Archive for the ‘Tips of the Week’ Category

What Winning Looks Like in VC

In today’s interview, we quickly discussed the key metrics by which venture fund managers are measured. I’d like to use this week’s tip to review what these metrics are, who values each and why some can be manipulated while others can’t.

The metrics we will review include: DPI, TVPI, IRR, Follow-on and Bulge Bracket Follow-on. And, in the case of the first three, I will use definitions from Silicon Valley Bank.

  • DPI: The ratio of cumulative distributions to limited partners divided by the amount of capital contributed by the limited partners. The nice thing about this metric is that it compares actual dollars distributed to LPs against the dollars that they invested. It is a true cash-on-cash multiple. The drawback is that it’s typically not usable, until later in a fund’s life. It’s rare for a new fund to have exits and cash distributions very early, so the metric doesn’t paint a clear picture early on. From my discussions, it appears that a 3-5x DPI puts you on the big board.
  • TVPI: The sum of cumulative distributions to limited partners and the net asset value of their investment, divided by the capital contributed by the limited partners. So this metrics accounts for both cash distributions to LPs and the net asset value of existing investments that have not yet exited. In theory, it sounds great but the problem here is that paper valuations, in venture, are pretty unreliable. Some may go to zero, others to the moon and yet others may languish in the private markets for many years… delaying an exit and cash distribution. It’s also worth mentioning that neither of these first two metrics accounts for the time it takes to return capital, which leads us to our next metric…
  • IRR: The annualized effective return rate which can be earned on the contributed (invested) capital, i.e. the yield on the investment. This determines the time-adjusted yearly rate of return. Many great firms are in the 20’s. Many not so great are in the low single digits. On paper, this would seem like the best metric for assessing winners. However, it’s an easy metric to manipulate. GPs can do a number of things to inflate their IRR. Namely, they can borrow money from a bank, at low interest, invest that capital in a startup, then call the capital from the fund much later. This effectively reduces the time between when the capital was invested and when distributions are made. I’ve even heard of cases, with early exits, where the capital isn’t officially invested until after distributions are already made. This causes some firms to show doctored IRRs that are very high, particularly early in a fund’s life.
  • Follow-on: This is simply a percentage that represents the number of companies that have received follow-on funding vs. the total number of companies invested in. This metric can be used to assess Series A follow-on ratio, Series B, etc… depending on how mature investments are.
  • Bulge Bracket Follow-on: This is a key metric that I hear about more often lately. Great institutional investors don’t care about follow-on alone; they want to see the percentage of follow-on by the best performing A and B investors. If you’re a GP, how many of your investments receive funding from Sequoia, Accel, Bessemer, KPCB, etc. When assessing funds very early in their lifecycle, this can be a helpful signal that shows both quality of investment, relationships with top firms and outcome potential.

In discussions with a wide range of LPs, including HNW, UHNW, family offices, fund of funds, sovereign wealth, foundations, pensions, and endowments… My big takeaway is that there is no silver bullet. Each type of LP and each individual LP looks at different metrics. Trey likely has his own priority and even cited the merits of DPI as it can’t be easily manipulated. Many HNW retail investors also tend to prefer cash-on-cash multiples over IRRs or follow-on. Regardless, each GP must measure them all and be measured by each. Those that optimize for one, at the expense of others, may not be raising a fund 2.


A Thesis Begins with a Moat

Defensibility, Switching Costs, Barriers to Entry…
 
We hear these terms often when discussing startups.  It’s not only important to build something of value, but value that can be protected.  Many in venture capital, refer to this as THE MOAT. 
 
Renowned investor Terrance Yang was asked recently, “As an investor, if you could ask founders only one question before making a funding decision, what would it be?”
 
Terrance’s answer:  “How are you building a unbreachable moat protecting a very valuable castle?”
 
There are different types of factors that can create a moat… some internal, others external.  An external example is regulation.  In a previous life, I dealt with regulatory agencies including the FAA, while working in aerospace and defense, and the EPA, while working in the water industry.  In both cases, the regulations were so onerous that getting a product to market was a multi-year, process.  We even employed lobbyists to work on our behalf.  While this put a strain on our new product development efforts, it also created enormous barriers to entry; protecting the value of products in-market.
 
There are also internal factors that create moats.  These are factors that reside at the company or product level.  Union Square Ventures has a thesis to invest in companies with network effects.  Big surprise, central to their thesis is a moat.  Network effects drive more user value, raise entry barriers and increase switching costs.
 
The problem with external factors is they often do more to limit innovation, rather than promote it.  External factors favor the incumbent, whereas internal factors favor the innovator.  We can argue the merits of internal vs. external moats, but it’s certainly easier to exert control over those factors that are in-house.  If the moat exists at the product level, you own the moat.  If you’ve hired a band of brigands to build and manage your castle’s moat, you may own the customer; but the master of the moat owns you.
 
Now, as an investor, instead of looking for startups with a variety of different moats, what if your thesis had a built in moat?  What if the very category of startup you invest in creates enormous barriers to entry, brand equity, and high switching costs?  This is why I invest in smart hardware.
 
Today, Ben mentioned a quote from Brad Feld, “I don’t invest in hardware.  I invest in software wrapped in plastic.”  There’s a big difference between a dumb gadget that collects dust and a smart device that gets more useful over time.  Shelfware is to SaaS as the Gadget is to Smart Hardware.
 
There are a number of reasons why I invest in Smart Hardware. 
-I’ve developed a smart hardware product. 
-I love the business model. 
-I love the annuities.
-I love that there’s constant pressure to create more customer value. 
-I love that a sale is the beginning of a customer relationship and not the end.
 
But the thing I love most is that the smart hardware moat is incredibly wide and enormously deep.  Not only is it exponentially more difficult to do smart hardware than software alone,  thus raising entry barriers; but the connection and brand equity for physical products far exceeds that of virtual products.
 
The reason for this is that smart hardware benefits from many principles of behavioral economics and human psychology.  These principles serve to deepen their relationship with the customer.
 
A sampling of principles that are far more powerful for physical products, than virtual include:
 
All of these factors make the customer more likely to buy, to use, to promote and to convince themselves that they’ve made a great purchase.
 
Does a moat have to be hardware?  Absolutely not.  But should a moat be fundamental to startup strategy from day one?  You know my position.  And if founders must face this when designing their business, why shouldn’t investors when creating their thesis?

What’s Your Gateway Drug?

In today’s interview, Jordan talked about how there are two kinds of startups.  Those that are solving a real problem and those that are addressing something that customers are totally unaware of and, in the process, changing their behavior.  I wanted to attempt to connect these two concepts and illustrate a pattern that I’ve observed with many founders.  And this pattern has revealed itself to me, in the form of two different startup types.  Without question, every pitch I come across can be categorized in one of these two groups.
 
Type 1:  We’re solving a narrow problem for a specific customer.
 
Type 2:  We’re building a platform that will change the way consumers behave.
 
There are problems with each of these types.  In the case of startup type 1, solving a narrow problem, often the problem is too narrow and the market is too small.  So even if their solution is incredible, the opportunity size doesn’t justify investment.  In the case of startup type 2, the market sizes are typically massive, but they can’t get adoption.  In the pursuit of boiling the ocean and creating a whole ecosystem, they’ve confused and overwhelmed users.  In the absence of addressing a real problem, there is no business.
 
To provide a quick example of each… let’s consider smart watches.  On one hand, you have GPS-enabled smart watches.  They perform a targeted function and solve a real problem.  I’d imagine the majority of the customer base is runners that are using the device to track splits and distance.  This would fall into Type 1.  Real business, real value, niche market.  On the other side of the spectrum, you have the Apple Watch.  This product attempted to recreate all features of the mobile device in watch-form.  Apple took a new use case and went from zero to 100 on day one.  The jury is out on success or failure of the Apple watch but clearly it has vastly underwhelmed vs. their expectations.  So, while it has massive capability, consumers don’t quite understand the value.  And the behavioral changes required are too significant to be comfortable.  Recall that the apple phone did not launch with thousands of apps and immense capability.  It was, quite literally, a mobile phone with beautiful industrial design.  The user experience was unrivaled, resulting in fast adoption.  Apple iOS and the “platform” we know today was a gradual development.  Consumers learned how to use the enhanced capability, app by app, version by version.
 
The best pitches that I see, have a Type 1 mandate and a Type 2 vision.  They are solving a real problem with a narrow customer-base, like type one startups.  But they are doing this as a Gateway Drug, so to speak.  The initial solution is a means to a much bigger opportunity.  The gateway drug gets customers in the door, using the product.  This allows the business to grow with the customer and become a type 2 startup.  If I were to have made a suggestion to Apple, it would have been to roll out the watch as they did the phone.  Find the single, most visceral problem to address w/ the watch… and create a product that is far better than anything else for that use-case.  Then, over time, they can become a platform, with many additional features, just as the iphone did.
 
So, today I facetiously recommend to find that Gateway Drug.  Use it to build something much bigger.  Founders that do will have real business and may have the opportunity to build a household name.

Vertical Integration and the Space Stack

Despite advances in recent years, the space industry still has it’s major challenges. Namely, launch, remains the biggest challenge. There’s the cost of launch including the payload, the risk that your payload blows up, and the timing of launch; many have to wait long durations to get their payload into a launch queue. Another challenge has to do w/ the human biological hazards of space. David thinks this may be one of the hardest problems to solve. And finally, there’s the ideological challenge of the “Space Stack,” so to speak. The leader in the sector, SpaceX, has found success by adopting a vertically integrated model. Similar to what he’s done w/ Tesla, Elon aims to build the components, sub-systems, systems, integration, and assembly all in-house. And it’s this approach that has driven much of their success, allowing them to re-think and re-design rockets from the ground up. But it also can be limiting. David discussed the technology ecosystem required to achieve objectives like inter-planetary travel and asteroid and moon mining. These are not easy challenges and, as with any industry, it’s unrealistic to think that one company can solve them all. I’d imagine many tech companies grapple with the choices of vertical integration, and ask the question, “Do we bring things in-house or do we leverage services and/or components that allow us to focus on our strengths?” It’s common for leadership to consider this when building a solution that addresses a specific problem. What’s more unique is a company asking their-selves this question about an entire sector. And Elon’s mission Mars is much bigger than solving the problem of launch. To illustrate the scope of this mission, we did an entire interview about w/ Tim Urban. So, in a way, David believes that Elon’s approach is limiting the advancement of Space 2.0 While Elon attempts everything in-house, David roots for technologists anywhere with both his voice and his wallet. It is reasonable to believe that, regardless of what Elon does, creators will continue creating. Building solutions to both narrow and broad problems. And regardless of how this plays out, I couldn’t be more excited to see how the Space Stack evolves and what the frontier holds.

 


What Makes SaaS so Special?

Many articles are written, every week, about how to succeed in SaaS. But less often do people write about why SaaS is so special. It’s a business model, applied to a product type that has become a massive focus area. Venture has not seen a category of startups like it before. Some investors create an entire thesis, just focused on software as a service. So, rather than spending this week’s tip on another top ten list of HOW to win in SaaS… instead, let’s explore WHY the category, itself, is so special.

It boils down to three simple reasons: Proximity to customer, measurables and value focus.

1. Proximity to Customer: Part of the brilliance of SaaS is that companies develop a direct relationship with end-users. They often sell directly to them and have an ongoing feedback loop with them. While this provides numerous product and versatility advantages, maybe the biggest advantage is in what this eliminates. Proximity to the customer dis-intermediates traditional channel players. Wholesalers, distributors, resellers, retailers… what intrinsic value do these players provide? None. They reduce margin, for the value creators, and they increase price, for the value consumers. By removing layers upon layers of mouths to feed, the only transaction necessary is between the creators and the customers… thus all the value resides with them.

2. It’s Measurable: When I think of metrics I recall Peter Drucker’s famous quote, “You can’t manage what you don’t measure.” Or you may remember this one from Dwight Eisenhower, “Plans are nothing; planning is everything.” The set of standardized metrics available makes the category much easier to assess. Problems are more easily uncovered. Best practices are readily transferable. This gives both founder and investor a playbook to work from. It helps each identify the root cause of issues and take action against them. The forecast itself may be terribly inaccurate but it drives the right discussions and allows for fast reaction.

3. Value Focus:  SaaS business typically charge upfront and ongoing. Strong value must exist from customers to pay for the product. And this value must sustain or the customer will select out. With many businesses, the value transacted ends after the initial sale. With SaaS, it’s the opposite. The first transaction is the beginning of a long, healthy annuity. This puts pressure on the startup to provide real, increasing value. And, as I wrote about in a post called The Customer-volume value curve, the startup can share in this value as they expand it over time.

It’s no secret that my strategic focus area is not SaaS. I’m a hardware investor. I hunt for compelling startups developing IoT with a recurring revenue stream…. for now, I’ll refer to this as IoTR, standing for Internet of Things w/ recurring. So, why would I knowingly choose something other than SaaS, when I’m aware of its massive advantages over other types of businesses? Read More…


Red vs. Blue in VC

Based on the title, you’re probably thinking this is a post about politics. It’s not.

This reference is to red oceans and blue oceans as discussed in the book, Blue Ocean Strategy, from authors Mauborgne and Kim. And I touched on this concept previously in a post called “Finding the Whitespace,” but I’d like to put a finer point on it here. And there is no topic that applies more directly than disruptive innovation.

In the interview, Mark mentioned that goal for disruptive technology is to compete against non-consumption. His position is that startups should focus on developing inferior products that can access a much larger number of customers across new applications. And this point was also discussed in detail in the book. A red ocean, is one where the market is set. There is a certain volume of customer that purchase a product at an average price. The market is well established and does not fundamentally change. Thus the strategies employed by large players in these marketplaces are one of share gain. Every player is trying to take market share from their competitors. It’s a competitive, bloody, fight for more market share… hence the ocean is red. Blue Oceans, on the other hand, are emerging markets. They’re not yet fully established. The number of customers and the price a product can command are both in flux… and there are no direct competitors. The fight is not one of competition but rather awareness. Companies fortunate enough to be playing in a blue ocean have the only product of their kind. By introducing non-consumers to their product, they grow the market itself.

This is why, at New Stack, we talk about companies that are creating new markets or fundamentally redefining the market they’re playing in. Every market is price * volume. If you’re familiar w/ Mekko Maps, imagine a Mekko. If not, think of a stacked bar on a chart. Each stack within the bar represents a competitor with market share. With a red ocean, the size of that bar is fixed. So, if you want more revenue, you’ve got to take it from others. With a blue ocean, the market is completely redefined along both price and volume. Price is significantly lowered, allowing access to a huge volume of customers that previously didn’t purchase a product for this problem. The original target customer is now only a small percentage in relation to total customers accessible. And, in addition to new types of customers, you get to add application adjacencies as well. So, you take a narrow customer that uses a product in a limited way. And you allow masses of customers to use a product far more than they had previously. Mark’s example was the Sony Walkman. A software example that just popped in my head is Read More…


Hubs and Spokes… Product AND Channel Innovation

I speak with many investors and entrepreneurs every week. Most investors get in touch because they want advice on how to differentiate. While I love to connect with others in the industry that are investing, I can save us all a lot of time right now… I can not tell you how you’re special. What I can do is talk you through the thought process of how one differentiates. In our business it’s simple…

1) How do you provide unique value that others don’t (ie. what’s your product)?
2) How do you connect with promising startups before they’ve closed a raise (ie. what’s your channel)?

That’s it. Value and Dealflow. Galen and Brian get it. While you can criticize the index approach as much as you want, it’s clear that they do offer value and they see a lot of dealflow.

The big issue I see is that folks often neglect one of these two things. And, more often than not, it’s number 2. There is a parallel here with the startups we are investing in. Every startup has a product strategy and a channel strategy. And the best startups are just as innovative on the channel-side as they are on product.

Let’s consider an example… Were Dropbox and Box the first companies to attempt file storage, sharing and access from the cloud? Of course not. But it’s clear that they were the big winners. While I think they both did a nice job on the product side, it was their channel marketing strategy that really accelerated their growth. Dropbox on the consumer-side, an early pioneer in viral marketing, and Box on the enterprise-side, employing a hub and spoke strategy.

I’ve spoken many times on the program about the innovative water analytics product that I launched. The existing water testing process was a 30 min, 15 step chemistry procedure, requiring expert precision. And we developed a product that allowed an unskilled worker to perform four procedures, in less than 5 minutes with just one step. And while the product is to thank for creating incredible customer excitement, it’s not what got us to $100M of revenue in the first year. It was the channel strategy that led to a fast, furious revenue ramp.

While conducting 500+ customer meetings during development, I learned a great deal about users… and not just what they buy but also how they buy. A customer at one of the largest water municipalities in California casually mentioned that they’d require around 100 units, but their network would need more than a thousand. It turns out that if you look at a map of large urban water treatment facilities, it looks very much like a series of hubs and spokes. The largest facility in the area exports their water to smaller facilities that export their water to the consumer’s tap. And, unbeknownst to me, each of these constituents “follows the leader” so to speak. Whatever processes and products the Hub is using, is then Read More…


VOC Makes Visionaries

On today’s episode, we talked a lot about customers. Chris emphasized the importance of being located close to customers, spending time with them, understanding their needs better than any other company does. It is the customers that will be the primary funding source for every successful business. We don’t often think of customers as a source of capital, but they are the primary and sustaining source for companies that are built to last

I’ve spoken many times in the past about VOC or Voice of Customer. The simple acronym that represents the practice of visiting, listening to and observing the target customer. It is frequent and focused efforts to understand a customer that makes for some of the most valuable businesses. And we discussed building a culture of customer obsession in the interview with Steve Blank. We also covered how founders don’t have to be oracles yet can look like excellent predictors of the future by intimately knowing their customer.

When I was developing my last product, I had over 500 discussions and visits with customers. And in the first year, presenting our new concept, customers were confused. By year two, they were intrigued. And, come year three, they became obsessed. I even had customers that tried to convince me to leave the prototype with them. They wanted it so bad, they’d take a glorified breadboard over a production unit. But, that wouldn’t have been the case had we not conducted 500+ voice of customer discussions. The product requirements improved and the product capabilities were better aligned with customer needs.

And yet, despite the tremendous customer data, the engineering team frequently pushed-back on customer feedback and new requirements. They often refused to believe the consumer input and quantitative data that had been collected. And ultimately, this was my fault. While initially, I thought it was the product manager’s responsibility to know the customer and define the product… the real job was to create an atmosphere where the entire development team could know the customer and define the product. My job was to include them in the process. Have them visit the customers. Make them ambassadors of VOC. And it’s this intense customer awareness that creates the best product insights and creativity. You’d be surprised how many conversations stared with me saying to the scientists and engineers: “We need X.” and the their response, “We can’t do X.” Yet, after spending time with customers the development team would be saying to me, “we need X… and can figure out a way to do it.”

As mentioned in the takeaways, Scott Dorsey cited customer focus as a reason for surpassing their valley counterparts. His CTO would go out and visit a customer every day.

So, how customer-focused are your product people? Are the engineers a part of the process? One doesn’t need to know the future to be a visionary. The only need to know their customer.


Thematic Driven Theses & Accessing Idle Supply

 

In today’s discussion, we did a deep dive on developer platforms and the key elements that separate the best from the rest. And I couldn’t help but see some parallels between Ethan’s framework and the theses we invest along at New Stack Ventures. Of our three thematic thesis areas, two of them are directly related to Ethan’s commandments. One of these items we refer to as Tractable or Automation… which gives anyone the capability to complete something that previously could only be done by a scientist, engineer or skilled professional. The other related thesis area we call Democratization, a term Ethan didn’t love but uses as well. In our case, we define this as businesses that are creating a platform or community where users are creating and driving the value; and as more users join, more value is created for all.

As I reflected on the takeaways from the discussion with Ethan and the themes that I look for in startups, I realized that his 8 commandments are principles that transcend even developer platforms. These characteristics apply and can drive value for startups in every category.

Setting aside developer platforms for a moment, let’s take a look again at the commandments… and I’ll use Uber as an example.

  1. Is the product or service delivered in a way that it can be measured? Clearly, with Uber, converted customers can be measured and their usage can be tracked at a very discrete level.
  2. Can the startup’s revenue increase as the customer increases use? Yes, in the case of Uber, the more one uses it the more money Uber makes. They are highly incented to create a positive customer experience and encourage greater engagement over time.
  3. Does this replace an existing service that the customer already spends money on? Yes, many people spend money on point-to-point transportation, most often in the form of taxis. But, even broader than that, Uber causing some millennials to forgo car ownership, a significant line item in the budget of most consumers.
  4. Is the User Experience Amazing? I’ve heard differing viewpoints on this. Some people hate Uber. Others love it. And as I had hoped, as I wrote in an article last year, Uber has now created a number of different tiers (ie. Select, XL, etc.) that appeal to consumers with different service needs. Usage per user continues to increase, which indicates that the experience is a net positive.
  5. Do customers love and promote the product/service? Whether you love it or hate it, I think the love for Uber bears out in the numbers. The growth per user and new user growth is off the charts, which indicates significant virality and net promotion.
  6. Are there strong network effects? As more people use Uber does it become more valuable for all? I don’t think I need to explain this one… it’s quite clear that the more users that request rides, the more drivers are required… and the more drivers that exist, users in well-served areas will get drivers faster and users in underserved areas will get drivers where they weren’t able to previously.
  7. Does the service eliminate something that nobody enjoys? I think it’s a safe bet to say that most folks enjoy arriving at their destination but do not like the process of figuring out how to get there. A service that significantly reduces the complexity of transit planning delivers on this commandment.
  8. Does it democratize something complex, allowing non-experts to execute expert tasks. To me, it seems Uber accomplishes this in two ways. On the consumer-side it allows any lay-person to move from one point to another, in a frictionless way, without learning a new skill. On the driver-side it allows almost anyone to become a personal driver, whereas previously only certified, medallioned taxi drivers could perform this task.

As I review these commandments and their application to a consumer startup, I can see why companies like Uber have become so successful. And there is a key characteristic of Uber that is not captured in these commandments. If I were to be so bold as to add my own commandment to the list, I would add something that I like to call: Accessing Idle Supply.

Taking a quick sidebar…  A couple years ago, I fell in love with a TV show on AMC called Halt and Catch fire. It’s a show set in the mid-80’s Read More…


Hidden Opportunities & the Best Kind of Pivot

In today’s interview, we talked about entrepreneurs that prefer to retain more control and either avoid or delay the perpetual VC fundraising cycle.  We also talked about startups that are not fundable in the eyes of traditional VC… maybe because it’s in the wrong sector, has the wrong founding team or the product just isn’t remarkable enough.
 
There are many reasons why VCs pass on startups.  Most do not want to invest in a business that requires significant changes.  In many previous episodes we have discussed pivots.  Charlie O’Donnell said that he would not invest in a company that he believed required a pivot.  Charles Hudson said that he is completely comfortable with pivots and significant product changes assuming the team is addressing a problem in an attractive market.  I think we can all agree that pivots aren’t ideal.  But, what about the startups that are a pivot away from great success?
 
In the pre-seed and seed stages, many of the best opportunities are hidden from view.  Sometimes they are overlooked b/c of an obvious flaw.  The real challenge for many early-stage investors is knowing which flaws are correctable and which are fatal.  Personally, if a founder is building the wrong product, I pass.  If the team is incapable of realizing their mission, I pass.  If the startup is entering in a terrible market, I pass.  But there is one area that sends most investors running, yet I hunt for actively.
 
Last year we invested in a company called Cybrary.  We co-led the seed round for this startup w/ Justin Label of Inner Loop Capital and chatted about our decision in an episode of Why I Invested.  And Cybrary has gone on to raise a subsequent, institutional seed round, at a healthy markup, from high-quality VCs, including lead investor Ryan Kruizenga and the team at Arthur Ventures.  Quick shout out to Ryan Corey and Ralph Sita… keep up the good work guys.  But the reason I bring Cybrary up today is not for what they did right early on, but rather what they did wrong.
 
Cybrary had built the online network for Cyber Security professionals to communicate and learn.  They had grown their user base faster than any startup I had ever encountered.  The engagement of their user base was remarkable… At the time we invested, I believe the average time a user spent per visit exceeded 30 minutes.   And, they had revenue to boot.  While many online networks discourage monetization during the growth hacking phase, the founders had figured out a way to accelerate user growth and revenue, in parallel.  But, one-by-one the large investors fled.  I made introductions and they did not yield investment.  So, out of curiosity, I picked up the phone and asked each VC for their reason for passing.  And the answer I received was universal: Read More…

Listener Feedback

Pete Maglio

The takeaways to end this episode are fantastic! Thanks @TheFullRatchet & @BenEinstein! pca.st/Fey4 #smartHardware #startups