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Building A Bust Proof Portfolio
I have no idea if we are headed for another bust. I sure hope not. But having lived through the 2000 bust with a portfolio that was not "bust proof", one of the things I think about all the time is how to build a "bust proof" portfolio.
And part of my thinking about this notion of a "bust proof portfolio" is driven by what happened with the Flatiron portfolio when the market broke. We had about 36 companies in the portfolio at that time, as we had exited about 21 companies before the market broke. Of those 36 companies, one third were out of business within 12 months, one third were sold during the "nuclear winter of 2001-2003", and one third made it through and are doing great. What was it about the ones that made it through? And what if you could construct a portfolio that had the characteristics of the companies that made it through and are doing great?
So here are the things that those "survivor" companies had in common:
- Lower burn rates
- Business models, revenues, and customers
- Good venture syndicates with real VC firms (as opposed to strategic investors, amateurs, new funds, etc)
- Realistic valuations (as opposed to valuations that could not be sustained when the market broke)
- Committed entrepreneurs who were in it for more than just money
- Long time horizons for everyone involved (entrepreneurs, investors, employees)
- Reasonable exit expectations
- Less capital raised and less preferences on top of the founders
I hope nobody takes this post as me saying that we've built a "bust proof portfolio" at Union Square Ventures. We may not have another bust, and if we do, we'll find out then if that's the case. What I am saying is that when you are taking the kinds of risks we take in the venture business, you really shouldn't increase the risk profile beyond what is required.
I am seeing some things in the market now that concern me. Rising private company valuations (particularly in the Series B and Series C rounds) that may not be sustainable in a different market. The rise of strategic investors in the capital structures (we saw how quickly those investors bailed when times got tough). Increasing burn rates. Rising expectations on exit valuations.
I am pretty sure that we are not in for a rerun of 1998-2000 because there is a lot that is different now about Internet businesses and Internet investing. But I am also sure that there are lessons to be learned from the bubble that burst in 2000 and we should not forget them.
Comments (10) | Posted November 17, 2006 in Venture Capital and Technology
Comments
There's a lot of talk about business models these days surrounding web startups. Yet it seems the consensus is that web startups need to focus on fulfilling a user's needs and the business model can be discovered later. However, I find this issue extremely unnerving because it's highly likely that if the business model is not obviously inherent in the product, then what is left is just a free product.
Now consider that the actual model should have been to charge users a fee, however the company has followed the web 2.0 rules, and led the way for hundreds of other startups that are also prepared to offer the service for free.
By the simple rules of competition these startups will never be able to charge a fee, and therefore all of them will eventually end up providing a free product with no model. The game is get acquired or die, sounds pretty risky to me.
I think the idea that "business models are subject to change or be discovered as long as you have a good management team" is overrated and used too often as a reason to invest in companies with no perceivable models.
Posted by: Eric Ni | Nov 17, 2006 10:49:41 PM
I don't quite get the freebird dialog on your avatar, but i can't help but clicking on it whenever i come to your site. It just cracks me up and I am not even in on the joke:)
Posted by: Parkite | Nov 17, 2006 11:39:57 PM
what're your thoughts on cbs interactive as far as strategic investors go (i.e. new head honcho over there who was very public about wanting to look for new deals at the seed/early stage, i.e. when they're 1/32 the size of youtube)? do you think they'll spook as easily as the strategic investors/vc's did following the 2000 bubble?
Posted by: JL | Nov 18, 2006 1:07:05 AM
Eric,
I don't think having free product today is a doodoo whacky...
Then how do MySpace, PlentyOfFish, this blog (don't tell me 30K a year is pennies :) )and many many many others earn??!!
Only thing you have to do is to make money pronto... as i said before YOU DON'T HAVE TO GET A VC's money!!
You only have to make profit, now if you'r gonna be mega-big in 1 year, 2 or five depends of how fast you want to go....
I thin'k it's like F1, are you shure you want to hop in F1 Ferrari that you bought on lease?? and then drive 200Mph in it?? on the open road?? and WITHOUT PREVIOUS EXPERIENCE??????
Shure not!! But if you'r suicidal then go forward,... i will certainly have a laugh when you crash, why? because you'r a damn fool!
Fact is: first take driving class, second go to instrucitons in driving, third lease or buy a go-cart and practice, fourth go with a go-cart on different championships and IF you earn different prizes and money go forward, summ up all that pize money and add something (80 K and up up up) from your savings and buy secon hand Formula 3, then win,win win then buy also secon hand GP2 Series then win win win win win then buy secon hand F1 car, and after that live like a king :) if you have Schumaher gift then you'r be next MySpace or YouTube :)
Summary: take it slow, and don't bash in others MM's for nothing!! :)
Posted by: Mayo | Nov 18, 2006 7:39:12 AM
y'up. couldn't agree with you more. I was talking about similar points a few weeks ago with a group of entrepreneurs that i've known for awhile. i was surprised that they told me I turned into an "east coast guy". amazing. that's what led to my "optimistic reality" post.
Posted by: bijan | Nov 18, 2006 7:48:03 AM
Fred,
could you please explain more on this
"Realistic valuations (as opposed to valuations that could not be sustained when the market broke)"
What prevents an entrepreneur from getting a high valuation if market is giving one. What is the motivation for taking a lower valuation.
"Reasonable exit expectations"
Why not high expectations?
I couldnt agree with the rest more, Could you please explain?
Posted by: Vijay | Nov 18, 2006 9:05:29 AM
An economic slow down based on the effects from housing are even in the short term tea leaves. The latent impact of oil finally reaching in for a bit of hard goods inflation will also finally start to hit stores as well. So I agree with your premise.
To build on your list, interesting to think of why web 1.0 had headwind in terms of valuations when the economy slowed last time were, in fact, not necessary economically driven:
1. Business models that counted on most hard goods sales transfering to web/distribution sales. As a matter of fact, one of the most successful contrarian moves in that time was Apple opening a store chain.
2. Reliance on consumer-driven interest in one-way advertising web technologies. Clearly this was how 2.0 was born.
3. Lack of big-media dollars flowing into the web medium. When it was all said and done, how many of the Ad Age Top 100 spent more than 20% on internet communications in 2001?
Looking at web 2.0 and an impending economic slow down. Here's my concerns on the current typical web business model with an economic slow down coming:
1. Economic slow downs typically mean advertising pull back. Just at a time when publishers are getting their business models in line partnering with advertisers, we may see a softening ST. Likely to impact the long tail more than the top traffic sites.
2. Luxury item purchases get deferred. In this case, the impending video blog explosion may take another year or two as video requires a bigger, better PC and much better upstream (not to mention the search/tagging technology to go along with it). Looks like PS3 and XBox upgrades are winning this holiday v. Quad Core Intel PCs.
3. Incremental efficiency wins over risky breakthroughs. Current technologies expand main stream adoption in enterprise.
Many areas of web 2.0 will see benefits in the coming slow down, in a way like Wal*Mart - thinner web platforms, shorter lead times to development, greater transparency between the writer and reader, advertiser and publisher. Blogging, advertising have a chance to get much more targeted and many Ad Age Top 100 companies are ready to abandon main stream advertising for a more efficient approach which may be a boon for the right technologies and web business models. This slow down will likely finally force the connection of the TV set, the internet and much more efficient advertising platforms. Think about how much more attractive it would be to advertise to a household instead of on a channel.
Interesting times ahead to be sure.
Posted by: CoryS | Nov 18, 2006 10:30:10 AM
While I agree that it's not yet feeling like a bubble, I do get concerned about the Ser. B & C valuations that you've observed, especially fm companies that have neither released a product to market nor generated any revenues.
I spend a lot of time focused on the search technology space, and recently we saw a group of entrepreneurs that I have a lot of respect for in Powerset, get a $30M pre-money on $10M+ raised. This gave me that "oh-oh" stomach sinking feeling that they're going to ruin it for everyone again ;)
Guess it's always seemed to me like any financing round that occurs before having revenue or customers/users s/b low, since there's no evidence of success yet.
Posted by: P-Air | Nov 18, 2006 2:09:43 PM
its all about exits. and the exit ecosystem is still hurting
VC funding and tech startups are rarely if ever about building "real" companies. 9 out of 10 times, the startup succeeds and has a successful exit because it filled an underserved R&D niche for a big company or companies that couldnt or wouldnt do the R&D themselves (e.g. the cost of real capital and risk of failure keep them from doing the R&D but when the R&D is proved out, then using their stock as currency to pay many times what the R&D itself costs, is easy and justified).
as for public market exits, the VC equation works when public markets are willing to continue funding the R&D in anticipation of the later, ultimate M&A exit. (yes, R&D -- even when the new company has sales and margins -- as typically the newco is not mature).
we can see this in the total dearth of big successful tech or media companies that started as VC backed startups. beside yahoo and google, what others come to mind?
NOT micrososft
NOT oracle
NOT apple
NOT motorola
NOT verisign
NOT IBM
NOT Cisco
NOT adobe
NOT sony
NOT IGT
NOT EA
NOT Dell
the truly successful big companies basically started as small smart businesses, not startups, and spent many years as seedlings before clicking then experiencing huge growth on a proven sustainable business platform.
by definition VC backed start ups never get there because VCs do their jobs and in a few short years (in the bigger scheme of things) start seeking and pushing for, you guessed it, exits. regardless of what is best for the company. (which, again, is just them doing their job as a VC)
so the scary scary thing these days (for me as an observer anyway) is the oversupply of capital and startups and undersupply of exits. such an oversupply keeps prices down low in M&A, and keeps the public markets quiet.
another more global/contextual factor is that, in general, technology is increasingly seen as a mature sector and in many cases as a commodity business -- that while silicon valley and technology in general will forever create fabulous businesses and markets, etc., the peak of silicon valley is behind us
i personally dont believe that. but a lot of smart folks do and the markets reflect that in the stock prices and valuations of the big tech companies (the valuations as reflections of forward earnings etc)
Posted by: steve | Nov 18, 2006 2:19:03 PM
Just to back up above about going F1 style - for all of you schmucks wanting to be next Schummy without even a drivers licence:
http://iamfacingforeclosure.com/33/will-i-go-to-jail-for-mortgage-fraud/
Loads of mumbo-jumbo of growing too quick and exiting pretty quickly - i.e. being dumb a##
Posted by: Mayo | Nov 18, 2006 3:32:09 PM
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