93. What’s Wrong with Venture? Part 1 (Dave McClure)

*Please excuse any errors in the below transcript

Nick: Today #Dave McClure joins us from Mountain View, California. #Dave really needs no introduction for a program like this. But if you happen not to know, #Dave is founding partner at #500 Startups and is one of the most transparent and honest investors I’ve come across. Of course, we were lucky enough to have #Dave’s #500 Startup’s partner, #Christine Tsai, on the program earlier this year. And also more recently had #Sheel Mohnot for a discussion on fintech. #Dave it’s a big thrill to have you on the program, and thank you for joining us.

Dave: Thanks for having me

Nick: Can you start off with your sort of your origin story and your path to venture?

Dave: Well, I’m not sure you have enough time on your program to capture all that. But I’ll, I’ll try and go over it quickly. I’ve been in Silicon Valley for over 25 years. I came out here from the East coast after barely graduating from Johns Hopkins University. I had a degree in Engineering and Applied Mathematics, and started out as a programmer. Did that for a couple years, sort of broke into consulting after doing that for a little bit. And started a small consulting group that we eventually grew to about 20 people. Kind of had a lot of entrepreneurial lessons and a lot of ups and downs. We had a small exit, nothing too huge around 1998. And then I stayed with the company for about a year and a half after that. And then started doing a little bit of dabbling around in different startups. I guess the dot com blowup happened in 2000-2001. Soon after that I joined #Paypal. I guess my first day on the job was supposed to be 9/11. I, I think I started the next day.

Nick: Oh, oh wow

Dave: But got to spend a couple of really great years, actually 3 years, just prior to the company going public. And then subsequently getting acquired by eBay. And then after that for maybe a year or two. But between 2001 and 2004, I worked with some amazing folks there, you know, #Reid Hoffman, #Peter Thiel, #Max Levchin, a bunch of other folks who ended up in doing various startups and also joining venture. So it was a very illustrious country club to have come from. Although I, I’m probably not as famous as the rest of the folks there. Anyway, I started doing Angel Investing as I was leaving #Paypal in 2004. Did that sort of on the side, kind of as a, as a fund, you know, side gig for maybe 3 or 4 years. Invested in maybe 13 or so companies and advised a few others. But deployed maybe about 300,000 of my own money into those 13 or so companies. 3 of those ended up being, you know, pretty decent sized wins, 100 million plus outcomes. Those were # Mint.com , #SlideShare, and #Mashery. Those didn’t happen until later, but at least I knew those three were doing reasonably well. Sometime around 2008 I kind of decided that I, you know, might want to try doing investing professionally. Unfortunately summer 2008 was not the best time to be raising a fund. As #Lehman and everything else were blowing up. So my backup plan was I ended up working with #Shaun Parker and #Peter Thiel at #Founders Fund for about a year and a half or so before I started #500. So that was a really great place to get started. And I got to work for #Peter again for a second time with some other ex-Paypal folks there too. And managed about a $3M portfolio there for about a year and a half. Made some early investments in some great companies. #Twilio was one of them, #Credit Karma, and actually I was also running the Facebook fund which was a joint venture program between #Accel and #Founders Fund for the summer of 2009. And we had to invest in #Zimride which was later became #Lyft, #Wildfire which got acquired by #Google I think in 2012 for about $350 million, and a few other companies there as well, #TaskRabbit and a few others. So it was kind of, you know, a pretty awesome first experience. I made about maybe 40 investments over that period of time, maybe about a year and a half. Mostly small cheques you know, anywhere from say 25 to 250K. But turns out we invested in some really great companies, you know, #Twilio which just went public, #Credit Karma which I think was valued at over 3 billion last year, and #Lyft which I think is probably valued somewhere around 5 billion, I think they’re looking at trying to seek some kind of strategic acquisition lately. Anyway, so did okay with that, and I think, you know, turned out 3 million hopefully into something around 100 or 200 million, at least in value. We got #500 off the ground I think in summer of 2010, and #Christine and I have sort of been, you know, raising as fast as we can to keep up with everything in the last 5 or 6 years since then.

Nick: Wow. Circling back to the #Paypal days, what sort of activities or what functions were you responsible for there?

Dave: Well I was managing a developer platform there. That was kind of before developer platforms were cool. This was I guess almost 15 years ago now or something around there. So managing a small 3 person team mostly doing education and evangelism for eCommerce developers and merchants, people who were using the Paypal platform to accept credit cards and sell products both on eBay and off. And also kind of experimenting with a lot of, you know, new techniques and marketing. So started doing search marketing, both paid and organic. Did some blogging, did a lot of email marketing. And things that are, you know, sort of, I guess almost old school these days. But at the time, it was you know 2001 to 2004, we were just starting to use online marketing techniques to do customer acquisition and education. A lot of those kind of experiments became very, you know, helpful later when I was working with companies that I was investing in or advising, as more and more of the US and global audience came online, understanding how to reach them via online channels, search and social and eventual mobile became very very helpful.

Nick: Got to imagine with some of #500’s differentiation today on the acquisition side and, and the growth hacking side, some of those tools come in handy?

Dave: Yeah, a lot of our initial philosophies are around, you know, how we differentiate from other firms particularly on customer acquisition and marketing came from some of those experiences.

Nick: Got it. Well, good. Well hopefully we can get into more of the #500 stuff later on in the interview here. But today we are talking about what’s wrong with venture? And

Dave: Okay

Nick: Recently I was reading #Jason Lemkin’s thoughts on #Quora about your comment that most venture capitalists are lazy and not innovative. So #Dave, why do you think that VCs are lazy and, and not innovative?

Dave: Yeah. Well, I would say because the gig is pretty good. You don’t actually have to do a lot. At least, at least for most VCs. I think, you know, a lot of the effort is really around getting the fund raised. Once you kind of get the money, for a lot of traditional VCs it’s mostly about taking meetings and saying no, and very occasionally saying yes. And, you know, then if you sit on boards maybe you’re doing work and helping the company and following up. But I would say that a lot of, the traditional VC lifestyle is, is not necessarily a hard job. And there’s quite a lot of folks who make a very tidy salary just on the management alone, whether or not they ever get to a successful investment fund or a carry. And I, you know, I don’t mean to denigrate, you know, the field too much, but I would say a lot of the ways that venture VC operates now are not really that different from maybe the way it was 30, 40, 50 years ago. And some people might say that’s, you know, okay, but I, I think there’s certainly a lot of innovation and opportunity to innovate that has not been happening in venture. Which strikes me as a little hypocritical since we’re in the industry of disrupting other industries.

Nick: What are some of the practices you’ve employed to, to sort of innovate around this asset class?

Dave: Well, I think for us, you know, one of the big differentiators is our belief that a larger portfolio, a larger number of companies in the portfolio has a beneficial impact on returns. I, I wrote a blog post maybe a little over a year ago that was called 99 Problems But a Batch Ain’t One, with some apologies to rapper Jay-Z. It was really about how our feeling that most venture capital portfolios are undersized by a factor of 2 to 5x. Particularly for early stage investors that are putting money into companies at seed stage. We really feel like, you know, portfolios with, you know, less than a 100 companies are just poorly constructed. We think given, you know, the data on returns, we need a minimum of a 100 companies and probably more like 200 or more to have a realistic chance of finding big outliners. So if you invest in a 100 companies or heaven forbid 500 companies, you end up doing a lot more work, at least making the investments but probably talking to companies and then, you know, helping support the companies to some extent as well. You know, like I said, a typical VC probably makes one or two investment decision a year, maybe a few of them make, you know, 5 to 10 investments a year. Our team typically makes anywhere from 10 to 30 investments per person. And like I said we made over 500 first cheque investments last year as well as maybe 50 to a 100 follow on investment decisions.

Nick: Wow, 500 last year in 2015?

Dave: Yeah. And I, I think, you know, we feel that doing about 20 investment decisions per partner per year is a reasonably scalable amount. So we are making, you know, more like one or two investment decisions per month, not one or two investment decisions per year. You know, through our accelerator program we probably do close to 200 companies a year. Through our seed investments we do another two or three hundred per year. That’s spread across maybe a group of 30 people, but still I, I think that we feel, at least for early stage investments, you know, we’re fortunate if anything more than 10% of our portfolio results in larger outcomes. In fact, we really kind of feel like the unicorn where 50 to 100x outcome probably happens not much more than 2% of the time. And even the large wins, you know, 100 million plus exits, things we like to call centaurs, those probably only happen maybe 5 to 10 % of the time. So if you really have that big win only 1 or 2% of the time, maybe the medium size win 5 to 10% of the time, you know, statistically speaking a portfolio of size less than 50 to 100, you’re really gambling at trying to find those large outcomes. As you start to get to a 100, 200, you know, 500 companies, then you have more statistically predictable outcomes and more likelihood of maybe 5 of those large outcomes, perhaps 20 or more of the medium size outcomes.

Nick: Right. And how early are you guys going? Will you invest in companies that are just idea stage?

Dave: Generally we don’t. I mean, we tend to look at the sweet spot for investing being after the company has a functional product and when they have some early customers or users. A lot of our companies may already have 10 to 50 thousand dollars a month in revenue. For those that maybe aren’t revenue generating, you know, we’d like to see hundreds of thousands of active users if not more. So we really feel like a lot of the initial, you know, building stuff in the garage, that should probably be done on the founders own time and money, or at least, you know, some of their savings or friends and family money. When we’re writing a cheque, at least 90% of the companies that we’re investing in already have functional product and early customers.

Nick: Got it. So back on, on the VC point here, I know that you’ve had many different interactions with VCs, you’ve syndicated with them, you’ve been a VC yourself, you’ve worked with some later stage VCs that are funding some of the startups that have been through your program or been through the accelerator

Dave: Yeah

Nick: What other things, if anything, frustrates you or complicates the process regarding VCs?

Dave: Well, I have to be little careful here, and try not to piss off the people who are actually going to be helping fund our companies.

Nick: That’s always the line, right? It’s a tough one to walk

Dave: I try not to mention anybody by name specifically. It’s always those other VCs that are the ones. You know, I think we, we spend a lot of time working, you know, with our companies, probably on two or three key areas. You know, one is around customer acquisition. That’s probably the most important thing we spend time on. How do we help them get that product that already has, you know, some customers, how do we accelerate customer adoption, how do we increase retention, how do we increase monetization? So a lot of that work is kind of nuts and bolts, focused on customer online acquisition and just kind of how the UX works and how the product works and how to keep those customers longer, reduce turn. The other thing we do is really trying to give them a foundation of connections in Silicon Valley. Particularly that’s the case for the companies that are coming from other parts of the US or other parts of the world is connect them with other entrepreneurs, connect them with mentors, connect them with the investor community, whether that’s angels or VCs. But most of what I would say is our emphasis is around how do we increase customers and how do we get them, you know, their first round of investment.

Nick: #Dave, on the LP side of things, I’ve heard some recent rumblings about sort of the increased influence of LPs over VC fund strategy. And I was exchanging messages with Sunil Shaw about this and how it seems like the tail is wagging the dog, not only in politics but also in venture. Have you seen this as an increasing trends, or what are your thoughts on, on this phenomenon?

Dave: Well, I don’t know that that’s necessarily a new trend. Perhaps for some of the new emerging managers that, that is something that they’re spending more time looking at. But I think it’s always the case that VCs are, you know, interested in understanding what LPs are going to invest in. And for the first time fund managers, that’s you know, probably more important than more established VCs. I’m not always sure that the LPs are influencing VC fund strategy in ways that are positive though. As I mentioned, I think it’s our strong, you know, philosophy and perspective that larger portfolios will tend to perform better, at least over time. VCs tend to concentrate their portfolios and I think the LPs tend to look at more concentrated portfolio strategies because at least the larger more successful VCs funds have operated that way. I think there’s always an interest in kind of new and sexy categories. And so, you know, whether that’s virtual reality or drones or some kind of biotech or other area. You know, there’s a lot of people who will, you know, move their strategy towards the sexy trend of the day. Or invent interesting terms to describe strategies that have been around for a while. So whether that’s big data or artificial intelligence, you know, we might just describe that as investing in smart people who are nerdy. But that’s not, that’s not exactly a strategy. I mean, I think that we always want to invest in smart people but we want to look for industry categories where there’s problems to be solved and, you know, opportunities for new companies to have a big market to go after. So I don’t, I don’t know that it’s a new thing, but I would say, you know, early and new fund managers are probably going to be more likely influenced or swayed by what LPs are looking at.

Nick: You know, there’s been an influx of capital at the, the very early stages. Lots of new angel investors, lots of articles written about sort of the amount of seed capital versus that of later rounds. What are you thoughts on how newer early stage investors are influencing venture capital at large?

Dave: Well I would certainly agree there’s a lot of angel investors that are new to the game. And we’re talking maybe about the last 10 years, not just the last 2. I think, you know, you’ve seen pretty dramatic growth in early stage, you know, seed stage capital where the first, you know, twenty five to a hundred thousand dollars coming from a lot more retail angel investment. I don’t necessarily think that’s a bad thing. Although that money may be less sensitive to valuation and maybe less experienced. In terms of the seed stage capital there’s certainly a lot more seed funds and seed fund managers getting into the business that weren’t there five years ago. A lot of us who started out, you know, in the late, you know, 2008- 9- 10 time frame. There weren’t that many. Maybe 5 or 10 of us that were really getting started around that time. Now I think there’s several hundred that are jumping in. Again I don’t necessarily think that’s a bad thing. If you looked at, you know, where a lot of larger funds were raising capital, maybe, you know, 5-10 years ago, and they’re still, you know, people raising billion dollar funds today. I think those vehicles maybe have a lot more to prove in terms of how they deploy capital and how they return capital. I think early stage investors maybe are successful, they may fail but at least the theory of investing early, you know, makes sense to me.

Nick: #Dave, there’s been a big valuation shift for SaaS companies. Where last year they were often valued around 10x of forward revenue and now it looks closer to 5x of trailing revenue. Why do you think it’s changed so significantly?

Dave: Well I think that’s probably more the case that for about the last 2 or 3 years there was a very generous valuation placed on those companies. So they come back down to a rational, you know, statements. And, and maybe it’s leveled up a little bit since then. But I think, you know, particularly earlier in the year when I think #LinkedIn’s stock tanked maybe you know about 40% in one day. And a few other vehicles also. There was a significant, you know, reduction in valuation multiples for SaaS companies, or at least some larger SaaS companies. And I don’t think that was irrational. I feel like probably the period of time maybe between, you know, 2012-13 and 2015 or so, up until maybe last just earlier this, this year, I, I think there were a lot of people trying to get into late stage private companies. There were, you know, international investors trying to jump in. There were private equity investors who wanted to go into, you know, startups and venture capital. There were a lot of corporates who were trying to get into, you know, venture and a lot more money coming from corporates. So, you know, there’s a lot more demand for the late stage private company and the next #Uber, or the next #Facebook. And that resulted in a lot more generous valuations and generous multiples for those companies prior to going public. Some of that I think has maybe calmed back down now. But I actually think there’s still quite a bit of demand from those sources of capital to get into late stage venture. And so, you know, and that’s not irrational, if you look at companies like, you know, #Facebook and #LinkedIn and #Twitter and others that, you know, have gone public, they went public very, very late. In fact they were already , you know, multi-billion dollar companies, in some cases tens of billions of dollars companies

Nick: Yep

Dave: before they went public. So the ability for private investors to get into those companies was, you know, very, you know, limited. It was very, you know, mostly people were not retail market investors. And so that’s why I think we saw , you know, funds like #Fidelity and others, you know, trying to jump into, you know, late stage venture.

Nick: You know, speaking of this point, #Bill Gurley wrote a post about how the unicorn financing market is becoming dangerous. One of his points is that the current crowd of unicorn founders and CEOs have never experienced a difficult fund raising environment. They have only known success. And that this has resulted in dirty term sheets from investors instead of just raising at lower valuations. What were your thought or what are your thoughts on #Bill’s position?

Dave: Well, I , I think he’s right to some extent, for people who’ve been in the market for maybe less than 5 years, who weren’t around for the 2008-9 time frame. You know, they probably haven’t seen much of a down market. They probably only have seen optimistic scenarios. I think, you know, dirty term sheets that’s a sort of subjective assessment. I would just say that that’s really term sheets with lots of “structure” or liquidation preferences and other types of terminology besides just valuation that allow the last round of investors to have certain privileges or preferences over earlier stage investors. That’s not necessarily dirty, but it does get complicated. And if the company doesn’t perform well, it can mean that a lot of the upside of the company ends up in the hands of the most recent round of investors. And so early stage investors and entrepreneurs and their employees who have common shares will end up having to perform and having to satisfy the needs of the requirements of the most recent term sheets in order to get capital. So if there’s a liquidation preference or if there is a high valuation, the late stage investors will need to get their money out first and then subsequently earlier rounds  of investors and preferred investors will need to get paid before common shares for founders and other employees.

Nick: Yep

Dave: Again that’s a choice that’s made by, you know, the founders or CEOs of the companies or the boards of those companies as they accept those term sheets. I might add that, you know, #Bill Gurley as much as he was railing against the industry is an investor in many of those companies who’ve done those types of term sheets. I would, I would expect that #Uber, one of his biggest, you know, wins theoretically, is probably a company that has accepted liquidation preferences on some of their later stage rounds as well as many other companies that #Bill has invested in. And I share his concerns. I mean, I, I think that his, you know, warnings sounds and concerns are prudent. But they are a factor of an industry where, you know, there’s lots of demand for capital, and sometimes there is desire for founders to have a very specific billion dollar valuation of a company, specially since a lot of the Unicorn kind of, you know, story became very popular.

Nick: Yep. You know, while we’re talking about entrepreneurs, are there any problematic issues or, or maybe trends that you’ve observed on the founder side?