Venture Capital / Angel Funding

Today the CEO of Yammer argues thus (after having sold to Microsoft for $1.2bn, oddly enough). In essence he argues that its hard to:

(1) Find an idea that the Big Guys haven't thought of
(2) Prove it in the c $5m runway the SV VCs will give you these days
(3) If it takes off, keep it going long enough to grow before some major player swats it with a competitive play, patent suit or other or spoiling manoeuvre.

As you'd expect, some prominent SV VCs take issues with this, Marc Andreesen arguing that there is an infinite amount of creative talent out there and the big companies are ponderous and often not well run (this being the same Andreessen you recall who watched his own Netscape get crushed by a fairly inept Microsoft's Explorerer in the mid-nineties, of course....but then he made good on Skype. Maybe one forgets....)

We have wondered aloud about the End Of Silicon Valley in in the past, but have always noted its ability to resurrect itself. But today, as well as the above, three other different articles, on 3 different aspects of this issue, seem to be painting an emerging picture:

1. Firstly, the Old School VC's aren't making any money anymore - Business Insider

Last year, in an attempt to cash in on the late-stage "private IPO" investing frenzy, Kleiner startled the Valley by launching a $1 billion late-stage "Digital Growth Fund." Many saw this fund as Kleiner's attempt to play catch-up and associate the firm's name with hot companies it had missed. Some also saw the fund as a sign that Kleiner had lost not just its edge but its valuation discipline and predicted that the firm might get clobbered on some of its late-stage investments.

These concerns were well-founded.

Armed with a boatload of new cash, Kleiner rushed out and made late-stage investments in, among other companies, Facebook, Groupon, Zynga, and Twitter. In most of these investments, moreover, Kleiner did not buy stock from the company--thus providing additional growth capital for the company--but, instead, bought stock from existing investors, helping them cash out with huge gains.

Kleiner's investment in Twitter may yet pay off, but it has been far from a home run.

Twitter is unlikely to make up the numbers. Many of the older VC firms took big hits in the DotCom bust (I recall seeing a McKinsey report that said no investment after 1997 made money). KP has been widely felt to be off the pace for a few years, and this was seen by many observers as a last ditch attempt to get back in the game.

2. Secondly, even the New Boys are backing out of their new investments- WSJ

Some of the early backers of Groupon Inc, including Silicon Valley veteran Marc Andreessen, are heading for the exits, joining investors who have lost faith in companies that had been expected to drive a new Internet boom.
....
Shares of Facebook continued to slip last week, falling to about half their May IPO price, as sales restrictions expired for some pre-IPO investors. Since Zynga's December IPO, its shares have dropped 70% as investors worry about its ability to keep making money from people who play its digital games.
....
The Groupon investment flurry that ended in January 2011 was part of a recent Silicon Valley trend of prominent investors jumping into young companies shortly before their IPOs. Critics say the phenomenon builds unsustainable valuations for those young companies.

"Groupon would never have gotten this big without that late-stage money," said Bill Gurley, a general partner at venture-capital firm Benchmark Capital.

At least they got in earlier, but its not a viable model long term when the IPO money knows its going into an almost pump 'n dump scheme, so no surprises then that.....

3. Thirdly, the huge Californian Public Service pension fund (CalPERS), a stalwart VC funder over the decades, is considering pulling out of funding VCs - PE Hub.

The nation’s largest public pension fund, CalPERS, appears likely to slash its investments in venture capital in what could be a blow to this still recovering asset class. Venture capital has wallowed through nearly a decade of difficult returns and sluggish fundraising. The decision by the California Public Employees’ Retirement System to largely abandon new commitments to venture funds will likely prolong the agony.

......

Over the past decade, venture capital has been the worst performing asset class in CalPERS’ private equity portfolio. It has delivered a net return of 0.0%, according to June 30, 2012 pension fund data. Part of the poor performance stems from the continuing fallout from the dot-com bust, which saddled many venture funds with negative returns [See 1 above} . Performance was hurt again by the recent financial crisis, which had an impact on almost all asset classes.

In the past year or so, venture returns have improved as IPO activity has risen. Still, venture capital has fared poorly relative to other asset classes at CalPERS. Buyout funds, which represent 57% of CalPERS’s private-equity portfolio, have produced average annual returns of 15.4% over the past 10 years, while credit related investments, another big CalPERS investment focus, generated 14.1% annual returns.

Granted they only put about 6% of their c $240bn fund into VC, but that is a very big number for the VC community

Of course, if CalPers had just shorted the stocks of the companies their VC investments were funding, like the banks did, they would have made out like bandits - WSJ again:

Profits made by banks underwriting Facebook Inc.'s initial public offering as the stock fell were distributed this past week from a pool of about $100 million, say people with knowledge of the deal.

The banks together made the money through a process known as stabilization, which is a standard procedure in IPOs, though Facebook's deal size made the profits larger than normal, these people said. The payout comes in a week that saw Facebook stock hit new lows, falling Thursday below $20 after an IPO price of $38 a share.

Thats on top of the c $175m they were paid to do the IPO. Easy when you know how.....but not good news for the whole VC ecosystem. Private profits, public (offering) debts....

Piece in TechCrunch on the shifts in the startup funding markets changin from the old pecking order:

Today things are much more complicated. More funds are arguably in the top tier – guys like Accel, Andreessen and Greylock have risen. But more disruptive are the angel investors. It used to be that angels worked with venture funds, doing the very early rounds and then handing things off when a company did well.

But the last several years have seen the rise of the cheap startup. Internet startups can use open source software and new scripting languages to ship products fast and cheap. Often there’s no need to go past an angel round of funding until it’s time to decide between selling and doing a big marketing push. Either way the VCs lose, because even if they get in at that late stage the valuations are much higher and returns plummet.

An entire generation of entrepreneurs have stopped thinking about hitting up those top tier VCs as their first step in the startup process. Many now simply begin with Y Combinator, or take a small angel round. These angels are fast and nimble and they are hanging out with the entrepreneurs at events, incubators, etc. They are in the fray, while many of the old VCs remain above it all, waiting for the entrepreneurs to come to them, hat in hand.

In my view the main issue is that market re-structuring is all very interesting, but the big thing underlying this is that what is happening is that money is flooding in again, and that will lead to asset bubbles - as with the pre Crunch Private Equity markets, too much cash chasing to few opportunities pushes up the prices. To exacerbate this, it does cost less to get companies up and running (but probably more to make a market in a world full of many small companies0so the funding stages have to be changed as well.

But the one thing that caught my eye was a shift in the payback theory of the startup market - it would appear that the market is shifting to many smaller companies being sold for far lower prices, and this is impacting the traditional "1 in 10 is a home run" model:

Some venture capitalists think that this “think small” attitude is driving entrepreneurs who may otherwise build the next Google or Microsoft to create something much less interesting instead, and then everyone loses. No IPO. No 20,000 tech jobs. No new buyer out there for the startups that don’t quite make it.

And without those occasional but huge exits, the entire ecosystem can fail. Venture firms need big returns to raise new funds. Without venture money a lot of the innovation in Silicon Valley would end.

I have always felt that the "home run" model's returns fitted better with the big VC fund business model rather than the individual entrepreneur. For most entrepreneurs I would argue that - as a game theory payoff - a reasonable probability of a few million dollars exit for a few years work is a more enticing prospect than an exceedingly small probability of a vey large exit.

In other words, would you prefer to count your chickens as they hatch or wait for a very rare Black Swan to show up?

I suspect this shift in the rules of the game is because, as money flows in, the power is going to the rarer entity - the good startup.

(Update - and another TechCrunch article points out that you don't need home runs to create the new jobs - large numbers of small successes are doing most of the heavy lifting)

Incidentally, having run and/or turned around a number of Tech startups, I would point to Fred Destin's post here as the key to that succesful exit:

In startups the only real sin is running out of cash, and the cardinal sin is running out of cash UNEXPECTEDLY.

Exactly - never mind the team, market or product - they are irrelevant if the company cannot manage its cash.

Fascinating study from IPO Dashboard showing the extreme unlikelihood of the "5 year dash to $50m turnover from startup" hockey stick business plan so beloved ov VC focussed business cases. The study was based on the top 100 publically traded (US) software companies, inflation adjusted. Some conclusions:

Most successful technology companies aren’t rocket ships.

Only 28% of the nation’s most successful public software empires were rocketships. I’ve defined a rocket ship as a company that reached $50 million in annual sales in 6 years or less (this is the type of growth that typically appears in VC-funded business plans). A hot shot reaches $50m in 7 to 12 years. A slow burner takes 13 years or more. Interestingly, 50% of these companies took 9 or more years to reach $50m in revenue. The fastest rocket ship of today’s software industry was Novell.

Novell (NASD: NOVL) was one impressive company. It took only three years to reach $50 million after it was founded in 1983. In 2008 it still pulled in almost $1 billion in revenue. You’ll recognize the names of a few of the other genuine rocket ships from various decades: Adobe, Autodesk, Electronic Arts, Interwoven, McAfee, Salesforce, Sybase, Synopsys, and Verisign.

Microsoft and Oracle weren’t rocket ships.

Who would have thought? They are two of the most valuable companies ever founded, in any industry, in any country. Microsoft took 8 years to reach $50 million in sales; Oracle took 10.

As IPO Dashboard notes, is it wise to prepare a business plan featuring steep hockey stick sales projections?

(Hat Tip Robin Klein)

Fred Wilson, referencing a Jason Calacanis post on the iniquity of angel aggregators charging startups to pitch to them, notes that:

..."startup agents" out there that charge entrepreneurs upfront cash to make intros to potential investors. They should also be avoided. A basic rule of thumb for fundraising agents is that they must work on a success fee basis or you should not use them. Otherwise, they have no incentive to see you actually get funded.

Both the agent groups and startup agents that want to charge upfront cash make the argument that it is a quality filter. But that is nonsense. Some of the best startups I've ever seen were totally broke and living and working in a friend's apartment. And some of the worst were well off and working in fancy offices. The ability of a startup to pay has absolutely nothing with the quality of the team and the idea.

Fred calls it a scam. I am told it occurs in the UK as well. The key point here is that one about "they have no incentive to see you actually get funded." if you pay them. Says it all......

Hmm..maybe we should set up a service to validate Angel organisations. For a small fee, of course...

Paul Kedrosky has a funny paean to VC's over on TechCrunch - there are some classic lines I wish I'd written, and probably will...... (actually, there is some Irony in them - is Paul actually Canadian?*):

Hating venture capitalists is profoundly satisfying. After all, they are slack-jawed, monied, oily, know-nothings who carom off innovation, fire capable founders, squash angel investors, and exist mostly to make commercial bankers look smart and interesting.

But as Paul points out, its not that easy:

Creating a successful startup is among the hardest things you can do in a capitalist economy. Entrepreneurs must successfully navigate a sea of multi-dimensional uncertainty, from technology (will it work?), to people (do I have the right employees?), to market (will anyone care?), to financial (can I finance doing this, and can I then sell the product or service for more than it costs?) At big companies you can fail at launching a product, fail at hiring people, fail at making money on a product, and fail at figuring out whether something will work. Your big company will probably be unaffected, and you may even get promoted. Do any of those things wrong at a startup and, in all likelihood, you’re dead. You are wandering a maze of dark and twisty passages — most of which are paved with trapdoors to hell.

The idea that anyone at all would build a business around funding startups is the remarkable thing. No revenues, no sure market ahead, no collateral, no liquidity, and doe-eyed founders who were in high school when Enron blew up. It all adds up to more ways to break down than an old Winnebago. Far from wondering why so few companies get venture capital, we should perhaps wonder why any do, and how venture capitalists remain so damn optimistic. To borrow an industry adage, the best venture capitalists retain the capacity to fall in love despite having had their heart broken over and over again.

And if it works, someone else gets all the glory while VC's remain non-venture capitalists in everyone's mind:

The “VCs as innovators” problem wouldn’t be so bad, of course, were it not for the scene-stealing entrepreneurs. Those bastards keep creating risky startups and getting all the glory. Damn you Sergey Brin and Jeff Bezos and Steve Jobs. Just in case you needed a reminder, it’s not VCs who create companies, it’s entrepreneurs. Blaming venture capitalists for their capital not changing the world is like blaming Pfizer’s treasury department for Viagra not saving your marriage. Yo, you have bigger problems, so to speak.

Wouldn’t it be nice if venture capitalist drove more innovation? Of course it would. But that’s like saying “Wouldn’t it be nice if supermodels followed you home?” Of course it would, but it’s fanciful.

It's a really good piece.

Except, except..... as an asset class its under major threat today, with diminishing returns as startup require less capital to get going, but also (like in media) stay on the hit parade top 10 for less time. I look forward to an equally sharp post from Paul about what they have to do to sort that issue out.

Also, I'm not sure that what they do is the hard bit compared to actually founding a startup. By definition a portfolio de-risks investment strategy. There is also a fascinating piece in Ian Ayres' book Supercrunchers where he notes that movie moguls hate using mathematical analysis to predict movie success, even though it provably works, because they prefer the system that those moguls in power have monopolised - ie a comfortable relationship game. There is also some similarity, I hypothesise, in predicting the success of movies and startups, but I have yet to see any serious study made apart from a few prediction market plays a few years ago. For a small consideration I wouldn't mind looking at this area

Just sayin......

*Americans are famous for their lack of irony. Brits are famous for a love of stereotypes

A short note on the eBay/Skype fiasco.....this is a chickens coming to roost thing.

I find it nearly impossible to believe that a due diligence team in this sort of size of transaction (eBay buying Skype) would not have been aware of the red flag that was the ownership of the underlying IP. (The biggest transactions I ever did were about 1/5th this size and for that price every jot and tittle was crawled over in minute detail). I would strongly suspect that there must have been a decision to overlook the IP issue.

So, what was eBay's management and Board thinking when they decided to press the button to buy? And more to the point, why were they thinking it? Why was it decided to overlook the IP issues? The mind boggles!

Fast forward a few years, and a soap opera like cast of characters manoeuvre to buy Skype from eBay, and even though most of the players seem to have been in place to see where the skeletons are buried, still the play goes on. As one of the commentators on the TechCrunch piece notes:

Niklas/Janus were obviously interested in buying skype, using the lawsuit to drive down the price which was effective… then Volpi who they hired to run joost teams up with Index who they let invest in skype, and Volpie/Index go on to steal skype from under Niklas/Janus without including them in the deal…

…that’s why this is getting uglier by the minute

I suspect anyone who has ever done M&A (and many who haven't) is pretty certain that a lot of dirty washing is going to come out now.......

The New York Times reports that eBay is soon to sell Skype, and they are looking for a price north of $2bn (they bought Skype for $3.1bn in 2005). On what basis, we wonder. Given that Skype doesn't actually own the technology that its based on (the founders still own that and are busy suing Skype) its hard to see how such a price tag can be justified on c $600m revenues and minimal (if any) profits*

As GigaOm notes:

That’s why the decision to sell the company at just over three times sales doesn’t make much sense to me. Unless, of course, eBay management is trying to use this deal to paper over the problems that continue to plague its core business of auctions. The other reason could be the legal problems faced by Skype. These legal problems are a primary reason Skype’s IPO dreams have turned into a nightmare.

As we reported earlier, Skype co-founders Zennstrom and Friis tried to buy the company back from eBay but were rebuffed. The duo own a company called JoltID, which has since then sued Skype, alleging that eBay over the use of its P2P technology, which is at the heart of the Skype service.

The sale is theoretically to Marc Andreessen’s new venture fund, Andreessen Horowitz, and the original Skype investors Index Ventures. Also according to The Times Silverlake Partners, a Silicon Valley-based private equity group, is said to be involved with the deal.

Looks like the typical PE deal - take over a distressed asset from a distressed company, tidy it up and throw it on the market 3 years later in better times for a tidy profit.

eBay paid way over the odds in the bubble years, and is now going to sell in the distressed times. I agree with Pat Phelan, in that at a price tag $2bn plus I wouldn't be surprised if the founders were also involved in the deal, as that to me is the only way that the buyers could throw this company into another proifitable sale or IPO in a few years time - unless you believe VOIP is in for another major growth spurt, which I don't.

Update - El Reg says the actual deal is 65% of the company:

It’s official - eBay has offloaded a majority stake in Skype to a gaggle of investors in a deal that values the VoIP outfit at $2.75bn.

eBay keeps a 35 per cent stake in Skype. The online auction giant will get $1.9bn in cash

Slightly better news in that they get a share in any upside - one hopes the risks are similarly shared, and we wait with bated breath to hear about the lawsuit going forward...... but still, $ 2.75bn. Also, I wonder what the conditions in this deal are - that price almost paints the PE guys as dumb money, and they usually aren't. I'd be prepared to bet there are a few guarantees and indemnities in there.....

#Update 2 - nice analysis at Bronte Media

The earn outs were not met and the company actually only paid $3.1bn. But also of note is that the firm only paid $1.8bn in cash and $1.3bn in eBay stock.

How does today’s announcement validate or invalidate the decision? Well the $2.75bn valuation means that eBay’s investment has a negative 6% internal rate of return (IRR). If the firm would have declined to buy Skype and instead parked the same amount of money in the S&P 500 they would have ‘earned’ a negative 10% IRR. So Skype has out-performed the broader stock market over the term of the investment.

But let’s dig deeper. eBay’s stock price was $38.62 on September 9, 2005 when the deal was struck. The stock is now $21.68. That means the company as a whole has declined at 25% per year since acquiring Skype. If anything, Skype has held up (more correctly Paypal and Skype to a smaller extent have held up) the great value destruction of eBay’s core marketplace.

Also it essentially means that on a cash basis eBay hasn’t spent a dime ($1.9bn back with the sale vs $1.3bn initially + $0.5bn earnout for the purchase) and that for the issuing of some over-priced stock in 2005 it now has 35% of a great asset in Skype.

Love the angle that compared to the Rest of Market, the Skype deal was value accretive despite itself.

*Apparently its making over $100m projected in 2009. Not clear if this is EBITDA or profit.

Very interesting story from the Sunday Times, (seen initially on TechCrunch UK) about the setup of European Founders Capital (EFC):

EFC is being led by Michael Birch, co-founder of Bebo, and Brent Hoberman, who set up the dotcom bubble era Lastminute.com but is better known more recently for being a serial angel investor and co-founder of MyDeco.

They are joined by Rogan Angelini-Hurll, an old friend friend of Hoberman’s and former City research analyst at Salomons. Peter Dubens, who built the Pipex ISP business, is also backing the venture. Dubens sold Pipex’s broadband business to Tiscali for £210m in 2007.

EFC will have an initial £20m of seed funding but is aiming for £50m in total. The idea is to increase the availability of early-stage funding in Europe, which historically lags behind the US, and has led to a gap between early stage and Series A funding. Europe’s seed funding eco-system has never matched Silicon Valley’s in part because the business angel environment for technology is undeveloped and because European VCs have historically not reached much lower than Series A rounds, unless in syndication with other parties.

Nice move, as its aimed squarely at the "Equity Gap" between "friends & fools" and VC funding, which is a real issue in the UK (as we have pointed out repeatedly).

There is also a bigger discussion that this news needs to be seen as part of, ie the restructuring of the global Venture Capital market (see this recent article by Sarah Lacy as an example of the issue) but thats a whole 'nother post.

Anyway, I hope the boyz will do well by doing good

Peter Thiel, one of the Facebook VC's on why the deal with Twitter failed:

In Facebook's first public confirmation of the talks, Thiel said the parties disagreed over price and structure when they seriously considered a deal last fall. "It became pretty clear it wasn't going to happen," Thiel says from the mid-Manhattan office of his hedge fund Clarium Capital. "The deal would have to be done with Facebook stock. And then you have to figure out how much the stock is worth."

And Facebook tried to over-egg its value:

Representatives of Twitter liked the sound of $500 million but balked when Facebook said its stock was worth $8 billion to $9 billion. Twitter's team knew that Facebook was letting employees sell stock on the secondary market at company valuations ranging from $2 billion to $4 billion. "We said it's not worth it," the person says. "Don't treat us like children."

At that point, Facebook offered Twitter around $100 million in cash, with the rest of the deal in stock. Facebook said it would come up with the $100 million by selling more of its stock to outside investors.

Quite right, what self respecting Web 2.0 startup wouldn't take it all in hard cash and run for Miami (After all, thats what the rest of them have all done). Facebook did not have the cash on hand to afford Twitter, so wanted to use stock. However, this option was effectively nixed by Facebook's decision to show an Order-of-magnitude overvaluation - who in their right minds would take stock from such an entity?

Interesting points:

(i) that its the VC, not the management talking here - how come, we wonder?.

(ii) its another abject lesson in the perils of stock overvaluation.

Timing, as they say, is everything and going into the Crunch with overvalued stock was not a good place to be.

Article in the FT today about the UK startup industry asking the government to provide more support to help young companies survive the recession:

Among the suggestions to aid start-ups are: a one-off financial stimulus package; a reduction in red tape; improvements in employment law; easier access to government loans; and the fostering of a more entrepreneurial culture.

Recently NESTA (National Endowment for Science, Technology and the Arts) called for the government to create a £1bn fund for “innovative technology ventures”.

But if I am honest, I think the word "innovative" is key. There has been (in the past anyway) a tendency for UK pork to often go to the well connected rather than the deserving. Any "bailout" money should not - in my view anyway - be used for companies that are doing me-too stuff, or are merely e-retailers, online consumer media plays etc.

What the government can do for all small companies is to reduce the friction in:

- Overall red tape - I still, after 4 years of running a small tech company, cannot believe all the arcane, irrelevant regulatory crap that one has to take on board as a director of a small company.

- Employment law - you could almost believe that UK employment law is designed to halt small companies forming. By the time every Health & Safety, Equal Opportunity, Protection of Workers etc special interest groups has had its say you wind up in a situation where the hassle of employing.
people is extremely high for small companies, and you need to take (expensive) HR people on board early to de-risk

- Getting Angel/Early Stage funding - as NESTA notes, withdrawal of venture capitalists from early-stage invest­ment has put pressure on business angel investors, making it “critical” government funding helps fill the gap. There are already 50:50 loans available, but many UK startups' experience of UK Angels is enough to make them want to get on a plane to San Francisco (and many do out of sheer exasperation)

- Equality of access to large corporate (and government) budgets - we went through a bidding process to supply to a large UK company last year, the time it took was the equivalent to a moderate project - in the £10-20k region - that sort of resource outlay hurts a small company much more than a large on (and yes, we got it thank you )

- More flexibility - last year we were selected as one of the promising startups for the CBA program, but in speaking to investors they hated the fact that we built innovative technology but also funded ourselves via consulting - they only wanted to fund us if we stopped consulting, which we are not prepared to do. In which sort of world is building a sustainable company model seen as a Bad Thing by investors?

- Make the grants system more realistic for Tech startups' needs - for example, there are lots of grants that are there to increase prospects for depressed areas, but the covenants are often too restrictive for Tech companies that need access to skilled people, high levels of connectivity etc etc

- Very simple and cheap ability to make companies pay on time - late (and increasingly non payment) is rife in the UK and still too hard to enforce for a small company

The trick in my view is to differentiate between the requirements of very small companies (less than 5 employees, c 80% of all UK companies), small companies (less than say 20 employees) and larger ones - currently far too much UK company/employment/regulatory policy is drafted with the assumption that all companies are at least medium sized.

I thought these two passages from the article articulated the key issue however, in that both are right:

Reshma Sohoni, chief executive of Seedcamp, an event held in London and across Europe for young tech entrepreneurs, said backers of start-ups that would in recent years have been allowed 18 months to start generating revenues are now being pushed to do so in two or three months.

Saul Klein, a partner at Index Ventures, said recently: “The best place to get money is from customers, that is the bottom line.”

Getting the balance between having a sufficient runway to actually build a business, but ensuring that the companies are actually viable (and what better way than real customers) is key.