Optimism and the Brazilian Online Market

I attended a get together organized by BayBrazil last night.  Lots of members of the Brazilian startup community are in town for TechCrunch Disrupt and the atmosphere was great.   I expect the same at the StartupiCon event on Thursday night.

It’s fun to see hard-working Brazilian entrepreneurs (and investors and mentors etc.) in the Valley/San Fran environment – there is something energizing about it, it provides a morale boost.  Anything seems possible here and entrepreneurialism is king.

The amount of quality Brazilian startups here proves how dramatically the startup ecosystem has improved in the last few years.  Several of the pitches I saw last night would fit seamlessly into the Y Combinator Demo Day I saw last month.

One big cloud hangs over my optimism, however, and there is insufficient discussion about it: the customer market for Brazilian startups remains small.

I am not talking about the size of the Brazilian economy, which is huge.  I am talking about the number of people who use and PAY FOR new online products and services.  We hear a ton in the news about the large size of the Brazilian market, the growth of the middle class, improving infrastructure, etc. — all true, all important — but the real size of the paying online community in Brazil is still extremely small.

Yes, people buy shoes and clothes online but, outside of that, we still don’t know when and where other parts of the online market will grow, nor how big it will actually be.

For the moment, the market for new online product and services is thin.

It’s true that startups face less competition in Brazil – in any given niche, there may be two or three competitors versus six or seven in the US – but the true market for those three competitors is proportionally much smaller than the market for the seven competitors in the US.

It is better to have seven competitors in an addressable market of 50 million users than three competitors in a market of 10 million users.

I don’t think anyone, including me, truly knows how large the online market will be in Brazil, what will people pay for (outside of normal retail goods), nor when they will start paying for it.

I am an optimist (come to think of it, maybe that what is in the air this week: optimism) but a lot of positive assumptions about the Brazilian online market remain unproven.

Vamos ver…

A War of Tweets Breaks Out

A war of  tweets broke out between Dave McClure, Fred Wilson, Mark Suster and some other high-profile VCs this week.

The subject involved Convertible Notes and whether different investors in the same convertible note should have different valuations.

In sum, Dave thinks they should, depending on when they invested in the note and how much value they bring to the company.

His point is that 1) an investor that comes in first deserves a discount for “leading” the round and 2) later investors in the same round often enter when the risk of the investment has lessened.

Regarding #1, I can see how an investor that has the courage to jump in first and “lead” a round should get a discount; only, however, if the company is having trouble getting others to commit.

Regarding #2, can a company reduce its risk so quickly that, during the funding process, the valuation changes measurably?  I guess so: notes are held open for a long time nowadays and, logically, if the risk profile changes, the valuation should as well.  But this approach can make things very complicated (imagine eight investors in the same round with eight different valuations).

There is also the argument that certain VCs deserve a discount because of their brand, i.e., a ” big name” investor has a positive effect on a company’s value and that VC should therefore get a discounted valuation.

Again, this feels awkward but makes logical sense.  Using the public markets as an analogy, if Warren Buffet buys a stock at $10 per share, the perceived value of the stock will immediately rise and subsequent investors, even ones that invest ten seconds later, will pay a higher price.

The bigger message of the debate is that, although we VCs like to think of ourselves as edgy financiers of creative destruction, it is now our industry that is being disrupted.   At the moment, it is Paul Graham, Dave McClure, AngelList, etc. but soon it will be…  who knows?  I do know that all of venture capital’s established practices will be thrown on the table, spotlighted and battered with the mallet of innovation.  Best practices will endure, all others will die.

Regardless, there is no need to worry about missing the action: in the venture world, “the revolution will be televised tweeted.”

“And Now for Something Completely Different…” Graffiti Brasil

Over the years I have become fascinated with street art (“graffiti”), especially in Brazil.  For some reason, the street art here blows away most of what I see in the States. Perhaps it is just more prevalent in Brazil or in more obvious places, I don’t know.

Graffiti in Brazil is a deep world, involving political, social and economic issues, which makes it all the more compelling.

Below, I posted some links and some recent photos I took.

At War With São Paulo’s Establishment, Black Paint in Hand

The graffiti culture of Brazil

GRAFFITI BRASIL

Lei descriminaliza grafitagem e proíbe venda de spray a menores

Murais de grafite em prédios de São Paulo são patrocinados pela GE

Is Your Company a Feature, a Product or a Business?

In these days of multiplying startups, it’s useful to divide companies into three categories: features, products and businesses.

A feature is less than a product and nothing close to a business. Using LinkedIn as a very rough example, the “advanced search” that you get with an upgraded account is a feature.

A product is more robust than a feature but not enough to be independent business.  An example of this would be LinkedIn’s “Talent Finder” product for Recruiters. Good stuff but, on it’s own, not terribly differentiated; it would not make an interesting investment.

A business is LinkedIn. It’s a huge platform of information on top of which the company builds products (with cool features) for which many people pay.

A lot of features can evolve into products and eventually into businesses — the problem is that it takes time and a lot of other people are doing the same thing.

I had an “uh-oh” moment (kind if like an “ah-ha!” moment but bad) a year ago when I looked at the “Share This” button and saw at least fifty “sharing” products (read: features), all with cool names, probably all with hardworking entrepreneurs, tech talent and many with investments from angels.  How could there be enough users, I thought, for even half of them?  How could there be enough acquirers for more than a few of them?

Two years later, other than the Tweet, Like, LinkedIn and (now) the Google + buttons, most are gone or somewhere out there “pivoting”.  The same fate awaits most of the features and products that are currently masquerading as businesses.

Weak features/products die from lack of usage; strong ones get extinguished by stronger competitors.   If a competitor has more resources (money, developers, users, etc.) and they can build the feature, they probably will.  And they probably will before you scale enough to beat them and before they need to buy you at an interesting price.

Of course, there is an alternative to win it all or die.  Look at the offline world for analogies.  Below the Fortune 5000, there are tens of thousands of good business that generate cash for their owners but will never “win” their markets, scale or have an exit.  The same will exist in the online world: below the Internet 5000, there will be thousands of decent businesses — the online version of restaurants and dry cleaners.

Below those businesses, however, there will be tens of thousands more that die, just like in the offline world.  The business pyramid is narrow at the top and wide on the bottom.

Despite some recent posts (like this one) that might seem negative, I’m not.  Evolution (of species, economies, businesses, etc.) works in cycles, often with periods of explosive growth followed by periods of large-scale extinction.  In the Information Age, these cycles tend to happen quickly, one after the other (think fruit-flies, not mammals).  The Internet ecosystem is in a period of explosive growth; at some point there will be an overpopulation problem, a shortage of resources (customers, users, money) and we will have large-scale extinction.  The strongest businesses will survive and, hopefully, the entrepreneurs and investors that didn’t make it will start over and try again.

Regardless, despite the ebbs and flows of the startup ecosystem, there is ALWAYS a place for good businesses, offline or online and there are lots of those being built everyday, in Brazil and elsewhere.  Many of those online businesses address large markets, are capital efficient, can scale quickly and have quality teams.   If you fit that description, I’d appreciate the chance to talk to you.

Silicon Valley – Brazil Accelerator

There is a new accelerator for startups that want to enter the Brazilian market.  The first part of the program would take place in Silicon Valley/San Fran, the second part in Sao Paulo.

The accelerator is for internet-based businesses from, well, anywhere: Brazil, America, doesn’t matter.   It seems like companies would receive fairly intense assistance, which I think is a good idea, given the challenges of doing business in Brazil.

Even if you are not accepted into the accelerator program, there may be co-working space available in the Valley/San Fran and perhaps in Sao Paulo.  This would be good for learning, networking, etc.

If you have an interest, they have a signup page here.

History Repeats Itself: the Internet Boom and Bust 2.0

The venture market in the United States is in a bubble.  In the US, including (especially) in SV and NY, valuations for companies at every stage are way too high.    Because most of these companies have no revenue, it is not possible to quantify how high but, if you do the math, there will simply not be enough exits at a high enough multiples to provide sufficient returns in exchange for the risk being taken.

Yes, the problem is worse in basic consumer businesses (B2C) than in enterprise businesses (B2B) but the problem is in pretty much all Internet verticals.

I feel more and more like I am re-living Web 1.0 – the Dotcom boom and bust.  I was part of building and investing in a VC fund beginning in early 1997 – we caught the wave and the fund did 90%+ IRR net of fees – this is top tier for VC returns.  It was useful because I witnessed how a VC fund can be successful.  I left for AOL later but my former colleagues – pretty much the same team of extremely smart and talented people – did the same thing with Fund II and it returned $0 because the bubble popped.  So I witnessed how a VC firm could fail.

So you can be smart and good but, with a traditional VC fund, timing matters.  (Timing matters in all investing but moreso in a fund that must be deployed over a fixed five-year time span.)

Some other indicators of a current bubble: the proliferation of “accelerators”.   You had the exact same thing happening during the Web 1.0 bubble – just substitute the name “incubator” for accelerator.   Some of these incubators even went public, then became penny stocks, then got delisted, then went bankrupt.  They all had promising startups inside which, in retrospect, were interesting ideas or products but not actual businesses, at least not sustainable businesses.

Instead of building businesses, the game was a chase to be acquired or, in Web 1.0, go public.  The same is true now.

Economic markets run on fear or greed and we are currently in a “greed” phase.  The Facebook IPO will only increase the frenzy.  Many people who were at FB at the right place at the right time will believe they are smart and either start new companies or become angel investors, which will make the bubble worse.  Again, substitute “AOL” for Facebook and you can see Web 1.0 all over again.

The only difference between the dot-com (Web 1.0) and this bubble (web 2.0) is that web 1.0 included inflated valuations in the public markets. The high prices in public stocks and the ease of going public led to huge valuations in private (VC) markets.  When the public market bubble popped, it immediately popped the private market bubble, since the latter’s valuations were based on assumptions of public market multiples.

The Facebook IPO will be the moment when the Web 2.0 bubble officially comes to the public market and it will be the beginning of the end of this cycle.  It’s not that FB isn’t an incredibly valuable company – it is – the issue is the psychological impact of the IPO on valuations and exit assumptions in general and, again, on the companies and investors lower down the chain.

Right now, the web 2.0 bubble is “trapped” in the private markets and, because it has been trapped in non-liquid markets, it has been hard to quantify just how big the bubble is.  Now, however, the bubble will float up into the public markets.  In the full light of the public markets – liquid markets that require disclosure and quarterly updates, etc. — it is a matter of time before valuations correct.

As an aside, many people have argued that we are not in a bubble because the public markets for tech stocks are not inflated.  This is ridiculous – just because private tech companies have not had access to the public markets, because they are receiving private financing, does not mean that their valuations are sane.  In fact, it is the opposite – a lack of liquidity, transparency and comparables in the private markets leads to the inflation of valuations.

Anyway, since access to the public markets for internet companies has been shut off for many years, we have a huge pent up demand for liquidity in the private venture market.  Dozens of tech companies are lined up like trucks in refugee convoy trying to get to the IPO border.   Investment bankers are once again at the wheel as the SEC directs traffic and public market investors prepare to dump bags of money off the back of trucks and helicopters.

You can’t outrun reality, however, and every business is a function of its current and future cash flows – at some point, the private and public markets will realize that, for most internet companies, the cash flows don’t currently exist and won’t ever exist.

One might ask why the bubbles hasn’t been worse or faster-inflating.  First, a lot of people over 35 remember the dot-com bust – these memories have provided a useful governor on the engine of hype.  Second, we are in the worst economy since the Great Depression – which has dragged on growth even in tech investing.

In sum, for all the negativity in this post, I still believe in venture capital, in early-stage investing and in the future of the US (and Brazilian) ecosystems.  Markets run in cycles, it is natural. We are near a peak right now — so what?

For entrepreneurs, there will always be a place for creating companies with products/services for which many customers pay.  There is as much opportunity to create great businesses as there ever has been in the history of the world.

As for investing: the best advice I ever got in football, maybe in life, was to “Focus only on things you control”.  Simple to say, hard to do. The amount we control is far less than we believe moment to moment.  The point is: ignore the outside noise, cultivate your core investment thesis and execute against it.

Jim Collins – Great by Choice

I have long felt skeptical about business books, especially quasi-self-help books that state common sense with an air of discovery.

Typically, even in the best business books, the 80/20 rule applies: 80% is either recycled truisms or common sense, 20% (or less) is new or interesting.

Soft science, e.g., lack of quantitative analysis often damns these books to mediocrity.

In my opinion, one notable exception is Jim Collins.  Someone recently gave me a copy of his most recent book, Great by Choice, and it is valuable.  Collins and co-author Morten Hanson base all of their writings on rigorous quantitative analysis.  Not all of their writings apply to startups but all of their findings are valuable.

Below is an outline of the book that I made for an internal presentation.

Great by Choice

10X Leadership:

Collins and Hanson studied a group of companies that provided shareholder returns at least 10X greater than their industry peers over a long period

Leader of 10X companies (“10Xers”) share a set of behavioral traits—fanatic discipline, empirical creativity, and productive paranoia—all held together by a central motivating force, Level 5 Ambition

Fanatic Discipline

10Xers start with Values, Purpose, Long-term goals and Severe Performance Standards and apply Fanatic Discipline to adhere to them.  All of their actions are consistent with those Values, Long-term goals, Performance standards.  10Xers are relentless, monomaniacal

Empirical Creativity

In confused environments, 10Xers do not look to other people but to empirical evidence  to drive their decisions

They use empirical evidence to create boundaries, within which they take bold risk

Empiricism as the foundation for decisive action

Productive Paranoia

10Xers practice hyper-vigilance even in good conditions

They believe that events/markets will inevitably turn against them and they prepare for that time

Level 5 Ambition

10Xers channel their ego into something larger and more enduring than themselves

Their ambition is for the cause, not for themselves

20-Mile March:

The 20-mile March is a set of concrete, clear, intelligent and rigorously pursued performance mechanisms that keep the company on track

One set of metrics creates a floor, a lower bound of performance not to go below and another set of metrics create a ceiling, an upper bound not to go above

If they miss the 20-Mile March metrics, 10Xers are obsessed with getting on track, no excuses

Consistently achieving the goals of the 20-Mile March builds confidence in the organization

External environment is impossible to predict and out of their control; the 20-Mile March gives the company an internal locus of control

Fire Bullets, then Cannonballs:

It is not necessary to be more innovative than your peers

Only 9% of pioneers end as final winners in their market

You must be innovative above a certain threshold but beyond that it doesn’t necessarily help

Fire bullets, then cannonballs

Fire bullets to figure out what will work

Once you have empirical evidence based on the bullets, you concentrate your resources and fire a cannonball

[Note: the Lean Startup method follows this system]

Example: The iPod was a bullet, derived from some empirical evidence, that led to more empirical evidence; then they fired a cannonball: iTunes and iPod for non-Mac computers

What makes a Bullet:

Low cost

Low risk – minimal consequences if the bullet goes awry or hits nothing

Low distraction for the overall enterprise (okay to be a high distraction for an individual)

10xers have a much higher rate of calibration before firing Cannonballs (69% vs. 22% for peer group) – example of using empirical evidence to drive decisions and contain risk

Calibrated cannonballs have a 4x higher success rate than uncalibrated (88% to 23%)

There is a danger to achieving a hit with an uncalibrated cannonball: good outcomes from bad process reinforce bad process

10xers make mistakes but learn and return to empiricism; only fire another cannonball with empirical validation

“In the face of instability, uncertainty and rapid change, relying upon pure analysis will likely not work, and just might get you killed. Analytical skills matter, but empirical validation matters much more.”

“That is the underlying principal: empirical validation.”

(Note: Lean Startup Method again…)

You don’t need to be the one to fire all the bullets, you can learn from the empirical evidence of others.

“More important than being first or most creative is figuring out what works in practice, doing it better than anyone else, and then making the most of it with a 20-Mile March.”

Questions to ask before firing a cannonball:

How can we bullet our way to understanding

How can we fire a bullet on this matter

What bullets have others fired

What does this bullet teach us

Do we need to fire another bullet

Do we have enough empirical evidence to fire a cannonball

10xers fire a significant number of bullets that don’t hit anything; they didn’t know ahead of time which bullets would be successful

Failure to fire cannonballs, once calibrated, leads to mediocre results.  The idea is not to choose between bullets or cannonballs but to fire bullets first, then fire cannonballs.

Leading above the Death Line:

Productive paranoia 1: 10Xers build cash reserves and buffers before disasters happen

Productive paranoia 2: contain risk; 10Xers took less of these three risks:

- Death Line risk – failure would result in the death of the enterprise

- Asymmetric risk – the downside of failure is greater than the upside if successful

- Uncontrollable risk – risk completely out of the company’s control

10Xers also manage time-based risk – if risk is growing with time they act

quickly

 “Sometimes acting too slow increases risk.”

if the risk profile is changing rapidly, then the speed of decision-making must increase. 

Zoom out, then Zoom in:

10Xers remain obsessively focused on their objectives and hypervigilant about changes in their environment; they push for perfect execution and adjust to changing conditions

Zoom Out:

Sense a change in conditions

Assess time frame: how much time before risk profile changes

Assess with rigor: do the new conditions call for disrupting plans? If so, how?

Zoom back In:

Focus on Execution of plans and objectives

Not all time in Life is Equal

Some moments matter more than others

SMaC – Specific, Methodical and Consistent metrics

“We’ve found in all of our research studies that the signature of mediocrity is not an unwillingness to change; the signature of mediocrity is chronic inconsistency.”

Return on Luck:

“Resilience, not luck, is the signature of greatness.”

Who Luck – one of the most important types of luck is finding the right people then building a mutual risk your life relationship with them

Summary:

10Xer behaviors - fanatic discipline, empirical creativity and productive paranoia; Level 5 ambition, never relax when blessed with good luck

20 Mile March

Fire Bullets, then Cannonballs

Return on Luck – 10Xers don’t cause their luck, they increase the chance of stumbling on something that works by firing lots of bullets, then using empirical validation before firing cannonballs

Leading Above the Death Line - They manage three types of risk to shrink the odds of catastrophe

Zoom Out, then Zoom In

Old School Venture Capital

LAVCA recently hosted an event at Monashees for venture capital fund managers, limited partners and service providers.

Most of all the VCs currently active in Brazil were in the room, which was cool, and it made for an interesting discussion.

One of the things we discussed was the size of a typical venture fund’s investment portfolio in Brazil, to whit: it’s smaller than in the US. That matters, because small portfolios increase risk (it concentrates the fund in a smaller number of companies, so if one fails it disproportionately impacts the fund.)

Portfolios are smaller in Brazil not just because funds are smaller here, nor because there are less companies per investor. It’s because, on average, an early stage company requires more time invested by the VC. One fact everyone learns in Brazil, the distance from business conception to market penetration is greater here than in the US. It takes more time, more resources, more perseverance.

Add to that the fact that many entrepreneurs are building a company for the first time and you will see that VCs need to spend more time per company than a VC in the US does.

In the US, the VC can make portfolio construction decisions assuming that, for most of his companies, a board seat plus a phone call every couple of weeks provides sufficient support. This allows them to put together a portfolio of investments numbering 30+ companies relatively easily.

In Brazil, if a VC puts together a 30-company portfolio in a short period of time, he will spend his days and nights putting out fires, fielding panicked phones calls and wishing he had gotten a job at Petrobras like his parents advised.

What’s the solution? Time and experience, both for entrepreneurs and investors. Aside from that, for early-stage investors, some form of shared space, incubation, acceleration, etc. is more than an interesting strategy, it’s essential. In the majority of cases, an early-stage investor in Brazil needs to be proximate to his companies until those companies achieve stability. Of course there are exceptions, and thank goodness for them. In general, however, I think early-stage funds will find that some form of shared space with most of their startup portfolio companies is a must.

In a way, that’s cool. At the LAVCA event, an attorney from K&L Gates, who has been in the business for many years, made the point that what is happening in Brazil is “old school” venture capital. In the early days in Silicon Valley, the pioneering entrepreneurs and investors did not have experience or examples to follow. They were joined at the hip in a new, risky, experiment. By necessity, the VC often took quasi-management roles – business development, operations, HR, etc. – to help his companies survive. Things are like that now in Brazil. It’s tough but it’s fun and, in some ways, it’s how early-stage VC should be.

What about New York?

Should Brazilian Startups Move to Silicon Valley?

I just got back from a couple of weeks in NY and Silicon Valley.    The NY startup ecosystem is booming and Silicon Valley is, well, Silicon Valley – cutting edge, best of class and incessantly innovative.