I'm back in the states this morning and up early (jet lag). The main purpose of my trip was to give a talk at LeWeb, which I did yesterday morning. Loic asked me to talk about the next ten years and what is going to happen. That's a big ask and so I dodged it a bit and instead talked about the framework we use to try to predict the future. I talked about three big trends (networks, unbundling, and smartphones) and four areas to watch (bitcoin, wellness, data leakage, and trust/identity). The talk is 25 minutes with a brief Q&A with Loic at the end.
I am taking a break from video of the week this weekend to talk about the work of Kevin Marshall and Nick Grossman on USV.com. After the USV team built and launched USV.com, Nick and Kevin did a rewrite of the core web app and then open sourced it. Since then, they and others have been iterating on the open source code base and they have implemented a bunch of new features which launched yesterday. Many of these features are ones that I have been begging for and ones that members of the AVC community have been asking for. Kevin lays out a list of the big ones in a blog post he wrote this morning.
First of all, we believe we have gotten integration between USV.com's profiles (based on Twitter auth) and Disqus working. If that turns out to be true, then I owe Kevin and Nick a dinner at any restaurant of their choice in NYC. And I will be glad to pay that debt because this has been a nagging issue for the new USV.com since we launched it.
Beyond that, here are a few features I am excited about.
USV.com Tag cloud
This shows the topics that the USV community is talking about most. Since #startups and #startup are the same thing, that would jump to #2, and since #vc and #venturecapital are the same thing, that would jump to #3. A feature request would be to map some frequently used tags together that mean the same thing so that this tag cloud could become even more valuable.
This shows the tag cloud of what I have been posting about, my posts, and there are tabs to see the posts I have bumped, and some other things. This is the beginning of a reputation system at USV.com. You can see yours by clicking on your twitter handle when you are logged in at the upper right of the main USV.com page.
I can't figure out how to screencapture this feature, but when you hover over the votes link on a post, you can see everyone who has bumped it. This works pretty much like the same feature on Disqus.
There are a bunch more features that I am happy to have and Kevin outlines all of them in his post. I would like to thank Kevin and Nick for all the work they have been doing on USV.com. It has been getting better and better and this recent push takes it to a new level. If you haven't been there lately, I would suggest you go check it out.
He's right, but I would go further. One of the hardest things to do in the venture business is to stick with a struggling investment.
I woke up thinking about this as I spent yesterday with Josh watching the hapless Jets lose badly to the Dolphins and then heading up to MSG to watch the equally hapless Knicks lose to the Pelicans. It is tempting to stop watching both teams and sell off our seats at MSG for the rest of the year. But we aren't going to do that and we will sit loyally and watch loss after loss at the Garden if that's what comes for the rest of the year. We are fans, even if our team sucks. And they sure do right now.
It is equally tempting to write off a failing investment and stop showing up at board meetings, stop responding to the emails from the founder, and stop thinking about the company. At some point, the company will run out of money, there won't be a reason to put more money into the company, and the investment will fail. Until that happens, as long as the founder is willing to listen to you, I think you have to give your struggling investments your all.
The truth is the investments that are working often don't need that much from an investor. They need more capital, they need recruiting help, and sometimes they need strategy and advice. But the reason they are having success is they are doing the right thing and doing things right. On the other hand, the struggling investment needs a lot of help. And I think the lead investor board member has an obligation to provide that help.
One of the characteristics of USV that I am most proud of is that we stick with our struggling investments. And we have made a lot of them. We have way more of them than our successful ones that are always cited when we are talked about publicly. I think how you treat your struggling investments says more about you than how many billion dollar exits you have had. You need both to be successful in the VC business, of course. The latter metric defines your selection acumen. The former defines your empathy acumen. And when I pick people to work with, I look for the latter. I suspect most people do that.
This is not a new theme. I've written about this here before. But it is an important theme for me and for entrepreneurs and investors. As we headed out last night to MSG Josh said to me, "I am not feeling good about this game". I told him I wasn't either, but all we could do was root them on as hard as we could. We did that. And we will do that again on Thursday when they head out to Brooklyn to play the Nets. We will be there too. That's what fans do and what investors should do too.
Longtime readers will know this is a topic near and dear to my heart. I did a whole MBA Mondays series on this topic and I followed that up with a Skillshare class on the topic.
So I was excited to see that First Round Capital featured a blog post by Andy Rachleff on this topic yesterday. Andy was a founding partner at Benchmark and knows his way around a startup cap table. Andy included this slide deck in his post and I will reblog it here.
You will notice that Andy's plan differs a bit from my plan. But not by much. The important similarities are that Andy and I both encourage companies to not only grant equity at the start date but also on an ongoing basis so that employees' equity ownership grows as their tenure and contributions grow. This is critical.
Where Andy and I differ a bit is how to calculate how much equity should be granted. Andy suggests using market comps. I don't like doing that because 0.1% of one company can be worth a lot more or less than 0.1% of another company. I prefer to issue equity based on a multiple of current cash comp divided by the current valuation of the business. I lay that all out in my Skillshare class.
While I don't call out promotion and performance bonuses specifically in my Skillshare class, I am a big fan of both.
It is so great that folks like Andy are taking the time to lay out an approach and model to this issue. It is something literally every startup we work with struggles with. Getting it right is hard, but worth it.
One of the things I am noticing is the trend to try to solve problems with software instead of dedicated hardware. That makes sense for a whole bunch of reasons, but the biggest ones are that the marginal cost of additional user is almost zero with software and that you can iterate your product much more quickly with software.
Smartphones make this trend possible because we have a hardware devices on us most of the time. A good example of this is the Moves app. Instead of using a device like FitBit, Up, or FuelBad, the Moves app turns your phone into an activity tracker. Right now, Moves eats your battery too much which is why it is not more popular. But fixing that is only a matter of time. Of course, iOS and Android could also make activity tracking part of their operating systems, and arguably should do that, but that's another story.
Chromecast is another good example. Why buy an AppleTV, a Roku, or some other hardware device to bring internet TV to your family room when you can buy a $35 dongle, connect it to your TV set, and your smartphone can now control your TV? It would seem that all TVs will eventually come with this feature that allows your phone to take over the screen and play whatever is on the phone. Then all internet connected TV innovation can happen in software instead of hardware.
This begs the question for me how the "Internet of things" will play out. What are the "things" that the Internet will connect to. Will they be smart cameras, thermostats, and doorbells or will all of those things run on our phones in time? And how will that be made possible?
This also makes me wonder about the health care diagnostic sector. Will I be able to take my blood pressure, blood chemistry, xray, cat scan, MRI, on my phone? Those last ones are kind of crazy, I know, but I am just aksing the question to make a point. Will healthcare diagnostics go the way of the compass, the flashlight, and the game console?
I don't know the answers to these questions I am asking. But it sure does seem that entrepreneurs are finding ways to do things with software and a smartphone that used to require dedicated hardware at a rapid pace these days. I think this is a trend to pay attention to. And it may, over time, make investing in hardare based business less necessary. Which would be a good thing from my perspective.
When I was early in my career, I casually mentioned to an older VC that I had yet to lose money on an investment. He replied "that's not good, you aren't taking enough risk." I have gone on to lose a lot of money over the years. And made a fair bit too.
So one of the things I like to look at when I look at our funds and other VC funds that I am an investor in are loss ratios. You can calculate loss ratios by "names" meaning how many investments ended up being worth zero. Or you can calculate loss ratios by "dollars" meaning how much of the capital invested in the fund went into total losses. Ideally your names loss ratio will be a lot higher than your dollars loss ratio.
Our first fund, USV 2004, has an "names" loss ratio of about 40%. That means 40% of the investments we made are going to be end up being worthless or near worthless. That fund will be the best venture fund I have ever worked on. So loss ratios are not really indicative of performance of a fund. That comes from the winners and how big they are.
I just looked at the financial reports for a seed fund I have an investment in. It has a 42% "names" loss ratio three and a half years in. That sounds about right to me. I feel good about that fund. If it had a lower "names" loss ratio, I might not feel as good about it.
I am not suggesting that a high loss ratio is indicative of good performance. It is not. But it is indicative of risk taking, and importantly, taking your lumps and moving on. The worst thing you can do in early stage VC is stick with your bad investments for too long and for too much money. If the "dollars" loss ratio is higher than the "names" loss ratio, that can well be an indicator sticking with your losers too long and that can be an indicator of poor performance.
The point of all of this is losing money comes with the territory in early stage VC. It is not something to be ashamed of. But it is something you need to be doing as quickly as you can.
Albert stopped by the OneEleven accelerator in Toronto after the most recent Wattpad board meeting and sat down for a talk with William Mougayar.
Topics they discussed include how Albert got into Tech, working with entrepreneurs, the USV investment thesis, Tumblr, Foursquare, education, homeschooling, healthcare, Canada, crowdfunding's impact on venture capital, the new USV.com, machine learning, surveillance, privacy and security.
The video is about an hour and half, including intro and Q&A.
Aileen Lee has a really good post up on TechCrunch, in which she analyzes the number of companies that have been started since 2003 that have gone on to be worth $1bn or more.
This is a very useful exercise in the VC business since it is these big wins that produce the vast majority of returns in the business. I am not sure it is that is worthwhile exercise for entrepreneurs since you can bypass the VC business entirely, keep all or most of your company, and sell it for $20mm and have a big personal and financial success. That's another way of saying that focusing on the huge wins is something VCs do, will keep doing, and need to do, but it can be a collossal waste of time and energy for everyone else. Unless, of course, you raise money from VCs. In which case, you are getting into the game and will be impacted by it.
So, with that disclaimer, let me say a few things about Aileen's analysis and then suggest an exercise we can all participate in.
The number of tech companies started each year that go on to be worth a billion or more has been a debateable figure for as long as I have been in the business. It is an important figure for VCs and the investors in VC funds. I have heard people say it is one or less. I have heard others say it is ten or more. I think it is at least ten, particularly if you think about this globally. Aileen calculates it as roughly four per year (39 to be exact) in the ten years since 2003.
I think it is bigger than four/year in this past ten year period. But we won't really know for another ten years. That is because the billion plus companies started in 2008, 2009, 2010, 2011, and 2012 won't all show up right away. It takes at least five years and possibly longer for some companies to develop into large and valuable companies.
It is also true that some of the companies on Aileen's list won't be worth a billion or more in a year or two. As David Hornik points out in the comments to Aileen's post, using private company valuations to do this excercise means you will count companies with inflated valuations that they won't be able to live up to.
But I think it is OK to use private company valuations as long as you come back and revisit the list from time to time, add new names, and subtract the ones that did not live up to the hype.
Finally, Aileen's list is US and Silicon Valley centric. It misses at least three of our portoflio companies and probably a bunch of others. And it has no companies outside of the US.
So I created a hackpad that we can all use to list, track, and revisit this question. It is here and I have embedded it to the end of this post. It is a public hackpad and anyone can edit it, add additional companies, add comments, etc.
My friend Matt Blumberg and I are co-teaching a class at Princeton in a few weeks. The subject of the class is the VC/entrepreneur relationship. As part of doing this class, Matt and I are doing two posts each in a point/counterpoint model. Today is the first of these two co-posts about the selection process. Next thursday will be the second. Matt's post on today's topic is here and should be read directly before or after this post.
From the outside, most people think that VCs are just looking for the best ideas that will generate the biggest companies. And that is true. We want to invest in big ideas, big markets, and big outcomes. That is a necessary part of our investment selection process, but not sufficient to get us to pull the trigger. We also want to invest in people and teams where we feel a personal chemistry.
Venture capital investing is not like angel investing or public stock investing. We don’t make a lot of small bets (angel investing) and we can’t easily get in and out of our positions (public market investing). We make big concentrated bets in a handful of carefully selected companies and hold these positions for between five and ten years on average. We sit on the boards of these companies and become business partners with the founders and management teams. We don’t run the companies but we have a meaningful amount of influence and impact on them.
For this model to work, VCs need good personal chemistry with the founders and management team. They need to like and respect us. And we need to like and respect them. The way investors choose teams to back and the way entrepreneurs pick VCs to take money from is very much like the way you recruit and hire a team. Or the way you date before getting married. It’s a process and the more facetime you can spend together before making the decision and the more asking around you do, the better decision you will make.
There are four phases to this process.
The first impression - That can be in a minute or an hour. It’s the first meeting. You walk away from that meeting and you think “I really liked that person” or “That person is awful.” Both the entrepreneur and VC will have an opinion coming out of the first meeting.
Subsequent meetings - If the first meeting went well enough, both sides are inclined to take a follow-up meeting or in all likelihood a series of follow-up meetings. This is where the first impressions are confirmed and validated or where they are determined to have been incorrect. This is also where others are brought into the process. In our firm, all the partners will meet the entrepreneur and, ideally, key members of the team as part of our investment process.
Reference checking - This is not about calling the references someone gives you. This is about triangulating between who you know well enough that they will tell you the truth and who has worked closely with a person. I like to call people who have worked with a person in a bad situation. When they tell you “she was the only person who really shined in that moment” you know you’ve got a winner. When they tell you “he created that situation and was painful to deal with” you know you don’t. You cannot take all the references you get as gospel because some people just don’t work well together. But if you call enough references, a picture will emerge with consistency and that is likely to the truth.
The negotiation - It is important that some stress is injected into this process to determine how well both parties work through a tense situation with some conflict. Because a five to ten year relationship between an entrepreneur and a VC will almost certainly include some difficult moments. Being able to work through those difficult moments constructively is the hallmark of a good VC/entrepreneur relationship. The negotiation of the investment deal is a good way to introduce that tension and both sides should pay a lot of attention to the little things that are said and done in the negotiation. It is a rehearsal for the main event.
If you find working with an entrepreneur difficult, you should not invest in his or her company. If you find working with a VC difficult, you should not take their money, no matter how good a deal they are offering you or how strong their reputation is. Personal chemistry is exactly that, a connection between two people. We all know that some people work well together and others don’t. Pairing the right people together to get something done is the central act of good business people. And it is the central act of venture capital investing.
If a Company is making huge profits this year but will not make any profits in the future, it is worthless in the eyes of an investor. But if it loses money this year and next year and may lose money for a few more years, it can still be very valuable in the eyes of an investor.
Amazon had negative net income in 2012 and pretty much zero net income this year to date. And yet it is worth $166bn in the eyes of investors.
This is because companies are worth the present value of future cash flows, not current cash flows, and certainly not past cash flows.
The lesson here is that you can't just value a company by taking its current performance into account. You really need to have a view towards its future performance. And you need to understand why the company is not currently profitable.
In the case of Amazon, it is making huge investments in warehouses and logistics to be able to continue to grow its retailing business and it is making similarly large investments in data centers to be able to continue to grow its AWS business. If Amazon did not want to continue to grow, it could stop making those investments and start generating profits. If you believe, as Amazon management does, that the future growth is going to be there for Amazon, then you ignore the current P&L and think about what a future P&L might look like.
In the case of Salesforce and Workday, they are making huge investments in sales and marketing to secure additional customers. They are also making significant annual investments in R&D to maintain the market leadership of their existing products and bring new ones to market. If you think that Salesforce and Workday can continue to grow their revenues at or near their current growth rates, then you ignore the current P&L and think about what a future P&L might look like.
Profits are critical to the health of a business, but that doesn't mean a healthy business has to currently profitable. It needs to be able to be profitable if it wants to be and it needs to be profitable at some point in the future, at least hypothetically. So when you read that a company is losing money, don't read that as a bad thing. It could be a very good thing. It all depends on why.