By John Mathon
In my last article that talked of the merits of the Silicon Valley miracle and how it is unique and unstoppable. More than one comment interpreted my article as an endorsement of VC’s. Today VC’s are a shrinking importance to the Silicon Valley story. Part of this article will discuss the traditional VC process and the benefits and weaknesses. I will talk about what VCs need to hear and why they turn companies down. I will also talk about why the model is failing and why that is largely unimportant to the success of entrepreneurship and the Valley. How investment is done today.
Traditional VC Mindset and Motivations
A traditional VC from 1970-2005 was a firm that was the traffic cop on entrepreneurship in Silicon Valley and elsewhere. Most of the rest of the world learned from and tried to translate the processes, values and methodologies of SV’s VCs. The basic VC is a partnership composed of individuals who each have some autonomy to pick companies to invest in and help. Usually there is a black ball exercise to make a final decision but each partner is free to succeed or fail.
I have looked at this as sort of an ultimate job. Sitting on high deciding which cool companies to invest in, helping struggling entrepreneurs succeed, helping create the future. This must be the best job in the world. In reality it is much much harder and more boring than it seems. I worked on the outskirts doing things that were mostly fun not having to do the really hard parts of the job.
A VC partner must find their investments, qualify them, lead them through the investment process, handle problems at the firm, provide guidance and sometimes enforce rules. Ultimately the goal is to exit the company and make a massive profit. A typical partner can only do this with a small number of firms. This is a scaling problem. If you have 1 billion dollars to invest you will need a lot of partners because each investment is small and there is a limit to how many firms a single partner can handle. Why?
If a firm wants to really succeed with its investments it needs to spend a lot of time with them. One huge advantage VC funded firms have is the experience and wealth of contacts a VC firm has having dealt with hundreds of startups. VCs see numerous problems over and over. They know people who can help this or fix that. In order to be competent VC you have to attend board meetings generally. This is why VC’s always prefer at least 80-100% of their investments are local. Traveling to go to board meetings is extremely costly in time. Most firms will rarely invest where they don’t have a presence.
A VC has investors in them. A large part of their job is convincing those investors that they are making good choices, that they are using that money wisely and getting the investor to put more money in the VC firm. So, they have to work both sides. They have to beg for money too just like the Entrepreneur.
Since they have to keep those people happy they have to have a reasonable time-line before a firm exits and returns the money they gave them. This is a source of a lot of the problems and conflicts with some firms. VC’s are very interested in quick wins usually because firms that hang on with promise but don’t have a liquidity event are a pain. Partners have to keep explaining at investor meeting after investor meeting how the firm is doing well or will do well to investors who are asking when will they get their money back? While VC investors usually are patient waiting 10 or 20 years is hard. Most want to move on. So, there is pressure to get you to sell or have a short term win that will enable you to sell your company. If a VC doesn’t see the possibility of a win they want you to close down so they can stop attending board meetings and wasting time they could be spending on the next Google.
I remember one VC firm I was an investor in had a investment that changed its business a couple times. From a high tech investment that was cool the firm finally decided on selling women’s cosmetics. This wasn’t a cool thing for the partner to have to deal with day in and day out. That firm could use a VC who specialized in consumer investments, maybe a female VC who related to the cosmetics business more. I hope this doesn’t sound terrible but it was funny at the meetings as he explained the investments potential and successes and failures. Ultimately this turned out to be a profitable investment but barely. It took a lot of his time over years to make a small profit.
Looking at it from the investors and VC’s point of view this makes complete sense but it isn’t in the entrepreneurs best interests. Sometimes companies simply will take a long time to succeed. They may be good businesses that simply don’t achieve the level that will return a lot to investors now.
A typical VC partner may have 5-15 investments. They expect 80% of those investments to break even or fail. What they need is one or two firms to hit it big with 10x-100x return. The others can average 1x return or less. Everything really depends on those one or two winners out of 10. A single win could easily erase and make hugely profitable 9 other complete failures. VC’s don’t really care about break evens that much. Investors are not investing in VC’s to get a few percent return. If the VC is not generating 100% returns over your original investment in 5 or 10 years then you could do better than investing in a VC fund so the fund has to have a number of big successes or it is a failure.
I’ve known VCs who want companies to spend their money fast. Get it over with. If you are going to succeed do it fast and exit or fail and move on. For some executives this is a good practice too. However, for me at TIBCO we took time building our business. We had an incubator model that helped us originally. We were profitable from the first year so we never took VC money until just before we went public and that was only to grease the finance wheels not because we had any need. TIBCO used its money smartly and emphasized profitability. This was the first “dissonance” I had with VCs. I understood their motivation to want to get out fast but I also understood the business practice that made sense to me was to grow the business as fast as it made sense to do it.
The Formula for Companies of the past
Another dissonance with Entrepreneurs and VCs that commonly pops up is over ownership. The VC has a formula for ownership. Companies get funded in iterative stages as “unknowns” are eliminated. When you get started you have business risk, people risk, technical risk, financial risk, market risk and many of these risks are the goal of the company to eliminate. You want to eliminate people risk as fast as possible and have the right people proven to be able to do it. You want the technical risk gone as soon as possible. Soon after that you need to eliminate business and market risks. You need to know their is a market for the product and that it is sustainable and you have advantage. Companies value goes up as these risks are eliminated and as the financial success of the company improves. Eventually as a company has eliminated most risks it is purely a matter of execution risk. You simply need more money to grow.
One company in the Valley is famous for screwing up that last piece of the puzzle. Osborne computers were widely recognized as the best computers in the fledgling PC business back in the early 80s. The companies sales were soaring when suddenly one day the company announced bankruptcy. It had simply run out of cash. There was no doubt it had succeeded, that it had a market and could be profitable but they had screwed up the funding of the company so badly they simply ran out of cash and had to cease business. Wow. That sucks.
When an individual first has an idea they cannot usually go to a VC just like that. Ideas are a dime a dozen and unless you are someone with unbelievable credentials who can make the claim that an idea is worth investing in, most VCs will eschew investing in an idea. So, the first investment you need is angel investing. In the past this was typically up to about 250,000 dollars or so. Networking with a bunch of rich people even doctors and lawyers or former entrepreneurs you can usually find some money. This became so common that Angels banded together into clubs.
After you had gotten your idea so that you had some good people to execute and you had eliminated a lot of technical risk you could go to a VC for an “A” round. At the A round you might get a few million. (Remember this is typical not a rule.)
The VC expects to take as much as 50% at this point in the company. This leaves the entrepreneurs 50% for them. The standard policy was to distribute 10-15% for the CEO, 2-5% for the CTO, 2-10% for sales, <1% for engineers. Usually in the valley everyone gets stock. In the B round the VCs give maybe 10 million dollars and expect to take 20% of the company. Usually there are multiple VCs participating by now including almost always the first VC fund which gets an advantage sometimes in the second round. Normally if the business proceeded well this is an up round meaning that the stock price has climbed. By the third round VC’s are investing 20-100 million. There may be 4 or 5 rounds sometimes. Each round reduces the entrepreneurs stake. So, it was in your interests to have fewer rounds.
Now the problems. If things don’t go perfectly the stock may not have an up round. If that is the case then you will raise less money and dilute the stock more resulting in the entrepreneurs owning less and less fast. If the down round is steep enough the VCs may request that existing investors be flushed. This will usually include employees who will have to be re-staked maybe even the CEO and others with new grants. This obviously pisses a lot of people off who thought they had ownership and now find themselves with minuscule ownership even though they were the ones to take the initial risk and put in money they may find they own practically nothing. Entrepreneurs may question why they are still doing this given that they own practically nothing. Many times they do it simply because it would be cowardly to run away and admit defeat.
In the movie about Facebook and Zuckerberg at one point it appears some original investor is “flushed.” This struck me as a weak point in the movie. In actual fact flushing investors is not possible without the agreement of all investors in that class and treating all investors in that class the same. Nonetheless it does happen. It’s just in the movie they obviously somehow obfuscated that.
Evolution in the 2000s
As the 80s and 90s went along the number of these problems was manageable but in the early mid 2000s problems started to happen. Due to the bubble crash in 2000 many firms faced down rounds. Also, the biggest impact was Sarbanes-Oxley which basically squashed public offerings for firms eliminating almost entirely the option of going public.
This meant your main avenue for liquidity was to sell the company to some other company. Remember we are talking VC funded companies which means unless you went public your fate was to sell the company. This might seem like not that big an impact since most firms were sold anyway prior to Sarbanes-Oxley law being passed. However for most entrepreneurs and VCs this was deadly. What happened was that there really weren’t that many companies willing to buy firms. Public offering was always an option if you didn’t get a good price from a buyout. Once that option was out buying firms knew that they were in the drivers seat. The prices for startups was frequently around $80 million. Many firms needed $20-40 million to make it to the point they could be sold for $80 million. This means after all the hard work of building a company the payout was only twice the investment.
I mentioned earlier that VCs rely on the 10x-100x investment. The number of buyouts that generated 10x-100x returns was much smaller. VCs were struggling to justify themselves. Entrepreneurs by the time of liquidity were getting practically nothing, in many cases literally nothing even after a SUCCESSFUL buyout at a good price. They had been reduced to practically zero ownership. Sometimes clauses in the stock agreements of subsequent rounds of financing made it so that some classes of investors got the first payouts at preferred rates laving other investors including Entrepreneurs with nothing. VC’s weren’t doing great either. The formula was breaking.
Several things happened in this time period which has changed the VC landscape dramatically again. The Cloud has had a huge effect on the costs of starting a business. Many costs of a small business relate to fixed equipment, offices, investment in expected growth which required capital expense first and income later. So, a typical firm needed $20-40 million to get to the point of being able to sell itself. However, if that process had not gone perfectly it was likely the entrepreneurs were facing dilution and a terrible risk/return.
The cloud drastically changes this. Now you don’t need a central office. The cloud lets you do this easily. You use free web services or cheap web services for running your business. Your business costs could be under $1000/month! If you are a software service business you can leverage the cloud to use only minimal services when your business is small. Yet when the business grows it is trivial to add servers at costs that are extremely low enabling you to grow costs with usage and business. As a result your need for capital is greatly reduced. One firm I was involved with reduced costs by a factor of 100 by switching to cloud services. That’s right 1% of previous costs!
You don’t need 20-40 million to get you to the point of viability. You may need 2-4 million. It’s a huge change in the entire formula I described above. This new model depends on growing the business incrementally and making revenue as soon as possible and keeping costs low.
As a result of this even if you aren’t a software business that can leverage the cloud directly you can dramatically lower costs. This means you don’t need as much Angel money or VC money which means the VC model breaks.
The VCs need to raise say $200 million – $1 billion in a single fund so that the profit is reasonable and they can pay everybody. The companies that invest in VCs don’t want to make small investments. They own $ trillions in assets. They want and need an investment that is large or its not worth their time to look at it. A small VC fund is an oxymoron.
If the entrepreneurs don’t need $50 millon/firm then VC’s have 2 choices. One, they can invest in more firms or they can be smaller. Smaller means shrinkage and less money for them and possibly non-viable as an investment themselves.
It also means they can’t get 70-80% of the firm like they used to because Entrepreneurs don’t need as much money they only have to give away a much smaller percentage. The Entrepreneurs keep 50% of the firm instead of 5-10%. More money for entrepreneurs is good but it also means the VC industry is in a funk. They could try increasing the number of investments but that is met with a much lower quality on average of firms they take on and less ability to help the firms. Their value decreases to the firms they are helping.
Some firms took this path and setup funds to make smaller investments in larger numbers of firms. You could get a seed round much easier but the next round was much harder. You had to pass certain stringent criteria to get to a round A like needing a million users or some real evidence of massive uptake of your idea. Normally one advantage of getting your “A” round from a VC was they pretty much guaranteed to help you get subsequent funding and to participate. With this strategy this seed round was more like a crapshoot and you needed to show a lot to get your next round meaning a lot more risk for you as an Entrepreneur.
In this time period the lower costs of the cloud and also what I call the network effect, massive innovation in open source software, APIs, mobile, social and other areas meant a massive new number of small companies were forming. Entrepreneurship was saved from the deadly early 2000s. For VCs this has not been an improvement, they continue to struggle.
Companies now deal with VCs on a more powerful setting. They have income sooner, they have less need for cash. By the time you go to a VC for serious money you have largely proven the investment which means anybody would make the investment. Everybody can see you’ve succeeded in eliminating risks, growing your business and the rounds for investment at this point are more like a bank transaction than a VC convincing session of the 80s and 90s.
It is much harder world for VCs and there has been massive growth of Angel investing.
Additionally entirely new methods of raising early funds have emerged allowing the public to participate not just rich VCs or Angels. Kickstarter and numerous other firms allow the average person to invest. It allows the average person to say: “if you build one of those I’ll buy it.” They don’t even get stock. This allows firms to raise $50,000 to $1,000,000 without selling any stock. The world for entrepreneurs just keeps getting better and better.
This encourages more entrepreneurs. The technology is growing at exponential rates as science keeps accelerating and our knowledge of the world keeps accelerating. The cost to try these ideas keeps dropping. We are in an innovation spiral the likes of which has never been seen.
Forbes now claims there are 140 or so unicorns. These are firms worth in excess of $1billion on paper. These are NOT publicly traded firms but firms which if they were to go public would be worth at least that amount it is thought. The total valuation of these unicorns is easily $400 billion.
Are we in a bubble?
I can say having seen and lived through the tech bubble of 2000 we are NOT in a bubble of that scale or scope. The behavior of investors and people are dramatically different when you are in a bubble.
There is also a significant amount of reality to these valuations unlike the bubble of 2000. IMO the financials of companies in the unicorns are dramatically better than the 2000 bubble.
There is reality to the technology change. In 2000 the bubble was composed of sometimes ludicrous ideas. Today there is a technology explosion of innovation that is real and well ahead of the curve of innovation. If you read my articles on the state of technology and the Network effects we are in what I call “An Age of Magic.”
The Age of Magic
The age of magic means that the amount of technology available to be used in new inventions and new purposes vastly exceeds its current usage. This is because most people don’t know about all the stuff that is possible. Most people are simply not aware of all the technical things happening and don’t know what is possible so when confronted with new inventions we are frequently astonished and wonder how it is even possible?
I keep up with technology but I am sometimes surprised with what I see. There is so much happening with Genetics, Robots, 3D printing, Artificial Intelligence, Hardware costs, new materials, new software, lower costs, smaller devices, less power consumption that everyday sees a dramatic jump in new things. In 2000 it was mainly one thing, the internet that changed. Today it is much bigger than that.
I have a number of websites I go to track as much technology as I can. I specialize in software and cloud technologies, security and automation so that is where I spend the most time but I am a weekend physicist and love to read up on the latest developments in numerous fields of hard science as well. It is breathtaking and exciting time we live in that I think the term“Age of Magic” is the best way to describe what is today’s world.
If I do seem ridiculously optimistic I question it myself
There are lots of reasons to worry. Our economic system is built on a precarious balance of trust. The entire future net worth of everything is based on expectation. If expectations are good then we seem to have nearly an infinite amount of money to play with. If expectations go south then it all disappears in a heartbeat and millions can be unemployed overnight.
Tsunamis of economics could happen anytime due to disruptions in China, debt problems overwhelming one country or another. Demographic changes like the aging problem in China or changing technology may cause severe disruption in economies that affect us all. We are extremely interdependent in ways we don’t even understand.
On top of that we are in an Age of Magic but there are technical worries. Our understanding is still early in many fields. We might make bad bets or cause problems in our environment or health that set back industry.
There is also the growing problem that the sheer number of new companies is making it harder to gain traction and succeed. I think we are running out of names for companies looking at the bizarre names people are having to come up with these days.
Lastly (but not exhaustive) many of the technologies have downsides not just upside. There are lots of things to worry about like will the technology disrupt employment and people’s livelihoods? Who will have access to technology? The growing disparity of wealth is hard to stomach. Will there be some crisis on this front?
We seem to lurch from one crisis to the next. Some of that seems natural. At least we don’t seem to go back to the same crisis. So, hopefully we are learning. We had a huge debt crisis. I really hope that isn’t the next crisis but I worry that we have traded one debt crisis for a more serious one possibly.
I am saying there is a lot of reasons to be highly optimistic about being an Entrepreneur. I am saying it is the Age of Magic. However, I am not saying we aren’t going to have problems or we won’t have more crises.
The fact is the key to investment is risk management. The key to success in business is managing risks as well.
I worked for a firm, called Bridgewater Associates. They are a Macro Hedge Fund which means they look at the overall state of the world, countries, industries and try to understand the dynamics of the macro economy. The whole economy of the entire world. They are the best at that of anyone in the world bar none.
They analyze every area they invest in to unbelievable levels. CEO Ray Dalio is an expert on economic crashes. He has studied the behaviors of crashes and crisis all his life. His goal is to create a fund which returns a positive return no matter what. The proof was in 2008 when almost all funds fell 45%, Bridgewater was up 14%. Rays entrepreneurial vision for Bridgewater had succeeded massively. 🙂
Bridgewater will take virtually no risks or seeks to eliminate all possible risk and still make a decent return. That’s impossible of course but by systematically studying how investments fail and all the things around them that could correlate to those failures you develop a much better understanding of risk.
If you reduce risk to 0 or what is called Beta in investment terms to 0 then what is left is Alpha. Alpha is the return from the intelligence of the investment itself. So, Ray’s goal is to produce a pure Alpha fund that returns no variability from systematic risk and instead returns the value of the investors intelligence about the way markets work and what is undervalued and what is overvalued.
Key to Bridgewater’s success was simulating past disasters again and again against all their assumptions in a systematic way. Bridgewater would go into many large pension funds or other asset funds and do an analysis which revealed massive risk that these funds didn’t understand.
Coming from the Tech entrepreneur / VC industry to Bridgewater is quite a jump. In the former industry there is lots of risk and you are looking at it all the time. In Bridgewater there is a desire to eliminate all risk. It was hard at times to make the mentality jump. The point is in the month of June 2015 Bridgewater All Weather fund dropped 4%. They missed a risk. They didn’t see China having a hiccup. I don’t know if that is why Bridgewater fell but there are always things that go wrong and fail.
The beauty of being an Entrepreneur is believing in your idea, your vision and carrying it through to success. Nothing beats that and I’ve had it a few times in my career. I really hope everyone who wants can experience that success too. I hope this article helps some understand the process and how it has changed and why it has changed. I have lots of experience and may follow this with another article on success in startups sometime. It is fun writing about this stuff.