the value of having a truly trusting and respectful relationship is hard to quantify. If you constantly find yourself managing information flow and creating knowledge asymmetry between the founding team and the lead investor, something is fundamentally wrong. That energy spent “managing” could be spent engaging the investor - who is really your partner - on issues that are truly material to the prospects for the business. Use this leverage to your advantage.

Invest in relationships

Even after picking a great investor whom you trust, in order to get the greatest benefit from their skills, experiences and relationships you need to commit to building the relationship. This requires time on both sides to identify the best means of communication, the areas where the founders need the most help and where the investor can help plug the gaps and the right cadence of communication given the company’s stage and needs. Good things don’t just happen spontaneously; they require hard work. This relationship should be framed in the same manner as that of a key person in your personal life: there will invariably be ups and downs, but each is deeply committed to the other and have a vested interest in having things work out. If you’ve done a good job picking the right investor / partner, this investment will yield significant dividends over time.

Clearly communicate your expectations, wants and needs

Every relationship is different. What one founding team needs and wants can often be quite different than another due to background, team construction and business challenges. Even the most committed investor / partner can’t read the founder’s mind, and can’t possibly know what goes on day-to-day within the business. It is incumbent upon both the founder and the investor to communicate succinctly and honestly, with a bias towards actionable take-aways, e.g., “Can you interview these three Lead Developer candidates for us, as your perspective would be really helpful?” or “We’d love to get two proofs-of-concept going in different verticals. Can you help us identify the best potential candidates in [adtech] and [financial services]?” Good investor / partners love concrete deliverables because (a) it specifically helps their investment, (b) it feels good to help and (c) being recognized as a real (not bullshit) value-added investor both cements the relationship with the current founder and builds reputation among prospective founder / partners. In short, good communication breeds goodness all around.

Building a great relationship with a lead investor isn’t hard, but requires work both before the right partner is chosen and on an ongoing basis as the relationship evolves and the company is built. Problems arise when founders either pick an investor that isn’t the right fit or don’t properly invest in the relationship. From the investor perspective, few things are more frustrating than when you’ve done a ton of work to identify a team you want to work with and a business you want to help build, but where the founders don’t want to engage with you. And it’s a shame. My most satisfying founder relationships have strongly correlated with business outcomes, and I firmly believe that the “money is fungible” mantra is a load of bunk. But it’s up to the founders to decide on the go-it-alone or partner-with-investors path. My message is that if you do elect to take venture money, by all means do it the right way. Eyes wide open.

Book value matters

Mon, 03 Dec 2012 20:11:30 PST

Solving an important problem is generally the credo of most entrepreneurs. However, the solutions can take a variety of forms: core technology (e.g., a new database); business model (e.g., peer-to-peer lending); or service (e.g., next-gen mobile optimized retail banking). Certain businesses give rise to differentiated intellectual property which is sometimes patentable and often salable. Others leverage business models and processes which themselves might not be patentable but which create valuable data assets. But sometimes start-ups give rise to neither, and are hoping for advertising, e-commerce or lead generation revenues to fuel profitable businesses - if they work - at scale. These dynamics beg the following question:

Does creating intrinsic value matter in technology start-ups, or are operating cash flows all that really count to a (hopefully) fast-growing early stage business?

By “intrinsic value” I’m referring to the worth of a business if it were to cease operating, with buyers offered the chance to purchase all or part of its assets. In barest terms, if you were to turn off the lights, is the company worth anything? Given a founding team whose mission is to disrupt a large market or to create a new market, it is unlikely that the notion of intrinsic value comes up in casual conversation. But in the cold light of day, the chances of achieving parabolic growth and creating billions in enterprise value is pretty low. But what if a business that was taking a big swing was designed such that it had lots of exit options at different stages arising from the creation and compounding of intrinsic value?

In early days the value might largely be attributable to team, a tight-knit group of world-class engineers who have shipped beautiful software together. Later on it might be team plus an analytical framework for extracting insights from certain kinds of data relevant to the problem being solved, a framework that might be applicable to a range of potential acquirers’ problems. And eventually the business at scale might result in a hard-to-replicate data asset that can be leveraged and used as a channel for other types of commerce. This step-wise accretion of value can provide founders with a much wider range of exit options than simply focusing on the “flow” (dependent upon transaction volume) rather than the “stock” (asset value realizable in a liquidation).

Don’t get me wrong, as an investor most excited by teams driven to build large and truly disruptive businesses over time I’m in this thing for the long haul. But I have the benefit of diversification. Founders don’t. What I’m suggesting is that there is no reason why founders can’t be a little more thoughtful about the process of creating asset value rather than less tangible measures of success. Going for the big win and creating asset value along the way are by no means mutually exclusive. But attention to this particular detail can be the difference between a nice, unspectacular but life-altering outcome and a goose-egg. You make the choice.

Knowing when it's time to go

Sun, 02 Dec 2012 20:30:54 PST

Do I wake up excited to start the day? Am I frustrated by the dumb things I do that I know I can - and should - do better? Can I feel myself learning, growing and developing in my role? Is there a sense, a hard to put into words but a know-it-when-I-feel-it sense that I’m making progress towards my career and life objectives? These have long been the hallmarks of roles in which I’m both personally and professionally fulfilled. But when one or more of these drivers are not at play, I’ve found myself restless and ready to disrupt the status quo and to find my next challenge. Having the foresight to know when I’ve started stagnating has led me to make some bold and aggressive moves in my career - on my terms. One thing is for sure: if you are coasting in your job, lacking passion and the drive to succeed, Mr. Market will find you and disrupt your career - and not on your terms. Do not let this happen to you.

Career management doesn’t just happen; it requires planning, effort and self-awareness. I’d argue that this is more important now than ever, as job security has become fleeting and employment by larger companies with richer benefits is generally contracting, not expanding. This renders career planning akin to a software release cycle: prioritize the development pipeline; build and release features; collect customer feedback; iterate in the wake of hard data and reset priorities (and therefore the dev pipeline). We’ve all become the VP Engineering of our own careers. Managing multiple constituencies (Sales, Product and Development) with an eye towards shipping the best product - the one with the features customers value most. Get lazy on the job, slack off of managing even one of these key relationships, and the whole system breaks down.

Regardless of role, seniority or stage of career, I’d suggest that everyone ask themselves these hard questions on a periodic basis:

Am I learning? If not, plan how to move into a new role at your current organization or consider looking outside for new opportunities. Not learning sucks. Unacceptable. Time to move on.

Do I feel good about what I’m doing? Learning is great, but if you feel ambivalent about what you’re doing the situation is not long-term stable. As long as you are building your skill sets, experiences and networks, ok. But without true passion for your mission, you should begin thinking about either a functional or organizational change.

Does my role fit with my long-term objectives? Careers leverage our cumulative experiences as well as our hopes and dreams. You can be learning and feel good about your current role, but if staying in that role isn’t going to help you move forward towards your long term objectives than you need to be disciplined about deciding when it’s time to move on.

Is my job meeting my short-term needs? Not everybody has the luxury of optimizing for the above when there are very real financial and geographic considerations that often come into play. Student loans? Children? Dependent parents? Whatever. Life happens, much of which is beyond our control. So while the questions above should always be kept in mind, sometimes the fact is that sacrifices have to be made to simply cope with reality. But proactively managing career through learning, the advice of mentors and outside activities can be done regardless of the situation. Just do it.

When I look at myself in the mirror do I like what I see? This fuzzy litmus test is helpful for cutting through the BS and self-rationalizations that plague even the most introspective and intellectually honest of us. Sometimes things look good on paper and sound good when we tell other people, but when we look back at ourselves and can’t fake that smile, you know something’s up. Time to speak to a mentor, a career coach, someone who can serve as a trusted sounding board to help you get to the bottom of what’s really going on. It is often too painful to let the truth in, whether it’s disappointment with one’s career trajectory, perceived appreciation at work or finding oneself in a job that others think is great but you do not. Shake things up. Get some help. Do not accept simply muddling through.

Subjecting yourself to regular self-review is a challenging and often frustrating task. However, the the rewards of imposing this discipline are many: clearer thinking about your job and career management; plans and actions for moving forward, not simply marking time; bringing others in to help you achieve your objectives and avoiding going solo; and knowledge of where you really stand in the one person’s eyes that really matter - yourself.

Karma

Wed, 28 Nov 2012 19:53:27 PST

Life is a series of interactions. How we manage these interactions plays a meaningful role in our future. This is particularly relevant for entrepreneurs and investors, between which exists a delicate symbiosis that teeters between cooperation and competition. This is further complicated by the fact that investors often work together, yet have the dueling agendas of doing right by their portfolio companies as well as their limited partners. It is difficult to apply game theory to this problem because of its myriad dimensions and the vastly different utility functions of the players involved. That said, there is one over-arching principle that applies in all cases which makes the math infinitely more straight-forward: karma.

Notwithstanding the trend towards short-term thinking and immediate gratification in Government, media and across society, there are a few immutable truths:

Life is a marathon, not a sprint; and
Relationships matter.

This creates stress when short-term behaviors are then viewed through the lens of long-term relationships. Old saws such as “What goes around comes around” and “Payback is a bitch” (or other notions of “karma”) didn’t spring from nothing: they came from the observation that those who act badly tend to have bad things happen to them precisely because they weren’t mindful of the longer-term implications of their behaviors. And the problem is that short-term thoughtlessness can take an awfully long time to overcome, as trust and credibility needs to be rebuilt and prior wounds need time to heal. It is much more efficient - and much kinder - to simply do the right thing in the first place, and to adopt a longer-term perspective from the start.

None of this is easy, mind you. Giving up your seat to an elderly person on the subway shouldn’t require thought: it should be reflexive. Few karma points for this. But when something is truly difficult, like a founder giving up a significant chunk of equity to bring on a great senior leader or a venture syndicate lead making room for smaller strategic investors, this is where the karma test is in play. Classic knee jerk responses to the above are often akin to the following: “I’m not hiring that person: no way I’m diluting myself like that” or “I refuse to make room for this investor: I want to keep the capacity for myself.” Sometimes it’s best to take a deep breath, step back and think deeply about personal motivations and the long-term implications. “Might this new hire truly transform the business and massively expand the equity value pie, separate and apart from my percentage ownership dilution? Perhaps it does make sense for the company,” or “While I’d really like to own those few more points in the business, the founders like and trust these investors and believe they can truly help the company.” This issue no longer becomes simply what I want for me, now, but what is best for me - and others - over time.

In short, it’s about the company, stupid. An easy concept to understand, but a hard one to put into practice when so many around us are perpetuating the myth that optimizing for the short term does not adversely impact the long term. I can tell you from experience that most (but clearly not all) of the time, short-term thinking is costly in the long run. It’s not altruism, it’s just good business. And good karma, too.

"We are small on purpose. We don’t want to be the market. We want to invest in a tiny slice of..."

Sun, 25 Nov 2012 07:55:56 PST

“We are small on purpose. We don’t want to be the market. We want to invest in a tiny slice of the early stage ecosystem where our thesis collides with great teams and unique and differentiated products.”

- Fred Wilson, What Has Changed, November 25th, 2012

Plan well, execute the plan

Sun, 25 Nov 2012 06:14:25 PST

A new market entrant. A competitor that gets a bunch of great press. A peer that just raised a ton of money. The external environment presents myriad distractions that can cause founders and their teams to “freak out” and deviate from their established game plans. And in my experience, when plans and behaviors are quickly adjusted in response to short-term exogenous events, bad things happen. Well-conceived strategies and plans get tossed on the trash heap, rendering those in reactive-mode rudderless and adrift. While it may feel good in the short term to be “doing something,” just ask a professional trader what happens when the goal is to “participate in a trend” versus putting on a position that is carefully thought out, tested and looked at in the context of the overall portfolio. The answer: a bad trade that is soon regretted.

This seems like basic stuff, but it is very hard to have confidence in a plan if there is lots of exciting activity happening all around you. And it is even harder to remain firm in your resolve if there is a lack of confidence in the plans themselves. So how can founders steel themselves against the noise and focus on executing their own plans with confidence and consistency? I’d suggest a very straight-forward 10-step process:

1. Develop hypotheses

2. Test these hypotheses and collect data

3. Interpret and analyze the data and adjust the hypotheses

4. Retest the hypotheses and collect data

5. Establish the base case plan in the wake of the new data

6. Create KPIs in order to be able to measure success versus plan

7. Execute the plan

8. Collect data throughout the plan horizon

9. Evaluate data relative to KPIs and develop new hypotheses

10. Return to Step 2 and repeat

This isn’t rocket science. This doesn’t imply sticking your head in the sand while the market might be undergoing dramatic changes. It means creating a process and using objective data to assess strengths, weaknesses and challenges instead of reacting to non-data driven external factors that appear to portend big changes but might mean nothing. It is impossible to judge the quality of your planning and execution without good process, and process, unlike external factors, is the one thing you can actually control. And while the output of the 10 steps will look different for each company, I believe the approach is fairly generalizable and something from which every founder can take comfort.

I get very frustrated when I see good people and companies knocked off kilter by glamorous, shiny stuff happening in their external environment without the discipline of thought, data and feedback. Don’t let this happen to you.

The great unbundling

Sat, 24 Nov 2012 06:33:56 PST

Earlier this week it was announced that the Big 10 conference (which currently has 12 teams) is undergoing yet another “realignment” - Maryland and Rutgers are being added for NCAA football, substantially expanding its geographic footprint and, at least in this man’s opinion, further diluting its history and tradition. This was a brazen move by Big 10 leadership for which its motives are crystal clear: money. Greater geographic coverage in advance of a new broadcast rights deal. This isn’t Notre Dame joining the conference (which would have made much more sense in light of rivalries, geography and tradition), it’s two middling programs in completely different markets. But you can bet conference leadership looked at demographic data, ran the attendance numbers, projected incremental merchandise sales and thought about the new rivalries that could be created to justify the move. Tradition be damned. It’s about money, plain and simple. No apologizing necessary.

After calming down, it dawned on me that this move, and all the other moves involving conference realignment, are merely a fixture of the “great unbundling” that is taking place across our society. Where power was projected from the top down, more and more is being driven from the bottom up. If one takes this to its logical conclusion, I can foresee a time when each big-time college program acts like Notre Dame, e.g., cutting its own TV deal and establishing its own rivalries. This has worked for ND because of its national brand and rich history, but few schools have this luxury today. But in tomorrow’s world, where audiences can be micro-targeted and schools promoted cheaply and broadly, why couldn’t rights deals be cut a la carte and not on a conference basis? Because if conferences really aren’t conferences anymore in the historical sense, e.g., schools linked by geography, culture and history, can’t we optimize the financial outcome by having schools as independent contractors and removing the friction of the conference leadership and the NCAA? Establish schedules based upon the shifting sentiment and “hotness” of specific teams and rivalries? Schools getting to keep more of their own TV money and merchandise sales? Would this be riskier for the schools who aren’t big brands on their own and national powerhouses in their own right? Absolutely. But they could opt to band together along different lines and brand themselves separately. The permutations are endless.

Department stores. Computer software. And even education. Products and services are being broken into their atomic units and optimized for price, selection, features and, most importantly, customer satisfaction. This is an inexorable trend that cannot and should not be stopped. But make no mistake, there is a cost: history and tradition. Seeing that favorite department store go out of business is upsetting but ultimately a wound that heals with time. But seeing your school playing against teams for which you have no historical reference and no fundamental reason for even caring, it is a bitter pill to swallow. As with everything, I’ll adjust and life goes on. But when the great unbundling begins to chip away at centuries-old traditions, you know that nothing is sacred.

Should raising money be a blood sport?

Tue, 04 Sep 2012 19:10:59 PDT

Andrew Ross Sorkin’s missive on mistakes made in the Facebook IPO has given rise to some strong emotions. While Andrew sought to lay much of blame at the feet of Facebook’s CFO, some others (here and here) view the CFO’s responsibility as simply being to get the highest price for the shares offered, full stop, and in that light David Ebersman did an absolutely flawless job. I personally find it easy to put myself in either mind-set. I had deep concerns about the aftermarket performance of Facebook stock, and shared my thoughts in May. I felt that those who played the Facebook IPO game, especially retail investors who were unlikely to get fills both long and short and times and prices that gave them a chance to make money were likely to get smoked. But this fact or today’s perspectives on the Facebook IPO miss the central question:

What is the nature of relationship you want to have with investors?

I’d posit that if the intention is to have a long-term relationship with your investors, then that should have a meaningful impact on how your price your offering and to whom you offer your shares. And this is the same for public and private companies alike.

The Facebook offering was priced as a win/lose - those doing the selling won and those doing the buying lost. Those who bought and who hoped to cash in on the euphoria get little sympathy, and they shouldn’t. But by continually raising the offering price it is easy to imagine that the stable, supportive, long-term investors who believe in the Company’s long-term prospects got forced out because of valuation concerns. At $38, those with more sober financial models would see it taking years to grow into that price. No surprise there. So what’s left is “hot money” investors who care little about the long-term and only about the flip. Now one can argue that why should Facebook care about this? The Company and its insiders reaped a cool $10 billion at a premium price - isn’t that all that really matters? It is, if you expect that Facebook won’t be tapping the public markets again for the foreseeable future and that potential hires don’t look at its price action and sharply undervalue restricted stock and option grants. And the argument that existing option grants can simply be repriced? They can, but this also comes at a cost: savvy long-term investors hate this, especially if they believe the restructuring is too heavily skewed in Management’s favor. It can be highly dilutive and is a terrible way to start life as a public company. Google’s repricing happened five years after they first went public. They had lots of public operating history and a lot of credibility with the investment community. People had already made lots of money investing in the public Google. No such thing can be said about Facebook, and won’t be said for a long time. So that line of argument is a bit of a red herring.

The dynamic in “hot” private companies can be very similar. Sometimes founders can focus exclusively on valuation, riding a wave that brings in a boatload of cash at a price that sets the bar extremely high. The investors in question were willing to pay the highest price, but may or may not be the best and most value-added long-term partners for the company. In these cases managements’ have effectively bet the company: if operating performance doesn’t hit the metrics which justify the lofty valuation, if product releases take longer than expected, if new competitors enter which make the environment more competitive, it becomes painfully hard to move forward. Sell the company? The post-money valuation has sharply reduced exit opportunities, as the last-in investors will balk at poor cash-on-cash returns. Raise more money to buy additional time? You will invariably not like the terms. So unless progress is up-and-to-the-right and of sufficient magnitude to justify the valuation, investor goodwill will not be there to soften the blow.

Finally, there is the argument that these seemingly touchy-feely issues are a bunch of BS and that the Company should be focusing on one thing: product and customer satisfaction. I am here to tell you that this perspective is BS. Once a company, be it public or private, has taken third-party money, its relationship with investors and the stability it has created in its capital structure is an essential element of delivering the best product to customers. This is one of the key reasons for having a finance function. Financial control, budgeting and strategic planning are critical, but long-term access to capital is and strong investor relationships are, without question, a key element of a company’s ongoing success. How Facebook and its bankers dealt with the offering did not detract from the Company’s focus on product: it should have helped its ability to block out the distractions of a disappointing offering and protected its focus on product and customer satisfaction. Much of the blogosphere, in my opinion, has this dynamic backwards.

The issue with Facebook isn’t who to blame: it doesn’t really matter. But if the Company believes it has best positioned itself for a stable and constructive long-term relationship with the investment community, it is sorely mistaken. They may have “won” the battle, but the war is still very much in question.

Mis-labeled bubble: it's the structure, not the valuation

Mon, 11 Jun 2012 21:07:40 PDT

I’ve lived through bubbles. Lots of them. They are powerful, make a few extremely rich and many wondering what happened to their pocketbooks and their pride. What I’ve witnessed in the seed stage venture environment has not had these hallmarks. Sure, some prices for pre-revenue and often pre-product companies in certain geographies, e.g., Silicon Valley, have gotten bid up, it hasn’t felt to me as if the market has become untethered from any sense of reality. What has become divorced from what I consider to be good investment discipline, however, is the structure of many “hot” seed stage financing rounds. And even more than poor investment discipline, I think these structures are placing the start-ups raising the capital in a very precarious, high-volatility position. What seems like sound fund-raising advice might, in fact, backfire to the detriment of the founders and their stake in the company.

The structure to which I’m referring? “Party rounds.” These generally come together in the form of a convertible note that is either uncapped or with cap prices substantially above where a priced round could get done, or if there is a priced round there is no ostensible syndicate lead. Seed rounds of $2-$4 million are not uncommon, and the syndicate is generally made up of a large group of angels with some participation by large institutions writing very small checks relative to their fund size. Frequently there is no Board at this stage, merely an informal confederacy of advisers and mentors working to support the founders.

All seems rosy, right? Raise a lot while the sun is shining and to the extent we can push off valuing the equity, all the better for us as price is going up, up, up. Higher price means less dilution which means more for us and less for investors. Hooray! Unless…

What if things don’t happen according to plan? We’re building fast but we’re burning cash. Revenues? Still a ways off. Engineers cost more, we hit bumps in our development pipeline, and there are material delays in shipping v1.0 of our software. All this spells a worsening cash position with no help in sight. Lack of hitting key operational milestones makes raising from outsiders unlikely or at terms brutally punitive. What about insiders? Isn’t this the time that the deal lead steps up to lead a bridge round assuming management is executing well but simply needs more time? Yes. But wait, we have no deal lead. We don’t have an investor with enough skin in the game to care. But what about that rapidly rising valuation that was going to blow through the caps and beyond? How about a bridge at 50% of the strike of the caps, if it’s even offered at all? By not having a lead, a partner who takes the long view and has the resources to back it up, the founders have placed themselves in a very risky situation. Yet the party round seems to be the recommendation du jour among the West Coast technorati. The reason for this is beyond me.

Sometimes I hear that founders get advice that they shouldn’t engage with institutions too early, that they’ll “lose control” and give up too much of their company. Let me tell you, any institution that is in the seed round for “control” is a jerk and shouldn’t be in the business. But I don’t know too many firms that roll this way. An institution who is a true partner is going to work with the founders to create the best syndicate possible, which often includes several strategic angels along with their own investment. Term sheets are clean and founder friendly, but contain essential elements such as pro rata rights and information rights.

As for the claim that having an institutional lead will introduce potentially fatal “signaling risk” should the lead not re-up in the next round, in actual fact this point is specious and absolute garbage. Every seed stage firm we co-invest with supports their companies through their pro rata in the next round unless there are dire circumstances, the same circumstances that would make it unlikely for the company to be able raise outside capital, anyway. Everyone has their horror stories: I’ve just never witnessed one or been part of one. In most circumstances seed stage investing involves buying a “two ride ticket,” where the founding team is given time through the seed and either an extension round or a Series A to achieve product/market fit and prove out the business. A possible exception to this would include incubation-type R&D dollars to hack on an idea. If the hack doesn’t work, no harm, no foul, but no more dollars, either. And this covenant is communicated clearly and right upfront so there are no misunderstandings when the financing decision comes around.

Bottom line, I hate party rounds and think they do a disservice to startups. Cynics will say I’m talking my book and I’ll say no, I simply won’t make those investments because I think they aren’t healthy. They look fantastic in a market that is only going up. But let’s see what happens when the market softens and go-go West Coast start-ups have to go fishing for Series A rounds with their legacy $15-$25 million strike caps on their no-lead, broadly distributed convertible note offerings. Things won’t look quite so pretty then. And then you can bet the party will be over.

Is FB the next BX?

Thu, 17 May 2012 10:12:33 PDT

The euphoria surrounding the upcoming Facebook IPO is reaching untold levels. Retail brokers have stopped taking orders. The offering price range has been sharply increased. And the amount of stock that sophisticated investors and insiders are offering has jumped dramatically. So what should one think about this in light of the upcoming IPO? I’ll tell you - buyer beware.

The market dynamic reminds me a lot of how investors were lining up to buy the Blackstone IPO back in 2007. The firm was on a roll. Private equity was scorching hot, supported by cheap debt that made almost any highly leveraged deal look good. And there was immense scarcity value as none of Blackstone’s peers had yet gone public (while certain specific vehicles of KKR and Apollo had floated shares, they did not represent shares in the parent company). And the firm was headed by the most visible figure in the industry, Steve Schwarzman, who commanded the respect of both public and private investors alike. Current operating executives such as Schwarzman and Tony James were selling large amounts of stock. Taken together this indicated to me that private equity in general and Blackstone in particular were on an unsustainable roll, and that the people who knew their business best - Messrs. Schwarzman and James - were sellers. Forget about asset allocation and estate planning; these gentlemen took home tens of millions to hundreds of millions of dollars a year in pay. So to say that liquidity was a primary motivator makes no sense: it was simply about buying low and selling high. That’s what these people do for a living.

So how did the story end? It started its public life trading under the ticker symbol BX. The stock popped from $31 to over $35 on offering day and has been worse than dead money ever since. It has oscillated in the $10-$20 range for the better part of four years, and currently trades at around $12. In short, while Schwarzman, James, Tom HIll, Pete Peterson et al sold shares at $31, IPO investors have gotten shellacked. This should come as no surprise given a stock that was priced for perfection and a savvy management team that was smart and motivated to hedge their personal exposure.

So what about Facebook? Like Blackstone, a great company and a leader in its field. Also a beneficiary of scarcity value given that there isn’t a public company quite like it that represents an opportunity for institutional or retail investors. And while its principals might not be the market-driven sharks like those running Blackstone, their investors firmly fall into this category. And while its business is indisputably powerful, the multiples being applied to its revenues and cash flows stress the imagination. Might it grow into its IPO price? Certainly. Are there significant risks to achieving this? Absolutely.

My Financial Times Op-ed concerning the Blackstone IPO was written over five years ago, yet a re-reading leaves me feeling as if I’m seeing the same movie five years later - except the company is called Facebook.

LTCM. Amaranth. JP Morgan?

Thu, 17 May 2012 06:37:27 PDT

Will Jamie Dimon go down in history as the John Meriwether of this generation? Or perhaps the Nick Maounis of our time? Either metaphor can’t make the current CEO of JP Morgan feel very good about his legacy. And if I understand the trade properly, the end of the story is nowhere near being written.

Banks hedge risks. This is what they are supposed to do. And when they don’t, the results have been disastrous (see: the failure of the S&Ls when their long-dated mortgage books were suddenly funded with short term, de-regulated deposits in the sharply rising rate environment of the 1970s). The best way to hedge is always through the cash markets, e.g., I loan out money for a period of time and assume credit risk, interest rate risk, liquidity risk and timing risk, but match fund the loan and mitigate three of the four risks (with only credit risk remaining, the precise thing that banks should get paid to do). The problem is, with the scale of banks and the increasing range and complexity of both business and retail products, match funding is a thing of the past. This risk gap is generally managed using derivatives. There is nothing inherently wrong with this.

However, problems arise when hedging strategies become excessively complex in their attempt to be as close to costless as possible and overly precise. As a long-time risk manager, the goal should be to mitigate risk to an acceptable level but to place a premium on hedge liquidity, transparency and simplicity. While a hedge might effectively hedge “delta” but not “gamma,” the best way to address this is to simply take on less gamma, not try to construct a sickeningly complex and illiquid hedge that models out beautifully but is essentially a custom suit on a person whose weight fluctuates wildly. Sometimes the suit fits, sometimes it looks like crap. And in JP Morgan’s case, they are sporting one of the ugliest suits we’ve seen in quite some time.

It actually reminds me a lot of LTCM. Super smart team. Could likely have put a man on the moon all by themselves. However, the bridge between theory and practice broke down in such a way that the global financial system was clearly at risk. Over a trillion dollars of notional risk supported by less than $5 billion of capital. And the strategies broke down in spectacular fashion because of what? Lack of liquidity and rising correlations. Hmm, lack of liquidity and rising correlations…that sounds a lot like what JP Morgan is facing at this very minute. And there is one other dimension that hastened LTCM’s decline and why the JP Morgan story isn’t close to being done - market knowledge. Once the market knew that LTCM was in trouble, the leaned hard against their positions until they cracked. Now LTCM’s capital base is a tiny fraction of JP Morgan’s, but what if $2 billion turned into $5 billion? Or $10 billion? Every sophisticated market participant is causing JP Morgan maximum pain, and it is simply a question of high-stakes poker. But let me assure you, JP Morgan is not holding many cards right now.

The JP Morgan debacle also reminds me of Amaranth. While Nick Maounis didn’t run the firm-destroying natural gas trade (a trader named Brian Hunter did), he certainly must have known about it and if he didn’t, he should have known about it. There was a total breakdown of communication, risk management and accountability. Regardless of whether the Managing Partner made the trades, what does it say about their culture that a trader was allowed to put a bet-the-shop position on of that magnitude that blew through billions of dollars of LP capital? One could say the same thing about JP Morgan, Jamie Dimon and the CIO’s office. While the transactions in question may have been for hedging purposes, the risk rebalancing exercise rapidly grew to a scale that placed the firm’s capital position at risk. That this was allowed to continue in the face of rising market awareness (which serves to exacerbate the problem) is incomprehensible, at least to this former Wall Streeter.

I understand why Dimon continues to lobby against the strictest elements of the Volcker Rule, because banks should be allowed and, in fact, have to be allowed, to hedge their books. But when bank managements’ lose sight of the hedging mission and risk management and common sense discipline break down, they shouldn’t be allowed to lead. This is what the Volcker Rule should really be getting at.