ScaleVP closed our latest fund, Scale Venture Partners IV, L.P., last week and not exactly in the way we had envisioned….we raised more and more quickly than any of us would have expected. While we are confident about our strategy (enough to double our GP commit in this new fund), we also assumed that it would realistically take us 6-12 months to finish. We published our PPM in early February targeting $250M, the same size as our current Fund III. We were pleased to announce that Fund IV closed last Friday, May 3rd at the hard cap of $300M.
We understand that a successful fundraise is not our primary goal but rather to generate great returns for our investors. But this milestone makes me sit back and ask, why? Isn’t capital only going to firms that are now into their tenth fund or more? Having listened to our investors, I have a few observations about the venture fundraising environment that impacts us all.
Of course, the ticket to the ball is to deliver cash returns to your LPs. ScaleVP pursues investments in early-in-revenue technology companies just beginning to scale. We are pleased to see this strategy yielding consistent exits, including the recent ExactTarget IPO and the sale of Vitrue to Oracle , and we have a great crop of companies yet to go, including RingCentral, BrightRoll, Box, Docusign and Hubspot .
But while good returns are necessary, they are not sufficient…so what were the other elements at play here?
First, despite our performance and our interest in putting slightly more dollars to work per deal, we targeted the same size fund that we had before, and set a hard cap that was only 20% above that target. That size limit and consistency appealed to investors who have seen other firms increase their fund size, sometimes significantly, once they have achieved success. This brings four questions to mind for the LP: Can the team profitably deploy a significantly larger amount of capital? Will they need to hire a lot of people I haven’t met yet? Are they doubling the size of their funds for the fees? Is there an alignment of interests? By keeping to a similar fund size, we took these questions off the table.
Second, we benefited from the interest in smaller, newer managers. LPs know that, while they want to stay with the proven names, performance is not 100% persistent. In fact, to maintain returns, they need to selectively refresh their portfolio with a handful of next generation funds, which is why peers like First Round, Foundry, Shasta, Spark, True, and Union Square have also been successful at attracting capital.
Third, we further benefited from a broad investing trend (consistent with our own) of LPs building portfolios that are sufficiently diverse but also relatively concentrated. They expect that “buying the index” in venture by spreading small amounts of capital across many names will not get them the multiples they require out of a high risk, high return venture portfolio. When our LPs started our early Fund IV conversations by announcing that they were pruning their portfolios and investing more per manager, we cringed, fully expecting to hear that we might be cut next. We were fortunate that instead, we had a number of investors who, having watched us through our prior funds, wanted to increase their allocation, and in a handful of cases, more than double it.
Finally, LPs want to do a lot of due diligence and want to have the time to do it. If they are going to be selective and invest in larger increments, their investing decisions get a lot of scrutiny by their investment committees, as they should. That focus on detailed due diligence included our returning investors, who started from scratch by doing on- and off-list reference calls, site visits, increased organizational & compliance due diligence in addition to a detailed review of the numbers.
Well, how did we accommodate that level of due diligence in 92 days?
The answer is advice I got when we raised for the first time…never stop communicating with investors, even if you are not fundraising. It starts by staying in regular touch with your existing investors, and not just at annual meetings or advisory board calls. See them or call them one-on-one as often as you can. Connect with them when there is good news, and more importantly, connect with them when there is bad news. We are in a long-term, high-risk business, and LPs are investing in us on a blind pool basis. The more they understand your decision-making and team dynamics, the more insight and confidence they have in your partnership. We stress the “partner” in the term “limited partner” and are incredibly grateful to have them, in turn, be so supportive of us.
Take the time to get to know prospective partners early. The best time to start that process is right after you close your last fund, when you clearly are not fundraising. With this new fund, we were able to add a handful of new investors, who had been following us for at least 5 years, and who we met with at least annually. Over that time, they not only got to know our team, they talked to our co-investors and even met some of the CEOs in our portfolio – and on an “off-list” basis, so they knew they were getting the straight scoop. Just like when we invest, they want to know a team over time to see if they do what they say they will do. For our new Fund IV LPs, the last 92 days was the end of a multi-year process, not the beginning.
The Scale Venture Partners team is fully aware that the most important focus for us is not to raise the capital for our next fund, but to deploy it profitably on behalf of the pension funds, foundations, family offices and other institutions who have entrusted us with their confidence and their capital. We will be working hard over the next 3-4 years to make sure that our LPs’ decision to invest in ScaleVP was a good one. It is the heart of what we do, and our efforts are fully focused on finding the best management teams in the highest growth markets to meet that goal.
“Why would anyone invest in a hits driven asset class that has yielded a negative IRR for the past ten years; where there are only a few good firms, and they are not taking new investors?“
That is what is weighing on the mind of many of the LPs we met in our recent fundraise. As yet, there are clearly LPs investing in venture, including newer managers like Scale Venture Partners. I would like to think our investment performance and our engaging smiles made the difference, but no institution would have invested in ScaleVP unless it first of all believed in the asset class and had answers to the questions above. What are they seeing that others are not?
Long term returns in venture are strongly positive
It is true that the pooled mean return for venture for the last ten years (2001 to 2011) is dismal at 3.3%, (and was -2.0% as of end 2010), but it is also true that thepooled venture return for the past twenty five years (1986 to 2011), even including the last ten bad years, is strongly positive at 18.6%. This mid to high teens return is the kind of outperformance relative to the Russell 2000 index, which has returned 8.7% over the same period, required to justify the extra risk and illiquidity of venture capital.
U.S. Venture Capital Returns
End-to-End Pooled Mean Return, Net to Limited Partners
|Cambridge Associates U.S. VC Index||13.18||3.27||18.61|
| The Cambridge Associates Venture Capital Index is an end-to-end calculation compiled from 1,347 U.S. venture capital funds formed between 1981 and 2011. It is a “dollar weighted” index that best represents the aggregate return of the entire venture industry.|
| The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership|
| NVCA Benchmark report|
LPs we spoke to, who continue to invest in venture, implicitly believe that the next ten years will be more like the average of the last twenty five years than a repeat of the last ten. In short, they are betting on regression to the mean, which is almost always the likely bet in investing.
Narrative Matches the Math
A bet on regression to the mean also tracks a simple narrative of the past twenty years that we have blogged about before at ScaleVP. The terrible results of the last decade are not a mysterious affliction of unknown origin, but rather the result of the stunning results of the ten years prior. The story starts with sensible levels of overall venture investment in the early 1990’s (at approximately 0.1% of GDP), generating exceptional returns (the pooled IRR for 1995 was 88%), money rushing in (2000 fund raising grew tenfold to 1% of GDP), and returns inevitably plummeting. Capital then started to leave the industry but slowly. It has only been since 2008 that the capital raised by the venture industry has returned to that 0.1% of GDP level that was so profitable in the early and mid-1990’s. Specifically, in 2012, the industry raised $20.6 Bn which is .13% of US GDP for 2012, just as in 1995, the industry raised $9.4 Bn which represented .13% of the US GDP for 1995. As discussed above that was a successful year for venture! The graph below illustrates the trend, and the comment that “there is still too much money in venture” is now simply not correct relative to GDP. The industry took a far longer time to adjust than predicted, but with a decision cycle only once every four years, in retrospect that is not surprising. The strong performance of funds in the last few years is plausible, though still early evidence that the long-term dynamics of the business are improving.
Investing in a hits driven world
Even many of the LPs we spoke to who are not investing in venture would agree with the analysis above. What LPs really wrestle with in venture is how to build the right portfolio to get that venture return. Venture returns are concentrated (“a hits driven business”) and are persistent (“only a few good names”). The risk that an LP does not get access to the right names, and ends up missing the few great companies that make all the difference, is what turns many LPs off the asset class. “If I cannot get access to Sequoia, (or fill in your favorite name), then what is the point?”
However, LPs who have continued to invest in venture have a more nuanced perspective on concentration and persistence, and thus what portfolio strategy is viable. Take the extremes. If returns were 100% persistent and 100% concentrated only one firm would make all the money, all the time. The only sensible strategy would be to invest in that one firm, or not to invest at all. If returns were 100% concentrated but zero percent persistent, such that every year only one deal makes money and it is random by fund, then the best strategy is to invest in every venture fund, every year, to be certain to get the pooled return, or not to invest at all.
Exploring the extremes illustrates the point, but most investors agree that reality is where returns are both concentrated and persistent but neither metric is close to 100%. In that world, the rational portfolio strategy is to build a portfolio with significant access to known, persistent top performers, but with enough portfolio diversification in newer managers to ensure that the fund does not miss out, if the out-performers turn out to be the newer managers. A strategy of just investing in the “five top funds” runs the risk that, if concentration outweighs persistence, an LP is under-diversified and could miss some home run winners. A strategy of investing in fifty plus venture firms is over diversification, and will likely result in underperformance if exits are concentrated in a smaller number of firms.
How concentrated and how persistent?
At ScaleVP, we have made estimates of both return concentration and return persistence. Return concentration is relatively easy to estimate, and no surprise, returns follow a rough power law with a few huge wins and many base hits. There have been 779 venture exits valued at $100M or above, in the last decade, but the current market capitalization of the top two companies (Google and Facebook) at $290Bn, equals the sum of the value of the bottom 739 exits. Miss the top eighty-six exits, (valued at over $1Bn) and you have missed 71% of the total value created.
Firm persistence is harder to measure without individual fund level data, but it is clear that some firms manage to deliver great performance for years and even decades, but some old firms, like McArthur’s old soldiers, never die, they just fade away. Because an ability to fundraise based on prior performance is a lagging indicator, firms can still raise money even with an investment performance that does not compare to newer, more focused firms. In the face of this, LP outperformance has to come in part from pruning firms as they underperform, and increasing commitments to firms that are doing well. Change is slow in venture. It is a lot easier to maintain an existing winning firm than to build a new one, but change does happen and the successful LPs are ahead of that curve.
What it meant for our fundraise
The comments above sound theoretical, but they correspond with the reality we found on the road. Our typical LP has either maintained a long term commitment to venture over the past decade, or even more interestingly, has been contrarian and elected to increase its venture exposure in the past five years when others were exiting. Most have a portfolio with a critical mass of proven venture relationships (or access to same via a fund of funds investment). Even though it is harder as a newer fund to win support from an LP with a strong existing portfolio, these are also the LPs that have enough success to maintain investment committee support in difficult times. The reverse was also true. LPs who have had a negative overall experience with the asset class, were rarely interested in adding new names. It’s just like in real estate, where you don’t want to be the best house on a bad block; for a GP, you don’t want to be the best performing GP in a bad portfolio because your neighborhood may not survive.
Our typical LP is an activist about their portfolio. Despite having a base of good names, they are believers that smaller, newer funds can outperform and are willing to take the risk of trying newer names, and then doubling down on winning firms as they prove themselves.
Finally, our typical LP knows that investing in venture is not easy and does not expect it to be. The prize is an 18% pooled return over twenty five years versus a Dow return of 10% in the same period. Accessing that return requires effort, persistence and perhaps a little luck, but it is a level of equity outperformance that is simply not readily available anywhere in the investment universe.
There is no one formula for product pricing, although it will be one of the most important decisions you will make. As with anything in business, you need to start with a deep understanding of your customers and what they value.
Read more of Kate’s thoughts on setting a price for your startup product or service at The Accelerators, a WSJ blog of startup mentors discussing strategies and challenges of creating a new business.
No other department has changed as dramatically over the years as marketing. The shift from offline to online and the ability to track, analyze, and optimize marketing spend has given way to a new era of marketers.
ScaleVP has invested in this evolution of digital marketing since the beginning. In 2005, we spotted a movement toward cloud-based, web analytics, leading to our investment in Omniture. In 2009, we saw that marketer reliance on direct mail was rapidly declining in favor of email marketing. This trend informed our subsequent investment in ExactTarget (NYSE: ET). In that same year, we noticed the growing prominence of inbound marketing and invested in Hubspot. And finally, in 2011, there was no denying the impact of social on marketers, leading to our investment in Vitrue and DataSift.
Today, we are thrilled today to announce our investment in Demandbase – a real-time targeting and personalization platform for B2B companies.
Through its unique targeting capabilities, Demandbase enables clients to understand who the web site visitors are and serves up personalized landing pages, content, and forms that match their interest. In an environment in which buyers are constantly bombarded by marketing messages, Demandbase empowers clients to break through the noise and deliver higher conversion rates through relevant content.
Most importantly, Demandbase’s technology works and marketers love it. In a recent CEO and CMO summit that ScaleVP hosted to discuss the “Reconciliation of Freemium and Sales”, Demandbase was touted as a must-have solution for B2B marketers looking to drive web leads. Furthermore, we learned that a majority of our existing tech portfolio uses them.
Demandbase continues to innovate, expanding its product portfolio to include targeted marketing solutions that focus ad spend on companies ready to buy.
This is the next wave in B2B digital marketing. ScaleVP is excited to work with Chris and the team to further scale the organization and lead the charge for personalized marketing in the B2B space.
Over 30,000 people attended the South by Southwest Interactive festival this year, double from just a few years ago. What struck me most about this year was the increasingly diverse geographic make-up of entrepreneurs. I spent lunch with a financial technology innovator out of Cincinnati, watched a hack-athon team out of Houston do incredible iPhone development, was pitched a wine discovery app from a rural Texan while standing outside Stubb’s, discussed next generation e-commerce with a passionate team from South Beach Miami, and the list goes on. I spoke on a panel where in the 50+ person audience less than 10% of entrepreneurs where from the major tech hubs of San Francisco and New York.
During those conversations, I consistently heard the same questions. How can you scale a business when you’re not in the valley? Here are a few tips:
Seek Advisors. Entrepreneurs should build out an advisory board early and quickly, focusing on three types of advisors: 1) customers, 2) experienced entrepreneurs, and 3) industry experts. These advisors can be anywhere and should be pro-actively sought out based on a profile spec. Find people who have strong value-add, are willing to commit time, and believe in your vision. They will provide advice, open doors, and support when things get tough.
Be A Local Thought Leader. If your community does not currently have a strong entrepreneur or technology community, be the catalyst. There are likely other passionate, like-mind individuals facing similar challenges or better yet, have gone through it before. Reach out to savvy business leasers to help think through issues and attract local capital. Find them and spend time with them. Meet regularly, create topics of discussion, and invite guest speakers.
Travel, Travel, Travel. Expect to live out of your suitcase. Your customers, advisors, and industry relationships may not be local. It is your responsibility to visit them. Coordinate trips to so you can attend industry conferences, meet-ups, and dinners all within the same trip.
Be Persistent. Make sure to consistently have touch points via travel, events, e-mail, and social media. Showcase why the geographic distance is not relevant and even more, why you are choosing to build your business where you are building it. Even though you are not local, make yourself totally accessible. Appreciate that you are going to have to work twice as hard as the next person who is local.
We, at ScaleVP, are big believers in the democratization of technology and how it can cross-geographic barriers. ScaleVP has invested in great companies in Atlanta, Boston, Charlestown, Indianapolis and Utah. Amazing opportunities and breakthrough ideas come from everywhere. We are excited to work with leading entrepreneurs scaling their businesses no matter where they’re based in the US.
The power curve is stark: Silicon Valley has always had a massively disproportionate share of VC deals. I spoke on a panel recently to review 2012 financings, which following a 20-year trend were mostly in Silicon Valley.
Today, I met with an entrepreneur who recently returned to the Bay Area after 2 years trying to scale companies in Austin, TX. He moved there looking for a lower cost, family friendly startup zone. Now he and his family are re-ensconced in the Bay Area. From him I got a taste of why the Bay rules in VC.
Californians are generally allowed to change jobs in a fluid labor market. Nationally, it’s common to have a “non-compete” clause as part of an employment agreement, restricting employees from joining another company or starting one of their own in a competitive space. In California, non-competes are not only unenforceable, they’re illegal. In other states, they can reduce labor flexibility. Texas in particular generally enforces non-competes, sometimes with limitations. Is Governor Perry going to change that law in his quest to draw high techs to Texas? Harvard Business Review says non-competes cause brain drains.
The founder told me that Austin has a smaller pool of super-talented execs than the larger Silicon Valley, but the bigger problem was that getting someone to leave a job for a startup in an adjacent space was very hard. Incumbents, whether existing employers or investors would threaten a lawsuit and keep people in place. Interestingly, non-competes signed in other states can’t be enforced in California, so if someone moves OUT of Texas, they’re free and safe. The other states that are most employee-friendly on non-competes are Louisiana, Alabama, Florida, Oregon and Michigan.
The two largest venture capital regions outside Silicon Valley, New York and Massachusetts have far more restrictive (for employees) non-compete laws. Massachusetts considered changing their laws to enhance job mobility coming out of the recession, but left the proposals un-enacted in 2010. ScaleVP has had great portfolio companies built in a variety of environments: ExactTarget (NYSE: ET) in Indiana, virtually bans non-competes, Omniture (Acqd: ADBE) in Utah allows restrictions on employees and Vitrue (Acqd: ORCL) in Georgia which recently changed to reduce non-competes. Law firm Beck, Reed, Riden conducted a useful survey of where each state stands on non-competes.
A non-compete isn’t the only reason why the abundance of VC $$ remain in Silicon Valley but it is an important item to consider. In the technology landscape, talent can make or break a business and the more fluid the resources, the better the chance of building a viable business.
For B2B startups, LinkedIn is where you need to be. HubSpot research reported that LinkedIn was 277% more effective for lead generation than Facebook and Twitter. That makes sense since LinkedIn has more than 200 million professionals, with 4 million of those focused on IT.
This doesn’t mean you should ignore other channels, but focusing on LinkedIn means you are investing precious resources (including your time) on the social channel that delivers the best return.
Read more of Kate’s thoughts social media strategies for startups at The Accelerators, a WSJ blog of startup mentors discussing strategies and challenges of creating a new business.
We are pleased to announce our investment in PeopleMatter. PeopleMatter provides an integrated cloud platform for online hiring, training, compliance, analytics and scheduling designed for hourly workers – think a SuccessFactors solution with scheduling for TGI Fridays employees.
Hourly workers comprise over half of America’s workforce, yet it remains a hugely underserved market. Many businesses that employ hourly workers are still operating on paper processing for applications, schedule spreadsheets and disjointed payroll. Add in new compliance regulations from ObmamaCare and the cost of not automating an HR system can be overwhelming.
PeopleMatter is disrupting the industry by providing an easy to use, automated process for the service industry to manage all of their people, processes and paperworkonline. At the same time, it is providing hourly workers with a centralized system to manage their processes from applying to jobs to switching shifts, all from the ease of their mobile devices.
The intersection of cloud and mobile, powered by SaaS, is a natural fit for ScaleVP. Even more important, PeopleMatter has used these tools to truly transform an industry and chart a new path. PeopleMatter CEO, Nate DaPore, and his team have built a great product that is setting a new standard for managing hourly workers — in fact; the company recently celebrated a major milestone by processing its one-millionth applicant. But that is just the start – we see an ongoing opportunity for success in a company that has built it right from the ground up. We are looking forward to working with Nate and the board to further scale the business and transform the industry.
The question of which business model to choose for your app is something Scale Venture Partners considered, so we did some direct research with the students at the University Venture Fund in Utah. We looked at the top 400 apps over a six-month period. The research netted several interesting conclusions about business models, pricing and the impact of the iPad.
What we found was that freemium works best when the mobile app is an extension of the web app. The web app can then serve as an up-sell opportunity for the company. Most successful business-productivity apps employ this strategy. Popular examples include Box, DocuSign (full disclosure: ScaleVP has invested in both companies), Dropbox and Expensify.
Our previous post introduced the concept of growth decay in recurring-revenue companies. We concluded, first, that there is a substantial persistence of revenue growth rates from one year to the next, and second, that growth rates decline relatively predictably as companies mature. We turn now to relating these two concepts to the valuation of a fast-growing, private SaaS company.
Investors usually take one of two broad approaches to valuing a company with current negative cash flows. Either a multiple of a point-in-time metric such as Price/Sales is used; or a full discounted cash flow model is constructed to determine the net present value of the future cash flows. Using a Price/Sales multiple is problematic because it doesn’t account for the future expected growth. Building a discounted cash flow is tedious and anchoring a valuation to positive cash flow in the future is too sensitive to model assumptions.
Using a growth rate decay trajectory is a compromise between the complexity of a time-based, cash flow approach and the simplicity of a point-in-time sales multiple. It uses two known inputs, current revenue and trailing revenue growth, and one assumption, namely the growth rate decay trajectory. It also fixes the time-frame of interest to a point five years in the future. We chose five years because that is a typical venture investor’s holding period from the initial investment.
For any given growth rate we postulate three possible growth paths forward:
While the difference in gradient between these three paths appears to be slight, the final column in the table shows that five years later the change in revenue altitude can be dramatic. Take, for example, a company at a $2M annual revenue run rate that is currently growing 100% YoY (the final three rows in the table). If the company is able to follow the high road of growth they will end up five years later at a $33M run rate; but if growth follows the low road, revenue will have expanded to a more modest $12M run rate.
Sorting the table by the 5-year revenue growth is revealing. For any SaaS company to be more than 10x larger five years from now, it must be growing revenue at a CAGR higher than 80% today and the growth rate must decay no faster than the norm.
Once we have an expectation for the expected growth trajectory, the next question is how one should value the company. While any approach is bound to be as much art as science, we’ve often observed that venture investors have a tendency to apply one methodology when investing and a different one when planning for an exit. There are times when applying a 12x forward sales multiple to calculate a pre-money valuation make sense. It is unlikely that an acquirer will apply the same multiple 5 years later when the growth rate has declined by 50%. It is important to use a consistent approach over time.
So what revenue multiple makes sense? Our approach is to simply use the expected 5-year revenue expansion and apply that as a sales multiple to the current revenue. We also apply a 25% discount at the time of investment to account for dilution from future capital requirements and the risk inherent in smaller companies.
What is clear is that maintaining a high growth rate is key to getting a venture return. In order to achieve a 5-10x return for investors over 5 years, a company must both start with, and substantially maintain, a high growth rate. Even starting with a 100% growth rate is insufficient if the growth rate declines at the typical 15% each year. The final CAGR is particularly determinant of the investment return for SaaS companies.
For both entrepreneurs and investors in recurring revenue business the conclusions are stark: in order to build a meaningful business and secure venture returns, it is vital to maintain exceptionally high growth rates for an extended period of time. This is only achieved by brilliant execution as an early mover in a massive market.