Redeye VC

VC - Back to the Future?

2009-10-28T18:35:41-04:00

I just came across a great report by Industry Little Hawk entitled the Venture Capital Rebound (pdf). In the report, the authors reach a similar conclusion to Paul Kedrosky (read Paul's great research for the Kauffman Foundation here) -- that too much capital has gone into venture capital. Paul has argued that we need to shrink the amount of venture funding by 50% -- a statistic that almost every VC agrees with. (Ironically, 100% of VCs would argue that their fund should be in the half that survives).

What is refreshing about the Industry Little Hawk white paper, however, is that they don't just advocate reducing the capital allocated to venture. Instead, they advocate allocating capital to smaller funds. And they articulate a number of reasons for their position (smaller funds are better positioned for the current exit landscape, better alignment with entrepreneurs (per my last post) and with limited partners, etc).

The "money stat" from the paper is that in the 1980's there were just 12 venture funds above $250M. Today there are over 408 - and 30 over $1B. And most of this fund-size growth took place in the last 10 years. The chart is below:

What is interesting to me is that the proposed solution isn't a radical change. It isn't a novel idea for re-structuring the industry. Rather, it's a realization that venture should go back to it's roots. So I spent some time researching the origins of many leading venture firms. And I was surprised to see that they all started with small funds. While venture is far from perfect, and can always improve, maybe we should spend less of our time working on "new solutions" to the "venture is broken problem" and spend more time working on old ones.

The data speaks for itself. My favorite factoid: the initial funds of Accel, Kleiner Perkins, CRV, Mayfield, Venrock, Greylock, NEA, TA & Sequoia COMBINED were under $125M! And even on an inflation-adjusted basis the average fund size is $55M.

Note: I pulled data from the web and from Udayan Gupta's book Done Deals -- if you think I have incorrect data, or you have missing data, just leave it in the comments and I'll update the post.

UPDATE: Thanks to Kent Goldman for running the numbers through an inflation adjustment tool.

Company Math vs VC Math

2009-10-15T11:40:48-04:00

Fred Wilson has a great blog post today entitled The 'We Need to Own' Baloney. In it he discussed the fact that many VC's apply arbitrary ownership thresholds to investments. I couldn't agree with Fred more - but I'd take it even further. This is not just limited to ownership requirements. Rather, VC's often impose "VC math" on companies in three areas:

The amount VC's "need" to own
The amount VC's "need" to invest
The return VC's "need" to generate certain exit returns

These "requirements" are a direct result of the mathematical model that venture funds are optimized for. And as fund's have gotten larger, their math has gotten more difficult. We're now witnessing the conclusion of a "10 year experiment" where money invested in venture funds has exploded and fund sizes have more than tripled in size. A decade ago, 75% of all venture funds raised were under $100 million. In 2007, fewer than 25% of all venture funds raised were under $100M. And I don't think it's a co-incidence that VC performance has fallen off a cliff during this time period. Indeed, we're approaching a point where the 10-year return in venture capital is negative. Paul Kedrosky recently authored a paper for the Kauffman Foundation which discusses this in great detail and proposes that the venture industry needs to be "rightsized" -- and suggests a 50% reduction. It's a great paper -- but if you don't have time to read it, the money chart is below:

Fred Wilson has previously written about the VC math problem -- but he approached it from the macro/industry perspective. I agree, and think it's even more scary when you look at it from a micro/fund perspective. Take a $400M venture fund. In order to get a 20% return in 6 years, they need to triple the fund -- or return $1.2B. Add in fees/carry and you now have to return $1.5B. Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value. So assume that one VC invested in Skype, Myspace and Youtube in the same fund - they would be just halfway to their goal. Seriously? A decade ago, any one of those deals would have been (and should have been) a fundmaker!

As a result of this new math, VC's end up super-focused on the longbets (or moonshots) and frequently remove optionality for mid-tier exits. It has, as Super LP Chris Douvos has written, become a game of finding the next Curtis Sharp. It is because of the challenges of "VC math" that First Round Capital chose to raise a relatively small fund -- allowing us to continue to make initial investments that average $600K.

I understand the importance of aligning one's time and capital to the upside opportunity, and recognize that there is some minimum threshold of ownership that is required for a VC to commit the time and attention to an opportunity. Does it make sense for an investor to spend the time and join the board of a company they own 2% of ? Probably not. However, the difference between 25% and 20% ownership -- or even the difference between 20% and 10% -- should not prevent a VC from investing in a promising opportunity.

It is the same "VC math" which drives a VC to seek to deploy a larger amount of capital into a company. (Often taking a capital efficient company and helping it become capital inefficient). And it is the same math which sometimes creates a lack of alignment between a founder and a VC around exit opportunities. I have previously written these issues when I discussed the "unwritten terms on a term sheet".

A company's outcome should drive VC returns. When VC's required returns drive company's outcomes, it's a recipe for trouble.

First Round Capital to open NYC office

2009-10-01T09:00:00-04:00

I believe that as the world has gotten “flatter” over the last decade, it’s created a big opportunity for venture investors who recognized that great entrepreneurs can come up with great ideas in almost any location. Indeed, over the last several years, First Round Capital has invested nationally and has funded companies in over a dozen states.

However, I do believe that certain ecosystems provide real leverage when it comes to the hard work of turning those ideas into reality. Take acting for example. Despite the fact that Philadelphia has some great theaters (like the Kimmel Center, the Walnut Street Theatre, the Arden Theatre, the Prince Theater, the Forrest Theatre, etc), I’m pretty sure that almost every young Philly-based actor recognizes the unique opportunities to really hone their craft on Broadway or in Hollywood -- and those who have big career aspirations typically move to NYC or LA.

The right ecosystem can take good raw materials and set it lose on a new trajectory. That’s why Stumbleupon moved from Calgary to San Francisco, why Jimmy Wales moved from Florida to San Francisco to start Wikia, and why Jingle Networks moved from Michigan to Boston. And that’s why, four years ago, First Round Capital set up our west coast office (led by Rob Hayes) to firmly plant ourselves in the silicon valley ecosystem. Today more than half of our portfolio is based in California.

Over the last several years, we’ve found that the New York City ecosystem has been particularly strong for Internet and media-based startups. In fact, we’ve met hundreds of really talented New York-based entrepreneurs and funded over 10 NYC-based startups in the last few years – including Appnexus, Knewton, On Deck Capital, Pinch Media, DoubleVerify and others. And while First Round Capital already spends a lot of time in New York, I’m super excited to announce our plans to increase our presence in the big apple by opening a First Round Capital office in New York City (led by my partner Howard Morgan) -- and the addition of Charlie O’Donnell to our team as an Entrepreneur-in-Residence (EIR).

The obvious strength of the NYC community was on display in the incredible conversations I had at our Office Hours event at Live Bait and in those between entrepreneurs at Meet-Ups around the city, at ShakeShack, at the quality of entrepreneurs involved in First Growth, and in the NextNY community to name a few. As we looked for ways to support this community, to listen to and learn from entrepreneurs and to help them build great companies in the city, I could not think of a better way to begin than by working with Charlie as our first Entrepreneur in Residence. Charlie’s belief that great companies are lead by great CEOs but also are born from great communities matches my experience as both an entrepreneur and an investor. His work as an organizer, supporter, and participant in the NY tech scene over the past several years has been amazing and I could not be happier to have him join the First Round team.

As seed stage investors we have the privilege of working with entrepreneurs as they establish the DNA of their business and we hope you will work with us as we put down deeper roots in the city.

A deal that was "mint to be..."

2009-09-14T11:42:04-04:00

I’m super excited by today’s news that Intuit has acquired Mint.com for $170 million.

It’s been amazing to watch Aaron Patzer and the entire Mint team transform a rough prototype to a world-class product over the last three years. As my partner, Rob Hayes (who led our investment in Mint and served on their board of director’s) wrote this morning:

"It has been a short 3 years since we met Aaron Patzer at a STIRR dinner in the Valley. Seven days after we met, he had a term sheet for his seed round and off he went. During that time we have had a ringside seat while the company grew from a rough prototype on Aaron’s computer to an amazing personal finance tool with well over 1 million users and critical acclaim... " (Continued here)

I look forward to watching the Mint team continue to thrive at Intuit -- this deal was mint to be. And while I know Aaron always preaches fiscal discipline, he's now a member of the First Round Capital "blank check club" -- and should he ever start another company, he can come to us to claim it ;-)

Congratulations to Aaron and the entire Mint.com team!

P.S. – And if you think you’re the next Mint, we look forward to seeing you at a future STIRR dinner – we’ll be sponsoring a bunch of them…

Help me rename "Lifestyle Business"

2009-07-08T21:12:06-04:00

While venture capitalists pass on companies for many reasons, one of the most common reasons is that they don't think the opportunity is "big enough".

What does this mean? It means that even if the company executes as planned, the VC doesn't think the exit will be large enough to generate the VC-sized returns. This determination is based on the venture capitalist's "fund math" and their expected returns model. It means that VC doesn't think he will make a big enough return by investing here.

What doesn't this mean? This doesn't mean that the business is not going to succeed. It doesn't mean that the entrepreneur will fail. It just means that the VC doesn't think that the return profile of an investment in the business is a fit for a venture capital investment.

Like all VC's, I pass on many companies that I think will be successful and teams that I really like. I do so because I think that the economic returns won't move my needle. (And as one smallest venture funds around, my needle is smaller than most other funds. And yes, I say this because I am self confident enough to handle the "small needle" jokes).

However when I do pass for this reason, I try to make sure that I communicate the reason for my decision. Specifically, I state that while I think the entrepreneur will make money here -- I just don't think I will generate the risk-adjusted returns I need.

I think the industry places too much of a premium on raising venture capital -- and it has become the default operating assumption for every entrepreneur. Entrepreneurs can create great businesses -- and have great outcomes -- without raising meaningful outside capital. Just ask James Hong at HotOrNot, Eric Marcoullier at MyBlogLog, and David Clouse of VRBO.

Part of the problem, I think, is that the technology startup ecosystem seems to be structured so that the goal of every entrepreneur is to raise venture financing. There is a pretty strong gravitational force that pulls entrepreneurs towards raising VC dollars -- and it's often hard for an entrepreneur to overcome the inertia.

However, I also think that a big part of the problem is that there is no good word/phrase to describe these type of companies. The only phrase I've heard used is "lifestyle business" -- but I think that is inaccurate and pretty demeaning. It falsely implies that these entrepreneurs aren't working as hard as those of VC-backed companies. It falsely implies that these entrepreneurs are choosing a better lifestyle than they would have if they were operating a VC-backed company. And, as 37signals has written, it condescendingly implies that "A lifestyle business is for the hacks and amateurs while a real business is for the big guns and grown-ups."

I think we need a new word. Something that isn't demeaning. Something that doesn't imply laziness or lack of effort.

And maybe the best way to generate that word is by crowdsourcing it. Fred Wilson posted a similar challenge in 2006 and it sparked the word "freemium". And Brad Feld just posted a naming challenge yesterday.

So here's my challenge -- help me find a new name for "lifestyle business". Post your suggestions in the comments. I've also created a public challenge for this on ChallengePost. Thanks!

San Francisco Office Hours

2009-05-28T18:42:04-04:00

I had a blast at our Philadelphia Office Hours. My partners and I met with over 50 entrepreneurs at our biggest Office Hours yet. My favorite was being pitched by an entrepreneur who arrived directly from Penn's graduation, still in his cap and gown.

Well, we are hitting the road with Office Hours again. This time in San Francisco. Please join us for Office Hours in San Francisco on June 11th from Noon - 2PM PST. This event will mark two firsts for us.

For the first time, the entire First Round Capital team will participate.
And it will also be the first time that we hold Office Hours in, well, our office.

As with all of our Office Hours events, this is your opportunity to meet with the First Round Capital team and start a conversation about your start-up, your ideas, or yourself. While the meetings are brief, we've found they are a good way to start a dialog and build a relationship. We hope to see you at our office...

If you can make it or would like more information, please sign up at http://officehours.firstround.com/

Calling all Philadelphia Entrepreneurs

2009-05-08T00:00:22-04:00

Over the last several months, First Round Capital has held our "Office Hours" events in San Francisco, New York City, Austin and Vancouver. Well, now it's time to bring it home! I'm super excited to announce our first Office Hours event here in Philadelphia. Please join us on Monday, May 18th from 3-5pm at World Cafe Live.

One of the greatest opportunities in college was Office Hours. Every professor held them and suddenly became accessible. It was a few minutes where you could walk-in, sit down, ask questions, develop a relationship and catch a professor in an informal environment. We think the same opportunity for dialogue should exist for entrepreneurs and venture capitalists. At Office Hours, we'd love to meet with entrepreneurs, people thinking about becoming entrepreneurs or folks who would like to join a start-up. No agenda needed. No presentations or preparation required. Just an opportunity to discuss entrepreneurship and startups.

We've met with 50-60 entrepreneurs at every other city -- let's make Philadelphia our biggest event yet!

If you can make it, please sign up at http://officehours.firstround.com/

True Entrepreneurs

2009-05-06T12:44:24-04:00

Last week the Wall Street Journal ran a story highlighting several entrepreneurs who are forgoing salary in order to keep their business alive. I’ve often believed that the true measure of an entrepreneur’s character comes not during the boom times, but how they react in times of adversity and challenge. Personally, I think I grew more as an entrepreneur during the years when Infonautics struggled (and the stock price languished) than I did during the Half.com rocketship. You learn a lot about yourself and the people around you when you’re in the foxhole and things aren’t looking good.

That’s why I’m so proud to have worked with Doug Camplejohn, Ofer Doitel, Roger Matus and Sean True. These entrepreneurs founded two First Round Capital companies - Mi5 Networks and Inboxer. These entrepreneurs experienced -- and overcame -- real adversity during their startup journey. These entrepreneurs went without salary at times, even investing personal capital to help their company meet payroll. These entrepreneurs all passionately believed in what they were building.

And last month their belief paid off, as these entrepreneurs succesfully led their companies to acquisitions. Doug and Ofer led Mi5 Networks to a sale to Symantec – a wonderful outcome for their team, their investors and their customers. And Roger and Sean led Inboxer to a sale to Safecore – allowing Inboxer’s employees, investors and customers to benefit from a much stronger platform.

I’m honored to have worked with all four of these men . They are true entrepreneurs. And I can only hope to have the opportunity to get back into the foxhole with them in their future ventures.

Board Transparency -- and the Implicit Web

2009-04-14T11:18:00-04:00

I just read Fred Wilson's post about communicating bad news to investors. I completely agree that it is important for CEO's to avoid surprising their board and to communicate bad news just as fast as you share the good news. However, one of the big changes I've seen in the last several years has been the incrased use of SaaS tools to manage reporting -- and how that subtlely changes the dynamic of board meetings.

For example, through Google Analytics, I have access to real-time dashboards of almost all my portfolio companies. So, when I walk into a Modcloth board meeting, I already have seen their traffic and revenue for the month. Several of my portfolio companies that focus on direct sales have created accounts on Salesforce.com for board members with a customized Board dashboard to provide a 30,000 foot view of the pipeline.

The power of the Implict Web is that data that previously had been in hard-to-access silos is now easily accessible and shareable. This can change the way information is used and shared within organizations. I've written about this before, and said:

By providing [a board with] open access to information sources there are a number of benefits:

It eliminates surprises. By providing a continual stream of information, the board should never be surprised.
It makes board meetings much more productive. Rather than spend a lot of time presenting the raw data, the CEO can now provide interpretation and analysis of data -- they can put the numbers in context.
It allows board members to make more meaningful suggestions. Different board members have different skills. Some are strong at enterprise sales -- and by tracking a sales pipeline over time they might be able to identify areas for improvement in the sales cycle. I personally am stronger at online consumer marketing -- and feel that by having access to website traffic reporting I can ask better questions and make better recommendations.

Sharing data with a board does not mean that you are sharing control. Rather, I believe that an informed and knowledgeable board will be less intrusive (and more hands-off) than a board that is in the dark. (That said, a CEO should clearly set expectations that they are not looking to get the "why are Tuesday's sales 2% lower than Monday's sales" phone call. )

Too many CEO's try to hide their bad news and setbacks -- they stick it in the fifth paragraph of a six paragraph email. I get extremely uncomfortable with that approach. It forces the investor into the role of detective -- constantly on the look out for hidden clues.

Shrink a Market 2.0

2009-03-30T18:29:14-04:00

Image via Wikipedia

It was almost three years ago that I first blogged about the benefits of "shrinking a market". Ironically, the example I used in that blog post was how Encarta shrunk the encyclopedia market (and basically killed Britannica and World Book). Well, we've now seen the encyclopedia market shrink again. Today Microsoft announced that they will be closing Encarta -- an apparent victim of Wikipedia.

The power of the Internet to remove friction, eliminate inefficiency, and drive innovation never ceases to amaze me!