Focus on the Upside

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Point Nine’s Pawel has a good post on why complex liquidation preference structures are bad for your startup.  It’s worth reading.

I agree with Pawel that complex liquidation preference starts entering term sheets in tighter VC markets.  Being notoriously lemming-like in behavior, the mood pendulum swings very dramatically in the VC industry.  You can go from SAFE term sheets with $30m caps at seed stage to offers with 2X participating preferred clauses in a matter of weeks.

More than the economics involved, complex liquidation preference terms are alarming to us in what they tell us about the VCs mindset. In our experience, success in VC comes from helping build great companies.  True, strong liquidation preference terms can theoretically boost a fund’s returns by a few basis points.  However, we believe that they do more harm in the precedent they set for future investors, the needless extra pressure it extracts on the others on that cap table and impede the VCs alignment with the founders.

We try to keep our focus on the upside in every investment we do and concede that some of our investments will not work out as planned.  The best way to keep those cases to a minimum is to stay aligned with our founders as much as possible.  Sticking with simple liquidation preference structures helps us achieve that.

Down and Flat Rounds

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There’s been quite a bit of talk on valuations over the past few months.  I think it began with Benchmark’s Bill Gurley’s April post On the Road to Recap.  The summer was a filled with similar news of flat or down rounds in highly-visible startups, including numerous unicorns. What prompted me for this post is the Ola news I saw today.

Whether valuations are spiraling down is a favorite topic of those chatting with VCs – I am not sure if this is schadenfreude or a genuine interest in what drives valuation trends – and I find myself repeating the same words when dealing with the subject: “It really does not mean much”.

The private valuation of a tech startup is the result of a complex equation with a very simple premise: the ultimate number satisfies the need of both parties at the table, the existing shareholders of the startup and the new VC.

In some situations the need is primarily cash. In that case the deal gets done at where the supply and demand curves intersect. In other cases, the company may want to maximize the PR from the financing, maybe get the coveted “unicorn” designation, and then the headline number becomes important.  The press loves lots of zeroes when reporting on startups.  As far as VCs are concerned, we can offer a startup any valuation, as long as we control the rest of the terms of the financing. That’s why the valuation is really less important than perceived.

Our advice to startups is to focus on just one coefficient when thinking of their business: the probability of success.  Of course, not running out of money is a critical factor of success so fundraising is very very important. However, the valuation is rarely the key factor in fundraising. I think it comes after:

  • Securing the right amount of funding to get your business to the next milestone
  • Partnering with the right investors
  • Making sure the company is able to focus on building its business rather than getting bogged down in fundraising-related bureaucracy or investor relations

In summary, as capital markets liquidity expands and shrinks with business cycles, there will be periods where we see valuations of subsequent rounds adjust accordingly.  I don’t think there’s much to read into in this phenomenon, other than noticing how the press can be distracting to entrepreneurs.

 

Celebrating Execution

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I am sitting at a board meeting, observing how a portfolio company of ours is out-executing its competitors by a wide margin.  Surprisingly, the primary narrative in tech startups is innovation, invention and capital leverage, and not on strong execution.  However, in my experience, strong execution has been biggest success factor.

In 2001, when Jim Collins published his influential book, Good to Great, he showcased how some companies were out-executing their competitors.  The difference between Gillette andWarner-Lambert was remarkable.  Similarly, it’s not difficult to see how much better Walmart has been out-executing Sears/K-Mart for decades.  A look at the stock chart provides a quick reminder.

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By contrast, in the tech industry, the discussion digresses to innovation silver bullets, very quickly.  The tech press looks for headline-making bold claims.  VCs try to see how a company’s business model can create an unfair advantage.  Founders, consequently, come to us pitching some clever shortcut they have figured out.

No one questions what a big difference execution has made in the Walmart -Sears case, but when you argue the same for an e-commerce company, eyebrows go up: “Are you sure?  Was it not through a high-tech warehouse, or drone delivery?”, is the question you get.

We see over and over that the winners usually get there by fanatical execution: sweat, hard work and resilience.  I think we need to celebrate execution more in the tech community.

VC Portfolio and Ownership Concentration

Michael Kim Dave McClure

Last month saw an online disagreement between two prominent investors, Michael Kim and Dave McClure.  You can see the Twitter back-and-forth on the topic here.

Portfolio modeling is a literally a monthly topic at our Earlybird. We find ourselves falling into Michael’s camp, primarily because in our region, we simply don’t think we can clear our comfort level threshold with enough companies to try to follow Dave’s strategy.  However, in a bull market such as the one we have been in over the last 8 years, I think both strategies can be viable, if you are investing globally.

In our Digital East portfolio, we currently hold >20% stakes in all but one of our investments.  It gives us the peace of mind that these positions will return meaningful multiples of our $150m fund, at successful exits, even if they are modest in size.

 

Big Numbers

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The press loves big numbers.  Why? Because, the readers love big numbers.  Look at the headline below:

FireShot Capture 10 - Meet the Man Who D_ - https___mail.google.com_mail_u_0_#inbox_1552f8f3a973098a

There are two very large numbers, $5.5 billion and $62.5 billion, referring to two highly ambitious and rapidly growing companies, Lyft and Uber.  I am a fan of both startups.  However, they are both quite tiny in the global enterprise scale.

When you say an $X billion company, one understands that it’s a top-line revenue number.  Apple is a $230 billion company and Walmart is a $480 billion company, in general business speak.

I would also understand referring to these businesses by market cap.  It’s the company value of these businesses based on very liquid market information.  By this measure, Apple is a $450 billion company and Walmart is a $220 billion company.

You’ll notice that these two sets of numbers are almost exactly asymmetrical, so it’s always critical to clarify what one means when the phrase “$X billion company” is brought up.  But I find both to be acceptable and practical.

Then, there is the startup version, with which I have a problem.  I mentioned that both Lyft and Uber are quite tiny.  To be specific, lats year Lyft had a rumored ~$100 million in revenues.  Uber, which is larger, had its revenues estimated at $1.5b billion.  Both numbers are very small compared to those of Apple and Walmart.  Bu this is not stopping the press to refer to them as $5.5 billion and $62.5 billion companies.

Why? VC round valuations.  These two companies, have been valued, in private rounds, details of which are not announced, at the larger numbers mentioned above.  So, all of a sudden, you find that you can get away with calling Uber a $62.5 billion company. And, jaws drop.  Your readers are awed. Links get clicked on.  Young entrepreneurs pull out their calculators and start multiplying their own metrics with the multiples they can extrapolate from Lyft and Uber numbers.  And, expectations rise, appetites get whetted…  And, bubbles form.

Because, the press loves big numbers.

 

 

The Disconnect in Online Advertising

Online ads suck, but it’s the main driver of today’s internet.

If you did not already know that, a great place to look for confirmation is Mary Meeker’s 213 slide Internet Trends deck, in which, slides 41 thru 110 are dedicated to the examination of how different forms of online ads are growing and that it’s accelerating.  It’s depressing really.  And the money slide is this one:

FireShot Capture 6 - 2016 Internet Trends Report_ - http___www.slideshare.net_kleinerpe

In summary, it will get worse before it gets better.

This is confusing to me.  Because, on the other side of the internet coin is that high quality, frictionless offerings are winning on the internet.  Look at the most successful apps.  Booking.com is eating the lunch of other hotel OTAs, primarily because it works so well.  Uber is a lesson in on-demand UX.  Airbnb’s user experience has helped its massive global network effect, in taking the big lead it has in global marketshare.

Ads, on the other hand, are pulling in the opposite direction.  1010!, a great game, is pissing me off with 5-second video after video, trying to get me to accidentally click on an app install.  And, I am not alone. Back to Meeker’s deck:

Millenials:

81% = Mute Video Ads
62% = Annoyed with / Put Off by Brand Forcing Pre-Roll Viewing
93% = Consider Using Ad Blocking Software

Here’s the slide:

FireShot Capture 7 - 2016 Internet Trends — Kleiner Perkins C_ - http___www.kpcb.com_internet-trends

This disconnect between how fast online advertising is growing while remaining a nuisance for internet users has made it tough for us to build strong investment theses for ad driven business models.  It’s also probably why we get turned on by technology that looks to improve the efficacy in the sector.

Your Biggest Investor

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One way we categorize startups is by whether they have crossed the chasm. I don’t mean that in the Geoffrey Moore sense (although I think it’s still one of the best books on scaling a tech business, and recommend that you read it), but whether you have made it to the other side of your cash flow bridge.  Will you need to raise another round of outside funding in order to survive?  If yes, fundraising should always be a front & center topic for you as a founder.

If you are not there yet, as a founder, you need to constantly think about your shareholders, and how supportive they are likely to be in the next round.  We see examples where the lure of a deep pocketed new investor is very high, and founders are exclusively focused on attracting a new shareholder, sometimes at the expense of keeping the existing investors educated on the progress of the company and motivated to keep up their support.

Those already around the table are a lot more likely to support you (if they can), as long as their confidence in the business remains strong.  They have a vested interest in not just seeing you succeed, but also seeing you survive.  This is a different type of motivation.  Any potential new investor is not motivated in the same way.  Therefore, when you categorize your investors, existing and potential, on the top of that list should be your existing shareholders with the capacity (capital-wise) to continue to support you. Their participation in or leading of your next round is your biggest weapon as you market your startup to the capital markets.

The Second Time Around

I just answered an interesting question on Quora.  I think it may be interesting to readers of this blog, as well, so I’ll copy it here, too.

Question:
If a VC did intense due diligence on my seed round but ultimately passed, should that impact my decision to consider him for a Series A?

Answer:
Our experience is that by the time we decide to invest in a startup, we have usually interacted with them over a period of time, sometimes at different milestones. There have been instances, where we’d passed at an early point and then decided to invest in a subsequent round.

We pass for many different reasons. Sometimes it’s about fundamentals – the chemistry with the team is just not there for us, or maybe the market size is too small. If we are passing for fundamental reasons, it’s unlikely that we’d ever look to invest later in that company.

However, many times, the pass decision is because we’re just not “quite there” with our investment thesis. In these situations, we try to make sure that the team is getting some value out of their interaction with us. And, we encourage them to stay in touch, come to us with questions, or if there are ways we can be helpful, we try to bring those to bear. Our hope is that we stay close to the company, see if we can get more comfortable with their business along the way – perhaps observe the team as they overcome their challenges, and if at any point along the way, we can come up with an investment model we can feel comfortable with, then make an offer for an investment.

From the company’s standpoint, the decision whether to accept that offer should be a rational one.

They would also have had the opportunity to get to know us along the way. They may have seen us demonstrate the characteristics they would want to see in their investors: whether we “get” them, whether we are smart, hard-working and ethical. Ultimately, the founders’ goal should be to maximize the probability of success for their startup.

In short, the answer to the question should not feel difficult at the point where an offer is on the table from the VC.

 

ChubbyBrain Ventures

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Startup data provider CB Insights had an April Fool’s Day blog post on how they are launching a new VC fund.  The announcement post was quite amusing, full of over-the-top claims on their plans and strategy.

Yesterday, they provided a clarification in their daily newsletter that this was a joke, since they had received messages from LPs asking for their PPM, pitch decks form companies looking for VC funding, and resumes from people looking for a VC job.

Not very surprising.  Our industry has become very buzz-word driven in how we talk about our strategy.  If you look at marketing language from VC funds, you’ll find a lot of throw-away language and realize that it’s difficult to tell one firm from the other.

Let’s hope that some real VC funds don’t eventually turn into jokes.

 

The Pendulum on Turkey

mars

In my conversations with non-Turkish friends lately, the dominant topic has been what’s going on in Turkey.  This is of course fuelled by the stream of news on the country over the last three years, starting with the Gezi protests: questions on the stability of the government, the sliding lira, the refugees from Syria, the war at our doorstep, the crisis with Russia, the back to back elections, etc.

For us, the most easily-observable impact has been the disappearance of western VC interest from the Turkish tech market.  Attending the annual Startup Turkey event in February, we were surprised at how it was only the local or regional VCs who showed up.  By contrast, just two years ago, the same event had attracted names from a long list of firms from Silicon Valley, New York, London, Berlin and Paris.  Even though many were there on early scouting missions, the sentiment was that Turkey may be “Europe’s China” when it came to tech opportunities.

The truth is it never was.

However, neither is it “the next Syria”, as the sentiment may be today.  The pendulum always swings too far, in both directions.

A great example for this is the recent exit by the local PE firm Actera of its stake in Mars Cinemas at an EV of $800 million.  About a year after the acquisition of YemekSepeti by Delivery Hero for $589 milllion, it comes as a reminder of the size and scope of the Turkish economy, and the fact that you can build large, healthy businesses serving the needs of Turkish consumers.

As investors, it’s critical for us to keep our eyes on data and metrics, and resist getting swayed by fickle public opinion.  That’s how you build value.