Bill Gurley wrote an incredible post yesterday titled On the Road to Recap: Why the unicorn financing market just became dangerous … for all involved. It’s long but worth reading every word slowly. I saw it late last night as it bounced around in my Twitter feed and then read it carefully just before I went to bed so the words would be absorbed into my brain. I read it again this morning when I woke up and I expect I’ll read it at least one more time. I just saw Peter Kafka’s summary of at at Re/code (We read Bill Gurley’s big warning about Silicon Valley’s big money troubles so you don’t have to) and I don’t agree. Go read the original post in its entirety.
Fred Wilson’s daily post referred to the article in Don’t Kick The Can Down The Road. Fred focuses his post on a small section of Bill’s post, which is worth calling out to frame what I’m going to write about today.
“Many Unicorn founders and CEOs have never experienced a difficult fundraising environment — they have only known success. Also, they have a strong belief that any sign of weakness (such as a down round) will have a catastrophic impact on their culture, hiring process, and ability to retain employees. Their own ego is also a factor – will a down round signal weakness? It might be hard to imagine the level of fear and anxiety that can creep into a formerly confident mind in a transitional moment like this.”
Fred and I have had some version of this conversation many times over the past twenty years as we both strongly believe the punch line.
Entrepreneurs and CEOs should make the hard call today and take the poison and move on
But why? Why is this so hard for us a humans, entrepreneurs, investors, and everyone else involved? Early in Bill’s post, he has a section titled Emotional Biases and it’s part of the magic of understanding why humans fall into the same trap over and over again around this issue. The “Many Unicorn founders …” quote is the first of four emotional biases that Bill calls out. If that was it, the system could easily correct for this as investors could help calibrate the situation, use their experience and wisdom to help the founders / CEOs through a tough transitional moment, and help the companies get stronger in the longer term.
Of course, it’s not that simple. Bill’s second point in the Emotional Biases section is pure fucking gold and is the essence of the problem.
“The typical 2016 VC investor is also subject to emotional bias. They are likely sitting on amazing paper-based gains that have already been recorded as a success by their own investors — the LPs. Anything that hints of a down round brings questions about the success metrics that have already been “booked.” Furthermore, an abundance of such write-downs could impede their ability to raise their next fund. So an anxious investor might have multiple incentives to protect appearances — to do anything they can to prevent a down round.”
Early in my first business, a mentor of mine said “It’s not money until you can buy beer with it.” I’ve carried that around with me since I was in my early 20s. Even when I personally had over $100 million of paper value in an company I had co-founded and had gone public (Interliant), I didn’t spend a dime of, or pretend like I had a nickel of, that money. In 2001 and 2002 I learned a brutal set of lessons, including experiencing that $100 million of paper money going to $0 when Interliant went bankrupt. And, as a VC, I experienced a VC fund that was quickly worth over 2x on paper that ultimately resulted in being a money losing fund. I didn’t buy any beer or spend all the money on random shit I didn’t need and fundamentally couldn’t afford.
This specific bias is rampant in the VC world right now. As Bill points out, many funds are sitting on huge paper gains which translate into large TVPI, MOC, gross IRR, or whatever the current trendy way to measure things are. However, the DPI is the interesting number from a real perspective. If you don’t know DPI, it’s “distributed to paid in capital and answers the question “If I gave you a dollar, how much money did you actually give me back?” This is ultimately the number that matters. Structuring things to protect intermediate paper value, rather than focusing on building for long term liquid value, is almost always a mistake.
Let’s go to number three of the emotional biases in Bill’s list:
“Anyone that has already “banked” their return — Whether you are a founder, executive, seed investor, VC, or late stage investor, there is a chance that you have taken the last round valuation and multiplied it by your ownership position and told yourself that you are worth this amount. It is simple human nature that if you have done this mental exercise and convinced yourself of a foregone conclusion, you will have difficulty rationalizing a down round investment.”
This is linked to the previous bias, but is more personal and extends well beyond the investor. It’s the profound challenge between short term and long term thinking. If you are a founder, an employee in a startup, or an investor in a startup, you have to be playing a long term game. Period. Long term is not a year. It’s not two years. It could be a decade. It could be twenty years. While there are opportunities to take money off the table at different points in time, it’s still not money until you can buy beer with it, so the interim calculation based on a private valuation when your stock is illiquid just shifts you into short term thinking and often into a defensive mode where you are trying to protect what you think you have, which you don’t actually have yet.
And then there’s the race for the exit, in which Bill describes the downward cycle well.
A race for the exits — As fear of downward price movement takes hold, some players in the ecosystem will attempt a brisk and desperate grab at immediate liquidity, placing their own interests at the front of the line. This happens in every market transition, and can create quite a bit of tension between the different constituents in each company. We have already seen examples of founders and management obtaining liquidity in front of investors. And there are also modern examples of investors beating the founders and employees out the door. Obviously, simultaneous liquidity is the most appropriate choice, however, fear of price deterioration as well as lengthened liquidity timing can cause parties on both side to take a “me first” perspective.
This is one of the most confounding issues that accelerates things. Rather than making long term decisions, individuals optimize for short term dynamics. When a bunch of people start optimizing independently of each other, you get a situation that is often not sustainable, is chaotic and confusing, and inadvertently increases the slope of the curve. In the same way that irrational enthusiasm causes prices to rise faster than value, irrational pessimism causes prices to decline much faster than value, which increases the pessimism, and undermines that notion that building companies is a long term process.
Those are my thoughts on less than a third of Bill’s post. The rest of the post stimulated even more thoughts that are worth reflecting deeply on, whether you are a founder, employee, or investor. Unlike the endless flurry of short term prognostications that resulted from the public market decline and subsequent rise in Q1, the separation of thinking between a short term view (e.g. Q1) and a long term view (the next decade) can generate profoundly different behavior and corresponding success.
Mark Suster wrote a great post yesterday titled The Resetting of the Startup Industry. Go read it now – I’ll wait.
Once again, as we find ourselves in the middle of a significant public market correction, especially around technology stocks, there’s an enormous amount of noise in the system, as there always is. Much of it is very short term focused and, like a giant tractor beam, draws the conversation into a very short time horizon (as in days or weeks). And, rather than rational and helpful thoughts for entrepreneurs, it often brings out the schadenfreude in even the most talented people.
Mark’s post is one of the first in this cycle that I’ve seen from a VC giving clear, actionable advice . One of my favorite lines in buried in the middle:
“I’ve heard enough companies say “we simply can’t cut costs or it will hurt the long-term potential of the business” to get a wry smile. We entrepreneurs have been spinning that line for decades in every boom cycle. It’s simply not true. Pragmatic cost cuts are always possible and often productive.”
Many companies have hired ahead of their growth rate because they had the cash to do so. In our portfolio, we generally don’t have this problem because we aren’t big fans of either (a) overfunding companies or (b) escalating burn rates based on headcount. But, occasionally we find ourselves in the position on the board of a company where, as you look forward, you realize you are burning more than you should be for the stage you are at. As Mark suggests, this is a moment when you can proactively make pragmatic cuts. It will suck for a few days but feel a lot better in the long term.
But, more importantly, is another point Mark buries later on, which includes an awesome post of his from 2010.
“If you need to clean up your own cap table first – while very hard to do – it will make outside funding easier”
Again, go read the post now – I’ll wait. It’s so nice there are other great VC bloggers who write this stuff so I can just point at it.
I learned this lesson 127 times between 2000 and 2005. I started investing in 1994 and while there was some bumpiness in 1997 and again in 1999, the real pain happened between 2000 and 2005. I watched, participated, and suffered through every type of creative financing as companies were struggling to raise capital in this time frame. I’ve seen every imaginable type of liquidation preference structure, pay-to-play dynamic, preferred return, ratchet, share/option bonus, option repricing, and carveout. I suffered through the next financing after implementing a complex structure, or a sale of the company, or a liquidation. I’ve spent way too much time with lawyers, rights offerings, liquidation waterfalls, and angry/frustrated people who are calculating share ownership by class to see if they can exert pressure on an outcome that they really can’t impact anyway, and certainly haven’t been constructively contributing to.
I have two simple rules for founders in my head from this experience. First, make sure you know where the capital is going to come from to fully fund your business. You might have it in the bank already. Your existing investors might be willing to provide it. Or you might need to raise it. Until you are consistently generating positive cash flow, you depend on someone else for financing. And, in this kind of environment, that can be very painful, especially if you need to go find someone who isn’t already an investor in your company (e.g. your insiders require there to be an outside lead, or you need to raise much more capital than your insiders can provide.)
Second, keep your capital structure simple. There are three things that will mess you up in the long run:
Mark’s post has good solutions for each of these, but the best is – as a founding team – to work with your investors to make sure that everyone is aligned for the upside case, rather than focused on protecting their capital in the downside case. For this, like so many other things in life, means “simple is better.” Most importantly, don’t be afraid to talk about it early, well before you have to go through another financing round.
I woke up this morning in Fort Worth, Texas. For the first minute I wasn’t really sure where was I but it eventually snapped into focus. This happens to me periodically when I travel.
I’ve got a stretch where I’m on the road a lot. Fortunately, I’ve got amazing partners. I was reflecting on this over a cup of stale coffee this morning.
One of our deeply held beliefs at Foundry Group is that all four of us work on, and are responsible, for every company we are investors in. We don’t have silos where there are “Brad companies” or “Ryan companies” or “Seth companies” or “Jason companies.” In about 90% of the companies we are investors in, two of us are actively involved. In about 50%, three of us are actively involved. But in 100% of the cases, we all know what is going on, have relationships with the founders and CEO, and can quickly engage and help wherever and whenever we bring something to the mix.
As a result, we’ve always been active at moving primary responsibility for a company (which we define as a board seat) between partners. This is, in effect, a simple form of load balancing that we are all technically aware of from our early investments in some companies that generated, or used, very visible load balancing products before some of these technologies started to become absorbed into the core Internet infrastructure (anyone remember early DNS round robin approaches?)
We have a full day offsite every quarter. One of the things we do is a full portfolio review. Part of that is a load balancing exercise. In addition, we do this exercise as each partner returns from their one month annual sabbatical, as the other three partners have already been handling that partner’s primary responsibilities.
The load balancing process is collaborative. We aren’t randomly moving companies around between us, but rather thinking hard about where a particular partner can help – both in terms of the specific company as well as reducing cognitive load on another partner.
We recently load balanced the companies I was primarily responsible for as (a) my load was excessive and (b) we knew I’d be on the road a lot in Q1. We made a few changes just before I went on sabbatical, talked about it a little more when I returned, and then made a few more changes two weeks ago.
As I sit here a little bleary eyed from the past few days, I realize how powerful this process is at many levels, most importantly eliminating any ego dynamics across the four of us when we think about the portfolio (as the load balancing includes a full range of companies – from those doing extremely well to those struggling.) And, I feel intense relief and satisfaction that I work with three partners who I trust as deeply as I do.
Two words: Mattermark Daily
When I started blogging in 2004 I think I was the third VC blogger after David Hornik* and Fred Wilson (if you were, or know, of another pre-2004 VC blogger, please tell me so I can update my historical recollection.)
I remember lots of people asking me why I was doing it. I heard plenty of trash talk from other VCs, especially second hand, such as “He doesn’t have enough to do”, “He’s not spending his time doing his job”, or “What a waste of time.” I didn’t care, as I was doing it – like Fred often said – to help me think out loud in public, learn about different things, and get a conversation going around topics I was interested in. In retrospect, it was also helping me “practice writing” and without all the practice, it’s unlikely I would have ever gotten in the rhythm of writing a book a year.
Today, hundreds of VCs blog. Some are focused on using content marketing strategies to build their brand and reach. Some seem to have a full time person on the team generating content for them. Some do it under their name; other’s do it on their firm’s web site. Even more have tried and never got past a dozen posts.
Regardless of one’s success, it’s become extremely hard to track all the new content coming out and sort the good from the bad. My somewhat up-to-date VC People Feedly collection has 139 feeds in it. But I stopped being rigorous about adding new people about a year ago and rarely added feeds that were directly on firm websites, so I expect there are probably closer to 500 active VC bloggers now. And, this doesn’t include the guest articles that regularly show up on various sites like TechCrunch, VentureBeat, and Business Insider.
Rather than struggle to keep up, I’m just defaulted to relying on Mattermark Daily to tell me what to read each day. And, I always remember what I tell entrepreneurs: “It’s just data – and it’s often wrong.” Read a lot, but always apply your own critical thinking.
*Update: Naval Ravikant told me that he, Kevin Laws, and Andrew Anker were also part of VentureBlog (dating back to 3/2003). It now appears to be Hornik’s blog.
In January, Jerry Neumann wrote a long and detailed analysis of his view of the VC industry in the 1980’s titled Heat Death: Venture Capital in the 1980’s. While I don’t know Jerry very well, I like him and thought his post was extremely detailed and thoughtful. However, there were some things in it that didn’t ring true for me.
I sent out a few emails to mentors of mine who had been VCs in the 1980s. As I waited for reactions, I saw Jerry’s post get widely read and passed around. Many people used it as justification for stuff and there were very few critical responses that dug deeper on the history.
Jack Tankersley, a long time mentor of mine, co-founder of Centennial Funds, and co-founder of Meritage Funds, wrote me a very long response. I decided to sit on it for a while and continue to ponder the history of VC in the 1980’s and the current era we are experiencing to see if anything new appeared after Jerry’s post.
There hasn’t been much so after some back and forth and editing with Jack, following is his reaction to Jerry’s piece along with some additional thoughts to chew on.
It is good that Mr. Neumann begins his piece in the 70’s, as that era certainly set the table for the 1980’s. You may recall I got into the industry in 1978.
The key reason for the explosion in capital flowing into the industry, and therefore the large increase in practitioners, had nothing to do with 1970’s performance, early stage investing, or technology. Instead, it was the result of two profound regulatory changes, the 1978 Steiger Amendment, which lowered the capital gains tax from 49% to 28%, and the 1978 clarification under ERISA that venture capital investments came within the “prudent man” doctrine. Without these changes, the 1980’s from a venture perspective would not have happened and the industry would have remained a backwater until comparable regulation changes stimulating capital formation were made.
Secondly, the driver of returns for the funds raised in 1978 – 1981 was not their underlying portfolios, at what stage, or in what industries they were built. Instead, the driver was the 1983 bull market. The Four Horsemen (LF Rothschild, Unterberg Tobin, Alex Brown, H&Q and Robinson Stephens) basically were able to take any and everything public. Put a willing and forgiving exit market following any investment period and you get spectacular returns.
So contrary to the piece, it wasn’t VC were good at early stage technology, it was that they had newfound capital and a big exit window. For example, my firm at the time, Continental Illinois Venture Corporation, the wholly owned SBIC of Chicago’s Continental Bank, had many successful investments. Some were Silicon Valley early stage companies, such as Apple, Quantum, and Masstor Systems. I handled CIVC’s investments in the latter two (in fact, I also “monitored” Apple as well). Take a look at the founding syndicates of each:
|Masstor Sytems (5/1979)||Quantum Corporation (6/1980)|
|CIVC||$ 250,000||CIVC||$ 200,000|
|Mayfield II||$ 250,000||Sutter Hill||$ 790,000|
|Continental Capital*||$ 250,000||KPC&B II||$ 775,000|
|Genstar**||$ 275,000||SBE+||$ 700,000|
|S & S***||$ 225,000||Mayfield III||$ 500,000|
|BJ Cassin||$ 75,000|
*Highly regarded private SBIC, **Sutter Hill Affiliate, ***Norwegian Shipping Family, +B of A’s SBIC
What is striking about these syndicates is that nobody had any meaningful capital, which forced syndication and cooperation. CIVC’s only “competitive” advantage was its ability to write a check up to $1 million. In this era, the leading VC firms such as Mayfield, Kleiner, and Sutter Hill (all shown above), rarely invested more than $1 million per company.
When we syndicated the purchase of the Buffalo, New York cable system, we literally called everybody we knew and raised an unprecedented $16 million, a breathtaking sum in 1980. As dollars flowed into the industry, cooperation was replaced by competition, to the detriment of deal flow, due diligence, ability to add value and, of course, returns.
CIVC had a number of highly successful non-technology investments made in the late 1970’s timeframe, such as:
None of these companies fit Mr. Neumann’s definition of the era’s venture deals and each generated returns we would welcome today.
For many years preceding 1999, the 1982 vintage was known as the industry’s worst vintage year. Was this a function of “too much money chasing too few deals” as many pundits claimed? Not really; it was a result of an industry investing into a frothy market at higher and higher valuations in expectation of near term liquidity, and suddenly the IPO window shutting, leading to no exits and little additional capital to support these companies.
Mr. Neumann’s post also misses the idea that it was a period of experimentation for the industry, This time period saw the rise of the industry-focused funds and the advent of the regional funds. Many of the industry funds were wildly successful (in sectors such as media communications, health care, consumer, etc.), while none of the non-Silicon Valley regional firms were long-term successful as regional firms. Some regional firms, such as Austin Ventures (in Austin, TX) did prosper because they subsequently adopted either an industry or national focus. The remainder failed as a result of the phenomenon of investing in the best deals in their region which typically were not competitive on a national or global scale. Just imagine doing Colorado’s best medical device deal which was only the 12th best in its sector in the world.
Some additional observations include:
The 1980’s proved there is more than one way to “skin a cat”. Early stage technology may be one; but it is not the only one and may not be the best one, then or now. My advice to a venture capitalist, then, now or later, is simple: Do what you know, do what you love; build great companies and over time you will succeed.
The other day, Mark Suster wrote a critically important post titled One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes. Go read it – I’ll wait. Or, if you just want the paragraph, it’s:
“If this note converts at a price higher than the cap that you have been given you agree that in the conversion of the note into equity you agree to allow your stock to be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”
I also have seen the problem Mark is describing. As an angel investor, I have never asked for a liquidation preference on conversion that is greater than the dollars I’ve invested. But, I’ve seen some angels ask for it (or even demand it), especially when there is ambiguity around this and the round happens much higher than the cap. The entity getting screwed on this term are the founders, who now have a greater liquidation preference hanging over their heads than the dollars invested by the angels. Mark has a superb example of how this works on his blog.
We’ve been regularly running into another problem with doing a financing after companies have raised convertible notes. Most notes are ambiguous as to whether they convert on a pre-money or a post-money basis. This can be especially confusing, and ambiguous, when there are multiple price caps. There are also some law firms whose standard documents are purposefully ambiguous to give the entrepreneur theoretical negotiating flexibility in the first priced round.
If the entrepreneur knows this and is using it proactively so they get a higher post-money valuation, that’s fair game. But if they don’t know this, and they are negotiating terms with a VC who is expecting the notes to convert in the pre-money, it can create a mess after the terms are agreed to somewhere between the term sheet stage and the final definitives. This mess is especially yucky if the lawyers don’t focus on the final cap table and the capitalization opinion until the last few days of the process. And, it gets even messier when some of the angels start suggesting that the ambiguity should work a certain way and the entrepreneur feels boxed in by the demands of his convertible note angels on one side and priced round VC on the other.
The simple solution is to define this clearly up front. For example, in the Mattermark investment from last year, I said “We are game to do $5m of $6.5m at $18.5m pre ($25m post).” When I made the offer, I did not know how the notes worked, what the cap was, or what the expectation of the angels were. But when Danielle Morrill and I agree on the terms, it was unambiguous that I expected the notes to convert in the pre-money.
In contrast, in the Glowforge deal, which Dan Shapiro talks about in his fun post Glowforge Completed its Series A with an Investor we Never Met, I was less crisp. I knew that Dan’s notes were uncapped with a discount and I knew his lawyer well, so I didn’t define the post-money in this case. Since the notes were uncapped, I expected them to convert into the pre-money. But I didn’t specify it. The notes were ambiguous and we focused on this at the end of the process after docs had gone out to the angel investors. Rather than fight about this, I accepted this as a miss on my part and let the post-money float up a little as a result. The total amount of the notes was relatively small so it didn’t have a huge impact on the economics of the investment but we could have avoided the ambiguity by dealing it with more clearly up front.
Recognize that this is simply a negotiation. In Mattermark’s case where there were a lot of notes stacked up, I cared a lot about the post-money. In Glowforge’s case where the note amount was modest, I didn’t care very much. And, while I care a lot about my entry point as an early stage investor, I’ve learned not to optimize for a small amount in the context of a pricing negotiation.
I think we are just starting to see the complexity, side effects, and unintended consequences created by the massive proliferation of convertible notes over the past few years. I’m pretty mellow about them as I’ve accepted that they are part of the funding landscape, in contrast to a number of angels and VCs who feel strongly one way or the other. As derivative note vehicles have appeared, such as SAFE, that try to create synthetic equity out of a note structure, we’ll see another wave of unintended consequences in the next few years. As someone who failed fast at creating a standardized set of seed documents in 2010, I’ve accepted that dealing with the complexity and side affects of all of the different documents is just part of the process.
Fundamentally, it’s up to the entrepreneur to be informed about what is going on. I hope Mark’s blog post, and this one, are additive to the overall base of entrepreneurial knowledge. And, if Jason and I ever write a third edition of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist our chapter on convertible notes might now be two chapters.
We are in a cycle again where how much you raise is the story. It’s what the press likes to write about (e.g. Company X raised Y from A, B, and C). Now that everyone is overly focused on unicorns, the headline number on the valuation (e.g. Company X raised Y at a valuation of Z from A, B, and C) has crept into the story on big rounds.
While this makes for press release fodder and ego gratification, it’s of very little use to entrepreneurs. There’s no real story there. No understanding of the human dynamics behind the financing. No understand of what actually went down. No underlying metrics that drive the financing. No real perspective on how people thought about things and the choices they made. Just happy talk focusing on the dollar raised. Zero educational value around anything.
Recently, the gang at SalesLoft told the detailed story of their $10m financing. Kyle and his team went through Techstars Boulder in 2012 before moving back to Atlanta and being leaders in energizing the Atlanta startup community. Kyle followed the tradition of extreme openness about the financing process that I think Rand Fishkin started with his post three years ago titled Moz’s $18 Million Venture Financing: Our Story, Metrics and Future.
If you’ve never read Rand’s post on our financing, it goes through an extraordinary amount of detail about Moz’s business, the financing process, the terms, and the timeline. Rand did NOT run this by me before posting it – I saw it at the same time as the rest of the world. He did ask if it was ok with me that he’d be this transparent. I reminded him that I signed up for TAGFEE when I invested, it was his company, and he could write whatever he wanted.
After he posted it, he sent around the link to a few prominent people in the tech media. None of them covered the financing in any way. A few days later, I sent out a few emails asking folks I knew at these sites why they hadn’t written anything, since they so quickly write Company X raised Y from A, B, and C. I didn’t get responses from everyone I wrote, but the ones I got back said something like “Rand wrote too much – there was no story here once he put that post up.”
I found that fascinating. When I pondered it, I realized how divergent the media was becoming from what entrepreneurs were thirsty for in terms of substance.
Late last year, Danielle Morrill followed in Rand’s footsteps with an epic post about our $6.5m financing of Mattermark. In it, she talked a lot about the process, just like Rand did, along with disclosing all kinds of information about the business, the valuation, and what she experienced. I also wrote a post about the financing using Mattermark as An Example of How We Decide to Invest.
Interestingly, the media wrote more this time. I don’t know if it’s because Danielle is in the bay area (while Rand is in Seattle), or the story has broadened. But when I go back and read the media stories, they are still overly focused on the amount of the financing, rather than the story behind it.
Another company that did an awesome transparent funding announcement was Buffer (and app and company I love, but am only a tiny investor in via an AngelList syndicate) when they announced We’re Raising $3.5m in Funding: Here is the Valuation, Term Sheet and Why We’re Doing It. Data, data everywhere. And lots and lots of story.
Now, I’m not suggesting that every entrepreneur should write transparent funding announcements. That’s up to the entrepreneur. But I think it’s super valuable to read the ones that are out there. The amount of useful information to entrepreneurs who are building their companies, both for process, dynamics, and comparables, is enormous. And, while these funding stories are positive, the path to them is often a complete mess, such as Rand’s Misadventures in VC Funding: The $24 Million Moz Almost Raised or Danielle virtually stomping her feet in frustration when she wrote Mattermark Has Raised $2M in Our Second Seed Round.
In my book, this is a lot more useful to read than Company X raised Y at a valuation of Z from A, B, and C. Thanks to the entrepreneurs who are brave enough to put this out there.
You may recognize Scott’s name – I wrote about him in my post When VCs Don’t Bullshit You.
The next person on the list of supporters is Scott Maxwell at OpenView Venture Partners. Scott and I were both on the Microsoft VC Advisory Board that Dan’l Lewin organized and ran. While we had never invested together, I felt like Scott was a kindred spirit. We both spoke truth to Microsoft execs, even though they mostly ignored us. I remember a meeting with the Microsoft Mobile 6.0 team as they were pitching us their vision for Microsoft Mobile 6.5. Both Scott and I, on iPhone 1’s or 2’s at the time, told them they were completely and totally fucked. They ignored us. A year or two later they had less than 3% market share on mobile. We had a blast together and as we went out to raise our Foundry 2007 fund, Scott made several introductions which resulted in two wonderful, long term LP relationships.
That’s how a friendship develops, at least in my world. You do stuff together, learn from each other, and then do things for each other. Simple.
Scott’s post is a great history lesson about the evolution of “value-added VC” behavior, especially around organization building by VC firms to “add more value” to their portfolio companies.
Before I dig in, I need to express two biases. First, whenever someone says “I’m a (adjective) (noun)” I immediately think they are full of shit. When someone says “I’m a great tennis player”, I immediately wonder why they needed to tell me they are great and it makes me suspicious. “I’m a deep thinker” makes me wonder the last time the person opened a book. “I’m a value-added VC” makes me think “Isn’t that price of admission?”
Second, I went through the scale up of the organizational VC firm in the late 1990s at Mobius Venture Capital. When we started Mobius, we were four founders and two EAs. At one point we were a 70 person organization, with 10 partners, 20 associates, two business development people, three recruiters, a marketing person, two incubators (anyone remember Hotbank?), a staff to run the Hotbanks, a big back office for accounting, EIRs, and some others folks.
It was a disaster. Now, you can argue that we were terrible at it. Or that we completely fucked it up. Or that our basic premises about what we were doing was wrong. Or that how we managed it was ineffective. Or that it would have worked great if only the Internet bubble hadn’t collapsed. Or probably 83 other arguments.
Regardless, it created a very deeply held belief that I share with my partners at Foundry Group that we wanted to run a VC firm that had none of this. We didn’t want associates. We didn’t want to grow. We didn’t want to build an organization. Instead, we wanted to be extremely close to the entrepreneurs and do all the work ourselves. It just occurred to me that we are bare metal VCs. That kind of fits with the word Foundry in our name.
So, my fundamental biases are (a) I don’t like the phrase “value-added investor” and (b) I have no interest in building a VC firm that looks like one that is configured the way many of the current larger VC firms are organizing themselves.
However, while it’s a bias, I have no opinion on whether it’s a better or worse approach. It’s a different approach. And that’s totally cool – there are lots of different ways to do things successfully. And there are lots of different ways to fuck things up.
In my opinion, Scott is one of the guys that is doing this effectively. I’m an investor in Scott’s funds and a very happy one. Scott’s also been thinking about this and working on it for over 15 years, now at two different firms, so he has a lot of run time with what works and what doesn’t. Many folks that are trying to incorporate “value-add infrastructure” into their firms would be wise to read his post carefully.
Now, if you are paying attention to my biases, you’d logically ask “So why did you co-found Techstars and why are you and your Foundry Group partners so involved?” Remember that it’s a different approach. We deeply believe that the way companies are created and funded, especially at the seed stage, is radically changing on a permanent basis. Techstars, at the very beginning, was based on this premise. It’s scaling magnificently around this premise and the iteration loop on learning is incredibly tight. And, while we are very close to it, Techstars is not “our firm” so we can help with our opinions, lessons we’ve learned, and belief system without having to run it.
Remember, there are lots of different ways to do something. However, there’s a huge difference between “doing something” and “doing something successfully.” The distinction is always worth paying attention to.
I got the following question the other day.
“If you get a chance, I’d request you to write a blog post about various business decision related conflicts or misunderstanding that might occur in a partnership and how you folks at the Foundry Group resolve it. My partners and I grapple with such challenges quite often.”
Every VC firm is different so to answer a question like this, it’s important to remember that the answer is one specific to Foundry Group. Never forget that VCs Are Like D&D Characters.
When my partners and I started Foundry Group in 2007, we created a set of deeply held beliefs that we carry around with us every day. Some of them are about our strategy and some are about our behavior.
One of our deeply held beliefs is that “We will address and resolve all conflict between us directly, clearly, quickly, and openly.”
This is easy to say but very hard to do. It means that there will be no passive aggressive behavior on anyone’s part. We won’t carry around things that bother us. Instead, we’ll put them on the table to discuss. We have to have a strong basis of trust, which we’ve extended to the notion of “business love.”
It has to be ok to be upset, to disagree, to be sad, to be disappointed, and to be unhappy. These are normal emotions. Things don’t work, they can be confusing, frustrating, or downright miserable. A partnership has to be a safe place to be open about these emotions, especially when they are being generated by someone in the partnership.
The deeply held belief is nice, but unless there are tactics and consistent action to back it up, it ends up being meaningless. There are three things we do to make sure we execute on this deeply held belief.
Weekly Time and Space for Discussion: We have a set time on Monday’s – between 11am and 1pm – where the four of us meet every week. Unlike many firms that chew up an entire Monday of “partner meeting stuff”, we do it over lunch. As part of this we have a chance to touch base with each other once a week. This is like flossing your teeth – it gets rid of the easy stuff.
Regular Dinner / Offsite: We have a full day offsite at least quarterly and as often as monthly. We spend at least an hour on the question “How are each of us doing?” In this case, “doing” means “emotionally doing” and covers what is on our mind, how we are feeling, what is stressing us (professionally and personally), and how we are doing with each other. Sometimes the discussion is balanced between the four of us; other times it ends up being focused on one person. We always end these days with a long dinner together, which allows us to spend more time on our collective relationships.
Be Direct: I wrote about this in a post last year titled Brutal Honesty Delivered Kindly. In all of these discussions, we are direct. We are kind to each other and never gratuitous in our comments, but always speak the truth. And when someone is wrong, he owns it.
Fundamentally, it’s about communication. Without the deeply held belief, we don’t have a clear context for how the communication works. But the combination of the deeply held belief and regular practice over the past eight years, has resulted in a highly efficient, trusted form of conflict resolution. Sure, we screw up plenty, but it’s easy to recognize, acknowledge, and course correct when we do.
I was on an airplane for the first time for business in a while and when I woke up from my nap I found my self staring at CNBC on the DirecTV seat back display. I never watch CNBC so I was attracted to the talking heads, who were silent since I didn’t have earphones in. I kept thinking I was watching ESPN with all the sports metaphors, blinking lights, constantly changing headlines, and tightly coifed and good looking men talking at me in rapid fire.
Between a headline about Carly Fiorina exploring a run for president and Zebra Technologies equipping all NFL players with tracking devices I noticed one about companies who were raising prices to inflation proof their business. At least, that’s what I thought it said since it flashed up there quickly between a headline about “Steel is on Fire” and then a video of Warren Buffett walking around without a headline so I had no idea why they were showing him.
The inflation proofing headline stuck in my head. We’ve had a very long period of low to no inflation, at least based on the way the government calculates it. While my cynicism around government math and how inflation is calculated is substantial, there isn’t much question that since 2008 capital has been extremely cheap. Fred Wilson wrote a great post titled The Bubble Question a while ago where his punch line was:
It is the combination of these two factors, which are really just one factor (cheap money/low rates), that is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime. I have no idea when and if that will happen. But until it does, I believe we will continue to see eye popping EBITDA multiples for high growth tech companies. And those tech companies with eye popping EBITDA multiples will use their highly valued stock to purchase other high growth tech business and strategic assets at eye popping valuations. It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.
But I think cheap capital is only half of the equation. The other half is ever increasing labor costs across all aspects of the wage chain. When I was in business school in the 1980s, we talked a lot about the productivity paradox. The premise was that computers and automation would drastically improve productivity, making labor less important as tasks were automated, resulting in lower cost of labor.
As the technology industry rapidly evolved, the notion of non-productivity kept coming up. Nicolas Carr’s HBR Article “IT Doesn’t Matter” was probably the capstone piece around this and how companies could take advantage of the commoditization of IT, rather than how IT was a transformative input into companies and societies.
Suddenly, in 2010, technology was disrupting everything and the technology industry was booming. By 2013 everyone was talking about a bubble, even though the companies being created this time around were substantial. Once again, wages for IT employees and computer scientist were skyrocketing and suddenly coding schools were popping up everywhere, to the point that people are now saying that Computer Programming Is a Trade; Let’s Act Like It.
Capital remains incredibly cheap, so it’s flowing into wages. But that’s only at the high end of the market around technology jobs. At the other end of the spectrum, we have the famed jobless recovery with the elimination of massive numbers of jobs that previously existed, especially in industrial and Fortune 5000 companies. While this is happening, we have an entirely new class of entrepreneurs, or self-employed, being created by companies like Uber.
Yeah – this shit is super complicated and it plays out over a long period of time. In fact, it might only be really possible to understand what is happening in hindsight. But the combination of cheap capital and expensive labor has created a very powerful economic dynamic which right now is driving massive innovation across virtually every industry sector around the world.
We know that extremely low cost of capital will not last forever. We know that eventually there will be real inflation again. And we know that wages can’t increase endlessly. I wonder what happens to the allocation of capital, entrepreneurship, and the impact on society when capital gets expensive again?