Five Years Too Late

November 15, 2008

The more things change, the more they stay the same…

Filed under: downturn, venture capital — Tags: — fiveyearstoolate @ 9:31 am

Another guest post from a member of the RRE Team – here Jim Robinson IV shares a few thoughts and anecdotes about a lot of the discussion flying around the web about the VC model being broken. – EDW

James D. Robinson IV

James D. Robinson IV

As this discussion gets underway – again – I pulled together a bit of perspective. I call it, “Things I heard when I first joined the world of venture capital as an intern in 1991”.  For those more recent to this industry, during that period the business was down and out after the ‘88-90 debacle. Many funds had stopped investing, there were few IPOs, older guys were retiring, cents-on-the-dollar returns, etc… I remember thinking maybe I should have my head examined for coming into VC just as it was dying.  My boss at the time, Bill Hambrecht, wondered the same thing…

So here are a few of the things people were saying in 1991:

  • “The VC model is broken”
  • “There is too much money chasing too few deals”
  • “VC’s are too arrogant and the pitching process is too inefficient”
  • “Superfunds with $100 million or more are in trouble and will fail”
  • “Software companies are much more capital-efficient and this requires a new way of thinking about VC”
  • “Software is over as a category. Just like disc drives, there are too many me-too companies. Only the big ones will survive”
  • “LP’s are moving away from VC as an asset class given the return profile and future prospects”
  • “The number of firms will decline dramatically” (was about 600 then, depending on what you count)
  • “IPO’s are much tougher and will stay that way; exits – and returns – will suffer for a decade or more”
  • “Future opportunities are in biotech and ‘specialty materials’, not IT.

The above were not just random comments, but in fact the ‘prevailing wisdom’ of the day held by many, including lots of VCs, entrepreneurs, LP’s, etc.

By contrast, here is what I hear today….

  • “The VC model is broken”
  • “There is too much money chasing too few deals”
  • “VC’s are too arrogant and the pitching process is too inefficient”
  • “Superfunds with $200 million or more are in trouble and will fail”
  • “Internet companies are much more capital-efficient and this requires a new way of thinking about VC”
  • “IT is over as a category. Just like web 2.0 companies, there are too many me-too companies. Only the big ones will survive”
  • “LP’s are moving away from VC as an asset class given the return profile and future prospects”
  • “The number of firms will decline dramatically” (is about 1200 now, depending on what you count)
  • “IPO’s are much tougher and will stay that way; exits – and returns – will suffer for a decade or more”
  • “Future opportunities are in ET and Nanotech, not IT”

I actually agree with a number of the sentiments above. Of course, I did back then, too. Yeah, I know. This time it’s different. Right? I wonder, in 15 years, what we will say.

Whenever I read these kinds of discussions, it always gets me to a more humble place, where I realize history tends to repeat far more often than not, no matter how much we wish it were not so. It also reminds me of a bunch of my favorite famous quotes from the past…

“640K (of conventional memory) ought to be enough for anybody.” – Bill Gates, CEO and founder of Microsoft, 1981

“There is no reason anyone would want a computer in their home.” — Ken Olson, president, chairman and founder of Digital Equipment Corp. (DEC), maker of big business mainframe computers, arguing against the PC, 1977

“We don’t like their sound, and guitar music is on the way out anyway.” — President of Decca Records, rejecting The Beatles after an audition, 1962

“Transmission of documents via telephone wires is possible in principle, but the apparatus required is so expensive that it will never become a practical proposition.” — Dennis Gabor, British physicist and author of Inventing the Future, 1962

“There is practically no chance communications space satellites will be used to provide better telephone, telegraph, television, or radio service inside the United States.” — T. Craven, FCC Commissioner, 1961

“The world potential market for copying machines is 5000 at most.” — IBM , to the eventual founders of Xerox, saying the photocopier had no market large enough to justify production, 1959

“I have traveled the length and breadth of this country and talked with the best people, and I can assure you that data processing is a fad that won’t last out the year.” — The editor in charge of business books for Prentice Hall, 1957

“Computers in the future may weigh no more than 1.5 tons.” — Popular Mechanics, “predicting” the relentless march of technology, 1949

“Television won’t last because people will soon get tired of staring at
a plywood box every night.”
— Darryl Zanuck, movie producer, 20th Century Fox, 1946

“I think there is a world market for maybe five computers.” — Thomas Watson, chairman of IBM, 1943

“Who the hell wants to hear actors talk?” — H.M. Warner, Warner Brothers, maker of silent movies, 1927

“The radio craze will die out in time.” — Thomas Edison, American inventor, 1922

“That the automobile has practically reached the limit of its development is suggested by the fact that during the past year no improvements of a radical nature have been introduced.” — Scientific American, Jan. 2 edition, 1909

“Heavier-than-air flying machines are impossible.” — Lord Kelvin, British mathematician and physicist, president of the British Royal Society, 1895

“X-rays will prove to be a hoax.” — Lord Kelvin, British mathematician and physicist, president of the British Royal Society, 1895(?)

“The phonograph has no commercial value at all.” — Thomas Edison, American inventor, 1880s

“Everyone acquainted with the subject will recognize it as a conspicuous failure.” — Henry Morton, president of the Stevens Institute of Technology, on Edison’s light bulb, 1880

“Drill for oil? You mean drill into the ground to try and find oil? You’re crazy.” — Drillers whom Edwin L. Drake tried to enlist to his project to drill for oil, 1859

“Rail travel at high speeds is not possible because passengers, unable to breathe, would die of asphyxia.” — Dionysius Lardner, Professor of Natural Philosophy and Astronomy at University College, London, and author of The Steam Engine Explained and Illustrated, 1830s

“…so many centuries after the ‘Creation’ it is unlikely that anyone could find hitherto unknown lands of any value.” — Committee advising King Ferdinand and Queen Isabella of Spain regarding a proposal to provide venture capital to Christopher Columbus, 1486

“Stock prices have reached what looks like a permanently high plateau.” — Irving Fisher, Yale University Professor of Economics, 1929 (two weeks later, the stock market crashed and the Great Depression started)

And finally, as it relates to predicting the future:

There are many methods for predicting the future. For example, you can read horoscopes, tea leaves, tarot cards, or crystal balls. Collectively, these methods are known as “nutty methods.”  Or you can put well-researched facts into sophisticated computer models, more commonly referred to as “a complete waste of time.Adams, Scott

Predicting the future is easy. It’s trying to figure out what’s going on now that’s hard.Dressler, Fritz

The more unpredictable the world is the more we rely on predictions. Rivkin, Steve

It’s tough to make predictions, especially about the future.Berra, Yogi

November 6, 2008

Self-sufficient is the New Sexy

Filed under: downturn, venture capital — Tags: , — fiveyearstoolate @ 5:59 pm
Stuart Ellman

Stuart Ellman

I was at a board meeting the other day and a portfolio company CEO surprised me. I was concerned that it was taking a little longer to sign up a key partner and therefore we would run short on cash. The CEO told me that he will never run out of cash. Not only has he run the company incredibly frugally, but he is only going to spend money when he is able to get that cash from revenues. In the short term, he will take on some consulting assignments that are relevant to his core business. Wow. This is music to my ears. This is a CEO that lived through the 2001 crash and knows what it is like to raise money during times like these. To VCs, this is incredibly appealing… even sexy.

Another CEO was telling a different story and not hearing what he wanted back from his investors. He has done a terrific job growing his company, the leader in a new and sexy space. He doubled his revenues last year and will double them again this year. His problem is that his company burns (and will continue to burn) a lot of money. He went out to market and assumed the environment would be easy given how great he is performing. But, as a very knowledgeable source said, many VCs are just out to hurt their friends right now. People only want to put new money in a deal at washout and vulture-like prices. I keep getting calls from other VCs to join them in deals at $0 pre-money valuations. Wow, I haven’t heard calls like that since 2001. So, this unhappy CEO is getting back indications of interest, but only at punitively low prices. As a result, he is looking to his existing investors to do the round. The problem is, existing investors do not have enough money to fully fund the company. Don’t forget, VCs also have time limits, percentage limits, and dollar limits on existing investments. That is not a happy boardroom. It is about as appealing as sitting in a middle seat on an airplane next to a smelly guy.

Right now, growth is not sexy if it’s accompanied by a high burn rate. To navigate through this climate, every CEO needs to perform a simple analysis: First, how much money is in the bank (not including debt)? How much runway does this give you at your current operational posture? And what are you going to do about it?

  • First choice, get to cash flow positive on that money.
  • Second choice, get the cash to last for two years..
  • Third choice, see how much money you can gather from existing investors to get to cash flow positive.
  • Last choice, go to outside investors to get the additional money. Yes, there may be exceptions to the rule, but it is not a pretty market for companies with a high burn right now, period.

If there is one thing etched into my memory from the last funding drought, it is that CEO’s always wished they had cut more deeply earlier. A company with 70 employees will think it is cutting to the bone if it goes down to 50 employees. “I just cant go any lower without killing the business.” That is true until they then cut to 35, and then to 25 employees. At 25 employees, the CEO always wishes he had done the hard cut earlier and saved the money and uncertainty. Yes, it is not fair to have to cut a company that has performed well. But, when markets change, you have to do it. Great CEOs have failed because they have not reacted appropriately to changes in the funding environment.

So, hear it from me, or hear it from the markets soon enough. Become self sufficient on the cash you have. Even at the expense of growth. Frugal is sexy again.

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November 4, 2008

The Truth, or What We Want to Hear?

Filed under: Pitching, Startups, venture capital — Tags: , , — fiveyearstoolate @ 11:18 am
Eric Wiesen

Eric Wiesen

Years ago, when I was a Silicon Valley lawyer, a VC client related an amusing anecdote about being pitched by early-stage companies (I know, VC jokes are always the funniest). The observation he made was that every startup, regardless of sector, business model or average sale price has the same 5-year revenue projection: $50 million, plus or minus a few. The reason, he explained, was that if the 5-year number is much lower than $50M, the VCs won’t be interested, and if it’s much higher than $50M the VCs won’t believe the projections.

Last week, a company that didn’t follow this rule pitched RRE for their Series A round. This was a good pitch – a credible entrepreneur with deep industry experience and network, looking to take a “2.0″ approach to a business where the entrepreneur had already had some success back in the 1990s with a “1.0″ solution. It was all looking pretty good, and we were progressing smoothly through the presentation, checking off a lot of the boxes I’d need to see in order to start a process internally. Until we arrived at the financial projections.

As a sidelight, the financial projections for an early-stage company are always speculative. Entrepreneurs know it and so do investors. But they help us, if nothing else, get a sense of how a given founding team thinks about the scope of an opportunity. And in this case, the financial projections showed the company quickly ramping up to about $15M and then almost totally leveling off, to the point where the 7-year projection was around $25M. And while I didn’t want to play into the stereotype above, I was professionally obligated to ask why the growth slowed dramatically in the “out years” in the model?

There are a few possible answers to this question, frankly none of them particularly encouraging.

  1. You can (and most people, facing this question, do) argue that the assumptions in your model are so overwhelmingly conservative that while your projections say a small number, you really expect a much larger one. That doesn’t do well – while we appreciate conservative projections, it should be at the margin. If you really think this is a $100M business, your number should be relatively close to that.
  2. You can tell us that this simply isn’t a particularly big market, and that the slow growth in the out years represent an early ramp to scale, and a tough fight for market share once the original ramp has been climbed. This is troubling, as early-stage VCs rarely want to get involved unless the addressable market is large enough to generate a big outcome.
  3. You can tell us that the market is very fragmented, and that growth will be hard to come by as you fight with incumbents for share. This, too, isn’t something we like to hear, as it implies that it will be expensive and difficult to grow, and as Stuart sometimes says, “Some markets are just too hard”.

When pressed, this entrepreneur gave answer #2 – this is a market with a finite number of customers, and the financial projections he gave me reflect his (expert, I agree) estimate of his ability as a newcomer with a superior product, to gain market share – quickly at first, and more slowly in the out years.

The challenge is this – I appreciate the honesty this founder showed in telling me his genuine viewpoint on where the company can go. He also shared that he views this is a “good but not great” exit. A “double” if you like baseball metaphors. He’s doing this the right way, building realistic expectations for his business rather than telling me what I want to hear.

And yet – what I want to hear is that this can be a $100M revenue business that we can credibly see as a billion-dollar exit if everything goes according to plan. Because early-stage investing is simply too difficult to bet on companies where the best-case scenario is a $100M exit, even if that’s a great multiple on a couple million invested. Because best-case scenarios are rarely achieved, and when they are, it needs to be a real event for RRE.

So if I were this entrepreneur’s friend, and he asked me for advice on pitching RRE on this business, what would I tell him? I think the route he chose is admirable, but isn’t going to get him an investor. I simply can’t pound the table at our Monday meeting and insist that we have to do this deal, because even though I really like the team and the product vision, if they don’t think it can be a huge winner, I can’t. And I certainly don’t want him to lie to prospective investors about likely success, because that will simply lead to an unpleasant and combative Board of Directors/Management dynamic, when investors realize they’ve been sold a bill of goods.

No, I think what I would tell him is this: Go back over your plan from the beginning and see if there’s a way to make it bigger. Are there adjacencies you can exploit once you’ve established a beach head in your target market? Are there additional streams of revenue you can exploit? Underlying data assets, lead generation, marketing partnerships, greater distribution? Are there different verticals or other opportunities for value-added services within the vertical you’ve chosen?

If you want to be a venture-funded company, try to find a way to have a $50M business doing what you’re doing. Because while the anecdote at the outset is amusing, the risk profile of early-stage venture capital is such that you are going to get a lot of no’s if you can’t look us straight in the eye and get to some number close to that.

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October 28, 2008

Adaptive Blue

Eric Wiesen

Eric Wiesen

When we launched Five Years Too Late, it was for a few reasons, one of which was to provide transparency into our investment process and how we think about both the investments we’ve made and those we choose not to make. We hope that this transparency will add some value to the overall conversation happening on the web around venture capital and entrepreneurship, and that entrepreneurs will better understand RRE and the deals we do through this effort.

Today we are happy to announce our investment in AdaptiveBlue, a Series B round led by RRE. AdaptiveBlue is a New York company developing semantic and social web technology and products. This announcement coincides with the release of the company’s new product, “Glue“, which allows users to socially interact and connect around common objects like books, movies, restaurants and music. Glue is a contextual network – meaning that it enables consumers to browse the web and seamlessly see and interact with everyday things, while simultaneously gaining a social layer of insight and reference related to those objects. Because of the way Glue attaches to the user’s browser, users don’t have to make substantial changes to their browsing behavior – the Glue toolbar will simply drop down where appropriate.

This investment is the result of a sector-wide analysis we conducted of the “semantic web“, a set of technologies and approaches that we think address some of the fragmentation issues starting to become problematic across the web. As users spend their time and attention on an increasing number of websites, both product-related and social, the user’s experience is being increasingly divided into smaller and smaller pieces when what is needed to create a better interaction is some level of connectivity between these silos.

At a high level, we chose to make this investment for two big reasons, and these reasons map pretty cleanly to the highly-abstract investment framework we sometimes talk about: People, Technology and Markets.

  1. People. We are extremely impressed with Alex Iskold and his team. Alex has struck us over the course of many meetings and time spent together, as a creative, thoughtful and deeply intelligent technical founder, who has been able to crack some pretty difficult problems in some very elegant ways. His public-facing web persona, as evidenced by his writing for ReadWriteWeb and his various other blogging bits and pieces, strongly reinforce this viewpoint. We think that he’s already developed innovative products, and we are happy to have the opportunity to bet on him to continue to do so as semantics becomes a bigger and more central part of the user experience webwide.
  2. Technology. The notion of using technology to understand the meaning and intent of pages on the web (rather than merely parsing for keywords) is a non-trivial exercise to say the least, and we are impressed with AdaptiveBlue’s development to date. We think there is real value being built in the company’s technology and that defensibility will be built along two fronts – difficulty of replication and a growing network of users. This first is further along today, but with the release of Glue the second can begin to gain some momentum. The dual goals of connecting silos of data and of providing social sentiment around the things contained in those silos are problems we think are well worth solving, and that Adaptive Blue is on the right track.

Where we think we might be taking some risk is the market today, only insofar as it is nascent. But we are quite confident that we will live in a world where semantics are used to digest, connect and curate the web in a way that helps us as consumers to consistently be presented with a sort of socially-filtered web experience, where the preferences and viewpoint of our friends and others around the web inform our consumption of web content. We think AdaptiveBlue is well-positioned to capitalize in a big way on this vision.

So, welcome Alex and the AdaptiveBlue team to the RRE family. Happy to have you on board.

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October 21, 2008

Setting the Record Straight

Stuart Ellman

Stuart Ellman

I admit it. We at RRE Ventures are terrible at public relations. We tend to want our investments to speak for themselves. So, this is what I hear all of the time, “Yes, RRE… you guys do later stage enterprise and financial services deals, right?”

Wrong. Here is the real answer. The quote above was true in 1997. Not now. We have evolved, much like the rest of the venture industry. We have figured out what we do well, and where there is opportunity. Here is a snapshot of what RRE does in 2008:

Roughly half of our deals are in the New York Metro area. When we started RRE, this wasn’t true, but as NYC has grown as an ecosystem for technology startups, we have allocated an increasing amount of our time, energy and capital to companies here. We love doing NY deals for a bunch of reasons. The environment is getting better and better, we know the entrepreneurs, we get an early look at great companies, and awesome entrepreneurs are starting businesses here. The downturn on Wall Street will only bring more smart people to startups in NYC.

Roughly half of the deals in our latest fund are early stage investments. Why? Mostly because we can. We have a reputation with entrepreneurs for being good startup investors and a firm that’s genuinely interested in the type of company building early stage investments require.  Also, because there are only a handful of VC firms in NYC that will make early-stage investments, we get a look at the very good deals. We have incubated two companies per year in our downstairs conference room during each of the past few years. Sure, there will be higher failure rates with seed investments, but we are often backing CEOs that we have backed before, getting in at lower prices, and having a significant influence on how the companies are built.

Here are the industries that we focus on:
• Consumer and Digital Media
• Mobility
• Green Technology
• Software and Services
• Financial Technology
• Infrastructure

The proof is in the pudding. Here are the early stage and NY deals we have done in the past two years.
• Drop.io
• Storm Exchange
• RecycleBank
• GoMobo
• M-Via
• Peek
• Payfone
• Skygrid
• Stealth Company #1
• Stealth Company #2
• On-Deck Capital
• Betaworks
• Tendril
• Certeon

So yes, we agree that the venture market has gotten tough all of a sudden. But we are still doing deals. The bar is set very high and our valuation expectations have been lowered but we are closing two deals this week. And we like them a lot. And moving forward, we’ll continue to invest in the same mix of early and growth stage deals we’ve been doing for the past few years. We’ll spend a lot of time looking at deals here at home, but will continue to be active in Silicon Valley, Seattle, Boulder and other geographies as well.

In sum, sure – if you’ve got a great B2B company, we’d love to see it. But if you’ve got a great early-stage B2C or B2B2C company, we do those as well. A big reason why we started Five Years Too Late was to take the opportunity to let people know what we do here at RRE. We’re interested in a variety of sectors across a range of stages, and across the information technology spectrum. Late-stage enterprise and financial services deals have been very good to us, but there are a lot of opportunities in a lot of other areas today, and we’re looking at all of it.

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October 15, 2008

You Can Lead a Horse to Water…

Filed under: Startups, venture capital — Tags: , , , , , , , — fiveyearstoolate @ 11:24 am

Eric Wiesen

When talking to companies, frequently consumer-facing companies, I often have a version of the following short conversation below:

Me: So the product looks really great – how are you going to convince consumers to switch to you from [old, hidebound web 1.0 service or manual process]?

Founder: Well, that old [site/product/service] is terrible! Ours has better functionality, is more reliable and look how pretty the rounded corners are (ok, I made that last one up). People will see how much better our product is and users will flock to us. Word of mouth will be inherently viral.

This is a dangerous place to be with your business, and if you’re talking to me or most of my colleagues you’re going to get a lot of push back on this line of reasoning.

Let’s step back. When I was in business school I was fortunate enough to have taken a strategy class from Bruce Greenwald. Professor Greenwald has a powerfully descriptive and predictive framework for considering the competitive positioning of a given company (although I am still working through how to best apply his precepts to early-stage businesses). The framework essentially posits that while there are many different strategic forces acting on a company (including Porter’s five, for the MBAs and business geeks out there), the one that matters far more than anything else are barriers to entry. And if you break down Greenwald’s view of barriers to entry, he looks to one of several sources.
1. Proprietary Technology
2. Economies of Scale
3. Customer Captivity

The first two are pretty well-known in the technology world. Many of the first several generations of successful companies were built by developing technology that others couldn’t match and couldn’t legally copy. There are plenty of examples on the web and elsewhere of companies that have built scale advantage (Ebay, Amazon). And the best companies will have all three (Google).

But I want to talk here about an aspect customer captivity and a how it potentially impacts early stage companies. Professor Greenwald argues (and I agree) that customers (particularly consumers, although businesses as well in limited circumstances) can become captive through sheer habit. There are other, more obvious forms of customer captivity (technology lock-in, ongoing investment, loyalty programs, etc…) but these aren’t present in, say, a consumer-facing web service. And so it seems pretty easy to lure customers away with a better product. And to some extent this logic is rationale, in that if you have chosen to compete against companies without these more obvious forms of customer captivity, you’ve done your business a favor.

But it’s a mistake to think you’re out of the woods just because switching costs are low. In fact, the unseen switching costs of customer habit can be dauntingly high. By way of example I’ll use (as I often do) my mother. My mother uses AOL. My dad got the whole family AOL accounts in 1995. I never used mine because I already had a university account and my younger brothers eventually ditched theirs as well. Even Dad ultimately switched. But Mom is still chugging away on AOL. My brother (who spent almost four years at Google) tried endlessly to convince her to switch to the more elegant, functional and reliable gmail. No dice. She’s used to AOL. And so she stays.

I bring this up because it demonstrates some powerful captive behavior. Email is an impure example because the archives and persistence of a long-standing email address provide additional sources of captivity besides habit. Think about someone you might know who still uses the travel site they started using in 1997. Or the mapping site they started using in 2000. Better alternatives have arisen since then, yet people frequently “just stay with what they know”.

This has powerful implications both offensively and defensively for your web business. Offensively it means that you can’t simply rely on “if you build it, he will come” product superiority. Customer habit is such that EVEN IF users can be convinced with marketing to check out your terrific new product, your war is far from won, because some large percentage of them will say some variant of, “Yeah that’s cool. But I’m fine with what I have”. Your marketing battle with this customer has just begun. On the defensive side, it is useful to think about instrumenting your product or service to encourage customer captivity. And while that sounds nefarious, it doesn’t have to be – building habit and addictive experience is powerful medicine, and by building customer habit you are generating captivity explicitly by delivering value to your customers.

Build something that users want to use every day and by the time someone comes out with something a little shinier, you will have the benefit of customer habit. Today, though, you need to work on how to overcome it.

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October 6, 2008

Good Money After Bad?

Filed under: venture capital — Tags: , , , , — fiveyearstoolate @ 4:42 pm

Eric Wiesen

Stuart Ellman

Lately we’ve been talking about how VCs respond to the current climate in terms of hurdles for new deals, fundraising and focus on specific sectors. But we’ve also been thinking a lot of about how to keep our current portfolio companies running effectively and successfully. Venture-backed companies almost always need additional rounds of financing, and turn first to current investors to provide that financing. Sometimes, the decision whether you continue to fund new rounds is easy. For example, imagine you funded a Series A company with a great CEO. He (or she) took the first round of financing and built a great product in a growing market that looks like it will have overwhelming demand. So when the time comes to fund again, you take (at least) your pro rata share in the new round of financing. Everybody is happy.

Unfortunately, the picture is not always so rosy. Let’s take a different and more difficult example. Let’s say your portfolio company previously raised a Series B round at a valuation of $30 million (your piece was $6 million) to roll out the new, exciting product. The company discovers that demand for the product is significantly less than budgeted. The CEO realizes that the product is in trouble and lays off much of the staff. He has a new idea for reformulating the product and offering it in a different market. But he needs $6 million from his existing investors to take on that market. On a pro-rata basis, it means a $2mm check from RRE. What should we do?

This is an issue that keeps VCs up at night. On the one hand, we want to support our existing portfolio companies, and we already have $6 million in this theoretical deal. If we don’t participate in this new financing, our equity position will be “washed out” (diluted into oblivion by the new money). The question we ask ourselves is: Are we putting in “good money after bad”? In other words, was our thesis good the first time but turned out to be wrong and are we just throwing money away now? On the other hand, was the original plan flawed, but the new one fixed the issues and it will now turn out to be a great business?

Guilt always plays a role in this decision. The company will likely go out of business if we don’t hold up our end of the syndicate. The other venture capitalists in the deal will scream and yell that we have tanked the company.

There are a number of reasons why we should invest our pro rata here:
• The new money will keep the company alive for another day.
• By continuing to fund, we don’t lose our previous investment in the company by getting washed out.
• We maintain good relationships with the other investors in the company, rather than being viewed as the firm that didn’t play and brought the company down.
• Funding maintains our relationship in the community as being VCs are who supportive of our portfolio companies.
• We’d like to maintain a strong relationship with management, particularly if it’s a team we’ve backed before and/or would like to back again.
• And lastly (but most importantly) whether we think the new product or strategy is going to make money.

The harder decision, which is often the right decision, is not to fund. Each time a VC makes a follow-on investment, it is a new and independent IRR decision. The money that went in previously is a sunk cost. In the above example, the product you invested in did not work, the money to create and market that product was wasted, the people that you relied on to make the product a success have failed or left, and the company did not live up to its expectations. You have to look at an old deal’s “new idea” as if it were a new company looking for funding in your office. That is the economic decision you are making for your limited partners. Trust me; you are looking for reasons to say yes to fund your existing deals. It is really hard to say no to them. But you have to be objective.

For us, just like with new deals, it comes down to markets and management. First and foremost, do we believe and trust the CEO? If it is the same CEO that sold us the last business plan that did not work, what led him to make his decisions all throughout the process? Do we still trust his judgment? Does he still have credibility within his company and in the marketplace? Has he done the right things in a timely fashion in reaction to marketplace changes? Second, what happened to the market? Was the company just wrong about the market or did the market change quickly? Where is the market now? Is the new product really compelling for the new market? These are tough questions, and questions that must be answered.

When financings are buoyant, new rounds are often led by new VCs at higher prices. When financings get tougher, there are more rounds that need to get done by the insiders and more companies that have missed their projections. Whether to re-invest in existing portfolio companies is a question that more and more VCs will struggle with in the upcoming year. Over the last 15 years, we at RRE have built a reputation for always trying to do what is right for our companies. We are clear to them, have open lines of communication and do everything we can to come up with reasons to support them. However, sometimes, the right thing to do is to not fund them. Prolonging the eventual demise of a company is not better for anybody in the long term.

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October 3, 2008

Please Hold the Google Comparisons

Filed under: Pitching, Startups, venture capital — Tags: , , , , , — fiveyearstoolate @ 8:56 am

We get pitched on a lot of products that are designed to be hugely profitable primarily at very large scale, or which are platforms for the underlying monetization of otherwise less valuable digital assets. And with the aim of highlighting the scope of the opportunities presented by the business being pitched, many stray into comparisons to a certain successful company that is very profitable at great scale, and that succeeded in monetizing a big piece of the web. Whether your business is directly analogous (as a few are) or not particularly so (as most are), I’m asking you to please be very judicious with the Google comparisons.

Every investor you pitch knows that Google was the most successful venture-backed company of the past 10 years. And it goes without saying that every one of them would like to back “the next Google”. But please also note that every startup that wasn’t Google didn’t turn out to be Google. It’s ok to analogize your service to either consumer or advertiser modalities that have been proven out by Google. Generally speaking, we at RRE don’t like to see business models that require major shifts in user or customer behavior underlying the success thesis, so if you think either your users or your customers (to the extent that they are different) have been “trained” by Google (or some other highly successful company) to act in certain ways that enable your business, by all means demonstrate that you understand your users well enough to make the point, and that you have seen major proof in the real world that users will act the way you project.

Ultimately, though, please be mindful that making repeated references to Google is not going to cause investors’ eyes to turn into dollar signs as they envision a 1000x return on your company. The more frequently you repeat it, the less effective it becomes. If what you’re doing is deeply vertical, don’t say “we can be the Google of fishing” because the whole point of Google is its staggering horizontal reach. A corollary of this is only say that you are the “Adwords of ___________” or the “Adsense of __________” if you have a really good story to tell. Adwords monetized search and adsense monetized the long tail of content. Those are big stories. If what you have an interesting self-service model, try to figure out a way to tell the story without claiming to be Adwords. If you have a cool distributed content story, tell it in a way that doesn’t just try to associate with Adsense.

In the end, the investors you want involved with your company won’t be fooled by Google analogies, and the companies good investors want won’t try to do it.

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October 1, 2008

Why You Might Want a Lower Valuation for your Startup

Filed under: Startups, venture capital — Tags: , , — fiveyearstoolate @ 9:55 am

The most obvious point of negotiation in any venture financing is the valuation of the company. The first-order logic is pretty simple: Founders want the highest possible valuation and investors want the lowest. Pretty straightforward. Founders want to go high because it minimizes dilution. Investors want to go low because they get a higher ownership percentage.

For those who aren’t familiar with this math, it works pretty simply. Investors are going to put money into a company. More accurately, they are going to buy shares of stock from the company at a certain price. The higher the price of the company, the fewer shares the investors get for a given number of dollars.

What this winds up meaning is that at a higher price (price = valuation), the money put in by investors (let’s say $5 million) buys a lower percentage of the company. If you say that the company’s valuation walking in the door is $10 million (the “pre-money valuation“), the $5 million put in by the investors buys one third of the company (because the company will then have the $10 million of presumed value plus $5 million of cash in the bank, resulting in a $15 million “post-money valuation“). If, on the other hand, you say that the pre-money valuation is $20 million, the new money will only buy 20% ($5M out of $25M) of the company rather than 33%.

Just to do the simple arithmetic, if you assume this is the first money into the company, the outcome of these two scenarios looks quite different for the founders. In the first scenario, the founders own 66% of a $15 million company. They are worth $10 million on paper. In the second scenario, they own 80% of a $25M company and are worth $20 million on paper. In both cases their company ends the financing with $5 million of cash to grow the business.

So you are now asking why I’m suggesting that you might not want to raise the round at the highest valuation you can possibly get. And a good many of you are rolling your eyes at the obvious self-interest we as investors have in this negotiation (which is undoubtedly true – we are interested, but bear with me).

There are at least two very good reasons why you might not want to go for the highest possible valuation.

1. You are probably going to have to raise money again.

2. The valuation you get today impacts your exit possibilities.

The first is critical, and many first-time entrepreneurs miss this. When you raise money, you should have it in the back of your mind that you will probably be raising money a second time. While most companies (especially web companies) come in with the idea that the raise being done today gets them to cash-flow positive, realistically it often doesn’t turn out that way. We understand this and it’s ok that you will need more money, but you should understand this too. When you go out to raise that next round, recognize that your current investors are going to want a step-up in valuation and so will you. Secondly, new investors are going to want to see momentum in the business.

The critical point is this: If you raise money at too high a valuation, you are going to have a very hard time raising money the next time around. Your current investors are going to balk at taking a flat or marked-down valuation, and they will almost assuredly have anti-dilution protection that will keep them whole while diluting YOU, the founder (and your team). New investors are going to be wary of investing in a company that has to be marked down from its previous price. Either way, your overpriced first round is going to be a huge headache when you go back out to raise money, and new investors are likely going to re-price the company anyway.

The second reason is equally important. Simply put, if you raise money at a high valuation it will be very difficult to sell your company for anything less than a significant multiple of that valuation. When your investors purchase a portion of your company, they do so with the hope and expectation that they will earn a multiple on their money when you eventually sell the business or take it public. Put in more concrete terms, if you raise money at a given valuation, you should assume that in the near term and in a success situation, you will be expected to get more than 4x that valuation in an exit.

So when you go to raise money, think about both of these factors. Think about what proof points you will likely reach when you go out to raise more money, and be wary of a valuation that puts you in a difficult position when that time comes. And try to be mindful of what constitutes a successful outcome for you. If you raise money at $50M post-money valuation, you are implicitly saying you can build a very large business and you are taking a good (but not huge) outcome off the table for yourself. Make sure this is a decision you make consciously.

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September 29, 2008

Oy Vey, says Stuart’s Mother

I got a call recently from my mother. She read in the New York Times that all the hedge funds and LBO funds are in real trouble and she wanted to know if RRE was OK.  Since most Jewish mothers like to worry all the time, she wanted to know if she could ratchet up the worrying about me.  While I hate to deprive her of the opportunity, the truth is that if a venture capital firm invested wisely, it’s likely in pretty good shape.  Let’s look at the current state of running a VC firm right now.

How does the Credit Crunch Affect the Venture World?

In a recent post we wrote about the current and near-term climate for fund-raising becoming more difficult because of mark to market issues and asset allocation.  So, let’s take for granted that the bar is raised for new investments and even supporting existing portfolio companies. Two critical (and related) points:

First and foremost, venture-backed companies have essentially no leverage.  With very few exceptions, the only bank lines these companies employ are tied simply to a balance equal to the amount of the loan in cash at the bank.  That is not leverage; it’s working capital management.  Given this lack of leverage, that bank lines are now essentially unavailable doesn’t interfere with these companies’ operations. These companies’ capital structure is (for the most part) 100% equity, 0% debt. Those companies that employ “venture debt” are few, and generally have a very heavily equity-oriented capital structure.

The second piece is that VC funds themselves are also 100% equity. Others have covered the basic structure of venture capital funds, but the short version is that we don’t use leverage. Hedge funds, private equity/LBO funds and some mutual funds raise money from investors (equity) and then borrow more money to juice their returns. VC funds don’t. We raise equity capital from our Limited Partners, and then make equity investments in companies. Those companies, as mentioned above, are also all-equity.

So the fact that the debt/credit markets are a complete disaster affects us only indirectly.

So What’s the Problem?

The real frustration for VCs is the lack of exits.  In the 1990’s, once you grew a company to $40 million in revenues, you could get one of tech investment banking firms to take you public, like Hambrecht & Quist (now part of Chase), Robertson Stephens (gone), Montgomery, or Alex Brown (now part of Deutsche Bank).   Then, after the bubble burst, the bar got raised.  In the post-bubble world, you grew a company to $100 million in revenues and then you could get Goldman, Morgan, or CSFB to take you public.  Once you filed for an IPO, or even got ready to, that also put you in play to be acquired.  Now, there is no current IPO market.  Which leads to the frustration.

RRE has a number of companies that had zero revenues when we invested and which are now doing $100 million or more in revenues and growing very quickly.  These companies have achieved what they needed to achieve, become market leaders, yet they cannot go public or exit under the assumptions that employees or founders assumed when they began.

So what do you do?  Sit tight, be patient, and continue to grow the company.  It’s as if somebody told you that your goal was to jump five feet in the air.  After a few years of practice, you build up the ability to jump five feet, and then they change the height to six feet.   It won’t kill you, it is just annoying.

What Next?

As the economy slows, there is no doubt that it has an effect on consumer spending.  Does this hurt all companies?  Some companies, certainly.  Other companies it should help.  Those companies that allow people to do things more cheaply or make money from activities should grow even faster.

RecycleBank will pay you for recycling.  Tendril will save you money on electricity costs.  Peek will give you cheaper mobile email service.  These companies should thrive in a down economy.  I am working on a seed deal that entails free items for consumers.   What could be better for those who have been downsized?  In addition, companies that make capital available when banks dry up such as PrimeRevenue or On Deck Capital should be huge benefactors.  There are lots of opportunities out there for startup companies.  We at RRE intend to take full advantage of them.

Mom, don’t worry about me.  We didn’t overpay for overpriced deals with no revenue.  We didn’t commit ourselves to cleantech deals that need $500mm of CapEx to get to scale.   We did mostly smart deals at good prices and continue to hold their feet to the fire to keep the costs down in these hard economic times.  And no, I will not stop buying these stupid sports cars.  And yes, I can still afford to take you and Dad out to dinner in New Jersey.

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