Wednesday, August 16, 2017

Big Banks And Blockchain

After the crypto run up of 2013, every major bank decided it needed to do something about cryptocurrencies and blockchain. The way many banks responded to this disruptive technology was:
Step 1. Set up a special internal "blockchain group". 
These groups were supposed to explore how banks could make use of blockchain. The cryptocurrencies themselves were largely viewed as speculative and the "interesting parts" were blockchains and distributed ledgers as technologies.

Step 2. Have the blockchain group focus on building private chains. 
Focus at most banks was on private chains and more recently some smart contract work. Nothing was adopted or launched, it was more R&D and prototyping.

Step 3. Have the CEO brag about blockchain group, then do nothing.
When asked by bank's Board of Directors about crypto, the CEO could point to the largely impotent blockchain group and say "we are all over this blockchain thing!!". The Board would break into polite applause and the topic would quickly move on to something more important, like FX risk being hedged and what fancy restaurant to convene to for martinis post-board meeting[1].

It's the Currencies Stupid!
In the last 6 months, large banks & brokerages have started to wake up to the other side of crypto - in particular the currencies themselves[3]. This is largely driven by high net worth clients, pension funds, and others, starting to ask the asset and wealth management divisions of banks how they can participate in BTC (bitcoin), ETH (ethereum), and other cryptocurrencies.

Banks now have an incentive to adopt cryptocurrencies - if it becomes part of the basket of assets they manage for a client, they can take an annual cut. For example, if a bank charges 0.5% of AUM (assets under management) and a client wants to put 5% of their assets into crypto, the bank has a strong incentive to manage it for their client. If the bank pushes the client out to third party sites or wallets, the bank is loosing the 0.5% a year they charge for assets directly under management.

In order to be able to meet the demands of their clients, banks are looking for solutions that allow their clients to participate in BTC et al. in a way that the bank directly manages and controls (or, at a minimum, that the bank can charge for).

The following products need to be built for financial institutions to fully adopt cryptocurrencies:

Mutual funds and ETFs: Financial products that allow people to easily buy a basked of crypto currencies.
Major banks would love to enable their interested clients to buy into a mutual fund or single currency tracking fund as part of their AUM basket alongside various baskets of stocks, bonds, and gold. This prevents the need for them or their client to think about the new crypto hotness and instead the mutual fund can add or drop positions over time. Recent funds for high net worths include Grayscale, ICONOMI, PRISM, the Token Fund, and others.

In parallel a number of efforts to create the first crypto ETF have been ongoing.

Crypto custody / wallet / cold storage.  When talking to private wealth managers about their crypto needs there is strong interest in a wallet where they can store their client's cryptocurrencies, track changes in value for clients, and of course charge their % of AUM. Obviously Coinbase has done amazing work in providing a wallet and cold storage for individuals and have made some interesting moves like their recent Fidelity integration. In parallel, companies like Xapo were founded with the original intention of provided a bitcoin vault. However, from discussions I have had with the wealth management community, there is still not a comprehensive solution in this area.

Hedge funds.
The pioneering early hedge fund of the industry Metastable, and more recently Polychain, have pioneered the crypto hedge fund market. There are a dozen new entrants coming, many of them likely to be crappy.

The banking and brokerage industry would benefit from additional high quality long funds as well as algorithmic trading funds that their clients can participate in, and can be sold to high net worth investors as part of a basket of goods.

Intriguingly a lot of the crypto trading at hedge funds started as young employees trading crypto for their own accounts. This will likely change soon with bank's internal hedge funds also participating directly in the crypto market.

Derivatives exchanges.
As people buy and sell different cryptocurrencies the ability to create complex hedges, options and derivatives becomes increasingly important. This can both dampen volatility in a position as well as create leverage on capital. For both market liquidity to accelerate, and hedge funds to thrive a strong derivatives broker and market needs to emerge. As an example, LedgerX recently received US CFTC (Commodity Future Trading Commision) approval to move ahead in this market. There will likely be more entrants here soon.

With the above product areas fleshed out, we will see an accelerated adoption of cryptocurrencies due to accelerated (and finally real) adoption in the banking and brokerage world.

Notes
[1] I tend to imagine board meetings at global banks always ending with martinis for some reason[2]. At least I hope this is what happens, in which case I would be interested in joining a top 5 bank's board. As an aside, New York tends to have much better martinis than San Francisco. I guess most people drink bourbon or rye whiskey these days so this point is moot. As an aside to this aside: Boston has a surprisingly good martini tastiness/per capita ratio.

[2] I also picture all the board members wearing pin striped suits and monocles, sort of like the Monopoly Man.

[3] Blockchains and smart contracts will still change our financial system outside of core cryptocurrencies, it will just take longer.

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Monday, August 14, 2017

Unequal Cofounders

One of the big myths in Silicon Valley is that co-founders should be equal. However, if you look at the most successful tech startups of the last 50 years, almost all of them had a dominant co-founder for most of the life of the company. This includes[1]:
  • Amazon. Jeff Bezos.
  • Apple. Steve Jobs famously split equity unequally versus Wozniak. 
  • Facebook. While Zuck had multiple co-founders, the website used to be called "A Mark Zuckerberg production" and he had multiple times the equity and power of his co-founders.
  • Instagram. Kevin Systrom as dominant founder.
  • Intel. Robert Noyce for 7 years and then Gordon Moore for 12 years[2].
  • Intuit. Scott Cook as dominant founder.
  • LinkedIn. Reid Hoffman had multiple co-founders but was really dominant in terms of equity and control (despite hiring a CEO to take over pre-Jeff Weiner).
  • Microsoft. Paul Allen stepped down after a few years leaving Bill Gates as dominant founder.
  • Oracle. Larry Ellison as founder.
  • Pinterest. Ben Silberman has driven the success of the company.
  • Salesforce. Marc Benniof.
  • Uber. Travis Kalanick as primary force until recently.
  • WhatsApp. Jan as dominant founder and equity holder.
Apple, Facebook, Intuit, LinkedIn, Oracle, etc. are all also examples where both power and equity splits between founders were unequal. While people tend to fixate on equity ownership and equality, what really matter is whether there is equal power sharing between founders. In general equal power sharing yields worse outcomes than having an (eventually) dominate cofounder.

The limited set of counterexamples with more equal co-founding partnerships includes Google (confounded a bit by Eric Schmidt being hired as CEO early in its life). Having an equal co-founding relationship is not impossible, just rare for the most successful companies.

Harj Taggar has a great point on this - "Another interesting way of thinking about this is reversion to the mean. Startups need to be outliers in many ways to be an outlying success, one such vector where I think this helps is in product decisions. Any time you involve multiple stakeholders in these decisions (whether it's cofounders/customers/anyone else) you risk having your product revert to the mean (i.e. no one particularly hates it but no one loves it either). Having a product dictator is probably actually optimal for chasing outlying success."

Early Days Are Different
In the early days of a company, it may only be two or three co-founders working together for an extended of period of time before you know what to build. If you have two co-founders and no employees, it may feel natural to always get to consensus and make decisions together. Its just the two of you, and each of you has to be fully bought in due to the giant leap of faith you are taking. While some founding teams always have a clear CEO and decision maker, some do not. As you hire people and raising money, you will need to shift how you think of decision making.

As you grow, you need someone in charge
The two biggest reasons startups fail is running out of money, and co-founder conflicts. Co-founder conflicts tend to arise when there is a lack of clarity on decision making, product vision, and overlapping founder roles. For example, if more then one founder wants to be CEO, or make final decisions on product or other areas, conflict will be inevitable. Alternatively, if founders are willing to truly share power a startup may not be as aggressive due to the need to find compromises versus charge ahead. In these situations you may end up with a product or strategy designed by committee instead of making a single choice on what to build. 

Unequal co-founder relationships are a way to dampen future co-founder issues. By making it clear how decisions are made and who is in charge early, you decrease the likelihood of a founder blow up. This is separate from how you divide equity - ultimately you want to compensate someone for the tough times and many years of pain ahead that comes with starting a company.

This does not mean you will always agree. It is constructive for co-founders (and executives once you have them) to challenge the CEO and each other. There are bound to be lots of disagreements, and the non-CEO may often be right. As the CEO co-founder you need to pick your battles on when to make the final call and override everyone else. All else being equal, most specific decisions are often less important than actually making a decision. As the non-CEO co-founder, you need to understand the importance of falling in line and backing whatever decision is ultimately made.

As an investor, a clear warning sign of future co-founder conflicts is when the founders say they are "equal but own different areas". E.g. "I make all the calls on business, and my cofounder makes all the calls on engineering." But what if a business issue and a product or engineering issue overlap? A company needs a single person who is clearly in charge and can make a decision across all areas. The worst version of this is co-CEOs, which suggests an almost inevitable blow up.

Cofounders may claim "we make all decisions together, and have not fought before, so no need for a single decision maker." This is a recipe for disaster. Startups are hard and the right strategy is usually ambiguous. You can not defer organizational and decision making clarity for later. It is important to decide up front which co-founder is in charge (i.e. the CEO) and that person needs to be able to make decisions without being second guessed.

Making decisions
This is not meant to argue against making important decisions with your co-founders. You are working with them because they are smart, capable people. Their opinions are important and they may be right when you are wrong. They should own areas of the company and be able to make decisions on those areas without micromanagement. However, at some point there needs to be a clear owner who can make a final call if there is an impasse or lack of agreement. Once a decision is made, the non-CEO co-founders need to get behind the decision and make it successful.

Equity splits
As mentioned above many of the most successful companies of the last 20 years had unequal equity splits among co-founders (Facebook, LinkedIn, Twitter, etc.) while some have had equal splits (e.g Google[3], SnapChat). Equal equity does not need to be the default and in some of the most successful companies is not.

Sometimes this is counterintuitive - for example the CEO co-founder does not always get the most equity (e.g. look at the Twitter S1). The key is to be pragmatic and to think through the long term value each person brings to the table, the relative leverage each has, and investment made in different ways.

Other perceived value
One common point of co-founder jealousy and conflict is who gets to meet investors or talk to press. Usually this is the role of the CEO, and early on having multiple people involved in every conversation is not time efficient. As the company scales, there will be plenty of opportunities for multiple co-founders to have external exposure. As CEO, you should also watch out for your co-founders and make sure they also get some exposure if this is important to them.

Thanks to Harj Taggar for feedback on this post.

NOTES
[1] A number of private companies also do not have equal co-founding relationships or equity splits but since these companies are not yet public it is harder to talk openly about them.

[2] An underreported phenomenon is the number of times one co-founder is replaced by another as CEO. This happened at Intel, Logitech, and other companies.

[2] Google was in reality slightly unequal with Larry Page having slightly more equity when Google went public. It is unclear if this was due to share transfers by Sergey or if it was set up that way.

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Monday, August 7, 2017

Feelings of Failure

As the founder of a high growth successful startup, you may feel like you are constantly failing. You are not alone in this. Most startup founders I know feel like they are screwing up on a weekly or monthly basis, even if their business is growing well[1].

Feeling of failure tend to come from:
1. You are constantly learning and doing new things.
For many startup founders, your CEO job may be your first time managing people, hiring and firing across various functions, raising money, selling a customer, managing your board of directors, or signing a business partnership. There is a lot to learn in each of these areas, and no matter how smart you are you are going to make mistakes.

When a startup grows from 10 to 100 to 1000 people, you have to relearn basic parts of the CEO job. How you communicate to a 1000 person organization is very different from a 100 person organization. So even if you learn how to manage at one scale, each step up in organization size is a whole new learning curve.

This constant learning curve means that even if you are doing well, you may constantly feel lost. You may also feel imposter syndrome or like a con artist. How can people think you are good at running a company when you have never done it before?

Take a deep breath - you started this company in part to feel stretched. Realize that other founders are in the same situation as you. Specific tips on how to deal with this are at the end of this post.

2. Absence of real feedback.
The higher you go up in an organization, the less real feedback you will get. People will laugh at your jokes and defer to your judgement whether deserved or not. As it gets harder to get real feedback, you may feel blind to whether you are performing well or not.

3. Humans inability to understand compounding.
If a company is growing 5X per year, it will grow by >15,000X over 6 years![2] $100,000 in year one revenue will equate to $1.5 billion in year 6. However years 1-3 will feel existentially bad to you. E.g. at $100,000 revenue year 1, $500,000 in year 2 and $2,500,000 in year 3 revenue you may feel that your company is on the brink of failing, even if it continues to grow at a brisk pace.

People find it hard to relate to compounding. One startup I invested in sold early just as they were hitting profitability. I thought for sure they could have been a $1 billion+ company within a few years. When I asked why they sold, the founders told me that they started the sale process 6 months earlier, and by the time the acquisition closed they were profitable. They had been growing at a compounding rate and hit profitability faster then expected, but had not properly anticipated the future.

They were so used to struggling and feeling like they were failing, they did not notice when they were actually succeeding.

4. Rocketship next door.
Silicon Valley has the occasional crazy fast exit where someone sells their company for $1 billion after a few years. This is not the norm, but if your expectations are set on these outliers you may feel like a failure even if you are doing great.

5. Constant crisis mode.
Startups are hard. Even the savviest teams face constant crisis and battles. This can cause founders to feel that they are doing something wrong or screwing up when growing pains are normal. There are ways to add process and executive bandwidth that will smooth out and delegate out these crisis points (see below).

How to deal with feelings of failing.
To mitigate feelings of failure (or prevent them to begin with) you can:
a. Find a series of mentors. Your investors or external industry executives or entrepreneurs can help coach and support you on managing, leading, and various functional areas. As you learn how to manage different team sizes, feelings of failing will decrease. Similarly, it may turn out that your instincts and actions are correct. There are certain things you will need to do at work that will never feel good (e.g. firing someone) but will be necessary. As you gain experience and feedback you will grow more confident in your abilities.

You should also do your homework. If you are hiring a general counsel for the first time, go and interview 3 great general counsel's at other companies to learn what they would look for. People in Silicon Valley are open to helping each other learn - take advantage of this network. Going in blind will both increase your feelings of inadequacy (and rightly so) but also increase the chances of hiring the wrong person or doing the wrong thing.

You will likely need new mentors and new sources of help as your company grows. At each scale of business, seek out new people for feedback, ideas, and support.

b. Hire competent executives. Having great executives in place to own functions decreases stress on you and allows you to focus on the areas you excel at. Startups are team sports and you do not need to be great at everything, you just need to hire a team that is.

Similarly, great executives will decrease the number of fires that both (i) exist and (ii) that you as CEO need to deal with directly. A deep bench is the best way to get leverage on your time, free you up to work on the things you enjoy and are good at, and to decrease feelings that you are screwing up.

c. Institute 360 feedback. Learn what you do well and poorly and have a basis for improving. Just as you may track a net promoter score for your customers, you can track what you are doing well and poorly. Do not assume you will ever be great at everything - no one is. Figure out what your strengths are and lean on your executive team for your weaknesses.

One of the great fallacies of business and management is that people think they should be great at all skills (analysis, management, organization building, strategy, deal-making, engineering, etc.). In reality, most people tend to be good or great at only a few key areas. Eventually you need to learn to play to your strengths instead of developing your weaknesses. Once your company scales, you should be able to hire people who can cover your weak spots.

d. Take a "monthly moment". Take a half day once a month to assess where the company is strategically and how it has advanced since the prior 6 months.  In a startup, a lot can happen over 6-12 months. Many entrepreneurs lose sight of this in the moment. Think through how much progress you have made and what you have accomplished. If your company is growing quickly, you will realize how far you have come in little time.

e. Get some sleep and take a break. Running on fumes makes the world seem bleak. Take a break and prioritize sleep and exercise. This will put things in perspective. Similarly, if you are making progress on another area of life (e.g. running goals, dating) it will smooth out the ups and downs of startup life.

Notes
[1] This post is meant to help with feelings of failure when things are actually going well (whether you as the CEO realize it or not). Often, a startup is indeed failing and you need to decide whether to shut down, exit etc. That is the subject of a future post.

[2] This is meant as an example. Usually high growth companies grow at e.g. 5-10X per year for the first 2-3 years and then slow to e.g. 2X at some point.

Summary
Many first time CEOs feel that they are screwing up or failing on a regular basis. This is driven by circumstance (you are thrown into new challenges every month), the difficulty of running a startup, the need to build an executive bench, and a lack of perspective. By building out an executive layer, pursuing 360 feedback, and getting sleep and perspective, you can mitigate these feelings of failure and focus on the task at hand.

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Monday, July 31, 2017

Cryptocurrency's Netscape Moment

Just as Netscape's IPO marked the real kick off for the Internet era, 2017 will be the starting gun for broad involvement of venture, hedge funds, and eventually average consumers in cryptocurrencies and related protocols and assets.

The recent run up in cryptocurrency valuations has caused a sudden and profound renewal of interest by entrepreneurs and investors in crypto[1]. In December 2013 there was a similar spike of interest in Bitcoin. As the time, there was a 10X run up and Bitcoin hit over $1000 and then crashed to ~$200. While the excitement in 2013 was largely transitory, this time feels different [2].



So what has changed?
There are multiple reasons why now is crypto's "Netscape moment":

1. Value store (AKA gold replacement) use case is becoming real.
When Bitcoin first launched, it was shrugged off as a toy. When each BTC was worth 25 cents, people would send them to each other as a novelty.

Recently, Bitcoin has emerged as a legitimate gold alternative and a hedge against the volatile times gold is often associated with. I have heard from multiple hedge funds that they have not seen the price movements in gold they have expected in "flight to safety" situations in the last 6 months. Instead, bitcoin has moved in step with what they previously expected gold to do. Bitcoin is slowly assuming the digital version of the role that gold (and gold company stocks) used to play for hedging strategies. One big impediment to BTC adoption as a large scale gold alternative is of course its own inherent volatility.

There are increasing numbers of anecdotal stories of families repatriating money, or people traveling across borders, with bitcoin. It is the only asset you can store in your brain and traverse borders

Just as there are other precious metal value stores beyond gold, there are other cryptocurrencies that are emerging as the potential silver and platinum of the market. Current contenders include LiteCoin, Zcash, and Monero [3].

2. New blockchains, technologies, and applications are emerging - growing the crypto market.
A few years ago BTC was the only game in town. While great as an asset store, BTC had a number of limitations that made it harder for developers to work with as well as limited its applications. For example, it has a hard to work with scripting language which is not Turing complete. BTC was purposefully designed with limitations that allowed it to function effectively as a value store.

Ethereum overcame a number of these limitations by providing a javascript-like scripting language which is Turing complete, as well as positioning itself as a distributed general-purpose computer, versus a distributed currency. Ethereum allows a number of more complex applications to be built on top of it. One of the primary applications of Ethereum's smart contracts is its ability to power a lot of other tokens and ICOs[4].

At this point, the argument is being made in the crypto community that any highly distributable, compute- or micro-payment based commodity should be able to be turned into a tokenized protocol. This would include things like compute (Ethereum), storage (Filecoin - a cryptocurrency with proof-of-reproducibility and proof-of-spacetime versus BTC's proof of work) but also items like power grids, wifi, and the like.

This wealth of new crypto protocols, applications, and tokens as well as newer cryptocurrencies like Litecoin, Monero, and Zcash, has driven recent developer and investor interest. In the Internet analogue, Mosaic and then Netscape allowed easier access to the Internet enabling a new class of startups (Google, Amazon, PayPal), but also a new set of developers to engage and build applications millions of people could access. Similarly, BTC's white paper and codebase has led to a whole new set of crypto projects with their own use cases and applications. While many of these have yet to be proven out, there is a lot of room for this technology to be applied.



3. New ways and infrastructure to monetize and raise money for crypto technology.
Ethereum smart contracts[6] enabled new crypto projects to crowdfund tens of millions of dollars to fuel their development and growth. These token sales are often implemented as smart contracts running on Ethereum. The ability to raise tens of millions of dollars in non-dilutive capital via an ICO (Initial Coin Offering) means that (a) some crypto efforts can avoid ongoing dilutive venture capital, (b) crypto efforts may be monetized quickly and (c) we are likely to see a fair amount of speculative investing and potentially abuse of these instruments (See SEC early response here).

The ability to raise non-dilutive capital, and in some cases cash out early, will drive a gold rush mentality as well as a fair amount of financial speculation. Coinlist is an interesting new tool in this area.

4. Outside of crypto and ML, there are few good entrepreneurial markets right now.
Every technology cycle include a period of mass focus on a handle of key areas (social, mobile, machine learning etc.). Some of these movements result in massively outsized companies (Facebook, Whatsapp, Twitter, Instagram, LinkedIn, Uber, etc.) and others fizzle out (location services, nanotech, energy 2.0). As we end one investment/entrepreneurial cycle there is often a gap in clear areas to work until the technology world hits on the next interesting area. Right now there is a major lull in mainstream software innovation. 

Given a dearth of alternative interesting large-scale markets and technologies to work in, entrepreneurial activity has accelerated in this market.

5. Some people got rich [7].
Cryptocurrency stands out as an area of interest in part due to all the people who suddenly made a lot of money in the price run up of the last 6 months. As people make tens or hundreds of millions of dollars, entrepreneurs, investors and press take notice. A lot of people are going into crypto out of ambition, greed, or simply because it seems increasingly de-risked due to ICOs and price rises.

6. Capital inflows.
We still live in a low interest rate world, with few good places for investors to deploy capital. While most institutional and consumer capital has been sitting on the sidelines for cyptocurrencies, it is now easier then it has ever been to buy and store these assets thanks to companies like Coinbase/GDAX and Kraken. Increased ease of trading in turn has driven recent adoption on a global basis.

To date, institutional investors and hedge funds have largely stayed on the sidelines. In part this is due to a lack of tools for institutions to invest and hold crypto. It is also driven by the conservative nature of most of these investors, with Abigail Johnson from Fidelity as a notable counter. Once large institutional investors inevitably move off of the sidelines and into crypto, there will be a large run up in valuation of currencies (and given the lack of savyness, probably a bunch of crap tokens will also get temporarily expensive too - see e.g. last internet bubble).

With the recent run up, over a dozen crypto hedge funds have been founded[5] since Metastable. This incremental capital coming into the industry should make the recovery from the recent crypto crash occur much faster then in 2013. However, if the past is any guide to the future, it is highly likely there will be at least one or more major corrections (e.g. 10-90% drop) in crypto prices on the way up. It is going to be a volatile and bumpy ride.

Summary
Cryptocurrencies are having their Netscape moment. Unlike December 2013, this time there is sustainable entrepreneurial and investor interest. Bitcoin has started to prove itself out as a gold alternative. New protocols and blockchains are driving a burst of innovation as well as ease fundraising via ICOs. A lack of non-crypto entrepreneurial opportunities is also driving people in. While there is a long way to go to prove out many non-currency applications, this technology and its implications are here to stay.

Thanks to David King and Avichal Garg for commenting on drafts of this post.

NOTES
[1] There are of course those who have been bullish for years now, like Naval Ravikant, Fred Wilson, Chris Dixon, Balaji Srinivasan, etc.

[2] As a random aside, I think if Satoshi Nakamoto had been a more traditional public person or founder, crypto would have been embraced by the investment community more quickly. Absent a public figurehead to run on the cover of Fortune, crypto took longer to catch on with investors than it might have.

[3] Litecoin differs from BTC in that it is memory-hard proof-of-work versus BTC CPU-hard proof-of-work approach. Zcash and Monero have extra aspects of anonymity that differ from BTC.

[4] Ethereum smart contracts have been abused in the past, leading to the split between Ethereum (ETH) and Ethereum Classic (ETC). (Hint: if you hold one consider ETH. By the way, none of this post is meant as investment advice. I am a naif in this area so do your own research.)

[5] Although a number of crypto teams are still raising seed rounds and or SAFTs to fund initial white paper design and eventual build out.

[6] The fact that many token sales are via Ethereum smart contracts is one reason ETH value has grown rapidly.

[7] This definitely seems to be the biggest driver of new VCs entering the market.

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Friday, February 10, 2017

Don't Ask For Too Much Money

A common mistake that founders make when raising a venture round is to anchor high and ask for too much money, at too high a valuation, with the hope the VC will bid them down. This is a common failure mode that prevents people from raising money successfully when they otherwise could. Asking for too much money is driven by misunderstanding the nature of a fundraise negotiation. When fundraising, you are trying to create an auction dynamic - not a 1:1 negotiation.

In a traditional negotiation, you want to anchor high and then have people bid you down. In a venture round, you actually want to do the opposite - you want to anchor low and pull multiple VCs into an auction around the company. Once a VC is emotionally engaged in the auction they will want to win against their peers. This will drive up the dollar amount you are raising and along with it your valuation (as VCs tend to want to buy a certain % ownership). In other words, the VCs will start to bid against each other and drive up your value.

A tangible example of this - suppose you want to raise a $10M series A. Rather then telling VCs you want to raise $15M (and an implied valuation of $60M to $75M post-money for 20-25% of the company), you should tell VCs you want to raise $6-7M (and thus a $24M to $35M valuation)[1]. VCs will view this as a potentially cheap company and kick off diligence, multiple meetings, and will get emotionally invested in the business and excited about the team and their prospects. Once the VC is emotionally engaged and excited, they are more likely to drive up your valuation so they can win the deal and you will get to $10M. In contrast, if you ask for $15M they will never put in the effort to get to know you and will just pass up front.

It Is Hard (Close To Impossible) To Go Back Once A VC Passes
Once an investor passes on your round it is almost impossible to go back at a lower price / dollar amount. You have already burnt that bridge. The VC has moved on to other potential investments and your company is seen as a "stale" or unattractive deal. After all, you could not convince anyone to give you money before, so that means the herd of other VCs is not interested (and therefore your company must not be great).[2]

What To Do If Everyone Passes On Valuation
If you get a consistent message that VCs are passing on you due to valuation you should:
1. Ask for additional feedback on what your company is doing and your story. Sometimes it is purely valuation, but sometimes VCs also use valuation as an excuse to pass if they don't like something else. Incorporate this feedback into your pitch and iterate on it. If at all possible, ask for this feedback over the phone. VCs will be less willing to be up front with you over email then on a call[3].

2. Add more people into the pipeline for your fundraise and go to them with a lower valuation then before. Even a $3M-4M drop in requested dollars raise can make all the difference (e.g. raising $6-7M versus $10M).

3. Iterate on (1) and (2).

If you can not raise money even after dropping your up front ask, there may be something more fundamentally at issue. Dig in and see what is turning investors off about your company.

Notes
[1] VCs tend to try to buy between 18-30% of the company in a series A with most falling between 20-25%. So, a rough rule of thumb for valuation is to multiple your capital raise by 4-5X to get your post money valuation.

[2] You can always engage with the VC at a later round e.g. 6-12 months later. You just can not go back to them for the same round.

[3] You can of course, ask a VC for 5 minutes by phone to get the feedback. Tell them up front on the call that your company culture is one of continuous improvement and getting feedback on your pitch is part of it.

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Monday, February 6, 2017

Market Caps & The 2% Rule

One way to assess whether a startup idea is in a good market is to ask what are the market capitalizations of the biggest companies in that sector. For example in consumer internet, Google ($560 billion) and Facebook ($370 billion), and in enterprise software Microsoft ($460 billion), and Oracle, ($167 billion) are all large, high margin businesses.

Market caps in a pre-existing industry[1] tend to be proxies for the potential of the idea you are working on. There are three reasons for this:
1. The market capitalization of a set of companies reflects revenue in the market, growth rate of revenue and earnings, and the margins of the companies.
These core metrics used by wall street to value a stock are all metrics that help you understand whether a market is overall large, growing and profitable - all signs of a good market to enter.

2. Often, potential competitors are also potential acquirers. 
Having a large number of high valuation potential buyers in a market creates strong exit opportunities for a startup. For example, for Google to pay $1 billion for a company, it is only 0.2% of its overall stock or market cap. In other words, Google can afford a lot of acquisitions in the $100 million to $1 billion range.

In contrast, the US car rental business is a tougher one. There are 4-5 major players. The largest by far is Enterprise, with $20 billion in global revenue and a $20 billion market cap. The remaining players are much smaller ranging between $1 to $5 billion in market cap. The key characteristic of these companies is that they trade at a low multiple of revenue (e.g. Enterprise trades at 1X revenue) suggesting low growth and a competitive, low margin, market.  Starting a traditional car rental company therefore may be a tough endeavor. Starting a software company that only sells its product to car rental companies also seems like a bad idea - you only have a few potential customers who will each have lot of bargaining power.

3. Strategic investors.
Large, high market cap, cash rich companies tend to be great strategic investors at the later stages for a company. This valuation-insensitive capital can help accelerate a company by giving it a large war chest to act on. For example, GRAIL, an early cancer detection company is raising over $1 billion for its series B. I would not be surprised to see a number of pharmaceutical companies, payors, and health networks participating in this investment round and investing e.g. $100M+ each.

Early Markets Can Be Misleading
The hard part about this approach is defining the real market you are in and the companies that make it up. You can also be fooled by smaller, nascent markets that grow really fast. These are the best types of markets to be in. For example, the consumer cloud storage market when Dropbox started was itself not a large market yet, but clear potential buyers like Google (who had a cloud storage product internally for many years that never quite could launch for some reason), Microsoft and Apple were clearly relevant and in the same general market area. Dropbox recently claimed $1 billion in revenue.

At founding, was Uber a black car company? A taxi company? Or a replacement for transportation and buying a car? If you thought Uber was just a black car company (which in some sense it was at founding) the overall market size seemed middling. Even as a rental car replacement the market size is small and the potential buyers for it like Avis, Dollar, and Hertz range in market cap from $1.5 to $5 billion. This means, with the exception of Enterprise, it would have been tough for any of these other companies to pay $1 billion for Uber. In contrast, thinking of Uber as a replacement for cars (GM alone has a market cap of $50 billion and car makers in general are worth hundreds of billions in aggregate) means Uber has enormous potential especially given its lower fixed costs and higher margins. If reframed as a technology company, Google et al. become potential acquirers and potential market value is even higher. It is therefore no surprise Cruise was bought by GM for around $1 billion - this is 2% of GM market cap and therefore worth the dilution by GM relative to the potential upside (and cataclysmic downside if self-driving cars happen and GM is not a player).

New, high growth markets are also hard to assess. For example, when Google was founded the internet was a much smaller place. So looking at the market capitalizations of search engine companies would be a bad proxy overall. However, if you viewed Google as an ads business, or as a technology business, it became more attractive due to the market caps of companies back in 1998 such as Microsoft, IBM, Time Warner, and others.

M&A: The 2% And $1 Billion Rule
In general, you want to be in markets where multiple companies could afford to buy you for $1 billion, or where 2% of their market cap is at least in the hundreds of millions of dollars.

For example, Walmart's acquisition of Jet.com for $3.3 billion was around 1.5% of its market cap, Cruise's $1 billion acquisition was 2% of GMs, and Unilever's acquisition of Dollar Shave Club was slightly under 1% of market cap. Above a few % of market cap, the nature of an acquisition and its approval by the company's board becomes a dramatically different conversation.

Thanks to Ali Rowghani for comments on a draft of this post.

NOTES
[1] Versus a new industry, which is addressed above.

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Saturday, February 4, 2017

Building VC Relationships

A common mistake founders make is to try to meet VCs to "build relationships" a month or two before going out for a series A or series B fundraise[1] . I explain why this is a mistake below. If you do not have strong VCs relationships and plan to fundraise in 2-3 months, wait to talk to VCs until you go out to raise. Do not do a separate "get to know you" tour. If you plan to go fundraise in 12 months, you can start to build select VC relationships early with a handful of firms.

VCs Remember Most Early Interactions As Pitches
Investors at top tier VCs are constantly deluged with a stream of companies wanting to pitch them. If an investor meets *only* 3 to 5 new companies a week, she is meeting with literally 150 to 250 companies a year. As such, it is unlikely she will remember every nuance of why and how you are meeting - and will default to remembering your meeting as a pitch. Additionally, relationship-building meetings a month or two before a real fundraise in reality often turn into a half-cocked fundraise. You are not really fundraising, but you really sorta are, even if you tell yourself otherwise.

For a VC round you need to have a well-rehearsed, pressure-tested pitch ready to go. You not only need to wow the investor in the first 5 minutes, but create momentum around an active fundraise. Going in half-baked will only backfire.

You also want the timing dynamics of a fundraise properly in place - e.g. if the VC is super excited about you, she will press for you to come meet with the partnership and your company will not have a competitive process in place. If she is not super-excited, she will think of your company as a "pass" and will decline to engage 2 months later when you have your materials and pitch honed. Either outcome is a loser from a fundraise perspective.

If You Want To Build Relationships, Do It 6-12 Months Before A Fundraise

If you want to build VC relationships early, choose a small number of select firms you want to get to know. If you talk to them 6-12 months before a fundraise, enough will have changed with the company since you last spoke that they will want to engage for your actual raise. Some general rules of thumb:

  • Choose which partner you would want to work with eventually - and get introduced only to her up front. VC firms have a relationship management system where the first person who meets a company becomes that company's lead (in some cases in perpetuity). This is crucial, as you are largely stuck with that person as point of contact going forward. If she ends up being a bad advocate for you, you will not get funded by that firm. Ask for intros only to the partner you would want to work with at a given firm.
  • Don't meet with too many VCs. Meeting VCs can become a full time job. Between the travel time to Sandhill / SOMA and the meeting prep VC meetings can take a lot of time. Choose the 4-5 people you really want to stay in touch with, and then meet with them every 6-12 months.
  • Learn to say no. Once you make the VC relationship, that investor may want to meet more frequently then you do, to introduce you to their portfolio companies[2], or otherwise engage. It is OK to reply with "I am heads down on product right now but happy to engage later when I come back up for air".

VCs (Usually) Won't Invest Preferentially In Friends
I have seen entrepreneurs build incredibly deep relationships to firms - who then never invest in the founder. A common message from a VC to an entrepreneur who is not fundraising is "my partnership loves you, and loves what you are doing - we want to fund you anytime". Unfortunately, this message often ends in tears when you go out for an actual fundraise if your startup does not have the traction to get funded. VCs make business, not personal, decisions around investing. They also need to convince all their other partners to invest in you and do not have unilateral decision making. It costs them nothing to emphasize how much you should really talk to them when you decide to raise money. Would you give any friend of yours $10 million just for being a friend? If not, why would a VC do that? Don't be deluded by the VC friendship.

NOTES
[1] I truly mean series A and later venture funds here. Angel fundraises are different and you can talk to them early if you want to suss out the landscape. Even there, I would limit conversations to a handful of folks. You do not spend all your time in meetings instead of building a product and team.
[2] VCs may sometimes do "blind intros" to other companies in their portfolio for you and that company to partner or work together. Most startup to startup intros are a total waste of time from a partnership perspective.

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