As Matt Harris of Village Venturestweeted, yesterday was de facto national Kohort day. Techcrunch announced the company's Seed round, in which Arpex was fortunate to participate alongside a group of excellent investors. News of the funding spread quickly in the twittersphere, in part because Kohort's CEO, Mark Davis, has a large presence in New York's venture and entrepreneurial ecosystem.
Mark is a tornado of entrepreneurial activity: at various overlapping points he has worked at DFJ Gotham, founded both the New York Venture Community and Columbia Venture Community, earned his MBA at Columbia and authored one of the must-read venture blogs. Mark provides a real-world example of an "inevitable entrepreneur", as described in my last post. We wanted to invest in Kohort because of the idea, of course, but were sold because of Mark and his team. Here's to a bright future for them.
In addition to dramatizing the birth of Facebook, The Social Networkillustrated the difference between the Silicon Valley mindset and the Brazilian mindset.
The movie’s basic conflict, and thus its drama, derived from the fight between Mark Zuckerberg and his Brazilian friend and business partner, Eduardo Saverin. Saverin insisted on monetizing Facebook quickly; he had invested $19,000 and urgently wanted to recoup that investment (in part because he felt pressure from his family). Zuckerberg ignored the revenue model and instead focused on growing the Facebook network.
Saverin was not wrong – his position was rational, highly defensible and reflected good business judgment – but Zuckerberg was right.
I believe that the perspective of Saverin is common in Brazil (and in most places outside of Silicon Valley) and is one reason why it will be hard to build the next Google, YouTube, Facebook, etc. here. We can do it and it will happen, eventually, but it will be tough. It will be tough because, when the next Google/YouTube/Facebook grows in Brazil, its potential may be squandered by premature insistence on revenue.
I know that sounds a bit crazy — don't companies want revenue? Yes, of course, but not at the expense of scaling the business early in its lifecycle. Facebook won because 1) it waited to generate revenue until it had achieved huge scale and 2) its investors supported that strategy. (Peter Thiel funded Facebook even before its business model was certain – the ad model may seem obvious now but, at the time, the ad model for startups had been highly discredited by the dotcom bust.)
We, investors and entrepreneurs, need to consider the Zuckerberg/Thiel mindset if we want to build the next Facebook in Brazil.
Just to be clear: I am not dismissing revenue — I want it, I look for it, I love it in portfolio companies. The biggest venture returns in history, however, have come from companies whose revenue model was, at time of investment, highly uncertain or even non-existent. Furthermore, at critical times in those companies’ lifecycle, investors and entrepreneurs doubled down on growth, rather than insisting on profitability.
I was going to write a post on the mad rush of VCs into Brazil and how that will inevitably inflate valuations to unsustainable levels, i.e., bubble now, crash later. But, it is what it is. After all, an asset is worth what someone will pay for it – nothing more, nothing less – so who’s to say what's an unreasonable valuation?
Better, however, to focus on something positive, like the fact that the world has become a global marketplace for web-based startups.
The previous post dealt with the globalization of startups. Experience tells me that a startup should focus locally first and expand internationally only when they have sufficient resources to do it but there are major exceptions to this rule, especially for web-based companies.
As opposed to a device company, or a cleantech business, a web-based company can launch instantly in a geography-independent way (i.e., world-wide), with little additional cost. Physical borders no longer matter. Now, the biggest hurdles are language and culture.
Even the language hurdle, however, is disappearing.
… perhaps three billion people are online, or around half the entire population of the earth… English and Mandarin dominate the online conversation with close to 500 million speakers online and more than a billion offline. Also growing in online influence: Spanish, Arabic, Hindi, and Portuguese. What’s interesting is that these languages also seem poised to drive cultural trends globally. Looking at average GDP and Internet penetration by language, we can map out a geographic playbook for any Internet startup to prioritize how they lay the online smackdown on the planet, and use geographic arbitrage to move the point of innovation, production, and transaction to optimal locations.[emphasis added] For more info on this topic, see p.5 of this 2009 report on global language trends by MyGengo, a 500 Startups portfolio company.
Dave makes two critical points about language: first, that a startup can use hard data about language, GDP and internet penetration to determine exactly where it wants to focus its company and, second, that startups can access increasingly cheap sources of translation (through, e.g., MyGengo). The language issue is disappearing.
The reduction of the language barrier strengthens the case that startups should consider targeting multiple countries (after analyzing factors like competition, culture, etc.). The startup can use hard data about languages to optimize its geographical markets and then access cheap resources to translate its product into the necessary languages.
Emerging markets drive tech adoption — The days are long gone when users in emerging countries embraced older technology. With growing middle classes in Brazil, Russia, India, and China — and plenty of wealth in other regions has well — the demand for tech goods will continue to expand. That trend has been driving sales in tech for some time — 80 percent of Intel’s sales are overseas now. But it will also happen with web services such as social network games. [emphasis added] Accel and Tiger Management’s recent $30 million investment in Vostu shows that the Brazilian social game market has a lot of potential. Success in an emerging market can generate the growth that a startup needs to get to critical mass.[emphasis added]
Two points jump out at me. First, just as the microprocessor business bloomed in the US then matured into a truly global market, so will many web services businesses (see, e.g., Facebook). It’s not an overly complex point but it’s an important one and Intel provides a nice analogy.
The second idea, that success in an emerging market can get a startup to critical mass, is more complex. Of course, growth in an emerging market can help a startup get to critical mass, but at what cost? Specifically, should a startup really think “globally” or focus on winning local markets?
Generally, I believe that a startup should focus on local markets, then expand internationally only if strategically compelled and only after reaching critical mass. Going beyond local markets requires resources that most startups don’t have – as a young company, “if you chase two rabbits, you will lose both”.
On the other hand, that applies less to web services companies and, as the Brazil and the US converge, even less to web services companies that want to address those two markets. In fact, for reasons that I’ll address in later posts, I believe that bridging the Brazilian and US markets provides huge opportunities for entrepreneurs and investors, as long as they have sufficient agility and deep knowledge of both markets.
Final caveat: some non-web services startups can/should break the “local markets first” rule but they are rare and require an inordinate amount of investment capital. I see them mostly in the cleantech area – Amyris is an example.
I learned a ton over the course of two days. Not so much about the investing side of venture capital but about the fundraising side: people often forget that VCs occupy the same position as entrepreneurs for much of their professional lives, i.e., asking other people for money. This blog (and others) talks a lot about investing, entrepreneurs, the startup ecosystem, etc. but, before a VC can invest, he/she has to raise money. That means pitching to Limited Partners – pension funds, endowments, family offices, wealthy individuals, etc. — and asking them to invest. It's as tough for us as it is for entrepreneurs.
Fundraising from LPs is a whole world unto itself and it changes all the time. Since we (Arpex) are currently raising a fund, I found the real-time information on the current fundraising environment invaluable.
Below, I share some random notes from the conference but, first, an aside: on the first night, I ran into Brad Pitt (literally). As I opened my door to run to dinner, I almost knocked him over. He was about to knock on my door – he and another guy were looking for someone and had the wrong room (I was 1410, they were looking for 1401). After a brief mutual apology, they moved on to the double-door suite at the end of the hall.
Kind of a strange moment — great conversation starter at dinner…
Now to the venture capital notes:
1.Venture fund managers always have a hard-time raising their first fund but second and especially third funds can be even more difficult. With a first-time fund, you can sell the team, the fund strategy, the vision, etc. In the latter cases, you have to show actual investment results. Given the VC market of the last ten years, that’s a difficult thing to do.
2.Super-angel investing does not work unless there is a massive updraft in the sectors. In other words, you can make a living as an angel investor if companies grow consistently and valuations continue increasing. If not, you are in trouble because a) you don’t have money to bridge your companies during the tough times and b) you will get massively diluted when (if) new investors come in.
3.Leave the entrepreneur alone to run his/her company. If you don’t trust them, fire them and get someone you trust. Otherwise, in the long run, the relationship will fail and so will the company.
4.When discussing specific portfolio companies with Limited Partners, the LPs want to know one thing: the percentage of the total Fund that the portfolio company will realistically return. The benchmark is 50%. In other words, LPs want to hear that a specific company will, upon exit, return half of the committed capital in the Fund.
5.There are signs of life for VC funds trying to raise capital but LPs are waiting to say “yes” until they absolutely have to: in other words, they want to wait to see what other LPs, if any, are going to invest in your fund before they commit.
6.Part of this “wait and see” attitude stems from the knowledge that the VC industry is going through a correction and many funds will disappear. LPs are waiting to see which VC funds will survive.
7.LPs tend to feel more interested in super-angel funds than traditional VC funds but, unless someone with an excellent reputation is running the fund, the LPs still prefer to wait.
8.LPs have adjusted their expectations for returns and feel ok with 10% per year into the future. This means they don’t need/want to take as much risk (e.g., by investing in venture capital funds).
I just spent two weeks in Brazil and, as has happened on almost every trip to Brazil since 2006 (I have been traveling there since 1999), I came back shaking my head at all the opportunities in that country. Unless I have misread the last four years of experience or am completely delusional, the venture capital market in Brazil has reached an extraordinary moment. I compare it to the US in 1994 – an inflection point where a critical mass of startups in certain markets will grow exponentially.
Like the US in 1994, a healthy balance exists between the number of startups and the market for their products and services. With proper execution and sufficient capital, Brazilian entrepreneurs have the potential to build the next generation of great companies.
Before my optimistic investment thesis leads you to you conclude that sun and samba have damaged my brain, however, let’s review and respect the anti-thesis (I'll continue the bullish case for Brazil VC in the next post).
Obviously, Brazil in 2010 is not totally analogous to the US in 1994: entrepreneurialism has shallower roots there and entrepreneurs are fewer in number and generally less experienced. The startup ecosystem is more nascent and scattered – Sao Paulo is not Silicon Valley, Rio is not New York and Belo is not Boston. Brazilian startups must cope with more burdensome tax and labor regulations than their compatriots in the US.
Angel investor networks have yet to fully coalesce and institutional venture capital is extremely scarce. Interest rates, while falling, remain high enough to compete for investor dollars – why invest in a high-risk startup when I can earn 11% a year buying a low-risk bond?
The specter of inflation never seems to go away and political risk in Brazil remains: the surprise 2% tax on FDI jarringly reminded investors of the potential for sudden moves by the government.
Perhaps most negatively, for the first time I feel a twinge of concern that there is too much optimism about venture capital in Brazil. I know that sounds crazy coming from a guy who hypes the market for VC in Brazil but I live by Warren Buffet’s dictum: “Be fearful when others are greedy and greedy when others are fearful.” I now know of at least four parties thinking of or actively trying to raise early/growth stage VC funds in Brazil. Those are the only the ones I know of, so there are surely more.
The people interested in raising funds have a high level of talent and sophistication — that's not the issue. The issue is whether too much early/growth stage capital would exist if all the new funds get raised: when combined with Ideiasnet, Monashees, Criatec, FIR, Confrapar and other, smaller funds, I begin to get worried about an imbalance.
Think of it as an equation, with good potential VC investments on the left side, investment funds on the right. There are only a limited number of good entrepreneurs and businesses on the left side; when too much capital pours into the right side of the equation, valuations get driven too high, more startups get funded than can succeed in the market and the venture capital asset class then fails to deliver sufficient returns on investment.
Unfortunately, a problem like this cannot correct itself quickly. Venture funds have a ten-year life and their investments are in private companies (and therefore very illiquid). So, unlike the public markets, which can adjust relatively quickly to imbalances, once the venture market is oversaturated, it takes a very long time to correct itself.
For a real world example, just look at the US. Since 2000, US venture capital asset class has had a negative return. Negative! VC is the riskiest asset class—LPs need a 25% IRR to justify investing in VC funds – and ten-year returns have been negative! So, of course, the US venture market is a disaster. Most LPs don't want to touch it and it will take another 3-5 years for enough tier two and tier three VC firms to disappear before a balanced equation re-forms: a sufficient number of good entrepreneurs and businesses on the left side, an appropriate amount of venture capital on the right.
Next post will make the bullish case for venture capital in Brazil and specifically address the concerns above.
Our expertise is in discovering and managing growth situations, regardless of stage[emphasis added], from two-person, seed-stage private companies to public growth companies with several hundred employees.
In other words, Crosslink leverages their domain expertise to make investments across asset classes.
This makes great sense to me.For example, if you believe that gaming is an attractive sector, shouldn’t you be able to invest in the best game companies, regardless of whether they are early-stage or publicly-traded?
Moreover, if the publicly-traded companies in gaming are overvalued, why not focus on private companies with more reasonable valuations?The reverse also holds true: rather than piling on with more VC investment in an overheated but important sector, find investments in that same sector but in a later-stage asset classes.
If you have the managers with expertise in each asset class and deep domain expertise, then your long-term track record should be better than funds limited to a single asset class.
I don’t known whether Crosslink has done better than other funds but I would point to hedge funds to support the argument: one reason that most hedge funds do better than most venture funds is that hedgies, while often focused on specific sectors (e.g., financial services), can usually invest in multiple asset classes, i.e., they can go after any investment that makes sense, including private equity, small cap public companies, junk bonds, etc.
If venture capital needs to “reinvent” itself, as many have argued, one option may be funds that invest in venture capital… and other asset classes.
Thanks to Larry Cheng of newly-formed Volition Capital for putting together a list of the top global blogs on venture capital. I was surprised (and happy) to see that we are #29!
Thanks to all of you that read this blog — we are fortunate to be focused on an exciting industry (venture capital) in extraordinary places (Brazil and the US).
Cheers
…well, not completely dead but the upside is very limited, according to my old friend Brian Taptich, who has witnessed firsthand the rise and maturation of the Internet ecosystem in Silicon Valley.
Brian worked at Red Herring from 1994-1998, co-founded a new media startup, Alarm Clock Worldwide, and held senior executive positions at Electronic Arts and Bit Torrent. Somewhere in there, he also managed to get his MBA from Kellogg. He now consults for the new media industry.
A couple of months ago, Brian was back in DC, where he and I attended high school together (we also went to college together) and I asked him for a download on the state of affairs in Silicon Valley.
The key takeaway from our chat was this: in the ’90s, the Internet ecosystem had deep instabilities and inefficiencies, which created a massive opportunity for startups to create value and capture market share. Now, however, the ecosystem has matured, which means that opportunities for value creation are fewer in number and smaller in size. Thus, investors and employees in startups have much less upside than they used to have. This holds important (negative) implications for Internet investors and entrepreneurs in the US.
I requested a follow up from Brian and, rather than paraphrase his response, I cut and paste the email below. If you have any interest in investing in or working at web-based businesses, read on…
When the Web was born as a truly consumer platform (thanks to the Netscape browser), THE enormous problem that needed solving was the lack of structure and stability to all the component stuff – from the network level to the UI (on one dimension), and from the enterprise to the consumer (on a second dimension). Through the late ’90s, all this unstructured stuff was both stabilized and organized, and many billions (trillions?) of dollars in market capitalization was created – by companies like Cisco/Akamai at the network level to Yahoo/AOL on the front end (on the first dimension), and Oracle/Symantec in the enterprise and Amazon/Ebay with the consumer (on the second dimension). Of course these dimensions are fairly fluid, and there is much overlap.
Today, the Internet is an entirely stable platform – all of this component stuff is now every bit as dependable as most every other utility in your life (eg electricity, gas, etc). And the vast preponderance of innovation happening right now is dependent on this stability, which has led to an entire generation of startups focused on incremental opportunities (ie most every consumer internet company not called Google) – we should expect that the aggregate market capitalization that is/will be created by this generation will be at least an order of magnitude smaller than the companies born just 15 years ago. Not only will the “huge wins” be smaller compared to the ’90s, there will be far fewer of them. Case and point: The consumer internet companies widely expected to be this year’s “huge wins” – eg Facebook, Twitter, LinkedIn, Zynga, etc – are not only a relatively short list, but also are tracking to public equity valuations (should they even get there) absolutely lower than the previous generation.
This is precisely why the early stage venture capital that led tech funding in the ’90s has been desperately expanding into areas like clean/greentech or medical technologies (in which they have little-to-no domain expertise), and/or seeking out international expansion opportunities in places like China and India and Brazil (ie self-sustaining markets that are about 10 years behind Silicon Valley in terms of localized innovation) – VCs need to find the next thing that will provide their LPs a 20% annualized return…and tech investing in the US ain’t it.
This is not an entirely novel hypothesis – everybody from Mark Cuban to hedge fund investors have made similar and widely circulated diagnoses in 2009.
However, what has not been widely discussed – even amongst those who provide the fuel that runs the Silicon Valley engine (ie the employees, not the founders or investors) – is how the compensation structure for tech startups in the US has not adjusted to fit this new world order. It used to be that top talent would take a paycut to work at a startup – trading the known compensation of a stable company (higher base salary, greater benefits, etc) for the potential upside on the equity (“sure I’m getting paid less but my 0.5% will be worth millions!”). In a universe where founders aspire to create $100 million not $1 billion in value, the potential upside for an employee is significantly lower than it used to be…and there is no economic incentive to take the chance on a startup…unless the startup pays employees significantly more cash or gives significantly more equity…and they are currently doing neither.
It may be that, for now, people are fairly content just to have jobs. However, as the job market loosens, and people have the freedom to risk-adjust their opportunities, there is the likelihood of a flight to more established companies and/or a departure from tech altogether. Which could have profound implications in the business of tech innovation in 2010 and beyond.
One of the most common misunderstandings between entrepreneurs and investors stems from the difference between a great company and a good VC investment. The two are often quite different.
Remember that VCs are judged by one thing and one thing only: return on investment. Limited partners – investors in venture capital funds – generally want VC fund managers to provide at least a 25% internal rate of return (IRR); in Brazil it is perhaps 30% (25% + 5% risk premium).
A 25% IRR roughly equates to making 9 times your investment over a period of 10 years. Again, this is the bare minimum and no VC wants to hold an investment for 10 years. (The average holding period for VC investments is now around seven years — even seven years is considered a painfully long time.)
Achieving an IRR of 25% or better means finding companies that can have huge “exits”, which often means taking a risk on unstable but high-potential companies and passing on solid, consistent companies.
For example, assume that Entrepreneur Y builds Company X to $20 million in revenue, 15% annual growth and 10% EBITDA margins. By most measures, Company X is a great success and Entrepreneur Y has probably sacrificed much of his/her time, money and relationships in building it. Entreprenuer Y would probably wonder, then, why Company X would NOT be of interest to most VCs.
Look at the math:
- Asssume the VC invests $5,000,000 at a valuation of 2x revenue, or $40,000,000 (this is 13x EBITDA – a high multiple)
- The VC now owns 11% of the company ($5,000,000/($40,000,000 + $5,000,000))
- Company X continues to grow at 20% per year until, in year ten, they are purchased by a larger competitor
- The competitor purchases Company X at a valuation of 2x revenue, or $206 million
- Assuming the VC has not been diluted by other investors, their initial investment returns $23 million. Pretty good, right?
- Wrong. The IRR for the investment is 18%, well below an acceptable minimum.
This example is oversimplified but conveys the basic idea: an excellent company does not necessarily make a good venture investment. To make a good venture investment, a company needs to have exponential growth, which in turn leads to a huge valuation when it is acquired or IPOs.
VC is a game of “hits”. More specifically, a game of many failures and a few huge hits. It is not a game of moderate investments in moderate companies.
That is why you often see VCs making many speculative investments that, in retrospect, appear ill-advised – they have to take risks in hopes of finding a few huge successes and this leads to a lot of failures but, hopefully, also to a Skype, EBay or Google.
