Focus on the Upside

upside

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

spiral

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

hard-work

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.

wmt-shld

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.

 

Merging into Monopolies

monopoly

The big news this morning is that Uber China and Didi Chuxing are merging. The rivalry was one of the biggest recent tech battles, with both parties well armed with billions of dollars.  I don’t think there’s a doubt in anyone’s mind anymore about who will win the massive Chinese ride-hailing/ride-sharing market.

Come to think of it, I think the same question is now pretty much answered for the global market, as well.  It would be rational at this point for Uber to acquire Lyft for probably about 10% of its enterprise value, and get rid of the last credible threat to its US dominance.

The picture in Uber’s market reminds me of Peter Thiel’s much discussed 2014 article about monopolies.  I suspect we will see other examples of merging into monopolies in markets with strong network effects.

Sapiens

51xwPegEzlL._SX333_BO1,204,203,200_

If you are going to read one book this year, I’d recommend Sapiens, by Yuval Noah Harari.  I think it would make for a great vacation read, if you don’t mind non-fiction on the beach.

The book reminded me of another old favorite of mine, Jared Diamond’s Guns, Germs & Steel.  However, I found Sapiens to be more philosophical and funnier.  It also coincided with a period for me where I am trying to connect many dots at work, and provided good accompaniment to my mental process.

Enterprise Sales in Turkey

1-1252593298WHAn

If you are a technology startup targeting Turkish enterprises, you’d better bring your magnifying glass with you.  Here’s an unpopular fact:

Turkish enterprises are tiny!

Let’s take a closer look.  On the 2015 Turkish Fortune 500 list, #500 is a company called Metag.  Annual sales: 284m TL (about $100m).  By contrast, the #500 company in the US is Burlington Stores with $5.1b in sales, 50X the size of Metag.

Another way to look at this would be by absolute size.  If you determine that your target market is companies with >$1b in sales, your target list would have only 40 companies in Turkey.

The US economy is about 20X the size of the Turkish economy ($16tn vs $800b), so you get the picture. It’s not just the relative market size.   There are a lot more enterprises to sell to in developed markets, and each one is probably a more sophisticated buyer of your services, with larger budgets.