The Return of the Capital Intensive Startup

This post is a bit more thinking out loud than usual but I am grappling with what I perceive to be a big change in the startup landscape.  Here are some of its symptoms: the return of TV, print and subway ads for Internet companies; Uber subsidizing their drivers to prop up NY supply; Level Up providing free point of sales Android devices; Udacity, Coursera and Minerva all raising large rounds.  All of these are in one way or another signs of the return of the capital intensive startup.

Historically startups were capital intensive because they had to spend a lot of money to build the product and bring it to market before they were able to generate revenues.  Now it seems that everyone believes in network effects and the capital intensity comes from trying to build the biggest network faster than the competition.  The use of capital has thus shifted to customer and/or supplier acquisition or maybe more generally towards network growth.

This is likely to be bad news both for startups and for investors (but potentially great news for customers).  A lot of capital will be spent but if network effects do exist in the end only one or maybe two companies will dominate the market and provide any returns.  Now for the part that I am grappling with.  What should one do about this as a startup and as an investor in startups?

One theory is to just go for a low burn and wait it out approach.  It’s unclear that approach can work though because it implicitly relies on all the big spenders stumbling.  But if one of them gets execution roughly right and spends a lot they will dominate.  And good and repeatable execution is becoming more common with more people having built a network or understanding how to build one.  So that alone cannot be the answer.  Right now the best I can come up with is the following: go after seemingly small problems (that turn out to be large when solved), look at out of the way geographies, or wait until the dust has settled.  The one thing that doesn’t seem advisable is to compete head on by spending lots of capital.

A Rational Internet Venture Valuations Bubble

There is no doubt in my mind that venture valuations have become incredibly stretched.  I have been thinking about why that is and what will come of it.

First off, here are the factors contributing to the stretching of valuations.  It starts with the genuine potential for building hugely valuable businesses, which is based on four key factors:

1. The immense possibility for scale on the Internet — global businesses with millions of customers can be created in relatively short time periods.

2. The huge operating leverage of many Internet business models, such as marketplaces, which have near zero marginal cost.

3. The potential to disrupt large markets, such as eduction and finance, with Internet based business models.

4. The winner-take-all nature of network-effects businesses in which the dominant business can be an order of magnitude more valuable than other competitors.

The fourth of these factors leads to an interesting interaction with the economics of the venture capital market to spur on valuations: If given a choice of investing in the perceived leader in a market versus one of the followers, a venture investor should be willing to pay a significant premium.  In fact, if the leader can be expected to be 10x as valuable, then even paying up by 5x will still produce a return that is 2x better than investing in the number 2 or 3 company.

So it is entirely rational given the Internet environment to see a dramatic stretching of the valuations for market leaders with network effects. It does, however, not bode well for aggregate returns for the venture capital asset class:

1. In a race to pick the winners ever earlier, valuations get stretched even for companies that have not yet proven that they really have strong network effects and that they will be the leader in their respective market.

2. These stretched early stage valuations will lead to depressed returns in a large number of companies and will also make many of these companies harder to fund.  There will be more of these companies and more capital invested in them (in aggregate) than in the winners.

This also isn’t great for entrepreneurs who happen not to be one of the market leaders.  They will have financed their businesses at too high a valuation along the way and will either face highly dilutive down rounds or in quite a few cases will find themselves with businesses that are hard to finance altogether (if they have taken their burn rates up too much).

All of this is reminiscent of other markets with strong winner-take-all effects, such as professional sports leagues or movies. The economics for a few winning teams or blockbusters are great but industry aggregates are terrible.  It is a prisoners’ dilemma type of situation where everyone is behaving individually rational but we wind up with a collectively undesirable outcome.  Investing at a significantly higher price for a perceived winner is rational for both the VC firm and the entrepreneur on any specific deal.

The situation is further compounded by the internal structure of VC firms and the overall financial market:

1. There are well-known agency problems between the GPs and LPs of venture firms.  Because of management fees, the GPs’ payout profile is relatively insensitive to entry valuations (for all outcomes that produce sufficient fund returns to raise a subsequent fund) and above that actually encourages swinging for the fences (remember that paying 5x for a winner in the example above still produces a 2x better return).

2. Most large LPs are themselves institutions (pension funds, endowments, etc) which suffer from internal agency problems which contribute to a concentration of capital among fewer venture capital funds.

3. The rates of return available on many other investments are at historic lows and/or suffer from much higher volatility, resulting in an acceleration of capital flows back in to venture capital.

Given these contributing factors and that this is a rational bubble, we can expect it to continue for quite some time until there is either an external shock (the European debt crisis might yet be that shock) or the collective returns become so bad that there is an endogenous correction.

Negotiating a Term Sheet

There  have been many great posts about the various terms that go into a termsheet for a venture investment.  As a result entrepreneurs are much better informed which is a good thing all around.  I am still puzzled at times though at the approaches taken by both VC firms and entrepreneurs when it comes to actually negotiating a term sheet.  Here are a few things that I have learned.

For VCs (I have written about the VC side before, but this seems worth repeating): Behavior during the term sheet phase is not an unreasonable predictor for later behavior.  So avoid exploding offers or sending fully baked and signed term sheets.  When it comes to justifying a specific term “we always get this” is not an actual argument.  In a reasonable term sheet every term is just that: reasonable. So be willing to take the time to explain why that term is there.  And if there is no good explanation, take it out.  Don’t send a term sheet that your firm doesn’t stand behind or has some undisclosed contingency.

For Entrepreneurs: Don’t play your cards too close especially for an early stage investment.  If you want to work with a firm and have an offer that you don’t like make sure to communicate.  You don’t know what someone is willing to change unless you engage in a dialog with them. Beware the high bidder.  They are much more likely to suffer buyers remorse the second you hit the first bump in the road (cf “winner’s curse” in auctions).  Optimize in the following order: syndicate (who do you want to work with), terms, and only then price.  Of course that prioritization applies only once the price is in striking range.  If you are very far apart on price with a firm you like take the time to understand why and consider changing the size of the financing. Don’t simply assume that a gap can’t be bridged until you have engaged in a dialog.

For both sides: Whatever you do, keep in mind this is not about “winning” a negotiation.  It is about starting a long term partnership on the strongest possible foundation.  With that as guidance you are likely to behave very differently and everyone will be better off.

VC Dog Fooding: Preditter

When investing in consumer services, we try to be active users of the services.  That tends to provide a fair bit of insight about what is working and what is not (as long as one keeps in mind that one may not be the exact target user!).  To do something similar for our more developer directed investments, I have long been meaning to build a little project using MongoDB and Twilio.  But usually the extremely rare cycles that I have available for code go into fixing something on DailyLit.  Over Labor Day weekend, however, I had some unexpected extra time and used that to hack together a little experiment which you can check out at http://preditter.com (warning: very raw at the moment).  It was a terrific learning experience and I will post some follow ups with lessons learned.

Inflation, Startups and VCs (Part 1)

I wrote last September about the competing views around deflation versus inflation.  Interestingly, about 9 months later we still seem don’t seem to have real clarity on the subject.  Over that time we have approached deflation but there has also been a ton of government intervention, which has prompted op-eds predicting future inflation and even a new fund run by Mark Spitznagel (a long time collaborator of “Black Swan” author Nassim Taleb) to bet on inflation.  On the other hand have been responding blog posts like this one by Paul Krugman and op-ed pieces like this one by Alan Blinder arguing that inflation is not a threat.  In a second post I will dissect the arguments a bit, but first why should startups and VCs care at all?

It is hard to remember when we last had meaningful inflation (in the late seventies and early eighties) and so most entrepreneurs and VCs active today (myself included) don’t have a good sense of the implications.  Generally, it turns out to be much harder to run a business during inflation especially when the business is equity-financed such as VC-backed startup or a VC fund.  Expenses tend to inflate faster than revenues — especially true of course for pre-revenue startups.  The amount of venture funding in your bank (or the size of your fund) on the other hand are fixed.  In 1980 when inflation peaked at nearly 15% that would have been a serious consideration.  Even at say 10% annual inflation, a $100 million fund is not really a $100 million fund at all considering that the money is put to work over a 5+ year-period.

Deflation, btw, is not pretty either but it tends to harm existing businesses more than startups.  So as a startup or a VC you should care about whether we might face a return of inflation.  In Part 2 of this post, I will describe why I am (cautiously) optimistic that we don’t need to lose sleep here but also should not dismiss the potential entirely.

No Such Thing as Too Much Seed Capital Availability

NYC EDC has been meeting with entrepreneurs, VCs and others from the startup community in New York City to figure out whether it is possible to create more startup jobs.  I recently participated in a discussion on this topic and there was an interesting discussion about the availability of seed capital in New York.  Several folks made the argument that there is already enough seed capital available and that if more were available it would just mean that businesses get funded that “shouldn’t.”

I don’t believe that to be the case.  In fact, there is no such thing as too much seed capital, even if it means that a lot more startups are formed and fail.  Startups have a large component of chance and if you want a few great ones to come out at the bottom, you have to put a huge number into the system and be willing to see the vast majority fail.

From society’s perspective even a failed startup is a good thing.  How?  First, for the duration that it lasted it did provide employment.  Second, and much more importantly, there is now one or more entrepreneurs who have experience under their belt, which hugely increases the likelihood that they will succeed with their next startup.

That is where angel investors come in.  True angel investors back an idea and/or an entrepreneur out of passion and not because they are looking at this as another asset class.  There is a reason after all why it is called angel investing.  Professional seed funds or individuals acting as such, by contrast, are looking for a return and as a result will always err on the side of caution (stronger team, more traction, etc).  The profit motive alone will result in a vast underallocation of money towards the seed stage.

What can New York City do about this?  For starters, it can promote the notion that folks who have made money over the years in media, financial services, fashion, etc should be active as angel investors.  The most compelling way to do that would be for Bloomberg to lead by example!  Second, the city could help raise public awareness of successful startups in New York and focus in particular on those that did receive angel financing.  There are other things the city could do to foster startups that will have more short term impact (e.g. give city contracts to startups), but long term if you want more startup activity you have to get more startups going and seed capital from angels is critical for that.

Freemium Revisited

With the economy in a tailspin and a gloomy outlook, there is a renewed focus on sustainable business models for startups.  One model that has come in for particular scrutiny is “freemium” with posts such as Is Freemium Really the Way to Go? and Freemium is Not a Business Model.  But not everyone has given up on it.  I just had a conversation with Dave McClure where he said that he has been thinking a lot about where to draw the line between free and paid features in the freemium model. A while back I wrote a post that also raised this issue and argued that it was a very fine line with problems on both sides.  Since my conversation with Dave, I have been thinking more about it and have concluded that it is maybe not the best question to start with.  Instead, anyone considering a freemium model should first try to answer the question: what do I want to accomplish by offering part of my service for free?

There seem to me two possible justifications for offering part of the service for free.  First, it can be a form of marketing.  You have or are planning to have a paid version (pro, premium, whatever you may call it) of the service and the free offering will attract users.  If that is the case, then you need to be disciplined about calculating how much it costs to support a free user, figure out what the conversion rate is and turn this into a CPA equivalent.  In other words, how much could you afford to pay someone per signed up user?  You can then take that CPA number and back into how much you could spend on CPC or even CPM campaigns under varying assumptions about conversion from those campaigns.  For instance, if you have a service that costs you (net of any advertising revenues) $2 per free user per year to support and only 1 in 50 free users converts to paying, then you could afford to pay $100 in a CPA model (this of course assumes that the lifetime value of a paying customer is at least $100 otherwise you definitely do not have a business).  This is not just a hypothetical alternative.  Anthony Casalena built SquareSpace into a very profitable business solely on the basis of keyword marketing and never offered a free version of the service.

The second possible justification for offering a free version is that users of the free version make the service more compelling for everyone.  For instance, LinkedIn has a massive network because it is possible to be on LinkedIn without paying.  That network is critical to LinkedIn’s value proposition.  In this case, there is no obvious alternative to offering a free version and it is therefore a stronger reason for offering a free version than marketing.  If such a network effect or data asset is the reason for offering a free version it is absolutely critical for the free version to offer enough value that it can become dominant in its field.  This is clearly the case for LinkedIn.  It is also true for Craigslist.  The free portions of Craigslist have created such massive liquidity in the marketplace that they can easily charge in those cities and categories where they have decided to do so.  In both examples it is easy to see that if the services had charged more aggressively they would be a fraction of the size and would not have achieved their dominant positions.

There may be other justifications for offering a free version, but these are the two that I can think of right now.  It seems to me that once you have answered this question about why you are offering a free version in the first place, you will be much better positioned to answer the question about the demarcation between the free and paid offering.

Optimism versus Overconfidence

A little while ago during Web 2.0 in New York, I expressed my sense of deja vu about being at a large Internet conference while the markets were imploding. If anything, this sense has deepened over the last couple of weeks. Not so much because there has been more volatility in the markets than ever before, but because there is such a wide range of attitudes among startups about the depth of this crisis and what it means for them. During the dotcom collapse there was a surprising number of entrepreneurs that were simply in denial. Now again I am finding myself in conversations with people who want to sign a long term lease, or postpone launching their product, or delay a fundraising effort, etc as if nothing had changed in the last three months. Just yesterday, I had a conversation with a team that is running out of money in April of 09 but their plan is to launch their product only in March of 09 and in the meantime optimize the user experience. Come again? Now this is an extreme example, but too many folks I talk to - including some in our own portfolio - seem insufficiently worried. This is likely a reflection of the optimistic nature of entrepreneurs. And the optimism of entrepreneurs is one of the reasons why I love what I do so much. But there is a thin line that separates healthy optimism from deadly overconfidence - the kind that kills climbers, pilots and companies. Until we know how bad this is going to get it is better to err on the side of thinking this will be a 100 year storm. That means preserving as much cash as possible. Drawing down venture debt lines before they disappear. Using short term sub leases. Letting underperformers go now. The list of things that can be done to prepare goes on. But prepare you must.

Leverage and Incentives

There was an editorial in the New York Times over the weekend talking about the likelihood of bankruptcies among companies that have gone through buyouts during the time when credit was flowing too freely.  I agree with the column that this is highly likely as we are facing a significant slowdown in economic activity and these companies have way too much leverage (and given the credit crunch, no real option to refinance).  Why did the companies wind up with so much leverage?  That reminded me that I meant to write a post about why Wall Street firms wound up with too much leverage.  The answer is of course the same in both cases: wrong incentives.

Lets start with the buyouts.  With credit super easy to obtain, a frequent deal pattern was that LBO funds would have the company pay a special dividend shortly after the deal which recouped most or all of the equity put up by the fund (more was generally reouped via management fees imposed on the company).  Sometimes these dividends were in fact funded by additional debt.  This completely disables the normal incentives that keep leverage down.  Regular equity holders have real equity at stake which would get wiped out in a downturn when there is too much leverage.  But if you don’t have any equity at stake to begin with, then why would you care?  Much the same logic applies to leverage in investment banks.  Most individuals inside the bank have comparatively small equity stakes in the overall enterprise.  Yet some of these individuals can create outsize gains for themselves through leverage (on the way up), that is a much bigger portion of the upside accrues to them than they face downside risk.

Some of the same incentive issues arise in startups.  While startups don’t have the obvious financial leverage due to debt, they can easily have payoff profiles for founders that will have similar effects.  Take a startup that has raised $20 million in preferred stock.  At any outcome below $20 million the founders make nothing.  Near $20 million there is huge “leverage” in the founders payoff.  For instance, in a $22 million exit the founders keep $2 million (this assumes straight, not participating, preferred), whereas in a $21 million exist they keep only $1 million or 50% less.  In the meantime there is no impact on the venture funds which get their money back in both cases.  Add to that the fact that most founders have their stakes for sweat equity which has quite different psychological implications from founders having invested cash.  The incentive result of this payout pattern is that with a high preferred overhang founders will take big risks to get to high payoffs.

In Praise of Heuristics

Entrepreneurs sometimes wonder why VCs are so bent on owning a 20% stake in the companies they invest in.  The answer is surprisingly simple: It’s a successful heuristic.  Heuristics are “rules of thumb” and they turn out to be really useful whenever you deal with a lot of uncertainty.  As an investor, one might be tempted to try to optimize the ownership percentage on a deal-by-deal basis.  But so much can go wrong with any particular company that such optimizations are likely to backfire — if you don’t stick to a simple heuristic, you would likely wind up owning a lot less of your successful investments and a lot more of your unsuccessful ones.  That makes it hard to generate a good overall return.

Entrepreneurs face as much uncertainty — in fact more, since they don’t have a portfolio. This means entrepreneurs too can benefit from using heuristics.  Take budgeting for example.  There is great value in creating a budget to make sure everyone in the company is on the same page and to be able to measure progress.  But it would be dangerous to think you can optimize your startup budget the way you might be able to optimize the budget of a low volatility manufacturing operation.  For instance, pulling expenses forward to accelerate revenue growth, can easily leave you with just more expenses when the revenues for some unexpected reason don’t kick in.  So when you are trying to budget to breakeven on your (possibly) last round of financing, a great heuristic is to just “double it,” i.e., make your initial plan to determine the time you think it will take you to get to breakeven and then double it.

In areas of high uncertainty, models — without heuristics — tend to provide a false sense of accuracy and control.  Many financial institutions have been learning this lesson the hard way (again).  They built elaborate models about how various mortgage backed securities and derivatives would behave and how much leverage they could take on given these models.  Those models led them to believe that they could operate safely at 30x or more leverage.  Had they instead followd simple rules of thumb about acceptable levels of leverage they would not have been as profitable on the way up but they would have survived on the way down.