94. What’s Wrong with Venture? Part 2 (Dave McClure)

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Today we cover Part 2 of “What’s Wrong with Venture?” with Dave McClure of 500 Startups. In this segment we address:

  • Dave McClure What's Wrong with Venture part 2Are there any problematic issues that you’ve observed w/ founders?
  • Any thoughts on who might be one of the most misunderstood people in the venture ecosystem?
  • How do you think about the landscape of accelerators and how do you differentiate at 500?
  • Any other comments on challenges in the venture environment and what you’d like to see change going forward?
  • On the other side of the coin, what positive trends have you observed in venture over the past few years?
  • What startup investor has inspired and influenced you most and why?

Guest Links:

Key Takeaways:


1- Lack of innovation in VC

Compared to building a business, investing is just not a lot of work.Dave talked about how the effort for VCs is concentrated on getting the fund raised. After that, most of the job is about taking meetings and saying no, with the occaisional yes. There’s a lot of folks that make a good salary on management fees whether or not they have a successful fund and receive a carry.

Because of that, a lot of the way VC operates now is not very different from how it did 30 or 40 years ago. And Dave believes that the generalist VC is going away. Going forward there will be more:
sector focus
business development

He sees much more competition and differentiation in the future, amongst the VC ranks.

Another issue, combating progress, is related to LPs. Dave said that LP influence over fund strategy may not be positive; but it’s also not a new trend. And those early and new fund managers, that one might think should be most innovative, are also more likely to be easily influenced by LPs. This results in fund managers that will move their strategy toward the sexy trend of the day. So those that should be driving change, end up as fast followers.


2- Fundraising Concerns

When discussing concerning trends in the fundraise environment, Dave mentioned both early and late stage issues. First, let’s review the early-stage…

Early-stage issues:

1.More Convertible Notes at increasingly higher caps

Dave has observed, over recent years, that many entrepreneurs are raising more than $1M on convertible note structures. And when these founders eventually get to an equity terms sheet; the conversion may not occur w/ reasonable expectations. They may expect to be giving up 10-20%, where they’re actually giving up 30-40%. And then there are those that raise on a convertible but never get to a subsequent equity round. Convertibles are debt capital, not equity, which brings another set of issues if conversion fails to occur.

2. Increase in Seed Investment

We also discussed the influx of new angels, new seed funds and much more capital at the early stages. Where there used to be handful of seed funds, there are now over 100. But Dave doesn’t see this as a major problem. While newer investors seem less sensitive to valuation and have less experience, this, overall, has had a positive impact on the ecosystem.

Late-stage issues:

1. Influx of non-VC capital

When discussing the recent reduction in valuations, particularly for SaaS, Dave’s opinion was that they’ve come back down to a more rational level. For a period, they were inflated and new entrants were driving some of this valuation increase. We’ve talked about this a number of times in the newsletter and venture weekly. Many late-stage private companies have stayed private longer, and grown faster into multi-billion dollar companies. This restricted the supply-side of growth tech companies in the public markets and caused much more demand for investment in late stage private companies. With this, a host of new players started investing in late-stage venture. Corporates, private equity, hedge funds and large financial institutions all became active financiers in the venture market. And this led to the second issue we discussed, which was the:

2. The Late-stage, dirty term sheet

While a number of these later stage investors became less valuation-sensitive, they also protected their downside. By including lots of structure or liquidation preferences, they’d could ensure that if the company raised again, or went public at a lower valuation then the current round, they would still get the return they needed. So they were playing both sides. If things went great and the valuation continued skyrocketing, they win. If things go poorly or flat, then they still get their healthy liquidation preference and the previous investors, namely the common stock holders (ie. founders and employees), lose a lot of their return. This is where the infamous Full Ratchet rears its ugly head. While full ratchets are typically less common or concerning at the early stages, they have become a preferred method for late stage investors to capture more equity.

3- What’s Going Right with VC?

Despite today’s controversial topic, we did also discuss what’s going well and who’s driving positive change.Regarding innovators on the investment-side… Dave mentioned 500’s efforts to have a much more diversified portfolio, both in volume and diversity of investments.

Others in the industry that he feels have been innovative include:

Y Combinator

Series A
First Round

B or Later
Google Ventures
Andreesen Horowitz

Dave mentioned some positive trends in venture including:

-VC has become more International
-There’s significantly more tech infrastructure and plumbing for entrepreneurs to build on
-It’s become a lot cheaper to build a startup
-It’s easier to get the information required to build and grow a company
-And, in general, entrepreneurs are smarter and more educated about the entire process


Tip of the Week:   Forever or Fleeting?

*Please excuse any errors in the below transcript

Nick: 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?

Dave: Well, I think maybe what you had identified in that, you know, a lot of founders may not have been around for the last downturn, they may not have seen harder times in raising capital. I think, you know, founders always have challenges. I don’t know that anything is necessarily specific to the upside of, of the market, you know. If you’re competing for customers and you’re trying to get a business off the ground, you have a lot of different challenges to face in terms of how you, you know, make product, how you acquire customers, how you manage and recruit your employees. I think possibly one thing that we’ve seen is, you know, a lot of use of convertible notes with higher valuation caps. There has been a trend for a lot of people to raise, you know, more than a million dollars, maybe up to two or three million dollars in some cases on convertible notes structure. When they, if and when they eventually get to an equity term sheet, the conversion of that capital into shares may not always occur with reasonable expectations.

Nick: Yep

Dave: And so they may need to really look at the math and understand how those convertible notes turn into, you know, shares. They may, you know, be expecting that they’re only giving up 10, 20% when they end up giving up more like 30% or more in some cases.

Nick: Yep

Dave: Probably even more of a concern than that is if they don’t ever convert. And that they’re raising dead capital and just never getting to an equity round. And so, you know, I, I don’t know that these are new problems. I think there’s, you know, always for many founders understanding term sheets, whether they’re convertible notes or equity, a lot of times it’s their first time and they certainly don’t see those terms as often as the investors or the venture capital investors do. So they are at a little bit of a disadvantage just by not being familiar with things operate. First timers are going to go through some had lessons and, you know, hopefully they learn.

Nick: Yeah, sure. So #Dave, I’d like to hear who you think might be one of the most misunderstood people in the venture ecosystem?

Dave: Who may be one of the most misunderstood people in the venture ecosystem? Me.

Nick: That’s why I’m asking

Dave: Most misunderstood. Well, I think, you know, there’s some interesting folks out there who are sort of pushing the envelope, at least on venture. You quoted #Jason Lemkin before. I think he’s one of the smartest guys out there. We’ve been co-investors in a few companies together. I don’t know if he’s misunderstood but I think, you know, he’s one of the guys I would probably be watching over the next few years. I think he’s going to be a real super star, and how he sort of promotes and, you know, identifies companies of interest. I think #Jason Calacanis is a little bit of a volatile figure and sometimes people may view him both positively and negatively. Maybe #Mark Cuban also, I think people put in that category. I don’t know. I think there’s a lot of colorful figures in venture, just like there are in other industries and, you know, we, we tend to try and promote and market ourselves, that’s one way that we get access to deal flow, that may be misinterpreted by some folks in the market. But I think it’s not, it’s not terribly unusual that people will try and market themselves differently from others in order to get access to, to companies.

Nick: You’re too generous, #Dave. I was hoping to serve that one up so that you could tell us all why you’re misunderstood.

Dave: Well, I, I think I probably tend to be a very loud and obnoxious voice. And sometimes I’m likely to use profanity to attract attention. But hopefully our investment strategy is one that’s based on logic and data, not just based on kind of sound and fury.

Nick: Well, I, I, we all appreciate the sound and fury too, from my perspective at least

Dave: I , I think you, as I like to say, it’s useful to have a voice that’s heard

Nick: Absolutely. So on that point with, with #500 as an accelerator, how do you feel like you guys differentiate versus other accelerators?

Dave: Well I think we’ve, you know, done a lot of work in the last 4 or 5 years to hopefully, you know, carve out our own space. I think we, you know, probably compete with #Techstars and #Y Combinator most prominently as national or global programs. I think like we mentioned, focusing on marketing and internet marketing and customer acquisition is one of the areas that we try and emphasize where we’re different. We have about 15 to 20 people on staff who do nothing but, you know, internet customer acquisition and consulting. We’re in Silicon Valley, that’s kind of one of the places where we feel we’re connecting with other companies and investors and other entrepreneurs. That’s not necessarily different than #Y Combinator but we both are right in the heart of where a lot of other activity is. I would say two of the things where we’re different is that we are pretty extremely international. So both our team and our investments, about a third of a team and about a third of our investments, are made outside the US. Our team comes from about 20 other countries. We invest in about 50 or 60 countries. That’s a really, really big part of what #500 is all about. In addition to international investments I think we’re probably one of the more notable investors in women and minorities in the US but just generally, I think, you know, a more diverse portfolio, again both our team and our investment strategy is a real big believer in  diversity in almost every kind of level.

Nick: Right. Any other comments on challenges in the venture environment that you’d like to see changed going forward?

Dave: Well, I think, you know, venture capital itself is challenging. I think probably not more than half and in fact maybe only a quarter of, of venture capital funds or investors are successful in getting to a substantial return on their investment. People in the industry talk about top quartile or even top decile performance. I think it’s hard to be consistent, a consistent top performer in venture. There’s probably not very many venture capital funds that are consistently, you know, winning three times in a row. That’s probably less than 10% of the industry. Again some of that I think is based on how we construct portfolios, some of that is based on not being really differentiated. But I think we need to continue to challenge ourselves to be just as innovative as the industries we invest, invest in. And whether that’s, you know, working harder to find companies, working harder to help companies, maybe not paying ourselves quite as much as the traditional VC who sits on Sand Hill Road and, you know, takes a lot of money and management fees. I, I think there’s a lot of innovation that can be, you know, done in the industry. I think VC companies like #First Round Capital may be at a Series A stage. You know, #Google Ventures and #Andreessen Horowitz and a few others at the later stages. And, you know, others like #Y Combinator and #Techstars and ourselves, that’s sort of the accelerator in seed stage. We’re all I think doing interesting and differentiated work that’s not maybe the traditional structure for venture. I think a lot more non-investment services offerings are definitely part of where we’re headed. I think, I think you’re seeing, you know, the, the generalist VC that’s probably going away. You’re going to have more sector focus and specialization in venture, whether that’s, you know, at the accelerator stage or at the late stage. I think you’re going to see a lot more services that might be helping with business development or recruiting or education, maybe marketing, that are specific to each stage and area. So I think, I think that’s a good thing. And I think you’re going to see a lot more competition and differentiation over the next few years.

Nick: Yeah. And while we’re talking about some positive things, what’s, what are some of the, the more positive trends or things that you see currently transpiring or, or happening in, in, in the recent years?

Dave: Well I think as much as I might hate to admit it, entrepreneurs are getting smarter. You know, there’s a lot of first timers out that  continue to have to learn lessons. But the lessons that they learn might be, you know, more available and visible in the market. They can, you know, see information on the, the trade publications like #TechCrunch and others. They can raise money online via #AngelList or #Kickstarter or #Indiegogo. Or they can use other online platforms like, you know, #Quora or other, you know, social platforms to exchange information. So I think the first timers tend to learn faster. There’s certainly a lot more infrastructure and plumbing available for people to build stuff on top off. So things in general I’d say are a lot cheaper to build these days than they were 5,10,15 years ago.

Nick: Yep

Dave: And I think you’re seeing this spread of kind of accelerators in seed capital around the world, not just in the US but globally as well. So access to capital, although it still may be challenging in some parts of the world, continue to get better and better. And as you see the consumer and business markets moving more and more online globally. I think the opportunities are just, you know, exploding all over the place. There’s a reason that we’re going after venture internationally. And it’s frankly just because there’s more market opportunity available there. Most, most of the growth that we’re going to be seeing over the next 10 years is not going to be happening in the US, it’s going to be happening in places like South East Asia, in India, in Latin America, in Africa and the Middle East. Most of those populations are still not at, you know, 50 to 100% internet penetration. There’s still a ton of growth that’s happening. There’s still a ton of online payments and option. So it’s really, you know, it’s pretty exciting when you think about, you know, the market opportunities are expanding, the cost of building platforms is going down, and generally we think the education opportunities and experience of entrepreneurs is going up. Those are all factors that are moving in our favor as investors. And, you know, for those willing to venture outside Silicon Valley or outside the US, it may be a little bit risky and rocky the first few years, but for those who are willing to, you know, invest that time and money, I think it’s going to pay off dramatically over the next decade.

Nick: Well despite all the opportunity internationally, I hope your, your geeks on a plane makes a stop here in Chicago at some point.

Dave: Well I, I’d certainly love to visit Chicago at least in the spring and summer and fall. I’m not so sure about the winter. But hope to be by the windy city again sometime soon.

Nick: I moved back here 3 years ago and I think it’s taken me the past three years to re-adjust to the winters. #Dave, if we could address any topic related to startups or venture, what topic do you think should be addressed and who would you like to hear speak about it?

Dave: There’s a lot of people that I respect in the industry who I think have a lot to add.You know, some of my investors and mentors, #Brad Feld, #Fred Wilson, #Mark Andreessen, #Mitch Kapor have all been amazing. I, I think those folks have, you know, really, really great perspectives. #Mark Suster is another person I, I hold highly a lot of respect for. Maybe if I were going to highlight a few new voices out there, I think #Jason Lemkin is kind of one of those. I think I mentioned him before.

Nick: Yep

Dave: # Aileen Lee at #Cowboy Ventures I think is pretty interesting also. But I might just, you know, promote a woman on our staff who’s just getting started and #Monique Woodard is going to be working in a fund that’s focused on black and hispanic entrepreneurs in the US. She’s a black woman herself, and I think we don’t really get to hear a lot of investment opinions or voices from folks who may be aren’t the more typical venture investors. So as much as I like to respect a lot of white male predecessors who have been around for a while, I think hearing from some other voices of color and diversity are important as well.

Nick: What startup investor has influenced you and inspired you the most and why?

Dave: Well, that’s hard to pin down to one person I think. You know, I think #Paul Graham certainly has been a huge influence from #Y Combinator. #Brad Feld and #David Cohen at #Techstars.

Nick: Yep

Dave: #Josh Kopelman at #First Round I think is probably one of the most thoughtful people out there. I think he’s really built a tremendous firm. Very, very thoughtful and how he, kind of constructs services that are helpful to his portfolio. Yeah, I don’t, I don’t know if I can point out just one. I think that really there’s a lot of people out there that have been thoughtful and we’ve tried to draw in bits and pieces from a whole lot of different people out there. But I think it’s important for everybody to kind of come up with their own sort of unique approach and strategy. I think there are lessons we learn from everyone out there. But, you know, you should be your own artist and try and come up with your own sort of unique flavor and strategy for what you’re going after.

Nick: And then, just to wrap up, #Dave, what’s the best way for listeners to connect with you?

Dave: Well I’d, I’d love to try and talk to as many people as possible, but I’m not always the person on our team that people should be pitching. In fact I’m usually out there trying to raise money than I am trying to invest it. There’s probably over 30 people on our team who are making investment decisions. Any of our founders and mentors are also great places to connect with. A lot of times, you know, we like to hear the people connect through our portfolio, or people who are, you know, familiar with the industries that they’re going after, mentions #500 and mentions me in a way that’s interesting, and hopefully not too much ass kissing. But again it’s probably easier to get a hold of other people at our company than it is to catch my attention. And like I said, I’m not the only one that writes cheques. We have 30 people who are doing that.

Nick: Awesome. Well, #Dave you’ve been a, a big inspiration to me for a long time from afar, and continue to be colorful, continue to be vocal and I really appreciate you sharing the time with us today.

Dave: You bet, thanks for having me