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I was in the bathroom this morning catching up on all the blogs (via Feedly) that I hadn’t read this week since my head was in a bunch of other things. I came across one from Nic Brisbourne (Forward Partners) titled I’m a stock picker. I wish he had called it “This Unicorn Thing Is Bullshit For Early Stage Investing” but I think he’s a little more restrained than I am.
My original title for this post was “How Can This Be A Billion Dollar Company and other bullshit VCs ask early stage companies.” It was asked by VCs to several companies I’m involved in last week. While I get why a late stage investor would ask the question when the valuation is in the $250 million range, I really don’t understand why a seed investor would ask this question when the valuation is in the $5m range.
Now, I’ve invested in a few unicorns in my investing career, including at least one unicorn that went bankrupt a few years later (I guess that’s a dead unicorn.) But I’ve also invested in a number of companies that have had exits between $100m and $1b that resulted in much larger returns for me, both on an absolute basis as well as a relative basis, than unicorns have for their later stage investors.
I’ve never, ever felt like the “billion dollar” aspiration, which we are now all calling “unicorn”, made any sense as the financial goal of the company. Nor have I felt it made sense as a VC investing strategy, especially for early stage investors. We never use the phrase “unicorn” in our language at Foundry Group and while we aspire to have extraordinarily valuable companies, we never approach it from the perspective of “could this be a billion dollar company” when we first invest.
Instead, we focus on whether or not we think we can make at least 10 times our money on our investment. Our view of a strong success in an investment in a 10x return. Our view is simple – we don’t really view anything below 3x return a success. Sure – it’s nice, but that wasn’t a real success. 5x – now that’s nice. 10x – ok – now we are in the success zone. 25x – superb. 50x or more – awesomeness.
We also know that when we invest in three people and an MVP, we have absolutely no idea whether this can be a billion dollar company. Nor do we care – we are much more focused on the product and the founders. Do we think they are amazing and deeply obsessed with their product? Do we understand their vision? Do we have affinity for the product? Do we believe that a real business can be created and we can get at least a 10x return on our investment at this entry point?
I recognize other VCs have different strategies than us, especially when they are investing at a later stage. Applying our model, if the entry point valuation is $100m or more, then you do have to believe that the company is going to be able to be worth over $1 billion if you use a 10x filter. But in my experience, most later stage investors are focused on a smaller absolute return as a threshold – usually in the 3x to 5x range. And, very late stage / pre-IPO investors already investing in companies worth over $1 billion are interested in an even smaller absolute return, often being delighted with 2x in a relatively short period of time.
So, let’s zone this in on an early stage discussion. Should the question “how can this be a $1 billion company” be a useful to question at the seed stage? I don’t think so. If it’s simply being used to elicit a response and understand what the entrepreneurs’ aspiration is, that’s fine. But if I asked this question and an entrepreneur responded with “I have no fucking idea – but I’m going to do everything I know how to do to figure it out” I’d be delighted with that response.
Almost exactly a year ago I wrote a post Your Words Should Match Your Actions. It was a generic rant that resulted from me watching a couple of VCs blow up their reputations with entrepreneurs I know because of how they treated them.
This morning I ended up on an email thread about this. I’m going to anonymize it, but you’ll get the point. The two people (who I’ll call “Entrepreneur” and “VC”) are both very successful, extremely smart, and very visible.
Entrepreneur: Thread below is 2+ years old, but resulted from VC asking me similar questions. Interestingly, when I (a year later) pinged VC about my new company, not even the courtesy of reply from him. Bad mojo.
Me: Welcome to the “assholeness-VC-factor.” Hey – I’m important – give me info. Oh – you are now raising money – fuck off.
Entrepreneur: I’m amazingly appreciative to short, polite “no thank you’s”. I don’t know whether VCs think that’s too much work, or whether they want to leave open the possibility of the “must have been caught in my spam filter” excuse when the startup becomes a rocket in 2 years?
I then went on a more serious rant explaining what I think is going on.
It’s worse that that.
In my book Startup Life (that I wrote with my wife Amy) I said that one of the key things that has made our relationship work is that I realized “my words had to match my actions.” After about decade of telling her she was the most important person in my life, and then being late to dinner, canceling things at the last minute because something else came up, or taking a phone call without even looking at who was calling when we were in the middle of a conversation, she’d had enough and our relationship almost ended.
My biggest behavior change 14 years ago was to focus hard on having my words match my actions, and my actions match my words. Simple to say, really hard to do.
Of course, it also works in a business context. I’ve learned, and deeply believe, that it’s the essence of being authentic. You can have any style you want – these two things just have to match up.
Sadly, many very successful people simply don’t understand or appreciate this. They put huge amounts of energy into developing a public persona. It could be PR, it could be speeches, or writing, or systematic campaigns over a period of time about themselves and their businesses.
But then their words and their actions don’t match up. Over and over again. It can be subtle or overt. It can be mild or jarring. It doesn’t matter – if they haven’t internalized the idea of their words and actions matching up, there is a long negative reputational effect.
And, as our email exchange demonstrates, it lingers. I have heard the same thing about that VC and I’ve experienced it personally. Yet his public persona is “entrepreneur friendly”, “very accessible”, “incredibly smart”, and “highly capable.” Yet, he completely blew you off, after asking you for something when you were a powerful and well-connected executive at a large company. Stupid behavior on his part.
Oh, and in addition, this VC missed a chance to invest in what is now a rocket ship. And the entrepreneur didn’t go back to him for the Series B because he got blown off the first time, so the VC missed two chances to invest.
Do your words match your actions? If you don’t know, ask yourself at the end of each day “did my words today match my actions.”
I woke up to a bunch of VC related things in my twitter stream this morning. I had a nice digital sabbath yesterday so I was a little surprised by how much there was. I tried cranking out a #tweetstorm of them using Little Pork Chop but I found the tweetstream experience to be very unsatisfying and very inauthentic feeling. The links are good, so here they are if you want to get in the headspace for what I really want to talk about.
1/11 Things I Read About VC This Morning I Think You Should Care About In A Compact Little Tweetstorm
2/11 Start with @fredwilson thinking about tweetstorms – http://avc.com/2014/06/tweetstorming/
3/11 Then @msuster on why VC is so much more compelling now – http://bit.ly/1mvIE5C
4/11 and @pmarca on why the IPO is not what it used to be – http://bit.ly/1ljhzlV
5/11 and congrats to @jeff on raising his new fund – http://bit.ly/1m0h6cD
6/11 thx @joshelman to the pointer to the @yoapp hackathon – http://bit.ly/1x0MhbQ
7/11 the #premoney conference recordings will be online soon – http://www.livestream.com/500startups/folder
8/11 the 2nd seed round trend @Mattermark by @DanielleMorrill – http://bit.ly/1iQTCI2
9/11 I end with Haiku
10/11 Tweetstorms perplex me a lot
11/11 Do you enjoy them
The response to 11/11 was generally “no” although a few people suggested that tweetstorming while a soccer game was going wasn’t a particularly useful test.
After I thought I was done I ran across a really interesting set of articles which didn’t make it into the tweetstorm. The first article, In Venture Capital, Birds of a Feather Lose Money Together, was a summary that let to the second article, The Cost of Friendship, which led to the actual article behind the annoying SSRN paywall. After reading the abstract, I decided to buy and read the article, especially since Paul Gompers, one of the great academic researchers on the VC industry, was the lead author.
I was once a Ph.D. student at MIT Sloan School studying innovation. Specifically, my doctoral advisor was Eric von Hippel. Eric was very kind to me, but I was a horrible Ph.D. student because I was also running a company at the time and had no interest in being an academic. Eventually I got kicked out well before I got my Ph.D.
Nonetheless, I learned how to more or less read an academic paper and some social science rubbed off on me. Actually, a lot rubbed off on me – enough for me to know that the headlines written about academic papers and studies rarely capture the essence of what is going on in the paper. Instead, reading the abstract and the carefully reading the non-analysis part of the paper, with a goal of putting yourself in the researchers’ shoes to understand what they are trying to figure out, will help you understand the punch line.
So when I read the first article, it was easy to conclude “VCs who are like each other do less well investing together.” Or, “VCs who like each other perform more poorly when investing together than those who don’t like each other.” This is consistent with the callout from the first article which says “The more affinity there is between two VCs investing in a firm, the less likely the firm will succeed, according to research by Paul Gompers, Yuhai Xuan and Vladimir Mukharlyamov.”
I read the summary, which is kind of the “PR piece” for the article, but I didn’t find it satisfying. It generalized too quickly and I kept wondering how affinity was defined. The hint was that it had to do with ethnicity, educational background, and employment history, which wasn’t how I was defining affinity when reacting to the title “In Venture Capital, Birds of a Feather Lose Money Together.”
Next, I read the executive summary of the paper. This was clear and felt fine to me. It separated affinity and ability. The punch line of the paper is:
“Collaborating for ability-based characteristics enhances investment performance. But collaborating due to shared affinities dramatically reduces the probability of investment success.”
Much different than the marketing piece about the paper that I read first. Basically, if you choose your co-investor because you think she is a great investor, that’s good, but if you choose your co-investor because you like him, that’s bad. But that felt too simple to me – no way that’s the basis for a HBS academic study. So I bought and read the paper, which was pretty easy until I got stuck in analysis stew on p.22. I hung in there and got through it, but once again was reminded of another reason I was a shitty Ph.D. student – I dislike reading academic papers.
I learned that affinity was narrowly and precisely defined, but not in the way I thought it was. Affinity to me meant that the two VCs liked each other, or had an “affinity” for one another, but instead affinity was based on biographic data, specifically gender, ethnicity, educational background, and employment history.
“The education dummy variables Top College, Top Business School, Top Graduate School, and Top School equal one if a venture capitalist holds, respectively, an undergraduate, business, graduate, or any degree from a top university and zero otherwise. Ethnic Minority takes the value of one if a venture capitalist is East Asian, Indian, Jewish or Middle Eastern. Dummy variables East Asian, Indian, Jewish and Middle Eastern pin down a venture capitalist’s ethnicity; the dummy variable Female identifies an individual’s gender.”
Also, success was defined as a company having an IPO (the data range for the study was 1975 – 2003). Now, I’m not going to argue the performance variable, but as someone who has had a lot of financial success with exits that were not IPOs, I’d be curious what happens when the analysis is done where success is defined by “at least 10x return on capital for the VC.”
The big reveal is buried in the middle of p.18.
“On one hand, people display greater inclination to work with similar others. Similarities may be in terms of ability (e.g., whether individuals hold degrees from top academic institutions) or affinity (e.g., whether individuals share the same ethnic background). On the other hand, these two sets of pairwise characteristics affect performance in opposite ways. Teams with more able participants are more likely to result in a successful investment outcome. On the contrary, investments are more likely to fail when groups are formed based upon similarities between members along characteristics having nothing to do with ability.”
Go read that again. If you pair up two people based on ability, they have better results than if you pair them up on affinity, where affinity is defined by “each went to the same school, each are the same ethnic minority (including Jewish), or each worked together in a previous company.”
Unless I missed something (and it’s entirely possible that I did), the message is “choose to work with people who have ability.”
I kind of feel like this applies to life in general!
It’ll be interesting to see how this paper gets interpreted, or misinterpreted over the next few weeks, assuming anyone else goes beyond the summary and reads the paper, no thanks to SSRN.
Just another reminder to look beyond the headlines. And don’t co-invest with someone who has no ability just because you went to the same school, are the same ethnicity, or once worked together.
I’m an investor in a bunch of VC funds. Some of them recycle their management fees; others don’t. I’ve never really understood why funds don’t recycle their management fees.
Understanding what “recycling management fees” means is a fundamental part of understanding the economics of a venture firm. Here’s how it works.
Let’s assume a $100 million VC fund that charges a 2% management fee and a 20% carry. In the typical case, a fund will get an annual management fee of 2% of “committed capital” (the $100 million) for the “investment period” (usually the first five years, or until a new fund is raised) and then an annual management fee of 2% of “invested capital” (whatever the fund has invested in companies that are still active) over the remaining life of the fund, which is usually 10 years.
Now, there are lots of minor variations on this, but the average “fee load” on a fund over its life is 15%, or $15m paid out over 10 years on the $100m fund.
So – if $15m gets paid out in fees, that only leaves $85m to invest in companies.
That’s where recycling comes in. When a fund has an exit, it can either distribute the money to its investors (the LPs) or it can “recycle it” and invest it in new and existing companies in the fund.
Now, assume that by year three the $100m fund has invested $50m. During this year, it sells a company and gets a realization of $20m. At this point, it would have taken $6m of management fees (2% * 3 years) so it could recycle the $6m (hence, reinvesting it) while distributing $14m to the LPs.
By managing recycling this way, the fund could end up investing the full $100m, instead of just the $85m. The advantage, for all the investors (the VCs and their LPs), is that $100m gets put to work as invested capital, rather than just $85m.
Our view as a firm is that a successful VC fund has a net return of at least 3x to the LPs. That means that if an LP invests $1 in the fund, they get back $3 over time.
Now we get to do the fun math, including the impact of carry on return.
If I’ve only put $85m to work, I have to generate $100m to get to a point where I’ve returned capital, which puts me in a position to get carry. Then for every $100m of additional returns, $20m goes to the VCs and $80m goes to the LPs. To generate an incremental $200m to the LPs, I have to return a total of $250m. So – my $85m needs to generate $350m to get a net 3x return. On a gross basis, my $85m has to generate a 4.1x return to accomplish my “net 3x return to LPs.”
On the other hand, if I recycle my management fee, then I put $100m to work. I’ve reinvested $15m over the life of the fund, so I’ve had to generate this $15m plus the $100m to get to carry and the $250m to get to a net 3x return. In this case, I have to generate a total of $365m (instead of $350m), but I now have $100m at work to do that. In this case, my $100m has to generate a 3.65x return to accomplish my “net 3x return to LPs.”
That’s an 11% difference just by recycling my $15m fee. It’s better for the LPs and better for the VCs.
My partner Jason and our dear friend Professor Brad Bernthal are attempting to teach everything there is to know about the venture ecosystem in 90 minutes on January 28th. The link to the event is here.
Now realistically, you won’t learn everything, but they have been teaching a class on the subject for the past five years and it is not only excellent, but was one of the reason Jason and I wrote our book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.
This should be a great event.