Fred Wilson

When Things Don't Work Out

2013-04-01T08:53:08-04:00

I have said many times that early stage VC is a lot like baseball, if you get a hit one out of every three times, you are headed to the hall of fame. And if I look back over my career, and also over the track records of the firms and funds I have helped manage, that is pretty much the hit rate I have seen. By "hit" I mean an investment that returns 5x or better. But of course, many of these hits return 10x or even 100x every once in a while.

So what happens with the other two-thirds? Well that is the part of the startup world that we don't talk too much about. Sometimes an entrepreneur will take an early exit. They will have raised a small amount of outside money, will still control the company, and will get an offer they can't refuse, and take it. That's a win for the entrepreneur but not for the VC. But it is a happy outcome for everyone anyway. That's maybe 10% of the total outcomes. So at least 50% of the outcomes are not a win for the VC or the entrepreneur.

So what happens when things don't work out? There are generally two scenarios.

The first is the "slog it out" scenario. This one is in many ways the most painful. It means that there is a business that can be built, but it won't be one that makes the VCs much money and because it takes so much time and money to "slog it out", it doesn't make the entrepreneur much money either. And in many cases, the entrepreneur chooses to leave and the company has to recruit outside management to operate the business.

In the "slog it out" sceanrio, the VCs are often left holding the bag. They have a lot invested in the business and have a responsibility to figure out how to get it out. In some cases, the entrepreneur sticks around and slogs it out along with the VCs. I have great admiration for the entrepreneurs I have worked with who have slogged it out. There is very little upside for them in this scenario. Mostly they do it out of a sense of responsibility. These "slog it out" businesses can go on for a long time. I am involved with some that are well into their second decade and I am afraid that they may be headed into a third decade. I have heard these kinds of companies called "zombie companies and "the living dead". That's a bit unfair because there is no way a company can operate for two or three decades without being able to sustain itself. VCs do not keep pouring money into these businesses, maybe they do that for the first five years, but not after that. These "slog it out" companies turn into real companies eventually but just not companies that have the growth trajectories or strategic profiles that make them great acquisitions.

The second scenario is "hit the wall". In this scenario, the company runs out of cash and there is no more coming from the investors. The company cannot sustain itself and one of two things happens. There is a fire sale or an acqui-hire, or there is a shut down. The fire sale is the preferred outcome and VCs and entrepreneurs have gotten pretty good at finding homes for the teams in recent years. There is such a vacuum of talent out there that a fire sale can often be arranged just for the talent that a company has assembled. But often the fire sale cannot be arranged and the company has to be shut down. Again, the responsibility for an orderly shut down often falls onto the VCs to manage. In a shut down, the employees must be notified and paid through the date of the shut down. All required tax payments must be made. Liabilities such as leases and bank borrowings must be managed. In particularly messy situations, a bankruptcy filing is required.

There are two interesting things here that I always think about. The first is that even the very best investors in the VC business only get a hit about 1/3 of the time. That means that they have their share of "slog it outs" and "hit the walls" too. I am certainly in that camp. The second is that we end up spending an incredible amount of time and energy (hopefully not money) on the 2/3 of our investments that don't work out. When everything goes well, you really don't need that much from a VC. Of course, I have added value in all of my winners. But its the ones that don't work that I have left my blood, sweat, and tears on. And that's the paradox of being a VC that cares. Which is the only kind of VC you want to work with.

Cross-posted from A VC: Musings of a VC in NYC.

Becoming a Boss

2013-01-15T09:50:41-05:00

I was watching this Charlie Rose interview with Lena Dunham and I was struck by this line: "It's really intense to be thrust into a managerial position before my time."

I have seen this a lot in my business and its always your talent for making things that puts you in this spot. And one of the big challenges is that the "managerial position" (as Lena calls it) is often in conflict with the talent for making things that got your there in the first place.

I am not saying that folks who are talented at making things aren't talented at managing people. I have come to believe that most people can be talented at managing people if they want to be. What I am saying is the time and energy and passion for making things can be all-consuming and managing people can also be all consuming. Doing both well is really hard.

When we had our USV CEO summit last fall, we kicked it off by asking each founder/CEO to open with the one thing they had learned the hard way during the year. The recurring theme was that they had to let the people they hired do the work even though they wanted to jump in and do it themselves. And as they are all going around the room telling this story over and over, I am thinking, "and I want you to jump in and do the work, too." Because these are the people who made the thing that got us to invest, the thing that we fell in love with, the thing we believe is big enough to build a business around.

One of my favorite stories is about an entrepreneur I visited in his office away from the office. That he had one is in and of itself is telling. He was playing his acoustic guitar and singing when I arrived and I said, "Wow. I didn't realize you were such a talented musician." He said, "I am an artist and the most impactful art that my generation can make is websites but I see myself first and foremost as an artist." And I thought, "Well it is a shame that you can't hang a website on a wall and move on to the next one."

There are a number of ways to handle this conflict that arises between the maker in you and the manager in you.

Many artists stick to making and hire a manager to focus on their business. Artists that build websites and mobile apps can do that, too. In a perfect world, the manager and the maker become partners and operate the enterprise as a duo connected at the hip. The Gotham Gal and I once watched a movie about Valentino and his partner Giancarlo Giammetti and I was struck at how well defined their two roles were in their business endeavors.

You can devote yourself totally and completely to the manager role and hire people to lead the making effort. That is what many of the founder and CEOs in our portfolio have chosen to do, at least in theory. As our CEO Summit discussion pointed out, that approach is riddled with tension and conflict because makers want to make at their core and being a hired maker working for a founder/CEO maker isn't a party. It can work but it will never work perfectly.

The third way is to keep your hands in both efforts. To be both the maker and the manager. The challenge with that approach is you have two full time jobs and I have not seen many who can do both as well as they need to be done. Some choose to hire leaders below them to lead the making and managing teams but then keep ultimate responsibility for both. That can work, but defining when you plan to step in and make the calls and when you won't is tricky.

I cannot and will not recommend one of these approaches over the other. Each founder/CEO has to figure out what will work best for him or her and then build the team around them appropriately. As always, the hires are critical. Some hired leaders can deal with a founder who drops in on the decision making process better than others. If you are the meddling kind, you should find someone who can handle meddling well. But understand that nobody handles meddling exceptionally well. Pick your battles carefully.

What I can recommend is that you stare at the elephant in the room, name it, and deal with it. The maker/manager conflict sits at the heart of many of the development challenges that founder/CEOs deal with as they scale their companies and scale themselves. Conquering it is possibly your greatest opportunity and will lead to your biggest success.

Lockups and Insider Selling

2012-08-21T09:05:42-04:00

There is a lot of sturm und drang out there in the worlds of social media, finacial media and just plain media about all the lockups coming off and all the insider selling going on in some big internet stocks. As someone who has played this game a few times, I tought I'd post some thoughts about this.

First and foremost, this post has nothing to do with what USV has done, might do, or is thinking about doing with specific stocks we might own or not. That's a disclaimer for those who aren't familiar with one.

When a venture-backed company goes public and is worth billions (or even hundreds of millions), the investors who provided the early capital to that company are going to be sitting on a lot of stock. They can easily own 15-20% or more of these companies. But even if they own less than 10% (as Accel Partners does in Facebook), they can be looking at billions of dollars of value.

It is an investor's job to return capital. I will say that again. It is an investor's job to return capital. That is how we are measured. Paper gains are fine. But at the end of the day, an investor will be measured by the amount of cash or liquid stock they return divided by the amount of cash that was invested in their fund. A multiple of three is good for a venture capital fund. A multiple of five is great. A multiple of ten is once a decade.

When an investor is looking at a single holding being worth three, five, or possibly ten times their entire fund, you can be sure they are looking to lock in that gain. That's a recipe for fantastic performance and the downside of not locking that in is a lot bigger than the upside of another one or two times their fund size.

And then there's the question of whether venture capital firms are good public market investors and whether they should be managing/holding public stocks. I don't have any hard data here, but my anecdotal data says that we are terrible public market investors. That is why many VC firms have a policy of moving the public stocks out of their portfolios as quickly as they can.

I think that is a good policy. Venture capital is about capturing the value between the startup phase and the public company phase. Others should be focused on capturing the value post the public offering.

So let's go back to the expiration of lockups and the waves of insider selling that result. This is to be expected and in fact is expected by the public markets. Look at all of the short positions that get built up in the locked up newly minted public companies in the weeks before the lockups come off. Investors know that a ton of stock is going to hit the markets and they make bets that it will impact the stock price and in most cases it does impact the stock price. As JLM likes to say, "This generation did not invent sex." This has been going on since I got into the venture capital business in the mid-'80s and I expect it's been going on for a lot longer than that.

So to all the folks out there who are shocked and outraged at all the insider selling going on, I would suggest they park their outrage at the door of capitalism. Those who took the risk of losing all the capital they bet on 28-year-old Mark Zuckerberg are entitled to their return. And they will get it. And anyone who thinks otherwise has their head in the sand.

Originally appeared on AVC.com

Some Perspective

2012-06-05T19:04:31-04:00

I don't disagree with PG when he says that Facebook's IPO performance (or lack thereof) has the potential to impact valuations in startup land. I think it will be particularly impactful on the late stage and secondary markets where most of the IPO valuation speculation is happening.

But let's put Facebook's current valuation in perspective. At the closing price of $26.90, Facebook commands a valuation of $57.5bn (according to Google Finance). Facebook had around $4 billion of cash prior to going public and raised about $10 billion, so let's assume they have $14 billion in cash on the books. That means Facebook has an enterprise value of roughly $43 billion.

In its last quarter Facebook had $1 billion of revenue and 40 percent pre-tax operating margins. If we annualize those numbers, that would be $4 billion of annual revenue and $1.6 billion of annual pre-tax operating margins. Let's use pre-tax operating margins as a proxy for EBITDA, because this whole post is back of envelope quality analysis and please take it for what it is.

That means that Facebook's enterprise value is greater than 10x current revenue run rate and greater than 25x EBITDA. These are big multiples, folks. I am happy to take those numbers for any company out there.

Clearly Facebook is a premium company and commands a premium valuation and entrepreneurs should not expect to get 10x revenues and 25x EBITDA for their companies in a sale or an IPO. But even at half those numbers, there are fantastic returns for investors and entreprenuers to be had.

If speculators are disappointed with the performance of the Facebook IPO it is because they had ridiculous expectations of what rational investors would pay. The market has put a premium valuation on a great company and we should be happy about all of that. I certainly am.

Tolerance and Prosperity

2012-05-08T16:19:44-04:00

Yesterday, my partners and I invited Paul Romer over to USV for lunch. For those that don't know, Paul is a leading thinker in the world of economics and currently a Professor at NYU. It was a fascinating conversation. My favorite part of it was Paul's "lecture" on William Penn, early Pennsylvania, and the reaction to the growth of Pennsylvania from neighboring states.

William Penn was a Quaker and when King Charles II gave him a large piece of his land holdings in America, Penn created the colony of Pennsylvania and grounded it in the notions of tolerance and religious freedom. Instead of limiting Pennsylvania to Quakers, they welcomed all comers. And the result was that Philadelphia became the fastest growing city in America with a vibrant economy and lifestyle.

The neighboring colonies, which were initially centered around a single religion, reacted to Pennsylvania's and Philadelphia's economic success by opening up their cultural norms and becoming more tolerant as well.

Paul told us this story as a lesson in why cultural norms, even more than laws, are a determinant of prosperity and economic development. And tolerance is one of the more important cultural norms in this regard.

As Paul was giving us this lecture, I thought of my friend Bob Young's blog post about North Carolina's Amendment One, which seeks to ban same sex marriages. North Carolina is the only southern state that does not have such a law on its books. North Carolinans will be voting on Amendment One today.

Bob's argument is as much an economic one as a social one. Bob says:

This proposed amendment to our state constitution is specifically telling them we don't want their friends and fellow Americans to come here. We need these talented, intelligent young Americans to come to North Carolina to help our technology industries succeed, but they have choices. They can go to states with mottos like "Live Free or Die" instead of states that attempt to tell them how to live their lives, such as this Amendment One does. And trust me, these bright young Americans can and will chose to join my competitors in Seattle, or San Jose, or New York.

North Carolina has enjoyed a vibrant tech/startup economy and Bob's Red Hat and Lulu.com are two of its best known successes. Bob asserts that changing the cultural norms (and laws) of his home state are not going to be good for the local start-up scene. Bob is right and his concerns are consistent with the lesson that Paul Romer gave us yesterday.

Tolerance and Prosperity go hand in hand. History tells us this. I hope the good citizens of North Carolina listen to Bob because I agree with him strongly on this one.

Previously published on AVC.com

Can the Crowd Be More Patient

2012-04-26T10:52:50-04:00

One of the most noticeable changes to the venture capital business over the past decade is the movement of investment allocation from capital and time intensive sectors like biotech and clean tech to capital efficient and fast moving sectors like internet and mobile.

This makes total sense if you think about it. Venture capitalists are professional money managers. We are provided capital to invest as long as we can return it to our investors with a strong return in a reasonable amount of time. A strong return is 3x cash on cash. A reasonable amount of time is ten years max.

Internet and mobile product development cycles are measured in months not years. And the capital required to get a product built and into the market is less than $1 million. And the returns, when things work out, can be enormous.

Contrast that with biotech. A new drug takes $100 million in capital investment to get to market. And that process can take a decade or more.

If you were a professional money manager, where would you invest? Where has USV invested our investors' capital for the past eight years? It's not even a contest. Internet and mobile wins hands down.

But internet and mobile will not and can not solve all of society's problems. We need new medical approaches to preventing and/or curing disease. We need new scientific approaches to generating, storing, and being more efficient with energy. Maybe we need more space exploration. Maybe we need more undersea exploration.

Enter the crowd.

When the Gotham Gal and I allocate our personal capital, we do it broadly. We give it away to good causes. We invest in things we want to see in the world regardless of whether there is a good return on it. We are driven by the outcome as much as the return.

I suspect that many people approach the allocation of their personal capital similarly. And that is very different than a professional money manager behaves.

So the advent of crowdfunding, for equity, for philanthropy, and for patronage, seems like a great fit with these capital and time intensive projects that the VC business has largely abandoned.

If we saw a promising technology that could prevent or cure cancer, we would be inclined to help fund that, regardless of the timing and magnitude of the financial returns it could produce. If we saw a promising technology that could store and move energy more efficiently, we would be inclined to fund that as well.

I can feel the crowdfunding movement coming. It's in the air. And I think it will be impactful and helpful in many way. And I hope that its impact will be most felt in the sectors that have been starved for capital, not the sectors that are awash in capital.

Staying Independent

2012-04-11T12:34:43-04:00

Possibly the most interesting running conversation I've been having with entrepreneurs lately is how they can keep their companies independent without having to go public and turn their cap table into a casino. There are a bunch of entrepreneurs thinking seriously about this issue and I've been thinking seriously about it too.

Of course if you bootstrap your business and never take outside investors then this is not an issue. You control the timing and the choice of exit and there are no investors to concern yourself with. But there are plenty of entrepreneurs who have built interesting businesses using outside capital -- angel, seed, VC, or some other form -- and they have a portion of their cap table that is seeking a return on their capital on some reasonable timetable.

The emergence of a vibrant secondary market may point to a solution. If one set of investors eventually cashes out to another set of investors who eventually cash out to another set of investors then you have a formula for staying independent while giving your investors liquidity over time.

To some extent this has already been happening in the buyout and private equity world. One financial buyer trades the asset to another financial buyer and so on and so forth. The venture capital industry could potentially adopt some of these practices while leaving the entrepreneur and their management team intact and in control.

Angels and early stage investors who have portfolios with high loss ratios might hold on to their strongest performers for five to ten times their money. Later stage investors who have much less downside risk might hold on for three to four times their investments. Companies could build enterprise value over time generating returns to their various stakeholders who might change over time.

Another possibility is leveraged recaps and possibly dividends. If you build a business with excellent cash flow, there will be cash that can be used to pay out dividends or used to service and pay down debt. Dividends are not tax efficient under U.S. tax law. The Company will pay income taxes on its earnings and then the investors will pay taxes again on the dividends. That is why leveraged recaps are more attractive in the U.S. Instead of paying dividends, the Company borrows funds it can easily service and pay down over time and uses those funds to repurchase stock from its investors.

Both of these approaches (dividends and leveraged recaps) require that the Company have strong recurring cash flow that when multiplied by a cash flow multiple will provide a meaningful gain to the investors.

Let's look at a model of how this might happen. Let's say a company required $10 million of startup capital to get to breakeven. Let's say $3 million of it came in for 20 percent of the business and another $7 million came in for another 20 percent of the business. The investors would then own 36 percent of the business. If over time, that business could earn $20 million per year of pre-tax cash flow, then it would have roughly $12 million of after tax cash flow to pay out. The investors could be paid out $4.3 million per year in dividends (36 percent of $12 million). Over the course of five to ten years, those dividends could deliver a 2.2x to 4.4x return to the investors. The issue with this approach is the tax inefficiency resulting from double taxation and the long time frame it would take to earn a decent but not amazing return.

On the other hand, $20 million of cash flow could be used to borrow $100 million (5x coverage) and that $100 million could be used to repurchase the 36 percent from the investors. The investors would get a 10x return on their investment and the founders would get all of that equity back. It would take 7 or more years to pay off the debt including interest and that would be a large debt balance for a company to carry.

Clearly the leveraged recap is preferential to paying dividends as a way to take out investors with cash flow. Some variation of the leveraged recap will be the way to go for as long as dividends are tax disadvantaged to leverage.

None of these approaches is likely to result in returns that are as good as what could be obtained in a strategic sale at a big premium or an IPO in a strong market environment. A company with $20 million of pre-tax cash flow is likely to have close to or greater than $100 million in revenue and could possibly exit or IPO for between $300 million to $500 million in a strategic sale or IPO in a good market environment. If the investors own 36 percent of the Company, their proceeds in that kind of an exit would be $110 million to $180 million, higher than what could be obtained in any cash flow based exit scenario.

But none of this says to me that new approaches to liquidity for venture investors should not be on the table. If the entry price is right (rare these days) and the investor is patient and if the entrepreneur and company is willing to get creative, there are ways to get early investors liquidity at acceptable rates of return that compensate for the risk of the early investment that do not require selling the company or taking it public.

I am working on this on a few fronts. Nothing urgent or imminent. But I am confident we will see our firm utilize some of these different approaches in the coming years. I think we have to if we want to continue to serve the interests of entrepreneurs and the companies they create.

This post was first published on AVC.com.

Cloning Successful Startups

2012-04-05T13:51:15-04:00

Jeff Leventhal, the CEO of our portfolio company WorkMarket, emailed me yesterday. He said:

i would love to see an avc post about copycats like samwer bros. what do u think of this form of entrepreneurs, etc?

I looked back over my archives and I guess I've never addressed this topic here at AVC. So here goes.

It's a free market out there. People can do what they want. That's even more true globally. If you are successful, you will be cloned. That's life. In fact, it's a sign that you've made it when clones of your website, mobile app, and business start cropping up.

That said, I am not a fan of this behavior and approach to making money. It is devoid of any creativity. It doesn't inspire me. And we avoid doing it and investing in those who do it. As Jeff said to me in an email reply:

the problem is that people make money doing it........these people should just internally understand that they are not entrepreneurs and not creating true value.

I agree with Jeff on that.

Some will say, "But you are an investor in Zynga and they copy others' games." I accept that critique but we committed to invest in Zynga when it was just poker on Facebook and that was an entirely new idea. They grow by adapting other games to their social model for sure. That's the history of the games business by the way. Even so, I'm not attracted to or inspired by this approach to making money.

Our approach at USV is to invest in the category creator, the innovator, the market leader. That's what attracts us to startups. And when the category creator executes well, we have found that it can win the market by a long shot and produce fantastic returns.

There are a few examples of USV portfolio companies that were not the category creator. Lending Club is a good example of that. We invested in Lending Club because they innovated around the peer to peer consumer lending model and came up with the winning approach and they are now the clear market leader. That was a late stage investment made out of the Opportunity Fund. I suspect that we will do that kind of thing more frequently in our Opportunity Fund investments.

But in the early stage sector, we are drawn to entrepreneurs who have new ideas, novel approaches, and big visions with long roadmaps. We are not drawn to those who seek to knock off another company and execute it better or in a different geographic market. If that is what you are doing, I am certain you can find investors and I am not looking down on your approach. But we are not the best investor for you and your project.

This post was originally featured on AVC.com.

The Management Team -- While Building Usage

2012-01-09T15:06:37-05:00

So you've built and launched your product. It is well received. You've acheived "product market fit" and it is time to get more users or customers. You've graduated from the "building product" stage and have entered the "building usage" phase. What does this mean for your team?

Well first and foremost, it means you are going to have start building your team. You will need more engineers because you will have to scale the product/service and you will need to continue to build it out, make it available on more devices, and listen to and adapt to the needs of the market. You will need to make sure your product team grows in lockstep with your engineering team and the demands of your users. You will need more customer support/community team members because more users means more users you must engage with and support. You will need to think about a marketing person because acquiring more users is called marketing. You will need to think about business development because you will want to talk with other companies for distribution and for product/service integration. And you may need to hire a sales team if your product has an enterprise/SAAS focus. Finally, you might think about staffing business operations/HR/finance/legal which is probably consuming a fair bit of your time.

The one/two/three/four/or five person team that got your product to market and achieved product market fit is going to grow to at least double that and you may find yourself with upwards of twenty people by the time you are moving out of the "building usage" phase.

Your first management issue is likely to be in engineering because that is where most companies of this stage have the vast majority of their headcount. Your technical co-founder or lead engineer will find themselves managing more than coding. Managing engineering means quite a few things. It means recruiting more engineers. This is a huge time sink but it has to be done. It means retaining engineers. And it occasionally means terminating engineers. But more than building and managing headcount, managing engineers mean making sure the right people are working on the right things, it means making sure the teams are performing well, it means resolving roadblocks. It means creating the right environment for your engineers to be successful.

And many technical co-founders and lead engineers aren't the kind of people who enjoy managing. They would rather be building the product than building the team. You have a few options at this point. You can help your lead engineer become a good manager. I strongly suggest that because everyone can and should become better at managing people. Even if your lead engineer doesn't become your VP Engineering in the long run, this will have been a good investment. But you should also be actively discussing the long term management roadmap in engineering with your lead engineer and if it makes sense, you may have to bring in a VP Engineering who is a great manager and move your technical co-founder or lead engineer into a more technical role. That is often the CTO role.

The other management challenge at this stage is likely to be your own. If you go back to that second paragraph, you will see that many of the hires that are made in the "building usage" stage are going to report directly to the founder/CEO. The additional product hires may report to you because it is likely that you are running product as well. The community team may report to you. And who is leading that team? The business development person, the marketing person, the admin/finance/HR/legal person, and probably all the sales people are likely reporting to you. Have you ever had ten or twelve reports? It is not fun.

A founder/CEO in a management crisis at this stage of the company is a very common thing. In some ways it is unavoidable. None of the teams, other than possibly engineering, is large enough to have its own manager. And so the founder/CEO is mangaing the rest of the business. The best thing you can do in this situation is find other members of the team who have management talent or inclination and invest in their ability to help you manage the team. These is your bench so invest in it and let it help you. During this phase you will find your leaders for the next phase. Just because you have a flat structure and a lean organization doesn't mean you can't be investing in management.

Investing in management means building communication systems, business processes, feedback, and routines that let you scale the business and team as efficiently as possible. I strongly suggest that founder/CEOs at the "building usage" stage start working with coaches. CEO coaches can help you build your own management skills and can help you think about how to build management skills and processes on your team as well. If you have talented managers on your team that you want to invest in, offer them coaches as well.

The "building product" stage is all about individual contributors. And the "building usage" stage continues to be largely about individual contributors. But management starts to creep into the equation at this point. Strong individual contributors are often not natural managers. Some can make the transition. Some can't. And some may not even want to try. This is a very difficult and painful process and a huge management challenge for the founder/CEO.

Next week we will talk about the "building the company" phase when management starts taking a front seat to everything else.

This post originally appeared on AVC.com.

The Management Team While Building Product: Keep It Small

2012-01-03T10:39:58-05:00

The first stage of a startup, what I call the Building Product stage is management light. The team should be small. We have portfolio companies like del.icio.us and duck duck go where the Building Product stage was accomplished by one person, the founder of course. That is not typical.

What is typical is a team of five or less. The founder/CEO is usually the product manager. There is often a technical co-founder who leads the development team. And there are often several developers (two or three). There can be a designer unless the founder is capable of doing the design. That is about it.

There are quite a few of our portfolio companies that had a two person founding team. Both members of the team built the product. Zach Sims and Ryan Bubinski of Codecademy are a good example. As are Daniel Ha and Jason Yan of Disqus. Both of these teams came out of Y Combinator. But two person teams are not limited to Y Combinator. Dennis and Naveen built Foursquare as a two person team. Greg Yardley and Jesse Rohland built Pinch which is now part of Flurry as a two person team. Billy and Yang built and launched Turntable.fm as a two person team. David Karp and Marco Arment built, launched, and ran Tumblr for well over a year as a two person team. I am sure there are other examples in our portfolio of two person founding teams.

Three person teams are also common. Etsy was built by Chris, Haim, and Rob. That is in many ways the classic founding team. Rob was CEO and product lead including all design. Chris and Haim were the dev team. They built and launched Etsy in about three months if I rememeber correctly.

Hopefully you get the point. Building product is not about having a large team to manage. It is about having a small team with the right people on it. You need product, design, and software engineering skills on the team. And you need to be focused, committed, and driven. Management at this point is all about small team dynamics; everyone on board, working together, and getting stuff done. Strong individual contributors are key in this stage. Management skills are not a requirement. In fact they may even be a hindrance.

Next week we will talk about the Building Usage stage where team building and management skills start becoming necessary.

This post originally appeared on AVC.com.

Continuous Feedback

2011-11-16T10:46:12-05:00

We have a portfolio company that will remain nameless that does something I want to call out as super awesome. Every board meeting, as homework after the meeting, they ask each board member to fill out a simple Google Form with two questions; three things we are doing well and three things we need to do better. They've been doing that every board meeting that I've been to.

They use this information as part of their continuous feedback loop to improve their management of the business and in turn improve the business. Based on their progress since our investment, I'd say it works pretty well.

This is one example of a larger theme I am noticing in our portfolio and the startup world at large. Companies are using simple web tools to get continuous feedback on their performance. They are using this kind of approach to do performance reviews of everyone in the organization, they are using this kind of approach to get feedback from their customers, and they are using this kind of approach to get feedback from their Board, investors, and advisors.

This makes a ton of sense. Startups are rapidly changing systems. If you use an annual review cycle, you aren't getting feedback at the same pace that you need to adapt and change the business. Doing this kind of thing continuously matches the frequency of the feedback loop with the frequency of the business.

I've written in the past about continuous deployment and how I have seen that work really well at some of our portfolio companies. Continuous feedback leverages many of the same principals and has many of the same advantages. If you haven't tried this approach, you might want to. From what I've seen, it works.

This post originally appeared on AVC.com.

A Veterans Day Story

2011-11-11T10:02:58-05:00

Yesterday I met with an entrepreneur from Israel who has built a Facebook app called Chat Rounds that allows you and a buddy to hang out, video chat, and play games and watch videos together. He told me that the service is particularly popular with military people stationed abroad and away from their families.

Skyping with your spouse works well enough but apparently it is hard to get the kids to hang out on Skype for long. But in Chat Rounds, the kids can play games or watch cartoons with their parent half way across the world in some war zone.

I was moved by that story. When my dad was in Vietnam, we lost a parent for a year. Thank god we didn't lose a parent for good.

Being in the military is a tough job. Not only do you have to put yourself in harms way in service of your country, you have to leave your families at home. It is a great sacrifice.

So on this Veterans Day, let's remember and thank all the veterans out there for their service to our country. It is too easy to take it for granted.

This post originally appeared on AVC.com.

What Is A Lead Investor?

2011-11-08T14:48:19-05:00

The term "lead investor" is often misunderstood. I have seen VCs negotiate to be called a co-lead or a lead in the term sheet. But you don't get given that designation. You earn it.

Glenn Kelman (a long time AVC regular) has a great blog post on this featuring former Sequoia partner, now Khosla partner, Pierre Lamond in the lead investor role:

Then Pierre Lamond, the Sequoia partner on the deal, began working out of our office, acting as the virtual CEO. Pierre made a point of being there the day one of his other companies went public. We looked at a news photo of all the smiling people, who seemed to be living in a gated community, on a planet I would never visit. Then Pierre said "that company was once even more screwed up than you are."

Glenn describes a strong parental figure providing support, encouragement, and criticism in equal doses. And he goes on to explain why:

That anyone gave us money was a miracle. But once we get the money, we prospered, eventually becoming one of only two technology companies to go public in 2002. I wondered why Sequoia went to such great lengths to get Plumtree funded when it would have been easier to write off the few hundred thousand dollars invested in our company. And the simple answer was that Sequoia cared about its reputation and stood by its companies.

That last bit is the key point. It is what every VC firm I respect and admire does. It is what VCs should do. It is the bargain we make with entrepreneurs when we invest.

I am old fashioned. I was trained by a couple VCs who are Pierre's age. This is how they taught me to do the VC business. It is how I do the VC business. It is how USV does the VC business. And I think it is ultimately the only way you can do the VC business.

The post originally appeared on AVC.com.

What Is A Revenue Based Loan?

2011-10-17T08:43:38-04:00

Back when we were doing our MBA Monday series on Financing Options For Startups, I got an email from my friend Andy Sack. Andy was one of the first entrepreneurs we funded by in the mid 90s with our Flatiron Fund. He's done something like a half dozen startups since then and he's a veteran in the very best sense of the word.

Andy said "You missed an important option Fred - revenue based financing. I've got a new firm called Lighter Capital that does just that". I said, "Can you write a blog post for MBA Mondays explaining how it works?" So today, we have a guest post/advertorial on Revenue Based Financing from Andy/Lighter Capital. I hope you like it.

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Fred's series on alternative financing options has been awesome to follow, especially because it broadens the discussion of how companies can fund business growth when they can't (or don't want to) raise venture capital or bank debt. Fred's original list missed one option - revenue-based finance - that's near to my heart and I've been encouraging entrepreneurs and angels to consider, and Fred graciously let me offer my insights here.

Disclaimer: I am founder of Lighter Capital and have a self interest in educating and promoting the use of this new type of financing called revenue-based finance. I'm also a serial technology entrepreneur and believe this type of financing has real advantages to traditional debt and traditional real advantages over equity for the entrepreneur.

A revenue-based finance (RBF) investment provides capital to a business by "selling" an ongoing percentage of a company's future revenues to the investor. For simplicity, you can think of it as a revenue share type of arrangement. Investor gives capital to company in exchange for a small percentage of gross revenues. RBF lives as a hybrid of bank debt and venture capital. This kind of financing has been around for a while in non-tech industries such as mining, film production and drug development, but it's recently been gaining traction in the world of growth finance and early-stage technology funding.

I want to explain how an RBF structure is different than traditional funding sources, detail what situations could be better suited for an RBF structure (for entrepreneur and investors alike), and offer a word of warning about the businesses that aren't a good fit for the structure.

First, let me explain how a revenue-based loan works:

Instead of a typical bank loan which requires a business to pay a fixed interest payment, a revenue-based loan receives a percentage of revenues over a specified amount of time, allowing "interest" payments to fluctuate when a growing company has inconsistent cash-flows or lumpy or seasonal revenues. In a world where business costs such as software and infrastructure are increasingly becoming "as-a-service" and adjust with the ebbs and flows of a business needs, RBF payments automatically ramp up and down along with a business. It's the inherent variability of RBF that makes the structure so appealing so appealing. Imagine if your business loan payment reduced to zero if your business revenue dropped to zero for an unanticipated quarter, and then automatically kicked backed on when your revenue returned. Another way of saying this is RBF turns loan repayment from a fixed expense to a variable expense.

So, when does it make sense to raise revenue-based funding? Revenue-based loans are, by nature, most appropriate for companies already generating revenues but without hard assets typically required to get bank loans. It's especially applicable for companies that have lumpy, seasonal, or hard to predict revenues.

 For entrepreneurs, revenue-based loans are attractive to founders who are allergic to dilution and loss of control. The structure of RBF is often non-dilutive to founders and does not require a board seat. The financing is obtained without having to agree to a valuation, which leaves management in control of the company and typically requires no personal guarantees from management.  RBF means you can grow without swinging for the fences

For investors, funding using an RBF structure provides an opportunity to get a return on their investment without needing an exit. While this is clearly an advantage for investors, it also means company founders shouldn't get as much pressure from investors to "swing for the fences" and the projected return due to the investor can be lower as the entrepreneur repays the investor more quickly.

As Fred has mentioned before, big exits are rare for startups. Some ideas have the potential to be home runs, but others are better suited to operate as smaller, standalone businesses. For the companies in the latter category, raising money from VCs who expect the big exits can misalign goals. A revenue-based loan has the potential to better align incentives for investors and founders in these cases. With that said, if you're a pre-revenue, startup still figuring out your business model or considering some kind of "go big or go home" strategy, there can be realadvantages to working with the equity-based venture capital or angel investors. Similarly, certain businesses, especially brick-and-mortar and manufacturing-focused businesses may not have the margin profiles to pay monthly payments of 2-5% of revenues.

An RBF structure isn't limited to specific funds - angels, VCs or banks could theoretically provide capital in this manner, but the risk/return profile of RBF doesn't always fit the investor's needs. Similarly, RBF may not be the best funding option for all businesses. In the right circumstances, the hybrid approach of revenue-based finance for startup funding can have advantages over traditional debt or equity, but there are admittedly situations where the more traditional options still make sense - such as restaurants or infrastructure-heavy startups.

If you're considering raising money from angel investors, I'd suggest discussing this in the event that it may align your incentives better or at least help avoid some of the painful valuation negotiations. There are a few funds -Lighter Capital and Next Step in Texas, among others focused on this type of structure and I'd suggest taking a look at those options as well. There are clearly different scenarios where any number of Fred's financing alternatives could prove more appropriate for your business, but the revenue-based loan structure can be a great option for profitable companies looking for a straightforward way to raise funding without dilution, change of control, or a personal guarantee.

This post originally appeared on AVC.com.

What We Are Seeing

2011-10-13T13:45:51-04:00

The Wall Street Journal has a story out today that says "Web Startups Hit Cash Crunch." There has been a fair bit of reaction in the tech blogs and I thought I'd toss into the discussion some things we are seeing:

1) There are so many startups out there raising money. I don't think this is a bad thing. It's a good thing. Entrepreneurship is in vogue. Innovators are innovating. Makers are making. But I cannot remember a time when we have gotten more inbound traffic. It is not just coming from entrepreneurs. It is coming from angels, seed investors, VCs, lawyers, accountants, friends, aunts, uncles, you name it. I'm waiting for the guy who sits at the front desk in our building to pass me a business plan on my way into the office.

2) There are a lot of "me too" investments out there. And the delineation between startups is getting narrower. Almost every investment that comes our way these days causes us to ask ourselves "is this too close to xyz?" with xyz being one of our exisiting portfolio companies. The startup market is hypercompetitive. The user base is finite at some level. The capital markets are finite at some level. And the number of startups chasing these markets seems to have doubled or tripled in the past couple years.

3) VCs are having a tough time raising money. The conventional wisdom is that 10-20% of venture funds produce 100% of the returns in the asset class. LPs (that's what we call our investors) are all chasing that top 10-20% and that leaves 80-90% of the VC firms struggling to raise money. The one bright sign in LP land is that emerging managers (what USV was a few years ago) are getting more attention from LPs. I'd rather be a new firm raising a first fund than a mediocre firm raising fund five right now.

4) Angels may be topping out, at least temporarily. This is more of a guess than the previous three. What happens to every angel is that they start making investments. They get excited. They make a bunch of them. And then two things happen. First, a few of their investments struggle and fail. And second, a few of their investments can't raise money and come back to them for a second round. They begin to realize that startup investing isn't so easy and that they have a finite amount of money they can invest or that they are willing to invest. They pull back a bit, see how things are going to play out, and become a bit more cautious. Given the massive amount of angel capital that has come into the market in the past few years, I wonder if we are seeing some cooling of that market as all the new investors take stock of where they are and where they want to go next.

5) The internet investing market is transitioning. Social was the driving force for the past three or four years. In the wake of Facebook and Twitter, how could it not be? Mobile has also been a hot theme. Both sectors have consolidated a few winners and a number of additional interesting emerging companies. But how many social platforms of scale will there be? Five, ten, twenty? And mobile is hard because distribution continues to be limited to the app store model where you get on the leaderboard and win or you don't and you don't. Investors are moving into new areas like cloud, peer to peer marketplaces, and trying to take what worked in consumer into the enterprise. There is no lack of interest in internet investing, but investors are having to learn new markets and new sectors. And that kind of transition takes the heat out of an overheated market.

So, is there a "cash crunch" for web startups? Not that we are seeing. Our portfolio companies have all been able to finance themselves when they have wanted to. And we have made more investments this year than any year we've been in business (maybe 10-20% more, not 2x more). But I do believe we are in for a bit of a reality check. We've had quite a run here and all big runs are followed by pullbacks. The public markets for stocks and bonds has been relatively weak all year and that has to have some impact. It is likely that we will see more startups having trouble going from the seed round to the A round, or from the A round to the B round.

That's a good reason to take money from a firm that stands behind its portfolio companies. At USV, we have never failed to do at least one follow-on round with the sole exception of Delicious, which sold to Yahoo! instead. We don't promise the next round. We don't commit to it. But we are supportive to a fault. And we are proud of it. Being an entrepreneur is hard. Having supportive and caring investors helps. In the market we are in (or heading into) it will help more.

This post originally appeared on AVC.com.