Posted: December 12th, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital | No Comments »
Last week I was one of many speakers at a BRNewTech event, the meetup organized by Bedy Yang, Flavio Pripas, IN Hsieh and Marco Fisbhen.
Each of us were asked to speak about 2011 and make predictions about 2012. Below are my notes about 2011:
- Kudos to Bedy, Flavio and Marco for creating BRnewTech — it is not the only startup community in Brazil but it is the biggest. It serves the critical role of providing community for entrepreneurs, investors and other members of the ecosystem here.
- Honestly, things changed so much and so rapidly in 2011 that it is hard to remember 2010. 2009 is a distant dream. As recently as 2010, many people questioned where there was a place for venture capital in Brazil, in part because they questioned whether there were enough entrepreneurs. That now seems like a ridiculous concern. Anyway, 2009 and most of 2010 was about private equity. 2011 has been about venture capital.
- I estimate 3x the number of investors and 3-5x the number of entrepreneurs in the market this year over last year. That's incredible.
- 2011 marked the year that the Brazilian ecosystem completely integrated with the American ecosystem — prior to 2011, they were two distinct ecosystems, now investors and entrepreneurs overlap in a very thorough way.
- 2011 was the year of the clone. In prior years, many businesses were similar or derivative to businesses in the States but they were organic/native to Brazil. In 2011, most new businesses were exact copies of businesses in the States or Europe.
Posted: November 12th, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital | 12 Comments »
I can’t tell you how many times I’ve heard that “Brazil doesn’t have enough good entrepreneurs”. I’ve never believed it. Brazil has plenty of entrepreneurial talent. Many of these entrepreneurs choose non-entrepreneurial paths, however, because of the high risk of starting a business in Brazil.
Specifically, punitive Brazilian bankruptcy laws make the cost of failure so high that many people prefer not to even try the entrepreneurial path.
Bankruptcy laws are complex but suffice it to say, declaring bankruptcy in Brazil causes many years of problems for an entrepreneur. Basically, he cannot take ownership of another company for at least two years and active threats from the bankruptcy loom for at least five years.
Of course, the cultural stigma of failure also hurts but that is a concept of the mind rather than a tangible problem like the liabilities that arise from bankruptcy.
Unfortunately, onerous bankruptcy laws force entrepreneurs to stay with losing ideas. Instead of closing their companies and applying their experience toward new and better projects, entrepreneurs get trapped in failing businesses — they simply can’t afford to close them because the cost (and stigma) is too great.
This “failure trap” has a devastating effect on innovation – it prevents agility and hobbles the entire venture ecosystem. Gates might have spent his career on on Traf-o-Data and Steve Jobs on the Lisa computer if they could not cut their losses and move on to Microsoft and the Apple II.
We are succeeding despite this trap but imagine the innovation Brazil would have if it were eliminated.
Posted: October 22nd, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital | 4 Comments »
Clones have overrun Brazil.
The country is currently awash in copies (“clones”) of US business models.
As recently as 18 months ago, “cloning” in Brazil was still relatively new or, at least, much less widespread. Now, it is rare to find a Brazilian startup that is not an intentional copy of a company in the US (or, in some cases, Europe).
The speed at which US startups are cloned is remarkable: a company from Silicon Valley receives attention on Techcrunch one day, the next day two clones form in Brazil.
Is there anything wrong with this? Absolutely not. In fact, in many cases, a clone has less risk because the concept has already been proven in the US; even if the concept has not yet been proven in the US market, it often has the imprimatur of smart money investors.
In fact, one of the first questions VC investors ask a Brazilian entrepreneur is whether a version of their company exists in the US. If no model exists in the US or Europe, it raises a concern. This may be unfair but, because the pace of technological and business innovation is higher in the Valley and New York, it makes sense that good ideas would normally arise there first.
Here are the good and bad of clones as I see them.
Good:
- Reduced concept risk: the clone starts out with a model that already has some market or investor validation.
- Reduced strategic risk: a roadmap for market penetration has often been written by the initial innovators; the clone just needs to follow the formula.
- Exit strategy: in many cases, the clone has a more obvious exit: in the event that the predecessor in the US wants to expand into Latin America, it will often be easier to buy the clone than start from zero in Brazil.
Bad:
- Competition: there is a disadvantage to not having your own innovative idea. A truly innovative idea creates a distance between the startup and would-be competitors (example: Twitter) that can greatly increase the chances of success. By definition, clones don’t have that distance.
- Execution: because the company does not have an innovation advantage, clone entrepreneurs have less “margin for error”: normal entrepreneurial mistakes can cost a clone its life. Just ask the dozens of "group buying" companies that started early enough to win the market but now are out of business. The best cloners are the best executors, the best executors are the best cloners.
- Execution in Brazil: “Brazil is not for amateurs” and most foreign businesspeople learn the hard way that doing business in Brazil is very, very difficult. For example, logistics and managing the supply chain for an ecommerce business in Brazil is much harder than in the US…
- Capital: investment capital is a helpful weapon for startups but, in the case of clones, it is essential. Money pays for rapid expansion (marketing, hiring, etc.) that creates the needed distance from competitors. Lack of money means you will be left behind.
- Value: the most valuable companies are not clones. Apple, Google, PayPal, Facebook, Twitter: they were “derivative” – everything derives from something before it – but they were not clones. A clone is a copy: these companies innovated to win their markets.
Expanding on this point: the most valuable, sustainable companies tend to be platforms and platforms don’t lend themselves to cloning. Most clones choose B2C ecommerce businesses for a reason: they are relatively simply to copy. But that also means the barriers to entry are low: to win, you need to spend a ton money on marketing and execute, execute, execute. Building a “platform” (see the companies in the previous paragraph) requires more than money and execution.
Exit type and value is also different: platforms can IPO, clones usually (not always) need to be acquired. The former usually results in greater returns than the latter.
In sum, there is absolutely nothing wrong with clones. Clones can make great investments for VCs and many clones in Brazil will make a ton of money. We will be investors in some clones. There are downside risks to cloning, however, and an entrepreneur should understand them before launching a clone.
Posted: October 20th, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital | 2 Comments »
I thought I'd share an internal email that I sent to the Arpex team today — it was in response to a longer email from one of our partners in which he shared his perspective on venture investing in today's environment.
I agree with what __ said and would add the following perspective:
– venture capital investment works in cycles — the current cycle in Brazil is becoming a bubble, in the US it is already a dangerous bubble
– in a bubble environment, there is a deal frenzy, with VCs scrambling to invest in the latest hot company without full consideration of business model or valuation
– i remember very well the "Dot-com" bubble and can name 30 companies from Web 1.0, with great teams, great investors and a lot of "buzz" — these were companies I wished I could invest in — that went bankrupt within two years (2000/2001)
– now, in Brazil, there are many companies that have investor interest and lots of buzz. As opposed to Web 1.0, these Web 2.0 tend to have less capital requirements and burn less cash — this is a good thing BUT, in many cases, these companies are not truly companies, but rather a single application or feature masquerading as companies. This means that it is unlikely that they will ever grow to a size necessary to achieve a meaningful exit. They are especially unlikely to achieve a meaningful return if we invest at a high valuation.
– in bubbles there are always many smart people who say there is no bubble and explain why "it's different this time". It is never different. Yes, technology changes, business models change, tactics changes but business principles don't change — a good business is a good business, a weak business is a weak business. the former will survive and the latter will eventually die.
– the best investments are in companies that don't need investments
– the best investment are in verticals that we understand well — become an expert in a given vertical and you will find (or create) good businesses in that vertical
– Arpex's managing partners are different people and therefore sometimes we do not think exactly the same about what deals we like –that is a good and important thing. We will always, however, come to an agreement before we allow Arpex to invest. So, while I probably take a more US/Silicon Valley perspective in the style of prospecting and the type of deals I like, we all agree on the companies that we invest in.
– I learned this principle some years ago and it has ALWAYS been true and always will be true — it is probably the most important principle of investing: Great deals don't find you, you find them.
Abs,
T
Posted: October 14th, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital, US Venture Capital | 4 Comments »
Last week I wrote that, out of the universe of good companies, only a tiny percentage make a good investment because most companies lack the potential for rapid growth.
That said, here are some exceptions/qualifications to the "rapid growth" requirement.
1. Growth Is Insufficient — a Company Needs "Scale".
Rapid growth implies speed but "scale" implies speed, breadth and efficiency. For example, a popular restaurant can "grow" extremely quickly — as quickly as a web-based business — but most VCs don't invest in restaurants.
Why? Because restaurants don't "scale": it's complicated to open new restaurants — to identify the right location, renovate the physical space, hire a new staff, etc. Each new restaurant requires a significant investment.
On the other hand, internet-based businesses can expand rapidly, efficiently and broadly with relatively little additional investment. Another way of saying it is that internet businesses have much less "friction" than offline businesses (e.g., restaurants).
2. Market Size Matters.
It is possible for a business to have excellent growth and a scalable infrastructure but still not make a good investment. For example, a company that drop-ships books written in the Tongan (south-Pacific) language can grow efficiently and quickly — assuming a sufficient demand for books in Tongan.
The business, however, will never get large enough to achieve a significant exit because the market for books in Tongan is too small (there are about 200,000 Tongan speakers). The small market size prevents the company from being investible, despite the potential for rapid efficient, growth.
3. Gross Return Matters
This point relates to #2. Let's assume that a $50,000,000 fund makes a seed investment of $30,000 in the Tongan bookseller.
In two years, the bookseller is acquired for $90,000. The investment achieved a 83% IRR — excellent — and yet the investment was a complete waste of time and money.
Why? Because an investment that returns $90,000 for a $50,000,000 fund is meaningless. It represents 0.18% of the fund. The investor would need 555 of these investments just to "return the fund", i.e., to generate $50,000,000.
Most VCs look for an investment to return a minimum of 50% of the fund. Any investment that, even if successful, would return less than 50% of the fund is not considered.
This is not always true but it is a good rule of thumb.
4. Risk Matters.
Simply put: the higher the risk of an investment, the higher the IRR required in order to compensate for that risk. The lower the risk of the investment, the lower the required IRR.
A social network that has already captured 50% of its addressable market is a lower risk — and therefore demands a lower IRR — than a clean energy startup that wants to turn coconuts into jet fuel.
That said, early-stage VC investing is inherently risky and therefore, in my opinion, a minimum anticipated IRR of 50% is required to justify almost any investment.
Posted: October 3rd, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital | 6 Comments »
All the companies that I saw on the panel or met with at the conference had good ideas that could turn into good businesses. Unfortunately, I can't invest in any of them.
Why? Because there is a difference between a good business and a good venture capital investment. In fact, in the universe of good companies, only a tiny percentage make good candidates for venture investment, because only a tiny percentage of companies will achieve the rapid growth required to provide a sufficient internal rate of return ("IRR").
Here are some important reminders about venture capital:
1. Investors succeed or fail based on the
IRR of their investments.
IRR is a bit complicated but it essentially calculates the equivalent of an “interest rate” on your investment.
Given the high risk of early-stage venture investments, an investment should achieve, at a minimum, a 30% IRR above CDI. Given that CDI is around 12%, an early stage investment in Brazil should provide a minimum 42% IRR.
Another way of saying it: an early stage investment here should pay the equivalent of a 42% interest rate.
[Note: I am not saying that the company needs to actually pay out 42% in interest every year, only that the final return should be equivalent to that.]
2. IRR calculations depend on holding periods.
The length of time investors hold an investment – the “holding period” – has a huge impact on IRR.
For example, a $100,000 investment that returns $500,000 in seven years has an IRR of 26%. That same investment return in four years has an IRR of 50%.
The same amount of money earned in less time provides a better “interest rate” on an investment.
3. IRR calculations depend on gross returns.
The amount of money received from an investment – the “gross return” – obviously impacts IRR. In the previous example, a $100K investment returned $500K. If that $100K investment returns $2,000,000, however, even a seven-year holding period generates an IRR of 53%.
4. High-growth companies have a) shorter holding periods and b) higher gross returns and therefore better IRR.
High-growth businesses achieve exits (acquisitions or IPOs) sooner than slow-growth businesses, so the investment holding period is shorter.
High-growth businesses also provide higher gross returns: acquirers (or stock market investors) will pay more for a high-growth company so the amount that comes back to a venture investor is larger.
A final theoretical example: up until last year, Twitter had no discernible business model; neither did Facebook for the first few years of its existence. But they had growth. Would you rather invest in a profitable, stable IT firm that is growing 25% a year or in Facebook circa 2005 when it was growing fast but losing lots of money?
The IT company may be a good business and provide a good living for its founders but investing in it will get a venture capital manager fired. Growth is the only choice for a VC investor.
Posted: September 26th, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital | 3 Comments »
Yesterday, Anna Heim wrote a compelling, thorough article on the Next Web about valuations in Brazil. I appreciate the fact that she accurately reflected my thoughts, despite the fact that I was in a crowded restaurant using a bad Skype connection when we spoke.
1. Investors are to blame for inflated valuations, not entrepreneurs.
Bubbles don't happen because entrepreneurs ask for high valuations. They happen because investors invest at high valuations. As Anna mentioned, I don't think valuations are a real problem with Brazilian startups — yet. If valuations become a problem, however, it will happen because investors become irrational.
2. There are costs to asking for inflated valuations.
Entrepreneurs can hurt themselves by asking for inflated valuations. For one thing, investors don't like to be treated like fools. For another, many VCs (me included) pass on deals just because of the entrepreneur's initial ask on valuation: if the entrepreneur is starting at 10x what I believe is a reasonable valuation, what's the point of negotiating? We won't get to an agreement, at least not without wasting a lot of time haggling like carpet salesman. Lastly, a crazy ask on valuation shows a disconnect between the entrepreneur and reality that feels unsettling to an investor.
3. Don't base valuations on the US market.
Important differences exist between markets. The US, Brazil, Europe, China, etc. all have different sizes, growth rates, interest rates, maturity, broadband penetration, mobile usage, etc. Most startups in Brazil are addressing the Brazilian market, so basing valuations on a different ecosystem, like the US, creates distortions.
In addition, the US market is still in a huge bubble, in my opinion, that will result in a massive die-off of VC funds and startups over the next 5-10 years and provide sub-par returns in all but the top 10% of companies. So let's not base our valuations on the US.
4. Returns take time.
There is a saying in Brazil, "Make money quickly." This makes sense in the context of past economic shocks and killer inflation: make money now because it's not clear what tomorrow will bring.
This connects to the mentality of asking for an extreme valuation now (and cashing out as quickly as possible) because the market could go away quickly.
But the days of economic shocks in Brazil are gone (hopefully) and, anyway, this mentality doesn't fit with venture capital. The average holding period — the time between an investment and a liquidity event — during the dot-com boom was 3-5 years. As of two years ago, it had expanded to 8-10 years. The historical average is something like 7 years.
Thus the opposite, cynical, proverb about VC, "Venture capital is a good way to get rich slowly." Actually, I'm not sure it's a good way to get rich at all but, if it happens, it happens over a long time period, both for investors and entrepreneurs.
My point is that, while valuations matter, we should always keep the primary focus on building great companies for the long-term. Silicon Valley wasn't built by entrepreneurs and investors growing features masquerading as companies, then cashing out at inflated valuations. It was built by entrepreneurs and investors with a long-term vision to build world-changing, sustainable companies like HP, Intel, Apple, Cisco and Google.
We can and should build the same kind of companies in Brazil.
Posted: September 23rd, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital, US Venture Capital | No Comments »
Yesterday's post addressed whether Brazilian startups should incorporate in the US.
I believe they should if
1. They plan to have operations (customers, offices, employees) in the US in the next 6-12 months.
2. They plan to seek investment from non-Brazilian investors.
3. They believe that their exit will likely derive from a source in the US (an American acquirer or IPO).
The most compelling reasons are #1 and #2 — #3 is a distant consideration.
Today's post addresses where startups should incorporate. The answer is Delaware.
At first glance, Delaware seems an unlikely base for corporations. It is a tiny state, the second-smallest in the US (Rhode Island is the smallest) and is notable to me mainly for the fact that Bob Marley lived in Wilmington and that my best memories as a child came from summers at Rehoboth Beach.
So, why are 60% of Fortune 500 Companies, 50% of publicly traded US companies as well as 50% of all American corporations based in Delaware?
1. The Court System (most important, see #6 below)
2. Cost
3. Efficiency
4. Flexibility
You do not need to have offices in Delaware in order to base your business there. (Delaware also provides structural efficiencies, such as allowing companies to have just one executive and one board member.)
5. Taxes
Your company will not pay any income taxes in Delaware if it does not conduct business in the state. You will only pay a small franchise tax.
Other US states have some combination of the attributes listed above but none have this one:
6. The Court System
Corporate law encompasses a huge amount of complex issues – taxes, shareholders rights, executive conflicts of interest, fiduciary duties, mergers and acquisitions, employment law, etc.
It takes subject matter experts to adjudicate corporate law cases intelligently and consistently, and Delaware judges ("chancellors") are the ultimate subject-matter experts. They are black belts in corporate issues and they, not juries, decide corporate legal cases in Delaware.
As such, a virtuous cycle has arisen: Delaware courts have become the best venue for adjudicating corporate legal cases, which results in more companies forming in that state, which in turn creates more case law.
Over time, this virtuous cycle has made Delaware the gold standard for corporate law, such that even lawyers in other states must study and understand Delaware law. (When I went to law school, the vast majority of corporate law cases we studied were from Delaware.)
A nice by-product of Delaware’s legal dominance is that, by incorporating in Delaware, companies can be certain of the legal standards they must obey and certain of the way those standards will be enforced.
In sum, I am not offering legal advice – always use a lawyer when analyzing these issues. I am suggesting, however, that you use a lawyer that will recommend that you form your company in Delaware…
Posted: September 22nd, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital | No Comments »
Before addressing this question, remember that this is a complex issue, each company’s situation is different and every startup should consult a good attorney before making a decision.
In my opinion, you should strongly consider forming a company in the US if:
1. You plan to have operations (customers, offices, employees) in the US in the next 6-12 months.
2. You plan to seek investment from non-Brazilian investors.
3. You believe that your exit will likely derive from a source in the US (an American acquirer or IPO).
Regarding #1: if you realistically expect, and the business realistically demands, operations in the US, then having an entity there makes sense.
I would strongly consider whether it is realistic to get sales in the US, however, before making this decision. Specifically, are there competitive companies already succeeding in the US market? If so, it will be hard for a new foreign competitor to have success. Not as hard as it used to be but still difficult.
Of course, this analysis greatly depends on the type of business involved. A Brazilian games company can just as easily reach US customers as a US company – there are few barriers to entry in the games market. On the other hand, most B2B businesses have a much higher hurdle.
Regarding #2: another reason to form an entity in the US is if you expect to receive investment from a US or, more generally, a non-Brazilian investor. This point can outweigh point #1; in other words, even if 100% of your operations are in Brazil and will remain there, if you realistically expect to receive investment from a US investor, you may want to form a US entity.
Why? Because for most venture funds, the ability to invest in a US entity makes a deal much more attractive.
First of all, many funds have restrictions against investing in non-US companies. Their Limited Partners (investors in their fund) signed up for a fund that has a certain geographic focus (US) and a certain risk profile (e.g., a fund that is not making investments in markets with separate tax, legal and governance systems).
Secondly, the ability to use standard US legal documents – Term Sheet, Share Purchase Agreements, Shareholder Agreements, etc. – makes the investor much more comfortable, as does the knowledge that, if there is a dispute, it will be resolved in the US court system. If there is an dispute with management, the investor does not want to fight in the Brazilian legal system for the next ten years.
Finally, many investors just don’t want to go through the long diligence process required to invest in a new market. It’s the VCs job to understand a portfolio company’s business, regardless of where they are located but it’s too much time and expense to learn all the aspects of a foreign market, including the tax system, governance standards, legal environment, etc. Even if the fund mangers can avoid spending time on those diligence items, they will need to pay a lot of lawyers to do it.
In sum, when I talk about this subject with Brazilian entrepreneurs, I usually say that, if ten US investors would like to invest in your company, roughly five will drop out unless you are a US entity (or unless you agree to become a US entity before the investment). The number of dropouts will be even higher with early-stage funds and super-angels.
In addition, although it costs money to form and maintain an entity in the US, usually the valuation increase of your company vastly outweighs the cash expense.
Point #3, regarding where your exit will likely take place, should not carry much weight. I hear a lot of entrepreneurs talk about IPO-ing on NASDAQ and for some it’s possible but the reality is that only the largest, most sustainable companies tend to IPO. This has been true for most of the history of the public markets, except for the period between 1996-2000, when NASDAQ became a market for “public venture capital”.
In addition, new regulations (Sarbanes-Oxley) in the US make it very expensive and bureaucratic to operate as a publicly traded company, so even firms that can successfully IPO often decide against it.
The more likely exit, acquisition, could happen more easily if you are a US entity AND the acquirer is a US entity but, obviously, it doesn’t help much if you are US entity and the acquirer is Brazilian. In sum, in most cases, I wouldn’t base the decision on whether to locate in the US based on speculation about where your exit will take place.
Posted: September 18th, 2011 | Author: Ted Rogers | Filed under: Brazilian Venture Capital, Macro Environment, US Venture Capital | No Comments »
Following up on yesterday's post on valuations in Brazil: the problem of valuing early stage companies is not new and one of the solutions that appeared years ago was the convertible note. The convertible note basically delays the need for valuing the company until the next round of financing, when presumably the company will be more mature and thus more accurately valued. Some VCs swear by convertible notes, others dislike them but they are one solution to a situation where the entrepreneur and investor are too far apart on valuation.
It's easy to find more information about convertible notes online: one of the great things about the venture ecosystem is the amount of quality information available on the blogs of VCs. I highly recommend Fred Wilson's AVC (spend time in the comment section, as well) and Brad Feld's Feld Thoughts. Brad also posts on an excellent site called Ask the VC.
Fred and Brad have weighed in on the convertible note issue multiple times and I recommend checking out what they say.
