“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.
It takes a passionate and driven individual to be an entrepreneur, but what happens after the company is launched? How does an entrepreneur go from an idea to building a long-term successful company? As part of our Scaling Q&A Series, we dive into growth strategies and successes from our rising stars.
Describe Axcient in one sentence?
JM: Axcient puts an end to down time and data loss by enabling businesses to store, protect and access all information and systems in the cloud.
What inspired you to start the company?
JM: I actually experienced data loss at my last company. It was very painful and I realized many businesses struggle with this problem. A company has two things: its people and its systems. If you take one of those away and you don’t have a company. I decided I wanted to start a company that solved the problem I experienced.
What is the biggest lesson you’ve learned through the process of starting a company?
JM: Always think bigger. Take Axcient for example, when we started we were thinking about helping companies that were 100 employees and 500 GB, now we are helping companies with thousands of employees and 50 TB of data.
You have to challenge yourself to always think bigger than your initial expectations – it will impact decisions you make regarding positioning, operations, product architecture, etc. My recommendation is to set your expectations and then scale it by 10X and apply it across all of your planning.
What advice would you give other entrepreneurs looking to start a company?
JM: Ask yourself why you want to start a company in the first place. I actually try to deter people from starting a company if they can’t truly answer that question. A lot of folks come out of business school and can be intrigued by the “glitz and glamour” of the valley. This mentality often causes first-time entrepreneurs to fail. Successful entrepreneurs are driven by a burning desire, obsession even, to solve a problem. If you don’t have that, don’t start a company. Building a company can be rewarding if you have that drive and obsession, but it isn’t glamorous and it is anything but easy.
Axcient has experienced a tremendous amount of growth? What’s your secret?
JM: Overall, it comes down to a lot of hard work, passion and focus, but three things do stand out. First, we have been diligent on hiring exceptional people and never compromising on talent. Second, we are very metrics driven. Whether it’s sales, operations or marketing, we make our decisions based on metrics. It forces us to be really ruthless with our priorities and keeps us on path to drive aggressively towards our goals, continuously monitoring as we go. Last, it has been the restraint to not chase every opportunity. We determine what we want to pursue and doggedly pursue it.
Who inspires you?
JM: I have always been a big fan of Richard Branson. I admire the culture he has built around him; one that is open, fair and fosters innovation. Too often, people associate the ability to build a large company with being a megalomaniac and I don’t think that is true. Branson is a good example of a true creative entrepreneur who has built innovative, market dominating companies while promoting a positive culture and a great place to work. I aspire to that with Axcient.
What was the best/most useful business book?
JM: Drive by Daniel Pink is a great book about understanding what motivates people. Understanding your employees and what motivates them makes you a better manager and better for your overall business.
What do you do for fun?
JM: I love to fly fish. You can be out for days and not catch anything, but it challenges me to enjoy the journey and learn from it.
Has it impacted how you run your company?
JM: Yes, I think the basic principles impact my approach to running a business. Fly-fishing is a test in patience, determination and focus. But more importantly, it gives me time to reflect. As I mentioned earlier, a committed entrepreneur is often obsessed with their company or project (and I am guilty) but it is just as important to step back once and awhile. We make critical business decisions every day and if you are too deep in the weeds all of the time it is hard to have the clarity and perspective to make the right decisions.
I have found it invaluable to have activities outside of work, where I don’t think about work and that separation gives me perspective.
Justin Moore is CEO and Founder of Axcient. Follow him at @justinrmoore
I wanted to describe our latest investment as an online multi-tenant complex query tool for filtering and analyzing large streams of real time semi structured data. Marketing stopped me. It turns out that DataSift, the investment we just announced today, is all about Big Data for Social.
I like both descriptions. The buzz word bingo of Big Data for Social is light on specifics, but it is accurate. DataSift is broadly in the trend of Big Data, and while Social Data is not the only data the Company analyses, it is by far and away the largest data set. However, it was in the specifics of the technology and the applications it enables, that we saw the compelling investment opportunity.
Big Data is a Big Tent. The phrase has at least three different meanings. It’s most precise meaning is the set of specific technologies around Mapr and Hadoop, publicized notably in the 2004 paper by Google, and brought to market by companies like Cloudera, Mapr and Hortonworks. This technology, which is broadly describable as the Hadoop stack, enables a non-real time (though that is changing) system for storing, counting and analyzing huge data sets. A second, more broad use of the term, has emerged to describe a whole range of newer technologies around NoSQL, HANA, and real time analytics, with the common thread being high volume data management technologies that move beyond the RDBMS paradigm of the last thirty years. These technologies can be either a substitute, or a compliment, to the core Hadoop stack.
Finally, the phrase “Big Data” now describes an entire movement in IT. The technology above made it easier than ever to handle enormous amounts of data, just as a range of industries, from genomics to the social web, started to generate enormous datasets. The combination has set off a mini gold rush as startups and large companies look to use data as a competitive weapon. Search for Big Data on the web and you get 2.3BN hits and the volume of searches is growing exponentially. In the startup world, we are seeing variants of the “Big Data for x industry” every day and this article by Geoffrey Moore gives a pretty good sense of how Big Data is spreading out.
Like any trend it can be overhyped, but the idea that more data and better analysis can lead to smarter predictions, is not a bad one. It received a stunning vindication last week, when Nate Silver predicted the 2012 election, simply by taking existing available information and analyzing it better than anyone else. Check out the hashtag #natesilver. Big Data is now mainstream, with Nate Silver being described as the Chuck Norris of Big Data!
DataSift fits in that second category of Big Data above. It is not building another Hadoop stack or even a Hadoop stack in the cloud. Instead the company has built a powerful platform and query engine that can sift through huge streams of real time data and find specific phrases, measure sentiment or find patterns. What is compelling about the technology is that it manages to be incredibly powerful, while at the same time, simple and accessible to use.
A user can go online, sign up, pay $100 dollars and using a visual interface, construct a sample query and run it against Twitter, blogs and every news source known to man. No complex analysis, no need to install software, and with the new user interface that was deployed last month, no need to learn the underlying language (although a more technical user can easily opt to look at the underlying Curated Stream Definition Language – CSDL – to write more complex queries). Finally, the platform allows users to query unstructured enterprise data as well as third party data.
Fires need fuel and Big Data engines need streams of Big Data. If you build an engine for querying large streams of real-time data, you pretty quickly want to point that engine at the mother lode of data streams, which is in social media and Twitter in particular. The Twitter stream is growing exponentially, and it has become the information pulse of the planet. Companies want to monitor that pulse for reasons that range from customer support to sentiment analysis, and news tracking, but how do you look at 500 MM unfiltered tweets a day?
You don’t. Through a partnership with Twitter, DataSift has full access to the Twitter firehouse. A customer can write a query, run it against the entire Twitter stream and set it up so that, on an ongoing basis, the results stream real time into a business application. The customer can filter by Klout score, geo location, gender, language, subject or any combination thereof. From 500 MM tweets the customer gets only the two, ten or one hundred tweets that matter to them.
Say you want to track every mention on Twitter relating to cars or any related term and you want to limit the search to males, within a certain age, based in or around Texas. The screenshots below showcase how easy it is to build the query.
1. Selecting Tweets by Geo
2. Selecting Tweets by Age
3. Final Query with Geo, Age and Subject Filter
The query can be set to run continuously against multiple feeds with the results pushed directly into an application which can provide user alerts, take action or simply follow what is going on. Maybe the purpose is as simple as just tracking consumer sentiment, or as narrowly commercial as finding auto enthusiasts in Texas that might be willing to test drive an electric car (maybe narrow the search to Austin).
DataSift works really well with software developers and application developers of all sorts. Part of how we discovered Datasift, was by seeing many of our software companies looking to partner with them to get access to the world of unstructured data DataSift handles the backend of managing the platform, integrating the data feeds and running the queries. The application company builds the application through which the results of the query are integrated into the enterprise workflow. Sample use cases include: customer support, lead generation, news tracking and financial trading. The company is also working with ERP vendors and relational BI tool vendors to enable easy integration of structured and unstructured data at the reporting tool level.
Just as Business Objects and Cognos were the query building tools of the relational database world, we believe that DataSift can be the query building tool for real-time streaming data. The way to make that happen will be to empower developers and end users to easily query all the data that is out there, and then let those developers find uses for that data, uses the Company has not even dreamed of.
We are excited to be working with @nik, @rmb and the team @DataSift.
Today, we are pleased to announce our Series B investment in Boundary. Boundary is the application performance monitoring solution designed for distributed application environments. The team is led by Gary Read as CEO, and technical founder Cliff Moon.
In every investment we make at ScaleVP, we look for two things, broad market trends and great execution. Boundary has both.
The Big Trend: Cloud Computing makes existing systems management obsolete
Sometimes we take the whole startup game for granted and we forget how audacious and crazy it all is. These companies come along, and in a world that is growing overall at 1.2% this year (go US economy!), they project five or ten years, of 100% and 200% year-on-year grow rates. What is more amazing is that some of them pull it off. How do they do it?
The do it by having a product and a vision that is linked to the wider trends that are driving change in the overall technology industry. Companies do not grow from $1 MM to $100 MM on internal effort alone, no matter how hard the team tries. They grow in part by being connected to durable long-term trends in the market that provide the lift that makes all the internal effort worthwhile. For Boundary, it’s the inexorable shift to cloud computing architecture.
Boundary helps the IT operations managers of these new, cloud based, distributed networks monitor what is going on in their network. It’s part of the systems management market – technologies that help IT guys know if their stuff is working – and it’s been around forever. When IT was running mainframes, companies like IBM and BMC sold software to help IT know if the Big Iron was running right. When the architecture shifted from mainframes to client server, with lots of PC’s and a smaller number of servers, IBM and BMC were slow to change, and left the opportunity open for new vendors like Tivoli. Every shift in computing architecture since, has disrupted the related systems management market, and created a space for new companies like Bladelogic, SolarWinds, New Relic and Splunk, four of the most impressive systems management companies of the past ten years.
The shift to a cloud based architecture is a big trend for IT and a huge disruptor for systems management software. When your computing is being done on thousands of virtual machines somewhere in the cloud on Amazon or Rackspace, then IT operations cannot use any of the existing technology to monitor what is going on in the network. All the existing solutions assume hardware level access to the physical network to enable monitoring and that just isn’t possible in the cloud. IT doesn’t own the hardware, cannot physically touch it, and most likely does not even know where it is.
Boundary solves that problem elegantly, by adding a meter/agent to every server or virtual server that transmits network level information back to the Boundary website. Customers can go to that website and see in real time the traffic flows for their system, regardless of where the servers reside. One of the fun parts of the due diligence for Boundary has been going on customer visits and watching the “aha” moment when IT sees, often for the first time, where their application is running in the network, and where every packet is coming from and going to. We believe that every IT professional who is responsible for the performance and security of a distributed application is going to have to have access to this type of information over the next five years. That is a lot of IT professionals. Amazon Web Services is already running 500 million virtual servers and this number is only going to go up. That is the long term trend that drives Boundary.
Great Execution: The Boundary Team
A great opportunity is a good start, but it takes great execution to deliver on it. The Boundary team has done a really nice job of getting the product to market, and signing early, tech savvy customers like GitHub. The early customer traction is strong and many of our portfolio companies have adopted it or are considering it right now.
The team is led by CEO Gary Read who has had prior success in the same market at Nimsoft and technical founder Cliff Moon who designed and built the product. What we like most about the team is that they absolutely understand the mission and what it takes to take it to the next level. Listening to customers and prospects on what higher level analysis is needed around a specific application or security threat. Boundary is turning that feedback into new application packages that run on top of the core platform and that can be tweaked by IT to answer whatever is the most pertinent question for IT right now. Stay tuned for more!
We are delighted to have made this investment and look forward to working with the Boundary team and Lightspeed Ventures. We think Boundary is more than ready for Scale.
There is competitive heat in the cloud storage market. Once the province of startups, the big players are arriving. Microsoft recently gave SkyDrive a major overhaul, and Google brought out its long-awaited Drive. Apple had already launched the iCloud product. It’s no accident that three of the world’s most powerful technology companies have entered this market in tandem. It speaks to the importance of cloud storage, and means that the theoretical discussion about what might happen will quickly give way to the reality of what does happen.
For startups like Box and Dropbox, this is a big deal. The typical risk early on in the life of a startup is, “will this change even happen?” That risk is behind us. Now, the issue is whether they ultimately become features, products or companies? Check out my guest post on GigaOm to hear more and share your thoughts.
Author’s note: A version of this article first appeared in Inc.
Some tweets really make me think. Check out this one, from @yonfook:
If u want to “do a startup” but don’t have an idea you’re passionate about, you’re just in love w idea of being a founder
Here in Silicon Valley, once again, every self-respecting ambitious twenty-something wants to “do a start-up.” They’re in luck: accelerators, incubators, and start-up programs are all making it easier than ever to start a company. The downside looks limited, especially if you, as the founder, are still early in your career. Success means Instragram riches. Failure means going back to the job you just left. Why not have a go?
Why not indeed? If this is the primary calculus you are using, my advice is simple: Don’t do it. Just because you can do something does not mean you should, as moms have been saying since the dawn of time. Starting a company might be easy now, but building a company is always hard. It usually takes many years and much sacrifice, and it will require persuading others to go along with your vision. Success is statistically unlikely and failure will involve disappointment–not just for you, but for anyone else you persuade to go along for the journey, including employees, investors and creditors.
My advice comes from the Book of Common Prayer, written in 1559. Just substitute the word “start-up” for “marriage.”
marriage is not to be enterprised, nor taken in hande unadvisedly, lightly or wantonly, but reverently, discretely, advisedly, soberly, and in the feare of God, duely consideryng the causes for the which it was ordeined.
Here are the factors you must consider – reverently, discretely, advisedly, and soberly. “Feare of God” won’t hurt, either.
What is the cause for which your start-up was ordained?
You have to have a reason for “doing a start-up” that transcends yourself and any desire you have to be a founder. No one else will want to work sixty hours a week just to fulfill your need to be founder, and after a year or two, neither will you.
At the core of a great start-up there is always a cause, a purpose, a reason for the company to exist. It has to come from the founder. The best founders are not driven to “be a founder.” They just get so certain that the future should be a certain way, and that they are going to be able to make it happen, that founding the company becomes a means to that end. Their vision can be a technical vision around a product, a business vision around how a market can be changed, or even a social vision of how the world should be. The vision can evolve. It can even pivot. But if you want to be a real founder, you have to own the vision and it has to be something you care about.
I am not naïve: There is also the sheer joy of running your own company, and the possibility that you might get rich. But a founder without a founding vision is an empty vessel.
Don’t fake it.
I just spent six months working with a very successful enterprise software CEO/founder looking at new opportunities. He looked at a series of consumer internet opportunities. These companies are fun, people can understand what you do, and you can strike it rich quick. He ultimately started another enterprise software company.
Smart call. The consumer deals may have been great opportunities, of course, but they did not speak to him and what he cared about. What he knew, from having built a company before, over more than ten years, is that hell would be taking people’s money, and committing to throwing his life into something, that deep inside he just didn’t care about. You can’t fake passion, at least not for years on end. Remember the marriage analogy? There are lots of wonderful, attractive, smart, witty people out there that you would simply hate to be married to for the rest of your life.
Do you pass the 10th hire test?
Peter Thiel of the Founders Fund spoke recently of the 10th hire test. It’s easy to get founders to sign on to a start-up. After all, they get to be founders and share the founders’ equity. If you are successful, it’s easy to hire people because you are a winner. The hard part is getting the tenth hire to be excited. At this point, there are no more founder titles, but there is still a lot of hard work ahead. Is the opportunity big enough, and is the cause big enough, to attract that tenth employee? A company that was founded simply so that you can be a founder has, by definition, nothing to offer someone who is not a founder. A company that has a vision and a cause does.
The Y Combinator experiment will prove me right — or wrong.
The best founders start with an idea and found a company to realize it. The idea might evolve, but by starting with an idea, rather than a simple desire to start a company, you end up with better companies.
Y Combinator, the most successful proving ground for start-ups in Silicon Valley, is about to run a test that will prove me either right or wrong. For the first time, they are accepting founding teams that do not have an idea. Their argument is that ideas change so often during the first few months that it is just as easy to start with an empty slate as with an idea that is going to change. In three years or so, we’ll know if they’re right. I am sure some of these teams will be successful, because they have smart people and are broadly focused on the Web market. But will they be as successful as the teams that go in knowing what they want to be? My guess is not.
If you have a vision to change one small part of the world, go for it. My business needs people like you. If all you want to do is “be a founder,” pause and think some more. Life is about doing, not being.
Author’s Note: A version of this article first appeared in Inc.
This is not what you want to hear from your largest customer: “If you can’t handle our business worldwide, then we will have to look at other providers.”
That’s exactly what one of our portfolio companies heard, from its biggest client, three years ago. The portfolio company provided internet marketing services to US companies. When customers started expanding into Europe and Asia, the company’s network of overseas contractors was quickly stretched thin. That’s when the company (which we’ll call PortCo, for portfolio company) got the ultimatum: You have twelve months to build a real presence in all the geographies we want to serve. If you can’t do it? We love you, but you’re out.
Investors and managers talk about growth as an option, but often, it’s a necessity. This is especially true for companies that sell to businesses rather than to consumers. Almost every large business on the planet has a couple of key imperatives right now. Going global is one. Reducing the number of vendors they use is another. The combination means that if you become a key vendor for a U.S.-based company, you have to expect that, as they go global, you will be expected to follow. A company can have multiple suppliers of office supplies worldwide, because office supplies are not strategic (sorry, Staples). But if the product you are selling is strategic to your customers and makes a difference to their business, they are going to want to roll it out worldwide. You have to be there.
Not that it’s easy. In the year before PortCo’s largest customer laid down the law, 98% of their revenue was from the U.S. and rest came from Canada. Customers had been asking them to expand, but frankly, they didn’t listen. The money wasn’t there. They were busy. Now, there wasn’t any choice didn’t have a choice. And if you haven’t been listening closely enough, you may not have one either. Here’s what our company did:
International revenues are now 30% of PortCo’s total, and represent the fastest-growing part of their business. They have offices in Asia and Latin America as well as Europe. More important is what did not occur: They did not lose key U.S. customers to a competitor or a subcontractor. That’s something that could easily have happened did they not realize that growth was not a choice, but an imperative.
The Senate is considering the JOBS bill this week. The bill looks to make it easier for companies to go public by reducing some of the cost and complexity involved in the IPO process. By making it easier to go public, the idea is that companies will go public earlier, and hopefully grow more quickly. Senate Democrats have concerns, and are afraid this represents a rollback of legislation designed to “stop the next Enron”. They also see advocates of this bill, including venture capitalists, as looking to profit by taking companies public and selling them off to unsuspecting investors at inflated prices.
On much of this discussion there is little new to say.
All parties would agree, because the facts prove it, that small businesses do not provide job growth, and neither does “Big Business”. What provides job growth are small businesses that grow fast to become big businesses. Apple, Cisco, Genetech and Home Depot, all started small, grew quickly, and went public. They and companies like them have provided all the job growth in the US for the last twenty years.
All parties would agree, because the facts prove it, that despite a recent slight upturn, there have been less IPO’s in the most recent decade then the prior one. I would then assert that given less of the one thing that used to create all the jobs, it is no surprise that there has been less job growth in the past decade, than in the prior one.
All parties would agree that regulations such as Sarbanes Oxley imposed cost and delay on small companies looking to go public but also mean that companies that do go public are on average longer established and have better systems and controls.
The substance of the debate, and where the parties clearly do not agree, is whether the above trade off is worth it. Is it worth it to have less IPO’s and have them happen later, if in return, those IPO’s that do take place, are less risky? I don’t think so.
The Sarbanes Oxley Act tries to protect investors against the kind of corporate fraud that sank Enron, Tyco and Worldcom. It does this by requiring a layer of cost and compliance that is manageable for a large Fortune 1000 company but can be easily 10% of the profits of a typical high growth IPO. The debate ignores the fact that none of the poster children for corporate fraud were the type of early stage high growth companies that would be the beneficiaries of the reduced regulation in the JOBS Act.
High growth early stage IPO’s absolutely are risky investments, but not because they have or do not have Sarbanes Oxley (SOX) type controls. They are risky because high growth companies are intrinsically risky and for every Apple that works, there are five apples that didn’t. The most significant impact of SOX on smaller companies in the last ten years, is that boards have decided to “wait a year or two” before going public so as to be bigger and more established before exposing the company and the board to the costs and risks of being a public company.
The result for public investors has been they have had less opportunity to lose money in risky high growth start ups in the last ten years. To that extent the regulatory mission has succeeded. The bad news is public investors have made less money too. Cisco, Apple and Yahoo all went public relatively early in their lives, and made public investors great returns, more than enough to cover losses incurred on less successful companies that went public at the same time. By contrast, Facebook is going public with $ 4 Bn in revenues and valued at $50 Bn plus. The upside has gone to the insiders not the public investors.
This illustrates the least understood part of this debate. When IPOs are scarce, private investors end up make more money not less, although the returns take longer. In general the current SOX regime has been a negative for early stage investors – by making exits take longer – and a positive for the much larger group of late stage financial investors, – by eliminating competition from the IPO market. This is precisely the wrong result from a policy perspective.
Public investors know this. Large mutual funds the work for the average investor have started to “reach down” into pre public rounds because they know that is where they can make the return that their customers, individuals saving for retirement, want and need. Do opponents of the bill recognize that they have put mutual fund managers between a rock and a hard place? They have to find high growth companies but unless the system is fixed, they can only find them in the private market, with much less investor protection.
It is clear that the trend to delayed IPO’s has cost the investing public in terms of lost investment profits. It is harder to prove the direct impact of SOX and the dearth of IPO’s on jobs. However I think the burden of proof on this issue is on the other side. When you can point to a process (IPO’s + high growth companies) that has created almost all the job growth in the US since the 1980’s and Congress passes a law that visibly impedes that process, and then job growth subsequently stalls, surely the burden of proof is on the other side? How can the AFL-CIO even think about voting for another jobs decade like the last one ?
All regulations, including the ones that the JOBS bill is looking to reduce, have both costs and benefits. For large public companies I believe SOX compliance is a manageable cost and a worthwhile obligation. For high growth IPO’s the benefits of SOX are light and the costs, have been significant. IPO’s have been reduced, job growth has been lower, public shareholders have been shortchanged and the benefits of the American economy have once again been channeled to a smaller group of investors who can work the system. It is time to change the law.
Author’s Note: A version of this article first appeared in Inc.
It’s hard enough to find the right price for your product or service — without everyone lying to you about it.
How hard a game is pricing? Learn from my example.
Many years ago, I ran a manufacturing company that supplied a number of large U.K. and U.S. retailers. Our customers beat us up all the time on pricing. Sometimes I gave them breaks, mostly out of fear. Eventually, in the recession of the early 90s, I had to close the business. A year later, I ran into the buyer for our largest customer. She told me how sorry she had been to see us close, because she had been unable to find a product similar to ours at a similar price. All of her alternatives were much higher-priced.
She was trying to be nice, but I went home that day knowing I was a fool. By allowing customers to push me around on price, I had been leaving money on the table–money that might have kept the business alive. I had priced myself into an early grave.
If you don’t want to join me there, you need to take a hard, hard look at pricing. Pricing is where the rubber meets the road – where your internal costs smack up against customers’ willingness to pay. Marketers love to talk about the four Ps: product, pricing, promotion and placement. That makes price one of four elements in the overall mix. That’s a fine way to think about marketing, but not about pricing.
If your business needs to make a profit –and most do– the price per unit sold times the number of units sold has to be greater than the total costs, fixed and variable, of running that business. That’s it. In this simplified but realistic view of the world, the CEO knows a good deal about his or her cost structure but much less about the real customer demand. The trick is to turn the dial on pricing to see if you can make the inside and outside realities line up.
This is the actual cost structure of your business. Sure, you know how much it costs to provide your goods or services. That’s just the start. To really understand your cost structure, ask yourself these questions:
Once two or more of your direct competitors have made a big improvement in costs, you have to match them or you are no longer viable. Price can cure many ills, but it is the rare company that can use price to cover for an uncompetitive cost structure.
Now you need to do a 180-degree turn and forget entirely about your cost structure. Instead, step into the customer’s shoes. What is your product worth to them? The customer doesn’t know what it costs you to make a product, doesn’t need to know, and sometimes doesn’t even care. What matters is the perceived value of your product and how much someone is willing to pay for it. More precisely, you want to figure out how many customers you’ll lose for every percentage point increase in your price.
It sounds easy enough to find this out, but unfortunately everyone you are dealing with will want to lie to you. Science fiction writer Robert Heinlein once wrote that everyone lies about sex. Well, in business, everyone lies about price. Your customers want to pay as little as possible, so they are not going to tell you what they will really pay. If your sales team is paid on commission, they see lower prices as a way to get deals closed. They don’t suffer (at least not right away) if the business loses money. They too will lie.
Your only option is to continually push the limits on price, testing the customer and monitoring the result. You have to find out what the real “walk away” is. If you’re selling to consumers, there are a myriad of ways to do this, using marketing, A/B testing, focus groups, graduated pricing schemes and even Groupons. If you’re selling to businesses, you have to be willing to push the pricing to the point that you will indeed lose some deals. And when you do lose a deal, you need to understand the real reason why you lost it, and not just automatically chalk up the outcome to price.
Finally, sometimes there is pricing version of the Hail Mary pass. If you have a business that is losing money, then the last step before giving up should always be to raise prices. This is the no-lose, last-ditch play. If it works, then you know your pricing was naïve, and now you’ve fixed it. If it doesn’t work, then you know that the world does not value your product enough to pay the costs required to produce it. You don’t have a business, but at least you know why. Don’t wait until it is too late.
In the last post, I outlined how the IPO gap emerged after 2000. We went from hundreds of venture backed IPO’s in the late 90’s, to about fifty a year in the mid 2000’s, and finally none for most of 2009. This was a real problem. Lots of people are working on fixing the problem, but what DST did was figure out how to make money from it. DST realized faster and with more clarity than anyone else that just because the public markets did not want to “buy” IPO’s, did not mean that technology companies did not still need what IPO’s offered. Great high growth companies still had a need to raise $100 MM plus amounts of capital, to continue to grow, and early stage investors and employees still wanted to cash out. That was what an IPO was about, and the IPO gap was a financing opportunity.
Look at how Facebook was financed. Up until the DST financing, it followed the quintessential Silicon Valley funding strategy. The first round came from a super connected angel (Peter Thiel), followed by the first venture capital round from Accel Partners, a top tier firm. Once in revenue, Facebook raised a late stage round, at a huge(!)$500 million valuation, from Meritech Capital, and Greylock Partners and then took a strategic investment from Microsoft. Under normal circumstances the next step would have been an IPO. But the founder did not want to go public yet, and the markets in 2009 were choppy. What was to be done?
At this point Facebook needed someone who would pay venture capital like valuations but at private equity scale. Venture capital investors could stomach nosebleed valuations for great companies, but they could not write $100 million plus checks. US private equity investors could write $ 100MM and even $ 1BN checks, but were not used to paying 10x revenues for high growth companies. What was needed was someone with a venture like understanding of the value of high growth companies, but the financial heft of a private equity firm. “Cometh the hour, cometh the man”. DST knew social networks from their Russian experience, and had access to capital that had not been raised on a promise of doing all early stage investing. Investing at mutual fund scale but with venture capital returns looked fine to them. They made the Facebook investment in 2009 , and for the next two years they were not the only, but were clearly the largest player in the, “Feels like an IPO financing but private” game. They have made investments that will make them a fortune in companies like Facebook, Zynga, Groupon and now Twitter. It is not that the returns are comparable to early stage investing. Accel Partners will make between 500 and 1000 times their investment, compared to the 5x to 10x that DST will make, but 5x to 10x returns in three years, on big piles of money, is a pretty good living.
The gap is shut, not just because the IPO window is more open, (it is, though not yet back to 1990’s levels). It is also shut because many venture firms as well as mutual funds, have moved to grab the ultra late stage opportunity. Motivated in part by the survival gene, the industry has figured out that one way to put those “points on the board” is to be in the great deals, regardless of price. If that means morphing a firm from being an early stage investor, focused on doling out small amounts of capital and large amounts of value add, to being a passive late stage secondary purchaser of shares from the ex-employees of successful internet companies, so be it, “needs must, when the devil drives”. A 3x return off a $1BN valuation is still a 3x, and it can get a lot of dollars to work. The table below shows the fifteen largest venture financings in 2010, and compares it to the fifteen largest financings in 2006. The top eight deals in 2010 were all larger than the largest deal in 2006, despite 2006 being a much better overall economic environment. The top deal of 2010 is almost 10x the largest deal in 2006. Interestingly, the 15th largest deal in each case is almost the same size at approximately $ 50 MM. This illustrates the (unspoken) mission of late stage investing in the last two years, which has been to stuff every dime possible into five or six perceived super hot deals.
This trend has attracted notice and criticism (this article by Sarah Lacy covers the issue really well). My perspective is that the real question is how long will the strategy work ? Right now the 2009/2010 deals are clearly on course to make money, and what’s to argue about that. The strategy of piling into the super premium deals worked brilliantly when almost no one was pursuing it, was working well as long as only a few firms were doing it, and will end badly sometime in the next two years when pricing massively outruns value and the cycle goes round again. At that point the biggest negative of the strategy, namely that the dollars at risk are huge, will become painfully clear and someone will lose big. You cannot stop the cycle, but you can enjoy the irony. The attempt to protect US public investors from being duped, and the overall inhospitable climate in the public markets for higher risk technology companies, has led to a Russian venture capital firm making billions of dollars and turned many early stage venture firms into de facto mutual fund investors. Not what was intended, but money has its own imperative, and the DST strategy has totally shaken up the late stage game. Smart guys.
See Related Blog Post: Scooping the Big Pot-Venture Capital Since 2007