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The segmentation of the venture industry

Ford Motors dominated the auto market in the early 20th century with a single car model, the Model T.  At the time, customers were seeking low-cost, functional cars, and were satisfied by an extremely standardized product (Ford famously quipped that “customers can choose it in any color, as long as it’s black”). But as technology improved and serious competitors emerged, customers began wanting cars that were tailored to their specific needs and desires. The basis of competition shifted from price and basic functionality to ”style, power, and prestige“. General Motors surpassed Ford by capitalizing on this desire for segmentation. They created Cadillacs for wealthy older folks, Pontiacs for hipsters, and so on.

Today, the venture financing industry is going through a similar segmentation process. Venture capital has only existed in its modern form for about 35 years.  In the early days there were relatively few VCs. Entrepreneurs were happy simply getting money and general business guidance.  Today, there is a surplus of venture capital and entrepreneurs have become increasingly savvy “shoppers.”  As a result, competition amongst venture financiers has increased and their “customers” (entrepreneurs) have flocked to more specialized “products.”

Some of this segmentation has been by industry (IT, cleantech, health care) and subindustry (iPhone apps, financial tech, etc). But more pronounced, especially lately, has been the segmentation by company stage.  Today at least four distinct types of venture financing “products” have become popular.

1) Mentorship programs like Y Combinator help startups ideate, form founding teams, and build initial products. I suspect many of the companies they hatch wouldn’t exist at all (and certainly wouldn’t be as savvy) if it weren’t for these programs.

2) So-called super angels provide capital and guidance to a) hire non-founder employees, b) further product development c) market the initial product (usually to early adopters), and d) raise follow on VC funding. Often current or former entrepreneurs themselves, super angels have gone through this stage many times as founders and angel investors.

3) Traditional VCs (Sequoia, Kleiner, etc) help companies scale and get to profitability. They often have broad networks to help with hiring, sales, bizdev and other scaling functions. They are also experts at selling companies and raising follow-on financing.

4) Accelerator funds (most prominent recently is DST) focus on providing partial liquidity and preparing the company for an IPO or big M&A exit.

In the past, traditional VC’s played all of of these roles (hence they called themselves “lifecycle” investors). They incubated companies, provided smalls seed financings, and in some cases provided later stage liquidity. But mostly the mentorship and angel investing roles were played by entrepreneurs who had expertise but shallow pockets and limited time and infrastructure.

What we are witnessing now is a the VC industry segmenting as it matures. Mentorship and angel funding are performed more effectively by specialized firms.  Entrepreneurs seem to realize this and prefer these specialized “products.”  There is a lot of angst and controversy on tech blogs that tends to focus on individual players and events. But this is just a (sometimes salacious) byproduct of the larger trends. The segmentation of the venture industry is healthy for startups and innovation at large, even if at the moment it might be uncomfortable and confusing for some of the people involved.

Howard Lindzon’s “Web is Dead” series

Howard’s Stocktwits interviews are always really fun.  Some people don’t get his subtly self-deprecating sense of humor but I love it. Besides discussing the usual suspects (Facebook, Twitter, Apple), we spend some time trashing Wall Street and chatting about some early-stage startups including Founder Collective investments Bnter, Giiv, Ze Frank Games, and Canvas (founder of 4chan Moot’s new startup).  Of course I also shamelessly promote Hunch.

Also, Fred Wilson’s interview with Howard is a must watch.

Converts versus equity deals

There has been a debate going on the past few days over whether seed deals should be funded using equity or convertible notes (converts). Paul Graham kicked it off by noting that all the financings in the recent YC batch were converts. Prominent investors including Mark Suster and Seth Levine weighed in (I highly recommend reading their posts). While this debate might sound technical, at its core it is really about a difference in seed investing philosophy.

I am a proponent of convertibles, but only with a cap (I’ve written about the problems of convertibles without caps before and never invest in them).  I believe that pretty much every other seed investor who advocates converts also assumes they have a cap.  So any discussion of convertibles without caps seems to me a red herring.

There are two kind of rights that investors get when they put money in company.  The first are economic rights: basically that they make money when the investment is successful.  The second are control rights: board seats, the ability to block financings and acquisitions, the ability to change management, etc.  Converts give investors economics rights with basically zero control rights (legally it is just a loan with some special conversion provisions). Equity financings normally give investors explicit rights (most equity terms sheets specify board seats, specific blocking conditions, etc) in addition to standard shareholder rights under whatever state the company incorporated in (usually CA or Delaware).

To the extent that I know anything about seed investing, I learned it from Ron Conway.  I remember one deal he showed me where the entire deal was done on a one page fax (not the term sheet – the entire deal).  Having learned about venture investing as a junior employee at a VC firm I was shocked. I asked him “what if X or Y happens and the entrepreneur screws you.”  Ron said something like “then I lose my money and never do business with that person again.”  It turned out he did very well on that company and has funded that entrepreneur repeatedly with great success.

You can hire lawyers to try to cover every situation where founders or follow on investors try to screw you. But the reality is that if the founders want to screw you, you made a bet on bad people and will probably lose your money. You think legal documents will protect you? Imagine investors getting into a lawsuit with a two person early-stage team, or trying to fire and swap out the founders – the very thing they bet on.  And follow on investors (normally VCs) have a variety of ways to screw seed investors if they want to, whether the seed deal was a convert of equity.  So as a seed investor all you can really do is get economic rights and then make sure you pick good founders and VCs.

Seed investing is a people business.  Good entrepreneurs understand this.  Ron was an investor in my last two companies and never had any control rights but had massive sway because he worked so hard to help us and gave such sage advice.  And most importantly, he carried great moral authority. We always knew he was speaking from deep experience and looking out for the company’s best interests – sometimes against his own economic interests.

Like it or not, the seed investment world runs on trust and reputation – not legal documents.

It’s not that seed investors are smarter – it’s that entrepreneurs are

Paul Kedrosky recently speculated that there might be seed fund “crash” looming. Liz Gannes followed up by suggesting seed investors are a fad akin to reality-TV celebrities:

In many ways, what [prominent seed funds] are saying is that they’re just smarter, and as such will outlast all the copycat and wannabe seed funders as well as the stale VCs with a fresh coat of paint. But then — Kim Kardashian is the only one who can make a living tweeting. At some point it will be quite obvious whether the super angels’ investments and strategy succeed or fail.

Here’s the key point these analyses overlook: It’s not the seed investors who are smarter – it’s the entrepreneurs. Consider the case of the last company I co-founded, SiteAdvisor. We raised our first round of $2.6M at a $2.5M pre-money valuation. After the first round of funding, investors owned 56% of the company. Moreover, the $2.6M came in 3 tranches: $500K, another $500K, and then $1.6K.  To get the 2nd and 3rd tranches we had to hit predefined milestones and re-pitch the VC partnerships. Had we instead raised the first $1M from seed funds, we would have been free to raise the remaining money at a higher valuation. In fact, after we spent less than $1M building the product, we raised more money at a $16M pre-money valuation. We never even touched the $1.6M third tranche even though it caused us to take significant dilution. This was a very common occurrence before the rise of seed funds, due to VCs pressuring entrepreneurs to raise more money than they needed so the VCs could “put more money to work.” When SiteAdvisor was eventually acquired, we had spent less than a third of the money we raised. Compare the dilution we actually took to what we could have taken had we raised seed before VC:

Professional seed funds barely existed back then, especially on the East Coast. And even if they did, I’m not sure I would have been savvy enough to opt for them over VCs. I thought the brands of the big VCs would help me and didn’t really understand the dynamics of fund raising.* Today, entrepreneurs are much savvier, thanks to the proliferation of good advice on blogs, via mentorship programs, and a generally more active and connected entrepreneur community. For example, Founder Collective recently backed two Y-Combinator startups who decided to raise money exclusively from seed investors despite having top-tier VCs throwing money at them at higher valuations. These were “hot” companies who had plenty of options but realized they’d take less start-to-exit dilution by raising money from helpful seed investors first and VCs later.

Will there be there a seed fund crash? Seed fund returns are highly correlated with VC returns which are highly correlated with public markets and the overall economy. I have no idea what the state of the overall economy will be over the next few years. Perhaps it will crash and take VCs and seed funds down with it. But I do have strong evidence that prominent seed funds will outperform top-tier VC funds, because I know the details of their investments, and that their portfolios contain the same companies as top-tier VCs except the they invested in earlier rounds at significantly lower valuations.  So unless these prominent seed funds were incredibly unlucky picking companies (and since they are extremely diversified I highly doubt that), their returns will significantly beat top-tier VC returns.

* Note that we have nothing but gratitude toward the SiteAdvisor VCs – Rob Stavis at Bessemer and Hemant Taneja at General Catalyst. They offered what was considered a market deal at the time and supported us when (almost) no one else would.

Builders and extractors

Tim O’Reilly poses a question every entrepreneur and investor should consider: are you creating more value for others than you capture for yourself? Google makes billions of dollars in annual profits, but generates many times that in productivity gains for other people. Having a positive social contribution isn’t limited to non-profit organizations – non-profits just happen to have a zero in the “value capture” column of the ledger. Wall Street stands at the other extreme: boatloads of value capture and very little value creation.

I think of people who aim to create more value than they capture as “builders” and people who don’t as “extractors.” Most entrepreneurs are natural-born builders. They want to create something from nothing and are happy to see the benefits of their labor spill over to others. Sadly, the builder mindset isn’t as widespread among investors. I recently heard a well-known Boston VC say: “There are 15 good deals a year and our job is to try to win those deals” – a statement that epitomizes the passive, extractor mindset. The problem with VC seed programs is they not only fail to enlarge the pie, they actually shrink it by making otherwise fundable companies unfundable through negative signaling.

The good news is there is a large – and growing – class of investors with the builder mindset. Y Combinator and similar mentorship programs are true builders: their startups probably wouldn’t have existed without them (and the founders might have ended up at big companies). There are also lots of angel and seed investors who are builders. A few that come to mind: Ron Conway, Chris Sacca, Mike Maples (Floodgate), Roger Ehrenberg, Keith Rabois, Ken Lehrer, Jeff Clavier, Betaworks, Steve Anderson, and Aydin Senkut. There are also VCs who are builders. Ones that I’ve worked with directly recently include Union Square, True, Bessemer, Khosla, Index, and First Round.

Given that there is a surplus of venture money, entrepreneurs and seed investors now have the luxury of choosing to work with builders and avoid extractors. Hopefully over time this will weed out the extractors.

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