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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.
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.
A few weeks ago Hunter Walk and Satya Patel of Homebrew, a one year old seed-stage VC firm that my partners and I are investors in, came and spent the day in Boulder. This wasn’t the typical “hey – I want to come see you for a meal when I’m in town” kind of meeting that happens with a lot of VCs. In this case, the firm (Homebrew) came by, committed a full 24 hours to being in Boulder, and went deep with me and my partners.
I’ve known Hunter for a while although our relationship is mostly from a distance – email, blogs, and twitter. He went to GSB with my partner Ryan’s wife Katherine so they’ve known each other for a while and have a handful of entertaining stories from their time together at The Lobby Conference. This was the first time I recall meeting Satya Patel although I’ve also known him from a distance.
Hunter’s blog, 99% Humble, 1% Brag, is outstanding. If it’s not part of your daily reading, it should be.
Hunter, Satya, Ryan, Seth, Jason and I spent two hours in a conference room with a white board. Hunter and Satya tossed a bunch of things they wanted to discuss up on the board and we went through the topics one by one. We shared our view about how we address them, they added some of their thoughts, asked some questions, and we cycled more on the topics. We got through most of them and then went to dinner at Oak for a few more hours of discussion, this time more casual, but just as deep and wide ranging.
The next morning Hunter and Satya hung out at Techstars and did office hours with a few of the seed stage companies in Boulder.
I had a great time and learned a lot. Hunter and Satya both sent thoughtful debriefs around which caused some additional discussion on our end about a couple of topics we felt we could learn more from. And we developed a deeper relationship, outside of a specific deal context, which will help us in anything we do together going forward.
This was so much more enjoyable, satisfying, and useful than a flyby. Hunter / Satya – thanks for making the effort to come see us.
I often get asked how I ended up becoming a venture capitalist. When people ask me how they can become a VC, I point them to my partner Seth Levine’s excellent blog posts How to become a venture capitalist and How to get a job in venture capital (revisited). But it occurred to me today – after getting another email asking me how I’d become a VC, that I wasn’t really answering the question.
Amy likes to remind me that when I was an entrepreneur, I used to regularly give talks at MIT about entrepreneurship. I’d say – very bluntly – “stay away from VCs.” I bootstrapped my first company and, while we did a lot of work for VCs, I liked taking money from them as “revenue” (where they paid Feld Technologies for our services) rather than as investment.
Feld Technologies was acquired in November 1993. Over the next two years, I made 40 angel investments with the money I made from the sale of the company. At one point in the process, I was down to under $100,000 in the bank – with the vast majority of our net worth tied up in these angel investments and a house that we bought in Boulder. Fortunately, Amy was mellow about this – we had enough current income to live the way we wanted, we were young (30), and generally weren’t anxious about how much liquid cash we had.
Along the way, a number of the companies I had invested in as an angel investor raised money from VCs. Some were tough experiences for me, like NetGenesis, which was the first angel investment I made. I was chairman from inception until shortly after the $4m VC round the company raised two years into its life. Shortly after that VC investment, the VCs hired a new “professional” CEO who lasted less than a year before being replaced by a CEO who then did a great job building the company. During this period, the founding CEO left and I decided to resign from the board because I didn’t support the process of replacing this CEO, felt like I no longer had any influence on the company, and wasn’t having any fun.
But I still wasn’t a VC at this point. I was making angel investments with my own money and working my ass off helping get a few companies that I’d co-founded, like Interliant and Email Publishing, off the ground. I was living in Boulder at this point, but traveling continuously to Boston, New York, San Francisco, and Seattle where I was making most of my investments. During this time, I started to get pulled into more conversations with VCs, helping a few do some diligence on new investments, encouraging some to look at my angel investments, and investing small amounts in some VC funds whenever I was invited to invest in their “side funds for entrepreneurs.”
One of the VCs I overlapped with while in Boston was Charley Lax. Charley was a partner at a firm called VIMAC and was looking at some Internet stuff. I was one of the most prolific Internet angel investors in Boston at this point (1994 – 1995) so our paths crossed periodically. We never invested in anything together, but after I moved to Boulder, I got a call from Charley one day in early 1996. It went something like:
“Hey – I just joined this Japanese company called SOFTBANK and we are going to invest $500 million in Internet companies in the next year. Do you want to help out?”
Um – ok – sure. I didn’t really know what help out meant, but on my next trip to San Francisco I had a breakfast meeting with Gary Rieschel and Jerry Yang. SOFTBANK had recently invested in Yahoo! and presumably the breakfast was to vet me. I remember it being pleasant and ending with Gary saying something like “welcome to the team.”
I still didn’t really have any idea what was going on, but I was making angel investments and having fun. Charley proposed being a “SOFTBANK Affiliate” which had a small monthly retainer, a deal fee for anything I brought in, and a carry on the performance of any investments I sourced. Informal enough for me to play around with it for a while.
I was in Boston the following week so Charley emailed me and said “can you go check out this company Yoyodyne and tell me what you think?” So I went to a generic office park near Boston and met with two people who would become close friends to this day. The first was Fred Wilson, who had just started Flatiron Partners (SOFTBANK was an investor in Fred’s fund) and the other was Seth Godin, the CEO of Yoyodyne. I vaguely remember a fun, energetic chat as we met a few people at Yoyodyne, ran through the products, and talked about how amazing the Internet and email was going to be as a marketing tool.
My formal report back to Charley was short – something like “Seth’s cool, the business is neat, I like it.” SOFTBANK and Flatiron closed an investment in Yoyodyne a few weeks late.
Suddenly I was a VC. An accidental one. And it’s been very interesting since that point back in 1996.
When David Cohen and I came up with the idea for the Global Accelerator Network (GAN) in 2010, we counted roughly 100 accelerator programs around the US that were founded following the Techstars model. We labeled Techstars a “mentor driven accelerator” and reached out to others who were using the same approach to create what became GAN. From that initial outreach, 16 high quality accelerator programs joined us to launch the network.
Since then, accelerators have appeared all over the world. Some accelerators are incredibly high quality. Others are not. Some are major contributors to their startup communities. Others are detrimental to it. As with everything new that grows quickly, it’s a chaotic system with lots of innovation, creative destruction, and rapid change and learning that – if done well – is a great example of the power of the Lean Startup approach to entrepreneurship.
Today, the Global Accelerator Network is a worldwide organization of 52 accelerators located in over 60 cities around the world. We’ve maintained a high quality across the membership while expanding the network by being selective. Not every accelerator is/could be/would be a member in GAN, nor is it designed that way. To become a member, each accelerator must meet the following strict criteria:
- Operate a 3-6 month long program.
- Provide some sort of seed capital to their founders.
- Take a small amount of equity (usually ~6%) and overall have terms that are favorable to entrepreneurs.
- Take no less than 5 and no more than 12 companies at a time.
- Surround those companies with 40-80 mentors.
- Have funding for a two-year runway of the program.
- Have physical space available for their program.
- Have a strong management team who are typically proven entrepreneurs
In addition to these eight criteria, all members follow the established ethos (give before you get; put entrepreneurs first) of accelerators in GAN, including a thorough review of an accelerator’s term sheets and numerous conversations to vet accelerator founders’ intentions and operational practices. We also review their leadership and mentor pool to ensure value.
Becoming a member in the GAN is not easy, but neither is operating a quality accelerator program. Feel free to drop me an email if you want to learn more about joining GAN.