I've been pretty clear as of late that I think the market for investing in web startups is getting overheated. When I talk to some people about this, they say "you should shut down and ride out the bubble on the beach." To which I say "we don't think we can time markets."
If you had a crystal ball, then doubling down when the market is ice cold and folding your hand when the market is white hot would be a great investment strategy. But nobody has a crystal ball and timing markets is a lot harder than it seems.
So I prefer to focus on pacing ourselves. What I like to say is "we should add the same number of names each year to our portfolio and put out about the same amount of cash each year." The number we try to add each year is 6-8 new portfolio companies. Union Square Ventures has been investing since November 2004 so we've been in business exactly six years. And we will have 37 portfolio companies soon. So that is almost exactly 6 new investments per year. We had 31 portfolio companies at year end 2009, so we've added 6 new names this year.
I don't have the cash outlay numbers handy this sunday morning but I do know that it took us four years to put the 2004 fund to work. And or current forecasts are that it will take us four years to put the 2008 fund to work. So that's a good proxy for cash outlay per year.
This strategy works particularly well in the venture capital business because we generally will make three to four investments in each company, spread out over a five to six year period. So no one investment at a "bubble valuation" will impact our average valuations across our portfolio. Said another way, we will invest in 20 to 25 companies per fund and we will have three to four investments in each company, so we will make 60 to 100 individual investments in any fund. If we spread those 60 to 100 investments over a six to eight year period, we can average out the valuation spikes and valleys.
I observed this strategy at work in the first VC firm I worked for. The partners had been investing for fifteen years when I showed up and they had evolved into this strategy and taught it to me. When I left that firm and started Flatiron Partners in 1996, Jerry and I started out with a reasonable and steady pace. It took us about three years to put our first $150mm fund to work. But when we got our second fund of $350 million in 1999, we adopted a different approach. The first mistake was to raise a much bigger fund just as the market was getting overheated. The second mistake was to put that fund to work in 18 months. We went from putting out $50 million per year to putting out $250mm per year, just as the bubble was reaching its peak. The results speak for themselves. We made greater than 5 times on that first fund. Eleven years later, we will be lucky to make 2 times on the $350 million second fund.
So when I look at where we are right now, it reminds me so much of 1999 and frankly it scares me. But we are not pulling back. We are sticking with our investment strategy and putting out cash and adding new names to our portfolio. But we are doing it with a very close eye on pace, both in terms of names and cash outlays. I think that is the right approach and that it will serve us well as we navigate the tricky waters we find ourselves in.
This post originally appeared on AVC.com on November 21, 2010.
Steve Blank: The New Internet Bubble And The New Rules For Startup Success
Roger Ehrenberg: Another Internet Startup Bubble? Depends Where You're Standing
Steve Blank: Venture Capitalists Are Not Your Friends
In any case, the article is very well-considered, well-written and perfectly clear.
The key idea behind "venture capital" investing is that, when you possess a very large tank full of very-liquid fuel, you have the option to selectively lift certain companies above and (you hope...) beyond the one limitation that normally limits them: "the availability of liquid cash."
"Cash you got, a'plenty." But if you pour it onto the ground without successfully igniting a fire, you've just poisoned a modest colony of earthworms.
Technology ventures, in particular, will =always= require cash, because "technology is a very hard crop to raise." It can't come to fruition at all without an incubator; a warm greenhouse. That can easily tempt you, though, into "breathing your own air" and thus convincing yourself that, "all they need is an incubator; a warm greenhouse."
If there is nothing adverse pressing against YOU ... if there is no "Court Jester who is the One And Only Soul who can speak his mind to the King without getting his head lopped off" ... what's to press you into making the wise decision as to who should continue to get money and who should not? In the last decade, there were lots of "dot-bomb" startups (I worked for several of them, and made stock-options from a very few of them) who frankly didn't care if they succeeded or not because their funding was not conditioned upon their "succeeding or not," AND they knew it.