October 31, 2008
October 28, 2008
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.
- 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.
- 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.
October 24, 2008
I was in a board meeting yesterday and somebody was talking about selling some shares. He just wanted to sell his shares at the same price as the last round of financing. No problem, right? Actually, yes problem.
This is an issue with mark-to-market pricing of private companies. The assumption tends to be that, since no new round has been done, the company is worth the same as it was the last time money was raised (and hence a valuation was determined). That just isn’t reality, although during normal conditions it tends to be close enough. Today, however, most of the major public indices are down 40% or really close to it. Some of the tech indices are off even more, but let’s stick with 40% since it is a nice, round number.
You might reply (and some do) that because there is no IPO market, the public market pricing has nothing to do with venture valuations. This is totally wrong. Everything is priced off of public market valuations eventually.
When a VC invests in a company, many factors are in play, but there is one overriding consideration: at what IRR (Internal Rate of Return) can I exit this deal? We work for our limited partners. We can be the greatest guys in the world, but if we don’t make money for our limited partners, we are out of business. So, we invest assuming there will be a public market.
Well, you may ask, what about acquisitions? The answer is that the best acquisitions happen when the alternative is going public. For example, if I can go public at $500 million, I might be willing to take $450 million from an acquirer to save the risk of an IPO. However, when I cannot say to the acquirer that my alternative is to go public at $500 million, what is he going to offer me? What is his incentive to offer $450 million? More likely than not, he will put in a low-ball offer because I have no liquidity alternatives. And, by the way, when I do want to go public, the bankers will value the company against public market comparables. In the end all pricing derives from where the public market comparables are trading – even when using typical discount models from recent private transactions.
So, the number is 40% down. What does that really mean? It means I can buy 5% of a public technology company for 40% less than I could have one year ago. It also means that private market valuations — all other things held equal — need to come down 40%. Thus, if you have a company that has grown so much that it warrants a 40% markup in valuation in a normalized market, you should expect a flat round in this market. If your company has a few issues and would likely have a flat round in a normalized market, then it should have a 40% down-round in this market. You get the idea.
The reason that it usually takes 12 to 24 months for private market valuations to adjust is because of our necessity to mark to the last round and the way that VCs can play with that. Whenever I teach my class at Columbia Business School, I explain that VCs can only mark to the most recent round. Students typically yell out that it is not fair (or clunky at the very least). But, there is no better way. There is no liquid market. If we try to mark down to an arbitrary marking, then we also need to mark up to one. Since VCs don’t like to take write-downs, they will sometimes starve a company that needs a new round so that it doesn’t take in new money at a lower price. Or, they put in a bridge which is un-priced. Both of those scenarios are simply stalling tactics where people are hoping that markets will improve. We at RRE try not to do that. More often than not, we push for the washout rounds to “right price” the companies, even when that means we hurt ourselves a bit in the process. We refer to this discipline as ‘living in the present’.
So, everybody in startup land, pay attention. Pricing is down 40% right now. Until the markets come back up, that is the reality. If you want to raise money, take a realistic look at yourself. You might not like the pricing being offered, but it beats the alternative of running out of money.
October 21, 2008
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
• Green Technology
• Software and Services
• Financial Technology
The proof is in the pudding. Here are the early stage and NY deals we have done in the past two years.
• Storm Exchange
• Stealth Company #1
• Stealth Company #2
• On-Deck Capital
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.
October 15, 2008
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.
October 9, 2008
October 6, 2008
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.
October 3, 2008
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.
October 1, 2008
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.