Fundamental vs. Technical VC Investing

Eric Wiesen

Public market equity investors typically fall into one of two camps: Fundamental or Technical Analysis. Sure, many combine both, but most are essentially one or the other.

At a high level, fundamental investors look at the underlying business to determine how well it will perform. They look at margin expansion or contraction, performance of suppliers and customers and new market opportunities. They meet with management and assess their ability to execute the company’s strategy.

Technical investors, by contrast, are much more focused on the movement of securities within the market, and have developed a whole science around price movement, volatility, volume, etc… They look at “support levels” and patterns in time series charts. They are essentially trying to quantify the psychology of the liquid market to predict what the mass of other investors are likely to do.

Put in a simple way, fundamental investors buy the business. Technical investors buy (or sell short) the stock.

So what does this have to do with VC investing? There are no liquid markets, so everyone is a fundamental investor, right? I would argue no – that there is a type of thinking among VCs that is analogous to technical analysis, and that some measure of a VC’s decision-making process is usually contingent on this process.

The basic evaluation model here at RRE (and I suspect at most VC firms) is often described on this blog: Market/People/Technology. It’s relatively straightforward – is a given company led by great entrepreneurs, targeting a big opportunity in a defensible way? This is the fundamental analysis we perform, and it generally drives our yay or nay decision on companies we see. Is this (or is it likely to be) a good business? But once we’ve gotten comfort on these first-order questions, we then ask another set of questions:

• Who are the company’s comparables, be they startups or public companies?
• How do the markets value those companies?
• What success stories can we find of companies taking a similar approach to the one we’re looking at?
• Who are the likely buyers for this company? What multiple of revenues or EBITDA do those companies enjoy in the market? How acquisitive have they historically been?

These aren’t questions about the business itself. They don’t speak to whether the company has good leadership, whether its customers will want its product or whether its business model makes sense. These are market attitude and structure questions. They poll, to the extent that we can, the psychology and appetite in the market for this type of company.

Ultimately, this is the technical analysis piece of VC investing, and often is a part of the pitch process that entrepreneurs don’t expect. While there aren’t head-and-shoulders or cup-and-handle charts, it’s the part of the evaluation that gets done more on the position of the company as a tradable asset rather than as an underlying business. How will it be valued, and when, and by whom?

The approach to this piece of the analysis varies from investor to investor. Some will ask the entrepreneur straight out, “Who buys this business?” to see how the she thinks about the exit opportunities. Others don’t consider this a part of the process, but will think about it internally. Personally, I like to have this dialog with founders, to see if they are thinking early on about the exit trajectory the business could take, even though we usually agree we’ll have very limited visibility at an early stage. It’s more process and attitude than anything else.

Ultimately, you can see evidence of firms who prioritize the technical piece more than others. When you see VC “momentum investing” in a sector – consistent funding of a dozen or more ad networks, for example, it is at least partially the result of investors looking at the market, seeing the big exits and robust valuations and wanting to make a bet in a market that’s clearly in favor. This is the VC flavor of technical analysis.

Generally speaking, this element is something we do at RRE, but it’s second-order for us. To put it another way, we will not make a bet purely on momentum and analogous big outcomes, but it will help inform a decision about a business we like. If the fundamental analysis comes back strong, but the technical piece looks very bad (public comps are valued very low, previous exits in the space have been at 1X revenues) it will admittedly give us pause. Because ultimately we need to see an opportunity to return a multiple of capital to our limited partners, and if the market isn’t interested in a deal we do, that is going to matter.

What’s in a Name?

Eric Wiesen

I’ve been on a few panels (and been in the audience for many more) that focus on starting up a company. A lot of the questions (unsurprisingly) are about starting up web companies and best practices around doing so. Inevitably, one question arises:

“How much does the name matter?”

What does surprise me is the answer I usually hear from VCs, successful entrepreneurs, and other luminaries:

“It doesn’t matter.”

They go on to say focus on your product, great customer experience, scalability and all the other important company-formation features. And I agree that those are all critical, first-order concerns. But I disagree that names don’t matter, at least where consumer-facing applications and services are concerned.

Businesses generally don’t care what things are called – they have the time and financial interest to due significant due diligence on various offerings (although truthfully it doesn’t always happen) and decisions are made around more metrics-oriented decision criteria. But consumers are a whole different ballgame. You need to grab a share of their increasingly overwhelmed and attention-deficit suffering consciousness. You need, to use a metaphor I like in many contexts, to be no or low-friction. And your name is the first thing they are going to see.

So I’d lay out three rules for naming a consumer-facing web product:

1. Be easy to spell
2. Be 8 characters or less
3. Be in plain language

You don’t need all three. But you need the first and one of the last two to have a good web name. Looking at some of the top (US) consumer-facing websites, let’s see how they stack up:

Yahoo (Easy to spell, 5 characters, arguably plain language): 2.5/3 PASS
Google (Easy to spell, 6 characters): 2/3 PASS
YouTube (Easy to spell, 7 characters, plain language): 3/3 PASS
MySpace (Easy to spell, 7 characters, plain language): 3/3 PASS
Facebook (Easy to spell, 8 characters, plain language): 3/3 PASS
Blogger (Easy to spell, 7 characters): 2/3 PASS
Ebay (Easy to spell, 4 characters): 2/3 PASS
Amazon (Easy to spell, 6 characters, plain language): 3/3 PASS
Flickr (5 characters): 1/3 FAIL

This is a somewhat cherry picked list, but most of remaining top sites by traffic are either abbreviations (MSN, AOL) or similarly compliant sites (live.com, photobucket, etc…). We find only one site – flickr – that doesn’t meet these criteria for consumer-facing name success.

We can speculate about why this is, but I would suggest that the obvious answer is likely the right one, as Occam would say. If consumers can’t remember, recognize or spell your name, they are unlikely to get to your site via direct, type-in traffic. That leaves you with SEO, SEM and other indirect methods for drawing in users, all of which are important, but without that initial primary funnel you may struggle. To pick on Charles (because I know he can take it), iminlikewithyou is not a good consumer-facing name. It’s 15 characters, is plain language, but includes a word with an apostrophe, so it only partially passes the spell test. Really good product, bad name.

We can draw some conclusions from Flickr’s success, or we can just say it’s the exception that proves the rule. Flickr built its audience largely of “net natives” who quickly adopted the “missing e” as the next creative web naming convention (sort of like ____ster became earlier), and we’ve soon lots of similarly-spelled “Web 2.0” company names. In fairness, a lot of this is driven by domain squatters taking many of the plain language names. But in the absence of plain language, I would argue that your new company’s name should be short and easy to spell, even if it’s meaningless (worked pretty well for Google). Sure, the tech-saavy crowd may figure out del.icio.us but will your parents or your friends who aren’t “webheads”? If you are comfortable building a big, successful business out of just us (it can be done), by all means. But if you are going for mainstream…

Ultimately, if you are being thoughtful about your core site, service or application, you are carefully instrumenting your processes (registration, sign-on, setup, etc…) to minimize the waterfall of dropped users and are being diligent about removing friction to lower bounce rate and registration failure. Don’t start out on the wrong foot with a name that won’t stay with potential users. Path101? Good. Xoopit? Well…

Kashless

Stuart Ellman

We recently made a decision to invest in the Series A round of a new company called Kashless. This investment is one we’re very excited about, and reflects a lot of our investment philosophy here at RRE. The company is still essentially in stealth mode, although certain details leaked out via SEC filings we did around the financing. Rather than go into a lot of detail about what Martin Tobias, the CEO of Kashless, is planning on doing with the company, we’ll talk a little bit here about our process and thinking that led to this investment.

As we’ve mentioned in this space before, at a highly abstract level, we (and most investors) look for excellence in three key areas: people, markets and technology (the order depends on which of us you ask). In certain sectors, technology will be the key differentiator (materials science-based cleantech or semiconductors), in others it will be the vision and execution capabilities of the management team that will primarily distinguish the big successes. In all cases you need a market that’s capable of supporting interestingly large businesses.

Two major positives intersected to make us very excited about the opportunity here. The first was the opportunity to back Martin Tobias again. As the writers of this blog discussed offline the other day, Martin is a winner. We don’t just know him in a business relationship, we know him as a friend as well. Stuart stays with Martin when he travels to Seattle. They ride the 200 mile Seattle to Portland bike ride each year. Stuart and Martin have spend a great deal of time trying to figure out what business to start. Kashless is the culmination of this strategizing, much of it done during bike rides. Martin has demonstrated a great nose for the very beginning of trends, and that’s a terrific quality in an entrepreneur. He’s also extremely good at building organizations and getting them to scale. We know Martin’s strengths and weaknesses. We know that we can work with Martin and we know that there is mutual respect. We also know that he has lived through bubbles and busts before and we have a shared history on the appropriate ways to react to new market information.

The second is that (true to form for Martin), we think Kashless is poised to catch a big wave. Often times when we evaluate companies that seem good, but don’t quite feel right, one question we ask internally is, “what wave is this company riding?”, which helps focus the conversation around large, meta-trends that can propel a company and its target market into a high growth trajectory. Kashless is riding a big wave – call it “green”, “sustainability” or what you like, but economic, cultural and social forces are all moving us toward a world where issues of sustainability are more important than ever. Kashless looks to enable people to live more efficient, sustainable lives, and that’s an objective of which we are both supportive and optimistic. Also very important for RRE, as we mentioned in previous posts, Kashless can achieve these objectives in a capital efficient manner.

Stay tuned for more from Kashless, but we think big things are coming.

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

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

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

Flipswap

We are happy to have our partner Harsh Patel here guest posting about our recently-announced investment in Flipswap. – EDW

Harsh Patel

It’s probably safe to say the current climate for startup venture financing has been thoroughly documented over the last few weeks, both here and elsewhere. I think you get it. But as my partner Stuart mentioned in a recent post, despite this climate we still see opportunity and we are still doing deals. We recently announced our investment in Adaptive Blue and now I’m happy to announce another new investment in Flipswap, a Series B financing co-led by RRE and NGEN Partners.

This investment reflects an evolving thesis we have in Fund IV around “Green Technology”, where traditional information technologies and associated business models intersect with a new set of global challenges. Recyclebank and Flipswap developed unique business models that generate real economic incentives that allow consumers, businesses and governments to act more sustainably while still acting in their own self-interest. Tendril is attacking the demand side of the energy problem by directly linking energy consumers to utilities, enabling both sides to proactively manage energy usage and reduce cost. So while financial markets may be busy painfully remaking themselves in the near term, they will not affect this macro thesis (or many other macro trends which underpin our investment decisions).

But of course macro alone is never enough. Underlying trends and investment theses are only academic unless embodied by entrepreneurs who can execute. Sohrob Farudi and his team at Flipswap did exactly that. Even as we all consult our tea leaves and crystal balls to see where the markets are headed, the best entrepreneurs know they don’t have that luxury. So instead they control what they can and react quickly when they have to. One of the simplest but most compelling points of evidence I look for as a VC is that an entrepreneur continues to perform throughout the fundraising process the way they said they would at your first meeting. Even in the best of times fundraising can be a lengthy process, and your ability to accurately forecast your business and execute against it is critical. So while any investment decision can be complex and the diligence process long, it very often comes down to this – do we believe in the market and do we believe in the team? We said yes on both counts and we’re delighted to welcome Flipswap to the portfolio.

Self-sufficient is the New Sexy

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.

The Truth, or What We Want to Hear?

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.