I’m delighted to share that I am now a general partner with Spark Capital. The team at Spark is an amazing group of people who teach me something new every day. I really appreciate all their support, and this endorsement of my work to date means a lot. I’m delighted we’ll have the opportunity to work together for many years to come.
While it’s great news, I view this less as an accomplishment and more as another beginning. I’m still really early in my venture career. I’ve got a lot in front of me I hope to build. I’m really grateful to the founding teams that I’ve been lucky enough to partner with to date.
The couple people I’ve shared this news with (before writing this post) all asked the same question, “What’s different now?” The answer is really nothing: I’m going to continue put my head down and do whatever I can to help founders build long-term enduring companies that make a big dent in the universe. It’s a great reason to get out of bed every morning.
A Passing Note
A while back, I was working with a CEO who was fundraising from VCs other than Spark. He showed me the list of all the VCs he was talking to, and where they all were in the process. At the time, a few of the VCs had decided to say “no.” I asked this founder who said “no” the best and how did he/she say it? Because I don’t believe in kiss-and-telling, I’ll leave the name of the VC out (I will say it is a VC I respect), but the way the VC passed stuck with me, and I felt it’s worth sharing.
The VC essential said: “Thanks for your time, but we have other investments we are looking at now that we’re more interested in.” This paraphrase was worded more nicely and drawn out over a full paragraph, but this was the gist. There was no constructive feedback.
I looked at this note and initially was surprised the entrepreneur liked this note the best. The reasoning the entrepreneur gave me for his preference was: A) it was dead honest, B) it wasn’t made-up feedback and C) it was a prompt response.
(B) is the most interesting part to me. When a VC is in the business of saying “no” 99% of the time, coming up with a good reason to say “no” is often a half-truth. The “no” might simply translate to “I’m not interested” in reality, but then the VC will create constructive feedback in exchange for the entrepreneur taking the time to pitch. The feedback will be a half-truth because it might be a well-founded critique of the business’s biggest issue, but even if you did fix the business in according with the feedback, the VC would still be uninterested.
The entrepreneur’s reaction to this note continues to stick with me. I am struck by the simplicity of all sides of the outcome.
The Point When VC Will Never Be The Same Again
Albert has a nice post this morning on the intersection of technology and openness in the VC landscape and how disruption of VC is starting to spin.
I don’t want to be redundant to his post, and I agree with much of it. But, I’ve long thought the disruption of VC will hinge on one simple change (that has yet to occur), and so I want to elaborate on that thought here.
But first, my assumptions: VC is about access. Knowing which companies are interesting and worth investment when they are fundraising is no where near as hard as actually getting access to those top quality deals. The problem is exacerbated by the fact that nearly all the returns in VC are generated by the top decile of deals in a given year. For certain fund vintages in the 90s, the only profitable VC funds were the ones that got access to one or two deals that broke out during the years of the investment period of the vintage… everyone else was left out in the cold. Given the explosion of new startups in the last 4 years (really… since The Social Network hit theaters), this problem of highly concentrated successful deals is less true, but it still exists.
Don’t believe me? Well… I can’t really talk about performance, but thanks to FOIA of public pension funds, much of the data is public. It’s no coincidence that Spark, USV and Foundry co-invest quite frequently, and they also are each in the top 3 managers in UTIMCO’s portfolio of 100+ VC/PE managers. This is the concentration I’m describing at work.
If you believe now that VC is largely about access to the best deals, then the next part will make more sense. The firm offering the best terms often doesn’t win. Founders choose their VC partner based on a couple criteria:
A) Economic terms (read: highest pre money valuation),
B) Control terms (read: control of the board… voting power), and
C) Value-add (read: how can this VC help make my company more value, beyond just the equity capital provided)
Getting access to the best deals is a careful balance of these three variables. If you give away the farm on terms (ie, you’re the best term sheet), you can easily still loose due to insufficient points in category C.
So, stack-tracing back up to the purpose of this post. When will VC be disrupted? When value-add and deal terms get evaluated and transacted separately. Imagine a clean layer of abstraction where the board member you add to a company in a financing round is a decision that is wholly separate from the terms of the deal you accept.
Picture a Series A round of investment that is crowdsourced capital from hundreds of investors, where the founders are accepting money strictly on their own terms. Once the funding is in place, the company then recruits a board member using the equity they saved by accepting the best possible deal terms.
Here’s a hypothetical: The “standard” series A VC deal might involve selling 25% of the company for a couple million dollars. Of that 25% the VC now owns, 20-30% of that will become carried interest if the VC fund is successful and will go to the general partners. The general partners will split that up amongst themselves, somewhat equally or otherwise. So:
25% of the company * 20% carry * 33% of the carry in a flat partnership of 3 partners = 1.65% of the company goes to the VC board member (assuming everything goes well for the fund… which is a tough assumption for the average VC firm). So, roughly 1.65% of a company is the cost to recruit a *great* board member by this logic.
So, you could take 2% of your company (to use a round number) and go out and recruit Dick Costolo to your board, and then accept a crowdsourced VC round from hundreds of angels on economic terms and control terms much better than the 25% of your company for a couple million dollars.
This strategy might only work for the hottest deals, but as I already stated, that’s where all the returns are regardless… So, that’s when VC gets disrupted: when “value-add” and terms get separated.
Unintended Consequence of Debt Notes: Inflated Liquidation Preferences
Frequently seed stage founders ask me my opinion of whether or not they should use a capped debt note structure or an equity structure to finance their company. I strongly believe equity is the right answer, and I have a reserve of 4-5 different reasons why I think equity structure is better for both founders and investors. One argument I use is most effective every time and is almost always overlooked by founders. I’m writing this post to really highlight this one single argument. It’s not simple, so I’ll try to go slowly, step-by-step.
Debt notes lead to inflated Liquidation Preferences, which exceed the total capital invested in a startup. For founders, this creates a higher hurdle to clear in a down-side scenario, which can be very meaningful. Let me explain with a specific scenario:
Company A raises $1mm in a $4mm capped convertible debt round. Lets assume zero interest rate for simplicity.
Company B raises $1mm in equity at $4mm pre-money valuation in 1x convertible preferred stock.
At this point, each company has effectively sold 20% of their respective businesses. (Technically, company A hasn’t sold any equity yet, and if the next round is a down-round, the Founders will suffer more than 20% dilution in their seed round, but this is an unlikely scenario, so both companies effectively sold 20%.)
Then, both companies A and B each raise $10mm in equity at $40mm pre-money valuation in 1x convertible preferred stock.
Both companies have thus sold 20% of their business in the first round, and then another 20% in the second round. So, after two rounds in both companies, the Founders and employees own 64% and the investors own 36% of the company.
(The fact that it is a 64/36 split instead of a 60/40 split might not be intuitive to some people, but it is beyond the scope of this post, so ill ignore it for now. If you want a post explaining the concept of dilution across multiple rounds, request it in the comments).
At this point it sounds like both Company A and Company B have identical ownership splits, and so both scenarios are equally preferable, right? Wrong.
Company A has $18mm in Liquidation Preference.
Company B has $11mm in Liquidation Preference.
Liquidation Preference means that in an exit, the investors “Preference” must be repaid in full before the cap table splits up the rest of the consideration. Unless the consideration is large enough such that the investors opt to convert their Preferred stock into Common stock, in which case they split up the proceeds just like Founders and employees without taking their Preference.
There was a lot of jargon in there, but hopefully the hypothetical scenario we have been building will help illuminate the problem.
Lets say the road gets a bit rocky and Company A and B each decide to accept a $20mm acquisition offer, here’s what will happen.
In Company A, all the investors will elect to take their Liquidation Preference. $18mm of consideration will go to them first. And then the Founders and employees will split the remaining $2mm. So the proceeds will be split as follows in Company A:
First Investors (the $1 on $4 pre round): $8mm
Second Investors (the $10 on $40 pre round): $10mm
In Company B, the first investors (the ones that invested at $4mm pre) will elect to convert their Preferred stock to Common stock and waive their Liquidation Preference. The second set of investors will choose to keep their Liquidation Preference of $10mm. So the proceeds will be split as follows in Company B:
First Investors (the $1 on $4 pre round): $2mm
Second Investors (the $10 on $40 pre round): $10mm
So, two totally identical companies raise identical amounts of money and exit at identical prices. If the Founders choose debt in the beginning, they see $2mm in value. If the Founders choose equity in the beginning, they see $8mm in value.
This often-overlooked unintended consequence of debt financings is worth digesting before deciding to raise money in a capped debt note structure.
Spark Capital IV
Spark announced our latest fund today; the fourth since the founding of the firm back in 2005.
I feel lucky to be working with such a talented team of investors. I learn from my colleagues at Spark every day. It’s a wonderfully egalitarian work environment where ideas and ambition are valued above all else. It has served us well in three funds thus far, and I can’t wait to see where our team takes us in fund IV.
While the team is great, we are the sideshow. We’d be nowhere without the tireless entrepreneurs that do all the work of building amazing companies that match their visions. And, we owe a big thanks to our LPs that continue to support us and believe in our thesis.
Venture capital works on crazy long feedback loops. The data on Spark IV’s success won’t be well defined until 7+ years from now, 2020. 2020… that’s crazy, and I can’t wait to see how this generation’s founding entrepreneurs are going to shape those next 7 years. I hope to help them a bit on their path.
Web Services with a Social Mission
I said recently in an interview with Roy Rodenstein (co-founder of Going.com):
Because attention is the new scarcity, it’s more important than ever that entrepreneurs work on problems that people genuinely care about, otherwise you will fail to capture users’ attention.
To make the point more directly, I feel that a social mission is an essential part of every consumer-facing web service these days, particularly in this noisy market of countless young web startups.
And when I gave this quote to Roy, I was instantly reminded of where I learned this lesson. It’s a good story:
Biz Stone was at a USV annual meeting a few years ago where he presented Twitter to all the LPs in the fund. He did a great job conveying the value of the service, took some questions and then sat down to watch the rest of the portfolio companies and GPs present. At the very end, when we asked the audience for questions, Biz raised his hand, and he asked (I paraphrase):
"Do you guys think about the social mission of the startups you invest in? Do you look for companies that have a double bottom line? At Twitter we think about our social mission and how we can make the world a better place regularly."
And then Biz went on to describe how Twitter had been helpful in a bridge collapse in Missouri as an example.
Biz’s question is a tricky one in this particular setting because it was being answered in front of all the LPs at USV in attendance of the meeting. The LPs want to know that the core mission of the fund is to maximize returns for themselves, the investors.
Brad Burnham fielded Biz’s question and said:
"Our goal is to maximize the returns for our investors, but we believe that these days, a consumer-facing web service cannot be successful without also having a social mission. Being successful on the web requires getting a large userbase and developing a network effect. You cannot get users’ attention with a completely selfish startup that’s only motivated by maximizing profit. So, yes, we do look for companies that have a social mission.
This is heavily paraphrased since it happened years ago, so I defer to Brad’s memory of the day and his words. But I think the spirit is right. The outcome was that both Biz and the LPs seemed happy with the answer, and, more importantly, Brad was being entirely genuine and honest to his feelings on the subject.
I agree with Brad’s thoughts, and this story was very formative in how I think about investing in web services. A social mission is essential for a startup these days, as users prioritize the value of their work, not just the financial benefit.
Working on a socially important startup or have a similar story to recount? Please let me know in the comments.
Ad Network Revenue Multiples
It’s audit season, so lately I’ve been doing a bunch of the blocking and tackling side of the VC world. Updating our records on our companies, determining fair value for our portfolio companies often using a comps-based analysis, and then running hypothetical liquidations to determine the value of our various classes of stock in each company. If this sounds interesting, I could write a post dedicated to the process (don’t all raise your hands at once!).
But, that setup is just the backstory to explain that I’ve been looking at the revenue and EBITDA multiples of both public companies and recent M&A activity. In the process, I stumbled on an interesting difference I thought merited a blog post about ad network revenue multiples.
There are two publically traded ad networks that one can use when trying to determine the value of an ad network: ValueClick and InterCLICK. ValueClick is trading at a 1.34x revenue multiple and InterCLICK is trading at 2.1x multiple (both based on a trailing four quarters of revenue). I consider ValueClick and InterCLICK to be a minimum baseline for a mature, low-growth ad network… they both largely play in remnant (though InterCLICK supplements their inventory with data from BlueKai) where the economics have been driven down by a race to the bottom amongst the competition. But, it’s a nice baseline to consider nonetheless.
Using data from publicized sale prices and a research report on mobile ad network revenue from IDC, in November ‘09 Google bought AdMob at a 24x revenue multiple and Apple bought Quattro Wireless 13.5x revenue multiple. By comparison to the more generic ad networks above, these two company sale prices are really remarkable.
The takeaway: the large difference in revenue multiples between these two groups of companies shows the value of A) being in a hot market — mobile advertising B) having significant strategic value to multiple bidding acquirers C) having a healthy growth trajectory.