Adventure Capitalist
Confessions of a globe-hopping, adrenaline-seeking venture capitalistArchive for Trends
The ‘grim reapers’ Get Some Comeuppance
The 'Don't Panic' wing counter-punches
As sure as the sun will rise tomorrow morning (and, given the market’s recent collapse, word has it there is a line going in Vegas against the sun rising, but I’m not taking that action) those ’sky is falling’ prognostications of last week by all manner of tech observers, investors and — yes — even some entrepreneurs has been met with a ferocious retort. This is a great thing; not so much because I conveniently find myself in the ‘buckle up, but don’t panic’ camp (see here, here and here) but because this is a very healthy–some might say cathartic–debate and it’s been a long time coming.
So, if you have not already done so, take a moment and review some of the superb contributions of others on this subject, not the least of which are Brad Feld’s OK Entrepreneurs, Time to Step Up, Fred Wilson’s Capital Efficiency Finds Its Moment, Alan Patricof’s Memo, John Borthwick’s Don’t Panic, Profit letter and, finally, Dave McClure’s brilliant and profane blogpost on the crippling nature of fear. Sure, you might still need that martini pictured at the end of Sequoia’s RIP presentation, but perhaps do without the Colt .45 chaser.
More later.
Another take on Sequoia’s R.I.P. presentation
Hold off on desperate measures for now...
In perhaps one of the venture community’s worst kept secrets in quite some time, seminal venture capital firm, Sequoia Capital, recently convened its portfolio companies for a State of The Union-type conversation about the current market environment for venture-backed companies. The PowerPoint deck that was presented at that meeting, which has since been passed around like an hors d’oeuvres tray by the venture community at large in the days since, (and available here for the two of you who have yet to see it) was, to put it mildly, apocalyptic. Indeed, the final slide in the deck is a photo of a white jacketed bartender doing the long pour on what can only be imagined is a very strong vodka martini — stirred, I suspect, and very, very shaken if current market gyrations are any indication.
Sequoia Capital is a great venture firm, for a reason. The presentation, as a work product, is impressive. Chock full of relevant, startling, and overwhelming data on the current environment, how we got here, and what the future likely holds for venture-backed companies, it drives to one unequivocal conclusion if you are a portfolio company CEO – buckle up: this is going to be a rough ride. Predictably, for a firm of Sequoia’s stature, almost identical sentiments were issued by other members of the community in short order. Within days, if not hours, Benchmark Capital, Norwest Venture Partners, renowned angel investor Ron Conway, and a host of other firms and their principals began issuing pronouncements (or previously confidential letters) of their own saying many of the same things articulated in the Sequoia presentation. [Whether these opinions were issued directly from the firms themselves or subsequently leaked by some other method is unknown and I am not suggesting I have any better info on this than anyone else.]
Now, these are all eminent names in the business, by any standard. The smart money might say to just echo these sentiments and find a shelter for the coming storm. That said, let me offer a different perspective on this if I may. But first, it might help to stop, take a breath, make a stiff drink if that’s your thing, and calm down. We’re going to be here a while.
First, Sequoia, NVP and the rest make excellent points. Many of these points are valid even in flush times – being disciplined over costs, focusing on your core market, etc. Second, it’s pointless arguing with the supporting data because it is available elsewhere and can be quickly corroborated. What is open to debate, however, is how to interpret that data and what decisions should be made going forward as a start-up CEO and as a venture investor.
For the CEOs of venture-backed companies, this will be a challenging environment, but not an impossible one. As I have posited in recent posts (here and here) while there are obvious drawbacks to launching and growing a new enterprise in a rough economic cycle, there are also clear advantages that the rest of the economy generally cannot enjoy in quite the same way — i.e. less competition for talent, more flexible terms on leases and equipment, more time to develop your product without worrying constantly about new competitors entering your space, and so on and so forth. As I learned during the tech slump earlier this decade, fortunes are made and lost during times of transition. While many companies (and more than a few venture firms) will undoubtedly shutter their doors in the next 12-24 months as we work through this market cycle, other companies and investors will see their growth and their financial fortunes explode. In short, you want to be in the latter category and, yes, it is still possible.
Warren Buffett has been attributed many quotes that are bandied about frequently but perhaps the most cited over the past two weeks has been his pronouncement years ago that the secret to his success was that he “tended to be fearful while others were greedy, and tended to be greedy while others were fearful.” This somewhat contrarian view has certainly served Buffett well and may even save some of us, if we approach it pragmatically and without undue emotion.
First, this is the time to take stock of where you are. The concept of sound, conservative business management practices have been around decades. They are not, and shouldn’t be, new concepts for venture-backed company CEOs. If they are, then a lot of people (from the investors to the managers) have not been doing their jobs. A company CEO should always be concerned with capital efficiency, containing costs, hiring slowly and firing quickly, and so forth. This market downtown or correction or whatever-you-want-to-call-it-this-week is going to drive this point home like nothing else because everyone will be focused on it now. This does not mean that it is a new phenomenon — just that now you do not have the luxury of playing with the idea: you need to push it down into the very being of your organization. There is no place to hide now.
Second, don’t be seduced by the idea that you can just cut down expenses to the core, retract your head back into your shell like a frightened turtle until the storm passes, and simply re-emerge once things calm down. The only real issue I take with Sequoia’s deck has to do with slide 46 which features a linear spectrum with Preserve Capital on the left side and, opposite on the right side, Gain Share. The slide infers that the two concepts are in opposition to one another and, hence, are incompatible and cannot be pursued simultaneously. I reject that notion. Indeed, I can scarcely think of any technology sub-sector where one can ‘wait it out’ by focusing on controlling costs and simply expect to re-establish itself in the market later on as if it were a chess game that all players decided to suspend for a bit for the purposes of a pee break and would simply resume at the same point where they left off. Tech markets move too quickly, even in a downdraft. Simply put, if you are an early stage company with a commercial product and you are not gaining share, you are losing share. Your competitors will be the ones gaining share– in good markets or bad. Like the theory of capital flows, market share is neither lost nor gained; it is merely transferred. As such, the only viable strategy is focusing on costs but continuing to gain share; perhaps not at the same rate or with the same intensity, but one most always be focused on gaining share.
Finally, returning to the subject of pithy quotes applicable to this market crisis, being a weekend auto racer, I am reminded of a quote from the 1966 James Garner film, Grand Prix, in which the antagonist, a fiercely competitive driver played by Yves Montand, is asked for the secret to his success on the track. He replies, “when I come up upon an accident – a really horrific accident – I put my foot down HARD….because I know everyone else is lifting theirs.”
Opportunities abound, regardless of the market. As I write this, on Monday, October 13, 12:30 PM Pacific time, the Dow is up a record 956 points. This follows the worst week in Wall Street history. Go figure. Some of these gains may very well be given back tomorrow, but volatility will clearly be with us for a while. Those companies that will emerge from this cycle in pole position for the rebound will be those that not only survived through prudent cost controls but prospered by using this market cycle while their competitors were scared and distracted to build their businesses and lock up customers that will ensure their longevity once markets return to a healthier equilibrium.
The Hedge Fund bubble finally pops
Tough times at hedge funds could be helpful to VC firms raising capital
As if the old adage about Main Street coughing and Wall Street catching pneumonia wasn’t tired enough already, new kindling was added to the fire in recent days in the form of abysmal performance numbers put up by some of the industry’s best known hedge funds as well as word that certain marquee portfolio managers were packing it in. Dan Benton, who made his name at Pequot and Andor Capital Management, announced he would be shutting down his fund in October. Former CNBC financial news commentator Ron Insana’s advisory fund-of-fund vehicle told it’s investors that it would cease operations shortly as well.
Predictably, the schadenfreude has already begun. There are some within the venture ranks that have maintained that hedge funds and private equity groups had effectively sucked all the oxygen out of the room for venture firms these past six years in terms of attracting limited partner capital. While there is anecdotal evidence that one could argue supports that claim, I remain unconvinced. The principal rationale for venture firms imploding, at least as far as I have witnessed, has had very little to do with competition for investor dollars by hedge and private equity funds and has been largely the result of mediocre returns from mediocre venture outfits, persistent legacy issues, partner infighting, a dreadful dot-com/tech meltdown that took longer than anyone expected to work its way through the system, and a host of other ills. In almost all the cases that I have heard of, blaming hedge funds and private equity groups for draining the capital flows from venture groups has really been about sour grapes and about finding a convenient straw man to punch. Add to that the caricature that the popular media has provided of hedge fund and private equity players throwing themselves lavish birthday parties, buying robber baron-esque country estates, and indulging in over-the-top spending sprees, and you have a convenient whipping boy that is begging for a pile-on and a great story line for glossy magazines about the imminent bursting of the hedge fund bubble.
Sure, it makes for great copy, but not so fast. In its own Oscar Wilde-ian way, the demise of the hedge fund is being greatly exaggerated.
I don’t pretend that my crystal ball is any clearer than most in these matters, but I have been wondering aloud for years how the mathematically unsustainable lofty hedge fund returns could be, well, sustained. The hedge fund industry did not grow inasmuch as it exploded. From 800 active firms to 6,000 firms a few years later, to some 20,000 funds some time after that. If one accepts the premise that markets are efficient, it becomes pretty clear very quickly that returns must normalize over time as the market becomes ever more crowded with hedge funds all trying to beat the market. The inelegant image it conjures up is that of Miami Beach retirees all walking a small sandy beach with their metal detector wands in hand looking for that lost Rolex or wedding band. One guy will probably make a bundle. If there are 10 retirees out there, perhaps two will enjoy “outsize returns” for their time investment while the remaining 8 will cover costs and eke out a living. What we have come to — to push this metaphor to its logical conclusion — is 500 people on the beach…and it’s bedlam.
Ok, perhaps not a great analogy, but you get my point. Everyone in venture (and, I suspect, in the hedge fund business) loves to talk about finding the “white spaces” — those elusive regions no one has discovered yet. [i.e. That patch of sand no one has yet tilled with their metal finder.] Raw, exciting areas of opportunity where other investors aren’t breathing down your neck (yet) and there is time to roll up one’s sleeves and make a go of things. As more and more people pile into these sectors, incentives get perverted, valuations go haywire, and it’s almost impossible to get to a positive outcome. Typically, only a handful of smart investors find a way to eke out a couple good deal exits and everyone else licks their wounds and moans about the sector getting “overfunded.”
As tough as this is in venture, it’s just dreadful in the hedge fund world because of the mechanics of that business. Like in a sailing regatta, everyone is tacking off everyone else. Show a little success and you will find entire platoons of me-too copycat hedge funds mimicking your every trade. Pretty soon, you need to go further out on the risk profile to chase that elusive outsize return and then, like Icarus and his wings of wax, things don’t turn out so well. Now I know why there are almost always empty bottles of Tums strewn on every desk I walk by on the times I find myself at a hedge fund’s offices – especially lately.
While I do not cheer at the knowledge that some of my friends on the hedge fund/buyout fund side of things are in crisis right now, such a development could be good news for venture. Pendulums swing in only one way — too much this way, and then too much the other. Forever.
As for the hedge fund business, it will survive and prosper. Of that, let there be no doubt. But it will be leaner and more differentiated that it has become in recent years. This is in large part because in order to provide “outsize returns” hedge funds really need to get back to their entrepreneurial roots and eschew the temptation to raise excess capital and become like the bloated, glorified asset managers that they seek to best in terms of market returns. As the saying goes, one starts out in both life and business trying to break the mold; pretty soon, you are the mold.
Social Climbing in Social Networks
Accepting Uncle Leo's friend request can bring its own set of problems for social network users
I had (briefly) planned to title this post ‘My Facebook friends can beat up your Facebook friends’ but thought better of it. Regular readers of this space will know that I am particularly conflicted when it comes to social networking companies. On the one hand I am increasingly impressed with how viral the better social networking platforms have become, how they can augment communications between broad groups of people, how they can facilitate social group overlap and instant information exchange, and how they can become–broadly speaking–quite robust as a communications tool. On the other hand, I’ve also found most to be vastly overvalued by the capital markets, too focused on branding and customer acquisition without sufficient development of applications and tools to help drive lasting, “sticky” value to users, and too vulnerable to being displaced by other social networks.
All that being said, as a lay consumer, I am endlessly fascinated by how emerging technologies typically alter cultural dynamics–both positively and negatively. We have all heard the lamentations in the popular media about how ubiquitous cell phone usage has turned us into a nation of unrefined bufoons blathering away about that evening’s dinner plans in line at the Post Office. In recent years, that might have prompted unapproving scowls from other patrons, but too often in today’s climate those “other patrons” are now too busy recounting their own details of last night’s cocktail party or their upcoming dental surgery on cell phones of their own to bother pointing out your faux pas. To hear talk radio tell it, it’s all become one big cacophony of jackasses.
Accept that premise of not, it’s hardly surprising to witness the crumbling of social peccadilloes when seemingly everyone is engaged in the same untoward behavior without any particular rebuke from society as a whole. Those of a certain age might remember when it was almost unthinkable for a gentlemen to enter a dining establishment sans blazer…and sometimes even sans blazer and tie. If one did, the penalty was to end up wearing the house blazer they kept in the coat closet, which typically was ill-fitting, came with a silly embroidered crest over the breast pocket, and had some vague coating on the right sleeve reminiscent of dried fettucine alfredo.
But times do change and in the current climate most dining establishments, with the exception of the most formal of restaurants, would fail if they insisted on adhering to that dress code standard today. Nowadays, in any given restaurant in New York, San Francisco or Los Angeles, the guys in the tailored suits are often not the power players—they are the accountants, agents and media consultants who work for the billionaires sitting next to them in the same booth wearing velour track suits, ironic T-shirts, and three-day razor stubble.
In the web 2.0 world, one social “slight” becoming increasingly evident among social networks has become the winnowing or “window-dressing” of Friends’ Lists. It’s subtle, but pervasive. One particularly cynical practice is for a new user to a social network to carpet bomb their friends’ email boxes with friend requests in the interest of getting a critical mass of friends and contacts and, by extension, links to other–ahem–more important friends and contacts. Once established the user then begins to quietly push the first batch of friends outside the herd, if you will. Indeed, de-friending has become such a common issue that a new wave of widget providers are rolling out new tools to manage this practice–secretly, of course.
To be sure, winnowing friends’ lists is to be expected in this new age of social networks. In some cases, it would be inappropriate not to allow the practice–particularly when it comes to removing an ex or former boss whose continued access to your updates and profile would be–gee, I don’t know–awkward? But I am not referring to that practice. Indeed, my comments are specifically around the ’social climbing’ aspect of social networking. As more people use their social networking page as a business tool, this practice will only become more common. Two independent consultants who work with the tech start-up community confessed to me recently that they window dress their LinkedIn and Facebook pages quite regularly. Their rationale? A lot of their business comes from other VCs and successful entrepreneurs, so they felt that as they were Googled and Facebooked and LinkenIn’d by prospective employers, they wanted those prospective employers to see an impressive array of bold-faced silicon valley VC and CEO names…not crazy Uncle Leo. As such, these advisors strategically “friended” every tech industry notable, bold-faced or not, that they came across in the hope that they might be able to get to other, even more notable, bold-faced “friends” through that contact.
Cynical as it may appear, the practice of window-dressing friends has been going on since time immemorial. People were quietly dropped off the Holiday card lists, return calls to unwanted parties–when returned at all, that is–were strategically timed in order to get voicemail, messages were conveniently lost by the maid, or the new admin, or due to “bad cell coverage.” We are all, to a certain extent, judged by the company we keep. Guilt by association, if you will. What web 2.0 social networks have done is simply take all the subtlety out of it. Furthermore, truth be told, we all do it to a certain extent. Next time you open your Facebook or MySpace or LinkedIn profile, chances are excellent that you’ve got a few friend requests sitting in your in-box aging like a fine wine. You are not ready to archive them quite yet, but you are not ready to admit them to the party either lest they make an ass of themselves once inside, put wine glasses down on your expensive stereo equipment, and generally embarrass you. So, they stand there behind that red velvet rope, waiting for your decision. I say, admit just about everyone whose call you’d return in normal circumstances. If they don’t merit that level of “friendship”, then listing them as a friend at all rather distorts the entire concept.
Enough with Retro…Innovate!
The--ahem--NEW Dodge Challenger
I’m a car guy. Always have been. As a penniless student I was one of those people that would make the (false) economy of happily subsisting on a steady diet of Top Ramen and Pop-Tarts if it meant I could pay for that new performance chip on my banged-up 911. But with age comes wisdom, and one reaches a point in life where the Bohemian pleasures of hitch-hiking or crashing on friends’ couches just does not hold the allure and proletarian nobility it once did. It was maybe that or the free breakfasts at Holiday Inn Express. Can’t decide.
In any event, get a car guy to reminisce about early Steve McQueen movies or discuss the plot twists in gear-head classics like Vanishing Point or Dirty Mary Crazy Larry and you’ll be there a while, so get comfortable. Car guys love to wax poetic about vintage horsepower and the evocative shapes and visceral, fry-your-loafers, bugs-in-your-teeth driving experiences inherent in 1960s-70s GT cars. It is perhaps not surprising, therefore, that the auto industry cleverly exploited the graying of the baby boomers by re-issuing versions of its most famous badges – Charger, Mustang, Beetle, Thunderbird, and now, Challenger.
Demographics are only part of the reason. Simply looking at the evolution of car names tells you a lot about the degradation of the automobile from a symbol of power, freedom and often excess to a dull, quotidian appliance. Cars used to have great names: Falcon, Dart, Fury, Cougar, Firebird, Mustang, Charger, Barracuda, Hornet, Starlight. Now we have Elantra, Sentry, Altima, Camry, Sienna, Corrolla, Tercel, Maxima. There’s even a Nissan SUV called the Murano. Murano is a small island off Venice famous for its artisans that produce delicate glass sculptures and figurines. Delicate glass is hardly something you want to equate with a muscular, go-anywhere, do-anything SUV. As Jerry Seinfeld might say, who were the overpaid branding geniuses that came up with that one? That’s almost as bad as the luggage manufacturer that—get this—launched a line of luggage named after Amelia Earhart. Yes, Amelia Earhart luggage. Luggage that honors someone most famous for getting lost and never being found. Braaaavo.
When the Beetle was re-imagined in the mid-1990s, I applauded. Smart thinking on VW’s part, I reckoned. The idea was a simple one: Resurrect the image and nostalgia of that instantly recognizable car that made your company famous–quick!: can you think of any other VW model?– and bring it into the 21st century. It worked wonders for VW. Ford followed suit shortly thereafter with the Thunderbird, although the line between tasteful homage and shameless exploitation was starting to blur. By the new millennium, the Mustang re-appeared and, with its success, the “retro” boom was in full swing. Some automakers that did not choose to resurrect a model from their glory days still played the retro card by simply launching new models that evoked the style and details of earlier road card, often not even their own models. Chrysler’s 300 and it’s PT Cruiser are the most famous and successful examples. The 300’s Bentley-esque front grill and the high waist of 1930s gangster saloons gave the 300 a sleek, slightly menacing stance. A clever marketing push followed and the 300 became (for a while, at least) the ride of choice for rap artists, athletes and urban hipsters.
But, with the Challenger, one must conclude that this trend has decidedly jumped the shark. Too often, what is worth doing is worth overdoing – at least for the Big 3 which have a terrible history of blowing huge strategic advantages by not pivoting quickly enough to address new market realities. GM’s recent shuttering of several SUV and light truck plants is another example of a bloated company not adjusting to changing market conditions. In a $4/gallon world, GM should have been throttling back SUV and light truck production for a while now. Everyone knew this day was coming. Instead, GM continued to stamp them out like CDs. Those blunders will continue to crush the SUV/light truck aftermarket and hurt its dealer network for years to come. How Rick Wagoner continues to hold a job baffles me.
The “new” Challenger epitomizes a troublesome trend of “retro rehash” that I have seen in too many markets now. The fashion and music industries are other segments where the pre-occupation with trotting out new spins on the golden oldies that worked for so long has eclipsed real intellectual work on their part in actually innovating new designs (fashion and apparel) or discovering and promoting new music that is not entirely derivative or referential. Interestingly enough, the woes of the music industry are eerily similar to those of the auto industry. Music industry execs love to whine about piracy, peer-to-peer file sharing, concert ticket prices, and a host of other evils to explain their troubles, but the real culprit is prevalent “me-too”-ism in signing artists and a lack of innovation and creativity on the part of the entire industry. The auto industry–and to a lesser extent, the music and fashion industries–have been for a long time utterly bereft of any real innovation. This “retro” boom is simply the most clear manifestation of this lack of innovation. Why bother creating new products that customers want when you can rest on old ideas that you can simply re-introduce with a little tweaking?
In the end, I think the “new” Challenger is as doomed as was its original namesake. Auto buffs will remember that what ultimately buried the 1970s Challenger was the one-two punch of a gas crisis and performance figures that did not break any new ground. The original Challenger simply debuted too late. By the time production ramped up, the muscle car boom that began in the mid-1960s was well on its way out. The 1973 oil shock was just the final stake through the heart. With the new Challenger, the similarities are ominous. $4 gas is killing the appetite for big, raw, powerful vehicles. Heck, even GM itself is considering selling the Hummer–the epitome of the brutish, thirsty, muscular SUV–and Ford has already sold Aston Martin, Jaguar and Land Rover. Perhaps now, the automakers, the music execs and the fashionistas will begin thinking more about innovation and how their very existence will likely depend on it. There simply aren’t any more bodies to exhume. Old wine in new bottles is simply not a sustainable strategy.
Notes from a Conference
Last week the 19th annual IBF Venture Capital conference convened in San Francisco. Not surprisingly, some of the bullishness evident at recent conferences was replaced by a more cautious, measured perspective from the attendees and panelists. While I would say there are few “new” ideas to emanate from these affairs, having esteemed colleagues articulate in front of 200 people what you have been noodling with in your head for the past few months helps underscore one’s intuitions about what is occurring in the venture business and how the industry needs to respond.
As is my custom, I like to scribble notes from panel discussions and keynote addresses when I come upon a pithy observation or insight. Rather than prefacing these remarks with context, I am simply presenting them here as uttered, without elaboration. Many speak for themselves and, surprisingly, retain more power when they stand alone, without comment or context.
From an “Investing in a Downturn” panel:
- “Money is a proxy for time, so make damn sure your company has enough cash to make it through the downturn. If a dollar does not absolutely need to be spent, don’t spend it right now. Spend for growth, nothing else”
- “There is always a bull market somewhere. The US market is tough, but the dollar is very weak and international opportunities abound. Have your portfolio companies look abroad for opportunities to sell their products and services.”
- “We are definitely entering a period of longer hold times (for venture investors.) Manage your fund and fundraising accordingly”
- “There is a lot of foreign capital in China, Korea, the UAE and elsewhere looking for a home. They will begin competing with venture investors for venture deals. They already are.”
- “Every portfolio company CEO and every VC needs to take a long-term view now. We must re-emphasize capital efficiencies”
- [For VCs] “Try to work with syndicate partners that will be around to support the portfolio company through the downturn. Work with firms that have a reputation for hanging in there in the tough times. Reputation is key.”
- “Make sure the board and the investors are properly communicating with one another”
- “Make sure the board’s investors are ‘walking the plant floor’ – i.e. they really know what’s going on at the company and who the people are at the company, not just grabbing a sandwich and Coke at the board meetings and not even getting to know the name of the receptionist.”
From an “Early Stage Investing” Panel:
- “This is great time for early stage investors because a lot of what we do has little to do with exogenous factors. Because such factors have little bearing on getting a company to build its first product, the downturn often means less froth, less distraction, less competition for talent and resources, and more time and attention to focus on building a young company”
- “In terms of deal flow, the downturn means fewer entrepreneurs, but better entrepreneurs. The ‘born’ entrepreneurs are still going to launch companies and find good partners; the entrepreneurs that are not as talented or driven will likely stay in their corporate jobs fretting over getting laid off, not trying to launch start-ups.”
- “We are seeing a renewed focus on disruptive business models as opposed to disruptive technologies. An example of a disruptive business model is one where a company is leveraging a spin on a large market that an incumbent can’t accomplish itself without cannibalizing its own business.”
- “Spending cash for eyeballs is totally dead as a business strategy right now”
- “Capital efficiency is tossed around liberally with regards to early stage investing, but it applies to all stages of venture capital, not only early stage. Great consumer internet companies, in particular, have launched with very little money and developed into powerful businesses. Companies that require a lot of money at the outset may still become great companies, but rarely make good venture investments”
And finally, most sobering of all…
- “VCs need to embrace the current market, not complain about it. They must adjust their investment models to the market. They can’t have it both ways: They can’t complain to their LPs that the market is unattractive and not invest and still expect to collect management fees on capital not being managed.”
The Rise of the Pledge Fund
Angel investing has existed since the very beginning of what we consider the modern age of venture capital. Indeed, long before there ever was much of a venture capital community, loose groups of semi-retired execs assembled regularly to discuss interesting young technology companies to fund. Routinely, there would be a “passing of the hat”, some cursory discussion of deal terms and, whammo, a seed investment would be made. Colorful stories of just such seat-of-the-pants financings of companies that later became tech industry juggernauts are now the stuff of venture capital legend.
Since the “institutionalization” of venture capital, beginning in the 1970s, angel investing has evolved quite dramatically. Sure, there will always be wealthy uncles and trusting friends willing to back energetic young entrepreneurs with intriguing business ideas, but finding strangers willing to do so out of their own pocket has become increasingly challenging. Indications are that it will become only more difficult as many “angels” have found themselves squeezed out of many opportunities and the prospect of backing companies in general increasingly fraught with risk and uncertainty.
To be sure, true angel investing is tough to do – and even tougher to do well. For this reason, even many successful retired venture capitalists steer clear of angel deals. The reasons for this are many. For one thing, it is not often that an investment comes along that matches one’s direct domain expertise, skillset, and network of contacts. As such, many angels get into the dicey business of investing out of one’s comfort zone and away from a relevant knowledge base that can actually help the company. This is fine when things are going well, but when things hit rough patches many angels find themselves unable to really be of much assistance. This can be enormously frustrating for both the angel investor and the company experiencing troubles and needing sound guidance from its investors.
But this is just the tip of the iceberg when it comes to the challenges of being a good, successful angel investor. For every Andy Bechtolsheim or Ron Conway there are a thousand well-meaning angels who made their money in shopping centers or tanning salons only to lose a chunk of it backing technology or life sciences companies where they had no expertise or understanding of what was really going on at the companies.
However, even with the risks, prospective angels understand that participating in early stage deals can bring staggering rewards for those fortunate enough to come in on the next Google, Skype or YouTube. And thank goodness for that, because angels provide a critical and increasingly valuable service to the venture and start-up community. As venture capital fund sizes have generally increased in recent years, many venture firms have moved upstream into more developed opportunities where more capital can be deployed and where the classic early stage risks can be somewhat mitigated. The result of this has been a dwindling universe of investors that still specialize in truly raw, early stage opportunities.
For years, the options available to individual investors determined to participate in venture were not terribly attractive. Option one: Become a limited partner (LP) in a top-performing venture capital fund. Sounds good, but in truth many venture funds have increased their average fund sizes dramatically in recent years and, as a consequence, have focused almost exclusively on big institutional investors (endowments, pension funds, etc) to make up their LP base. In many cases, individual investors need not apply — unless, of course, you were in that particular VC firm’s last few funds and have an established relationship with the partnership. Secondly, the need for a venture capital firm to openly solicit funds outside a narrow group of previous limited partners is proportionate to an extent with how successful it has been historically. In short, the more successful and renown the firm the less it probably requires or wants your investment commitment (again, unless you are already a known quantity with that fund and there is a relationship already.)
Option two: Become an angel investor. For reasons cited earlier, this is tough. Even with a technical background and some operating or investing experience, how does a prospective angel begin to create deal flow? How will entrepreneurs of promising companies even find the angel or learn that he or she is interested in making early stage investments? Of course, the prospective angel can try to join a prominent angel fund to gain access to their deal flow, but such groups are often very exclusive, require one to go through a lengthy and competitive membership process that can take months, and are often closed to new members for years at a time.
Now, fortunately, something of a third option which can mitigate some of the inherent risks in angel investing has begun to emerge. Enter the Pledge Fund.
What is a Pledge Fund?
A Pledge Fund is essentially a non-committed venture capital fund, or a fundless VC firm if you will, that operates as a bit of a cross between a traditional venture firm and a loose confederation of individual angels making early stage investments together. The logic is fairly simple: take the best elements of both structures to create a model that enables individual parties to make angel investments in a standardized, formalized way that eliminates many of the traditional pitfalls of angel investing on one’s own.
How it works:
The Pledge Fund is typically run by experienced angels or former (or even current) VCs. These individuals constitute the “GPs”, as it were, of the fund. The GPs handle all of the admin functions of the fund much as one would expect at a traditional venture firm: outreach to the entrepreneurial community; sourcing, vetting and presenting deals to the Pledge Fund’s “investors” (often called “Members” – more on that later); handling term sheet negotiations; drafting documents; and handling post-investment support by means of sitting on company boards, etc.
This GP management layer, if you will, is critical because individual angels are just not set up to handle most of these functions. Even assuming an individual angel can find good deals (and that’s a big assumption), will that person even be able to properly evaluate it? Will he recognize the flaws? Can he properly size up the team and do thorough due diligence on the technology? on the market? Would he have access to broad groups of experts in various fields to help him vett the opportunity and the management team? Even after an investment is made, will the angel sit on the company’s board and, if so, can he really expect to make much of a contribution?
A good venture firm performs most, if not all, of these management, deal-making, and post-deal support functions. So, in a sense, a Pledge Fund does much the same thing on behalf of the angels. The key difference is that, unlike in a traditional venture fund, the Pledge Fund does not operate a blind pool of capital from which to invest in deals. The Pledge Fund can only source, vett, and scrub deals for its members. It is the members that ultimately determine what deals they participate in. Traditional venture capital firms, by contrast, typically offer their limited partners little to no say in what deals the fund invests in and in overall day-to-day firm operations.
On becoming a Member:
Most Pledge Funds have a straightforward process to gain admission to the organization. There are usually some questionnaires to complete and accreditation requirements to meet, but they are far less onerous than one would expect at many private equity funds. Once admitted as a Member, the only commitment is a small annual management fee (usually to cover overhead and ancillary fund expenses) We’ve heard management fees in the $5k-$10k/year range. The thinking behind the fee is not so much to be a revenue generator as much as a way to cover basic costs and to weed out people who are not serious in actually making seed stage investments. The logic goes that if a prospective angel is considering $100k-250k in angel investments over the next couple years, paying $5k a year to see scrubbed and vetted deals should not present an issue; if it does, then the investor was probably not serious to begin with.
This management fee permits the Member to gain access to the Pledge Fund’s deal flow but does not commit him in any other way. Each month, the Pledge Fund’s deal review committee scrubs all that month’s deal submissions, meets with the most promising companies, conducts a preliminary due diligence process, and selects the top 3-5 deals. Those deals are then scrubbed again, executive summaries in the Pledge Fund’s standardized format are prepared, and the deals are submitted to the Members.
Members are then given a fairly narrow window (we’ve heard a few days, some as long as a week) to review the deal submissions and respond back to the Pledge Fund GPs about which deals, if any, they are most interested in. In short order, the Pledge Fund GPs can determine what syndicate, if any, they can pull together among their Members to make an investment. If it can, then deeper diligence is commenced, the Pledge Fund’s attorneys are summoned to draft deal documents, and things move apace at that point.
Once an investment is made, another interesting twist occurs. In the past, angel deals sometimes suffered from a bit of a stigma within the venture community. Venture investors looking at an investment that was previously seeded by angels sometimes grew concerned that they might be inheriting unsophisticated investors on the board and/or otherwise involved with the company that could potentially cause problems down the road. Stories of neophyte ”friends and family” investors throwing up roadblocks or being obstructionist when a professional investor got involved are fairly common in the venture community. For this reason, some venture investors are leery of angel deals unless the angel group is already well-known and respected within the venture community.
To get around this problem most Pledge Funds structure the investment by creating a separate limited partnership entity to make the investment into that specific company. The Pledge Fund’s Members are then LPs in that new entity that, in turn, makes the actual investment. The impact of this is two-fold: (1) for the purposes of the Capitalization Table, there will not be a list of every Tom, Dick and Harry angel investor and their individual investments; there will only be a listing of the Pledge Fund’s name and the name/number of the LP — i.e. Acme Pledge Partners, Fund I, etc. That keeps the Cap Table pretty clean; (2) If a board seat is part of the investment terms, then a member of the Pledge Fund’s GP group will take that board seat. Since the Pledge Fund’s GP group is often made up of former VCs or well-known angels, there is less concern from professional investors that the member representing the angels will be unsophisticated and/or obstructionist.
Obviously, it’s still early days for this new form of Pledge Fund and it will be some time yet before we can opine on whether this model will become commonplace in the venture community. That said, we have seen versions of this in the past and always found it intriguing for the reasons cited here. It appears that, at least in this 2008 iteration, this modern Pledge Fund approach is presenting a well-constructed and well-reasoned model for those individuals interested in early stage investing while mitigating many of the classic pitfalls long associated with the practice.
[Updated Note: In light of the response to this post, readers interested in learning more about Pledge Funds and/or interested in being put in touch with funds pursuing this strategy are asked to contact me directly at jtower(at)citroncapital(dot)com for more information.]
More Musical Chairs on Sand Hill Road
Time was (and that time was not all that long ago) that the departure of a recognized general partner/managing director at a similarly recognized venture firm would be a buzzworthy 2-3 day story within venture circles. Turn that “departure” tale into one where the departure involved that same investor joining a competitor firm and tongues would be wagging for some time.
In just the past few days, word has come out of the NVCA annual meeting that not one, but at least four, well-known and well-respected GP-level investors have left their respective firms to — in most cases — join a rival firm. If not unprecedented, this revelation certainly strains my memory to recall anything remotely similar in recent years. To be sure, partners retire. Other times, particularly when a firm has suffered poor returns or during a market downturn, partners are sometimes asked to, ahem, ”make other career arrangements.” This is often so the firm can retrench or reposition itself; it can also just be because of a strategy shift or because there has been internal rancor in the partnership for some time and, as such, a decision was reached to make a change.
Regardless of the particular circumstances, in virtually all cases there have been carefully planned transitions and sealed lips on where things went off the rails in these investor-partnership relationships. “Smiles and handshakes all around” is often the party line.
While I send my best wishes to all those investors who have recently moved to new firms, I do ask myself whether this is a harbinger of things to come in the industry. To state that many partnerships have been under strain in the past year is to state the obvious to anyone with regular dealings in this industry. Conventional thinking has long held that continuity is critical in investment partnerships. I think that belief is going to be strained. It is a truism that many limited partnerships, when considering an investment in a venture fund, look at the continuity and ties of the investment team. This is particularly the case when you are talking about venture funds that typically have a 10-year life. That said, with this spate of recent departures — and the community’s response to them by taking the news in stride, for the most part — one has to wonder whether we are entering a new period in the venture community where “moving across the street” from one firm to another much in the traditional style of investment bankers or corporate attorneys will become the norm in the venture community. I don’t have a crystal ball here, but I am anxious to hear other people’s viewpoint.
The Jackass Quotient….why it matters more now than ever
October 23, 2008 at 4:26 pm · Filed under Commentary, Starting up..., Trends and tagged: Barack Obama, Charles Keating, Jackass Quotient, John McCain, Pascal Levensohn
Start-up teams are staying together longer. Make sure you like the people you work with.
Look no further than the current US presidential campaigns and you will see how the power of personal or business ‘associations’ can be leveraged, fairly or unfairly, to boost or damage a person’s career prospects or a company’s fortunes. A Barack Obama, for example, might be able to rattle off a litany of well-respected names to boost his candidacy, but he will also have his William Ayers’ and Reverend Wrights to contend with. A John McCain might be able to offer a similarly impressive list of supporters, but he will have to shoulder the burden of his Charles Keatings and Phil Gramms as well. I will leave it to the political pundits to determine the wisdom of pursuing an opponent’s associations as a political strategy, but the weight of associations and the decisions around who you surround yourself with in business and in life does have impact; more so now than ever.
In the start-up and venture capital world, there is the well-worn maxim that “A-list people hire other A-list people, while B-level people hire C-level people.” The idea is that truly exceptional people are not threatened by others of high analytical horsepower and competency and want to be surrounded by people of such caliber, while mediocre managers are more prone to be nervous about maintaining their station and, as such, don’t want to be challenged or threatened for their jobs. Hence, they ostensibly hire beneath them to preserve their position and authority.
To be sure, the issue of high caliber and competency within an organization’s ranks should be paramount regardless of market environment. In the current market swoon and anxiety that that brings, however, it bears even closer examination and discussion.
As I alluded to in an earlier post, the laws of good business practices were certainly not repealed in the somewhat frothy market we are just now leaving; it just seemed that way some of the time. To be sure, there were a lot of excesses that now bear serious re-examination. As we are painfully coming to realize across our economy, easy credit and cheap, readily available capital can pervert incentives and can blur what should be clear lines between good, fiscal discipline and fast-and-loose management practices. In a frothy environment, however, strategic mistakes can be easily covered up and bad employees have places to hide. Not so in the market we now inhabit.
With few exceptions, venture-backed companies are becoming leaner. Those companies who were not fortunate enough to have raised their venture rounds before the financial crisis took center stage will now have to contend with lower valuations, less competition for their deals, and with venture investors more distracted with challenges in their current portfolio and less apt to dive into new deals as they were just a few short months ago. Yes, deals are getting done, but they are taking longer to do and are coming in at much lower valuations.
Whenever there is a downturn of any magnitude affecting the start-up environment, all venture investors begin re-thinking how they are evaluating new and existing opportunities. What items that were once “let’s see what develops” are now mission-critical? What questions that we could wait on for an answer do we now need real clarity on before proceeding with a new or follow-on investment? In short, what is acceptable risk and what, in the current marketplace, is no longer acceptable?
Arguably, the top item on anyone’s list of “fundability measurements” and criteria is going to be the team. Furthermore, I would venture a guess that team dynamics, competency, experience, integrity and demeanor has only increased in importance as a factor in determining for venture investors what deals get done and which companies fall by the wayside. In a heated market, more investors are willing to ‘wing it’ with a less seasoned CEO or VP Engineering hoping that once the company gains traction with its product or service and hits certain milestones, the exercise of bringing on a more seasoned pro will be a formality; not so today. In a tough environment, experienced CEOs who have actually navigated a company through a downturn are worth their weight in gold. Moreover, every investor wants one for his or her companies. This, ironically enough, also occurs at a time when experienced CEOs are more reluctant than ever to leave the relative calm and security of their current roles as Sr. VPs, CEOs, or heir-apparents elsewhere to take on the challenge of a venture-backed company in the midst of a market swoon.
Many venture investors will undoubtedly agree with the Darwinian sentiment that market downturns tend to force a somewhat healthy attrition upon the start-up landscape. Weaker companies find themselves unable to raise follow-on capital and quietly (or not so quietly) shut their doors, leaving more breathing room for their more able competitors to achieve their destiny and become eventual market leaders. Dilettante angel investors stop investing and retreat to the shopping mall or tanning salon businesses from whence their fortunes came, thereby pulling capital from the market and bringing deal competition and valuations back to a more healthy equilibrium. And, finally, inexperienced entrepreneurs who wanted to take a swag at a mediocre start-up idea decide to table their dreams in favor of holding onto their day jobs, hence leaving the highways and byways of I-280 and Rte 128 to more serious, purposeful entrepreneurial teams. And, thank goodness for that….especially now.
Therefore, some points to keep in mind:
Teams will need to be intact longer:If there is one thing I am detecting among colleagues at other funds it is the sense that a start-up team is going to need to be intact longer than in the recent past. The notion of swapping out key players later in the game has fallen out of vogue to an extent as the reality of how difficult it will be to find top-notch management available, interested, and affordable down the road is sinking in. This puts added pressure on start-up CEOs to button down their senior management teams now. Make sure you have as complete a team as possible before seeking funding.
Tie up the right people, and pay up if you have to:Take a hard look at your team and do the right things now. If the CEO is being too stingy with comp and options packages, correct that now by making sure the top guys (and gals) are properly incented to stick around and build the company through this tough cycle. Don’t expect to be able to get the rock star VPs later on. Pay up if you have to, but do it now.
Have a State-Of-The-Union type conversation about what to expect: Make sure everyone on the senior team has got religion about what is expected, what is required, and what is coming. People sleep-walking around the office waiting for options to vest might have been OK when venture rounds were easy to raise and no one was sweating their jobs (really), but it is not permissible anymore. That guy that everyone likes, tells good jokes at the office beer bashes, but no one really knows what it is he does? You know, that guy? Fire him.
Don’t Pre-Hire:On the other hand, don’t overhire or pre-hire. In other words, be conscious that everyone’s talents are leverageable now, not at some point down the road when the organization is much further along. It might never get there. Some CEOs make the mistake of hiring a perceived hot talent before that person can actually do their magic on the mistaken belief that it’s more important to have them on the team now before they can really do anything to help the company – like a talented CFO when a Controller would suffice, or a VP Sales that only knows how to manage large sales teams and can’t be scrappy. Everyone has to have a clear function and everyone’s talents need to be leverageable now.
Practice good Investor management relations:It’s too often said that CEOs need to manage their boards more effectively and that their venture investors are really long-term partners. This is no longer stuff on the VC firm’s website you can ignore: it’s the new new reality. So, expect that if everything goes in your favor, you will be a venture-backed company for the next 4-7 years and you will be meeting with (and occasionally arguing with) your investors at least every month for the next 4-7 years. This is not a process you can wing; it needs to be managed properly. Build good relationships now with all your investors, board members, and significant stakeholders. This is a big topic not suitable to getting into in great detail in this post, so do some homework. There are tons of good resources on best practices for managing BoDs and other matters, particularly the white papers by Pascal Levensohn , his venture firm, LVP, and/or some of the stuff I have written on the subject over the years, available widely online. Make them your new mantra. You’ll be glad you did, because tense board meetings when bad news has not been communicated properly will make your worst and most awkward family Thanksgiving dinner look like a day in the park. Ask me how I know.
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