Dumb Money

One of the most nefarious forces in the venture market during the last bubble was dumb money. It drove up valuations and financing sizes, drove down decision making timeframes, pushed smart money out of syndicates, harassed management, fed venture fratricide, and worst of all, was gone in a flash when the bubble burst.

I know because I cleaned up a bunch of companies from the messes left by the "Drive By" investments that dumb money favors.

And I am seeing every single one of these things happening now. It's deja vu all over again. It's scary.

Comments

[Ted]

Fred,

No offense to you personally as I know you have a MBA. But, I call this the MBA'ification of America. Where the lessons of old (or in this case just a few years ago) do not apply. It seems to be a steady theme from many recent (i.e last 10 years) MBA grads. In the attempt to "seize the moment" they lose sight of the long-term.
Why don't companies focus on the long term any longer? Why do all shareholders expect double digit growth in perpetuity. Most business plans I have either written or seen have a period about 4-5 years out where they make capital improvements and hence there is a hit to the bottom line. But that was planned for thus should be expected. What I see is these individuals have a business plan for soliciting investment, but do not follow it.Interestingly enough the financial backers are sometimes the people pushing them to be less cautious to reap quick rewards. However, when it goes belly up they cry afoul.

There is a reason why you do a five year pro-forma. Yet once the seed money is there, they throw it out of the window. The investors are so enamored about the "concept" that they too throw caution to the wind and disregard basic and long-standing principles on a gamble that is worthy of the lottery.

As you are a VC, you make your living by taking risks. Its inherent in the territory; however, reading your blog, you at least analyze this from a long term perspective and place an importance on basic business practices in order to mitigate loss. Why, oh why, don't we learn these lessons? Flickr, Skype, Indeed et al have been successful but it does not follow that Pets.com will be despite the sock mascot.

I have had clients come to me and say that their business model is based on Donald Trump and Mark Cuban's model. I probe and ask what do they mean by this? What are you attempting to do? They say, well we just push forward and figure it out as we go. It is usually then that I withdraw my representation or modify it substantially. I love entrepreneurs and their indelible spirit, but in order to be successful you have to at least know the fundamentals. Yes, Cuban ignored a lot of the 'rules' and is seen (perhaps unjustifiably) as a maverick. However, I also think that he at least had thought things through and it was not like one day he said "you know I am just going to call Yahoo and sell broadcast.com today." These clients of mine just don't think about that.

A successful entrepreneur is like Picasso. Schooled in the old masters, but then carve out your own destiny. Incorporating the traditional in a novel way.

I just hope you are wrong on this subject. But based on my own personal experience of late- I think you are dead on!

[Motts McGregor]

Fred, I'd be curious as to your view of hedge-fund investors being active in the venture financing marketplace. It's a recent development that reminds me of Bubble 1.0 -- you?

Not saying it is necessarily synonymous with dumb money, but certainly seems to be correlated.

-Motts

[Darren Herman]

Is this a warning as to what will be coming around the corner? I believe a shakeout is inevitable, but are you suggesting something a bit more?

[lonelybloggers]

Sure feels alot like the late 90's again to some degree. Perhaps lessons were learned, maybe not..

I think the craziness around all things online video right now will drive that exuberance even further to a boiling/break point over the next year or so..

[Peter Davis]

This would be a good post to illustrate with some examples, otherwise it's just a rant.

[rob]

But because very few companies are going public, there shouldn't be a big hit to the stock market and therefore less effect on the overall economy, correct?

[Kendal H]

AS I was too young during the last bubble, i always wished that i could have been a part of it, because i know i would have created something amazing and "valuable".

Being in this time, it seems like the opportunity is arising all over again. Friends want to start websites every day with this genius billion dollar idea. Everyone thinks they can do it and can get the funding for it. Since when is it this easy? Oh right, 1999.

I was a skeptic of a "bubble" earlier this year, but more and more I do see some form of "bubble" forming.

HOWEVER, it will be different. Since exit strategy is no longer IPO, how do we define a "crash"? No more funding? No more M+A's?
I think that is something we are all still unsure about.

[Randy N]

I would be interested in hearing how you define "dumb money" and how it can be identified and avoided.

And in response to Ted, having recently completed my MBA, there were definitely two classes of students. The ones who not only understood the material, but also the environment under which the necessary generalizations operate. The others were there, skating by (like so many do in college), just doing the assigned work, but not really grasping the underlying concepts. Unfortunately the former group seems to be shrinking while the latter group is growing. Grades aren't even a good way to tell them apart as it's easy to get good grades without understanding the concepts.

The issue then becomes who hires whom. For so many managers, seeing those 3 letters is enough. Hamburger management leads to ground meat and no one benefits. Like all systemic problems, the cause and solution necessarily involve the highest level (executive management).

[Martin]

There probably is some excess in the market right now, but I would argue that it's governed by two forces that are distinct from the late 90s: 1) So far, we have not seen a public market for bad companies emerge. So exits are limited, 2) While some bad companies have exited to strategic players, most are either profitable companies or are exciting technology platforms. So while the dumb money may be pouring in, at least right now, it has no where to go.

[Philip James]

I don't see these things as this decade's bubble, just a general 'evolution' in the industry.

There are more VC's today than before, there's more money in the industry, the LP's expectations are higher etc.

What I think is significant is that the playing field is flatter for the entrepreneurs. Barriers to entry are lower and people have stars in their eyes. I think every idea will have 5 or 10 or more companies chasing after it, and if it’s not funded by a good VC, then it’ll be funded by a bad VC, or it’ll be bootstrapped. Now, more than ever entrepreneurs need to expect people to steal their idea and shadow their developments.

As an entrepreneur I think this is a good development - the most efficient teams will succeed. If you are good, who cares who copies you - try playing chess one move behind!

[Shelley]

Here Here Fred (and Ted with the comment)! Yes, there are parallels between dot.bomb and now. The best thing about getting older (maybe the only good thing) is the perspective you gain. I was a stock broker in 1980, before the bull market began (and it has never really ended even though there have been a couple of healthy pullbacks) and worked as portfolio manager institutional investor, and eventually a kind of VC. I left that world in 1989 and started a research company, one that looked at, among other things, corporate disclosure, governance, accountability and transparency.

And here is where I agree with Ted above: companies that lived through bubble 1.0 were those that had a clear strategy, specific targets, revenue models, succession plans, and numerous other grown up ways of holding themselves accountable. In a study I did of 1999 annual reports, comparing 50 Old Economy companies with 50 New Economy companies, the results were very predictive of the dot.com crash. Those with the poorest disclosure were New Economy companies and the ones that didn't survive (find an article about this research in the WSJ October 20, 2000 called "Study Says New Economy Firms Supply Less Information.")

What I want to rant about is all of the companies that have and continue to launch with no revenue models. This is a repetition of 90s stupidity. I secretly hope that Google doesn't have deep enough pockets to support one of those companies, YouTube through lawsuits and lack of revenue. But I will accept that perhaps there are a few exceptions and maybe a few companies will be able to convert eyeballs to something financially viable. For the countless startups who want to follow in YouTube and MySpaces' footstep, this is the time to look back at history to see just what kind of companies survive in the long run. I just want to pull my hair out each time I hear a VC so excited by yet another company with a great idea but no way of making any money. I think those who survive this bubble will just have to get back to basics. Show me the money, honey! Its really just that simple.

[Michael Hoffman]

Having started dumb companies with dumb money back in bubble #1 (along with a smart one or two), I do see some of the same signs now, but I think there are fundamental differences. As several have pointed out the lack of public market changes the equation. In addition, I think it takes a lot less money to start companies. There are more small funds, more small first rounds. And I think investors and entrepreneurs have learned a lot from bubble #1 and so they are less likely to see the total stupidity that we were guilty of back then.

[Jim Eiden]

I would fascinated to know how you cleaned these companies up.

What specific steps did you take?

You should write a book about it. Now is the time.

I consider myself a contrarian, and it is very refreshing to see a VC not buy into the hype but see things for what they really are.

Perfect example was Webvan. Anyone in the distribution industry could tell you why it wouldn't work. But the CEO was from one of the big 6 consulting firms and had no distribution experience.

I'm still wondering how come the middle-man is still in business. I thought all these dotcom b2b's were supposed to drive all these middle-men out of business.

This is why I own taste-like-chicken.com. I bought the dotcom name to make fun of the dotcom mania. I told everyone it was going to be a b2b for the poultry industry so that Tyson and Perdue chickens could sell to supermarkets. The B2B would then take a percentage of each transaction. No one ever asked my why can't Tyson & Perdue do these things themselves since they are already selling to supermarkets. I had several people tell me it was a great idea. I told them it was a joke.

[ellen]

People have short memories. Why is everyone shocked about the rate of real estate foreclosures and subprime loans not being paid? Had everyone forgotten about the former real estate bubble in the early 80's and again in the early 90's. The craziness of really stupid real esate deals just a few years ago. No one remembers Dime Mortgage, or the savings and loan institutions that went belly up lending money to deals that would have never made sense if the market slowed. People were not buying investments but only something to quickly flip based on an inflationary time. People are always optimistic that this stuff won't happen again, so they become reckless. funny thing is, it always does in all businesses. That is why the older you get the more cautious you become, because you lived it all before.

[Phil]

may god bless the dumb money.

may he remain nut flush
and rolling in the mudlicious
liquidity ya ya but for his
soon departed jelly roll pocket hole.

show me u got that chango macho
darling and lift another offer...

buy 'em high like a montana sky!

[Charlie Crystle]

I love dumb money from smart people who trust me. I feel a deep sense of responsibility to them. They have helped us move so far forward, and we would have had to do it much less strategically than without it.

We need some smart money around September as we grow from 21 to 60 or so. Things have never been better, and it's all because of great people (I love everyone in our company), a grteat, supportive group of mostly dumb money smart people, a team of excellent advisors, and a fantastic executive coach.

Now I'm talking about angels, and I know you mean institutional. I'd rather not have dumb institutional money and am glad I'll never need it. We have the luxury of breaking even (May) and not needing to make a bad choice.

Of course, I'm still on percoset for my broken shoulder so I have no idea what I'm saying. Unless you like it, then I really mean all of it.

Have a great weekend!

[Jimbo Wales]

Fred says: "I know because I cleaned up a bunch of companies from the messes left by the "Drive By" investments that dumb money favors."

Fred:

If you had to clean them up does this mean you were an investor in these drive by companies? Then you fed the bubble.

If you accepted "dumb money" in your good companies, and then had to clean them up, then acceptiong that money was your decision.

Fred be honest: FlatIron partners was one of the best examples of the Internet Bubble 1.0. Raised too much money in your second fund after luck in your first (that every VC had in Internmet 1.0), invested it too fast in companies that could not get funded once business metrics were applied to your companies.

Don't be a hypocrite.

[fred wilson]

Jimbo

I have talked endlessly on this blog about the mistakes we made during the first bubble. I am not trying to hide from them in the least.

Allowing "drive by investors" into our companies in the second and third rounds at big valuations was certainly one of the many mistakes we made.

That said, there weren't very many investors who stood by their investments post bubble, paid off the loans, supported the management, dealt with the loss of big parts of our financing syndicates, etc, etc.

This post was a reminder to me (my blog is in many ways a public "note to self") and others that we really should not make the same mistake again.

And as it relates to Flatiron, I am proud of the record we have with that firm. We invested a bit over $500mm (yes, way too much). We returned about $1.5bn in the "lucky" years. We then wrote down most of what was left. We still manage the Flatiron portfolio and have returned approx $200mm more and we still have six companies left that should return between $300mm and $500mm more.

Flatiron was not pure luck. We were seed investors in companies like Comscore, Bigfoot Interactive, Geocities, TheStreet.com, ITXC, Multex, and many more that were/are important companies. Sure we made our mistakes, but when I look back over the eleven years that Flatiron has been in business, I am incredibly proud of everything we accomplished.

[Charlie Crystle]

Amen. I've always been impressed the degree to resonsibility you and Jerry have taken for your investments post crash, and am grateful for your consistent level of honesty and generosity in sharing what you've learned from it all.

Jimbo, he's not a hypocrite, he's a veteran who's not just seen both the bad and good of deals and played a part in the bubble, he's quite qualified to comment on the current flurry of both bad and good deals. And while I don't know you well, Fred, I've developed the impression from your blog and our private emails that you have strong character.

Sorry, Jimbo. You're off base here.

BTW, Fred, what interests me about all of this investment is the concept of the Attention Economy with respect to thousands of new offerings. While there might be thousands of great new ideas with competent teams ( I doubt it), is there enough collective attention cross sectors and interest groups to support them? I don't believe so, certainly not on the consumer side.

Anyone else?

[mark slater]

Fred -

i was reading mr Buffet's annual letter and my eye caught a quote that i felt appropriate to this blog.

"be fearful when others are greedy, and be greedy when others are fearful"