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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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When VCs Invest Together, Does Ability or Affinity Matter?

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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.

Why VCs Should Recycle Their Management Fees

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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.

Learn Everything You Need To Know About Venture Capital in 90 Minutes

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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.

I’m A Talking Rubber Duck

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Phin Barnes at First Round Capital just nails it today with his post To get the most out of your investors, turn them into rubber ducks

Go read it – I’ll wait and will be here when you get back.

I love Rubber Duck Debugging. I use this approach when writing, which I call “Writing with Yoda.” I have a little Yoda figurine staring at me at all times and when I stall out I just talk to him for a little while and then get started again. He always looks serene and wise and I almost always get going after talking to him for a little while.

Phin describes five steps to turn your investors into rubber ducks:

  • Frame the problem you are facing: describe the challenge in enough detail that I can understand it without being an expert (because I am probably not an expert)
  • Create context for an answer: Explain why this problem is a priority for you and the business and why you need to solve it now (because I am not involved in the day to day operation of your company)
  • Propose a few solutions: Describe a few paths you might take and talk through how you would choose between them (this helps me understand the outcome you want to achieve)
  • Be patient: Be open and engage deeply in the questions that I have and explain your answers with specific detail (even if it seems obvious)
  • Be active: The goal is to debug the system and the builder is most likely to find the bugs we seek (and to see others along the way)

These are similar to how to engage a great mentor, which we teach over and over again in Techstars – both to the entrepreneurs and the mentors. If you’ve ever done a Top of Mind Drill with me, you’ll recognize the Rubber Duck approach with one twist – storytelling.

I’m a storyteller. I learned this from my dad. It’s part of why I love to write – it’s a way for me to think out loud and figure stuff out while telling stories. So – my favorite Rubber Ducks are the ones who can also tell stories, at the right time.

The risk of a Rubber Duck only approach as a VC is that you become overly socratic. We all know the VC who just asks question after question after question. The questions are often good, and they drive you deeper into the problem, but at some point you need to take a break. You need a breath from answering more questions. You need an analogy to relate to.

This is when the Rubber Duck should tell a story.

At a board meeting recently, the CEO looked at me and said “just tell me the fucking answer.” So I did. And that works also. But not until the CEO wants that. Until then, be a Rubber Duck.

Remember – the CEO makes the decision, not the VC. Unless the CEO explicitly asks. And – if as a VC you don’t trust the CEO to make the decision, you have that discussion with the CEO right now. And if you are a CEO who’s VCs aren’t letting you make the decisions, buy them some Rubber Ducks.

The Reputational Damage of Non-Responsiveness

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VCs love to say things like “we are entrepreneur friendly.” It’s trendy, catchy, and looks good on a blog post. But, as I’ve said in my post Your Words Should Match Your Actions, one can “damage their reputations by having their words not match up with their actions.”

Now – this post isn’t about responding to emails. Nor am I trying to be preachy. I’m not trying to explain a new behavior. Rather, I’m making an observation about something I’ve experienced – both as an entrepreneur and investor – since my first angel investment in 1994.

Here’s the situation, as reported this morning by an experienced CEO of a company we are investors in.

“We’re raising money.  I have a good intro session.  Prospective investor wants to meet in person, see a demo.  We have a good 2nd meeting.  We agree on action items.  I go away and follow up.

Radio silence.

Follow up again.

Radio silence still.  

The first time it happened I was inclined to think it was the investor and that they just couldn’t find the time to send an email response saying, “sorry – no longer interested”.   Then, it happened again this month.”

Now – initial non-responsiveness – whatever. Lots of people don’t respond to emails, intros, or requests for meetings. But after two in-person meetings, to be non-responsive is just plain rude.

How hard would be it be to say “Hey – great spending time with you – but this isn’t something I want to pursue.” Or maybe “Sorry for being slow – I’ve been swamped – I don’t have time for doing this right now.” Or – well – anything.

I’ve had this situation come up so many times that I’m immune to it. I assume that the VC isn’t interested. But I’m amazed at how the reputational damage follows the person around. And then – at some point in the future – that VC is looking for a response for something. Hmmm …

I’ve had this happen with LPs. When we went and raised our first fund in 2007, plenty of people wouldn’t meet with us. That’s fine. Lots said they weren’t interested after a first meeting. Totally cool. But some met with us but then were completely non-responsive after the meeting. Ok – whatever. But when those non-responsive LPs call me today asking for something – whether it’s to get together to “get to know me better”, or to get a reference on someone else they are looking at, or to learn more about what I think about the market for hardware investments, it’s really hard to get on the phone and spend time with them. I do – because that’s my nature – but I always remember their non-responsiveness.

I hear – and say – “No thank you” all the time. Every day. 50 times a day. That’s just part of the role I play in business. But I always try to say “No thank you.” It’s just not that hard. Especially when I know someone, or have engaged with them in some way.

Are you the guy the experienced CEO just encountered? How would you feel if your name – and your firm’s name – just went out via email to 60 CEOs attached to this story? Maybe you don’t care, but if your message is “we are entrepreneur-friendly VCs” you just undermined the reputation of your firm in a major way.

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