Articles filed under 'Private Equity & Venture Capital'
Buttonwood has posted an excellent analysis of why financial markets are unlike other markets for goods and services:
This apparent contradiction can be resolved. Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.
Which explains why bubbles develop and burst and why ‘market fundamentalism’ does not generally serve us well when thinking about financial markets (as opposed to other markets.) Buttonwood also alludes to the fact that bubbles often develop at times of great change (has he read Perez???):
Why not just let the markets rip? Some would say that bubbles tend to coincide with periods of great economic change, such as the development of the railways or the internet. Individual speculators may lose from the resulting busts but society gains from their overoptimistic investments. However, this argument is harder to sustain after the recent bubble in which society “gained” some empty condos in Miami and holiday homes in Spain.
His conclusion is that because of these structural characteristics of financial markets, central banks (and possibly regulators and/or governments) have a natural, pro-active role to play in trying to mitigate or counter these problems.
Of course a few investors – the most high profile being Warren Buffet – have successfully arbitraged this weakness in capital markets buy being countercyclical, being “greedy when others are fearful, and fearful when others are greedy”; but as most people know this is bloody hard to pull off and exposes the investor to significant liquidity/solvency risks if they get the timing wrong. As Keynes said, “the markets can stay irrational, longer than you can stay solvent…” If you have an edge, even a small one, doubling down will usually work as long as you have an infinite bankroll. Ooops, small fly in the ointment. (Besides, if you have an infinite bankroll, what the hell do you need to bother about worrying about returns!)
Well I have neither an infinite bankroll nor the skills (and/or luck) to adopt a Buffet-esque investment strategy. But I do have some skills. And some experience. And I can recognise patterns reasonably well. And I have conviction. And a reasonable track record for building new markets and adopting and executing novel business models. So a few years ago I figured out that by focusing these modest talents and skills on investing in and helping to build new businesses, with a lot of hard work and days and months of research and reading I could generate pretty decent financial returns that were (almost) completely uncorrelated with the massive tides that buffet the world’s financial markets. And most importantly, this lack of correlation is structural – ie it doesn’t disappear in violent bear markets when almost all mainstream asset classes discontinuously jump to near perfect correlation (much to the chagrin of the VaR boys.)
It’s not hard to understand why. In fact it’s pretty obvious. For a new business, the ups and downs of the market, GDP, etc. have at best a second or third order effect on the company’s value. These factors are overwhelmed by the single most important factor driving value creation which is of course, can the company successfully sell it’s products or services to paying customers (or be more and more clearly on that path.) As someone wise once said: a “start-up is not GM” ie They are not correlated to GDP.
Now don’t get me wrong, I’m not suggesting that investing in new companies is without risk. In fact as most people would glibly observe, investing in start-ups is ‘very risky’. Well yes, but the risk is almost entirely idiosyncratic and manageable – much much less dependent on vast, uncontrollable, macro-economic trends and forces. And just because the risks are easier to identify and name, doesn’t mean it is easy to manage them, just that they are potentially (more) manageable.
So if this is true, why have venture capital returns generally been so poor (at least in the last decade or so) and why don’t more smart people try their hand at this (rather than trading/managing other types of assets)? Answering the second question first, I suspect this is because failing together is much nicer than failing alone, and so if the global financial crisis wipes out your hedge fund or investment bank or savings, well that sucks but, you know, shit happens. If however you pour your own (or worse your investors’) capital into a couple of dozen new companies that crash and burn, well that’s just a very lonely place to be. The answer to the first is not simple and you could probably write a book on this (perhaps Paul Kedrosky will?) but with the disclaimer that I don’t pretend to really know, my short and dirty take would be that there are two related factors at the heart of this failure. First, investing in new companies is hard to scale – at least compared to many/most other asset classes and secondly, the traditional structure of the industry is poorly adapted to this reality. Private equity legal and economic structures (which is how most venture partnerships are structured) doesn’t really fit the risk/reward/resource profile needed to invest successfully in new companies. Of course their are exceptions – both temporal and human – but just because their are some investors clever and/or lucky enough to make it work doesn’t make it right.
I could of course be wrong. And I could fairly be accused of hubris, especially as at this point I don’t have a long enough track record and/or enough exits to prove without doubt that my approach is correct. And while I am confident in my own abilities and have backed that up with a lot of “skin in the game”, I am even more confident in my larger analysis that while the venture capital industry might be broken / poorly organized, the risk-adjusted returns available to those who chose to invest – methodically and with a well-calibrated capital and incentive structure - in new companies, are excellent and, for the VaR-boys out there, truly uncorrelated to mainstream asset classes. The challenge is of course to find these investors and not to swamp them with too much capital. This problem isn’t solved but it looks a hell of a lot like the problem facing hedge fund investors (in most strategies that also do not scale beyond certain amounts of capital) and the asset allocation community would do well to try some of their more successful solution there on finding and seeding managers in this asset class.
And if you ask me, the rise of the ‘super-angel’ much talked about in venture circles these past months, is a step in the right direction and perhaps an indication that asset allocators are (finally) waking up to this opportunity.
Today I had the opportunity to be on the other side. Presenting our CiRX idea at mini-seedcamp London; attending as a ‘founder’ and not an ‘investor’ or ‘mentor’ for the very first time. And it was totally worth it. Not only was it valuable in the normal / traditional ways that seedcamp can help a founder but interestingly – although not altogether surprisingly – as an investor, it was very enlightening to sit on the other side of the table for once. I learned a lot. About CiRX of course but also about how a founder perceives the world (as opposed to an investor.) The only regret I have is that I don’t think I did a very good job of being mentored, especially with some groups and wish I could have another go. (Basically I talked too much. I know. Shocking.) Partly because well, I unfortunately do that sometimes, sorry. Partly because at almost a subconscious level, while I was supposed to be the mentee, my default tuning in this context is to be the mentor so sometimes I perhaps did both! And partly because I haven’t yet nailed the best way to succinctly articulate the value we see in the CiRX proposition.)
This last bit was a great takeaway because even though I probably knew that before, I definitely know it now and having muddled through a half-dozen live sessions has already now given me some ideas of how to better describe and deliver the value proposition of CiRX. Indeed it was funny to fall into the exact same trap I’ve (patronizingly? hope not!) warned so many founders about myself: ie to remember that 99% of the people you will speak to about your vision haven’t spent the last 6 months bathed in it and so the threshold of obviousness is much much higher than you think it is. What you take as given, is anything but to most people you will meet. In any event, I would highly recommend that anyone investing in early stage companies walk a mile in those shoes. A bit humbling, but more importantly very enlightening.
I’d like to thank all the mentors whom we met and really underline how much we appreciated their forthright opinions and incisive analysis. Farhad and I got a lot out of it and I suspect that we will tweak our plans based on some great insights and suggestions we received throughout the day. Also at the risk of sounding a bit soppy, I’d really like to publicly thank Reshma
and Saul
for the incredible job they have done building the seedcamp community and ecosystem. I am reminded of the summer of 2007 when I made a rash decision to invest in this new thing a guy I barely knew named Saul (who admittedly had come highly recommended) was organizing and thinking now what a terrific investment that has been. And that’s before getting any of my capital back!
Finally, I just have to say how impressed I was by the quality of the other teams that were invited. Really really impressive. Not so many in our investment space (although Subsify is a company that caught our eye and we’ll be interested to learn more about) but the two that really stood out for me were Editd and Memrise. Would be very surprised not to see these two make it through to seedcamp week in September. Eyequant too.
As for us, well we certainly have a lot to digest and a lot to work on…but that’s exactly what we hoped for.
You may have noticed, I haven’t been posting much here lately. It’s not that I don’t have anything to say, probably just the opposite (!) but have be full out from dawn until dusk working on a number of exciting new projects including our own development (more on that in a few weeks.) One project that has been front of mind the past few weeks is a new company we are developing that is directly inspired by Paul Graham‘s great advice to “solve problems that affect you directly”.
A bit of background. When I was in banking, one of the achievements I was most proud of was effectively using web technology to transform how (debt) capital was raised (at least in Europe*.) At DrKW, we built what for many years was the state of the art capital raising platform, whose core product was our eBookbuilding platform (now in Commerzbank yellow!) It completely revolutionised what had heretofore been a disjointed, manual, somewhat ad hoc process into a seamless, collaborative, mostly painless process. Initially it met with enormous resistance from other (much bigger and more successful) banks and syndicate managers, who as ‘guardians of the temple’ jealously guarded their power, derived (in their minds) from the information asymmetry they enjoyed (vs issuers and investors.) However – and despite being at best a middling player in the fixed income new issues market – our disruptive technology was such a big improvement on the status quo that eventually the market adopted our standards (with everyone then rushing to build their own analogous platforms.) In the spirit of making sure these platforms could ‘play well together’ we even published our XML-Schema for new issues and invited all our competitors to contribute to it and use it. (Which had the effect of basically freaking out our competitors. They thought we were crazy – like Ali
– because they didn’t have the slightest idea what it means to compete in a world of information abundance and platforms, but that story is for another day…)
Anyhow, when I became seriously and then professionally active in ‘venture capital’ or more generically speaking, in investing in private companies, the lack of technology available to manage workflows surprised me; I was particularly puzzled because ostensibly this was a world populated with techophiles, early adopters and people who ate disruption for breakfast (quite unlike the world of institutional capital markets). Further, there is much talk (and consensus) around the fact that it is hard/impossible to scale venture investing. And while I think this holds at some level, it struck me that a significant number of the gating factors limiting the ability to scale could be vastly improved. Not to infinity but substantially, perhaps by an order of magnitude. Pulling out an example from my old career, when I started life as a bond trader 20 years ago (ack!) the number of bonds that a typical good trader could manage numbered in the dozens at best (and even then, you would find that a trader really traded 10 to 20 bonds 80% of the time and sort of went through the motions for the other bonds hoping most of the time not to trade.) Then came Bloomberg. And excel spreadsheets. (And later bespoke pricing and analytic tools and platforms.) And all of the sudden, a trader could manage a book with hundreds of securities. There was still a degree of 80/20 but everything was an order of magnitude bigger.
I don’t know if our new initiative will definitely achieve that degree of change in the private investment market, but we are convinced that there is a better way and having a fit-for-purpose platform to help company management, non-executive directors and investors communicate, collaborate and manage their positions and responsibilities would be a huge step forward. It’s not that nothing currently exists, but I would say we are at the ‘excel spreadsheet’ phase to use my bond trading analogy – with many firms and people starting to use things like Google Apps or Basecamp and the like to better manage information flows and collaboration. But while this (and excel for traders) is (was) a good start, the real juice comes when dedicated, purpose-built platforms emerge. If you have a screw that needs driving, a hammer is better than nothing (or a rock) but a screwdriver is even better! (A power screwdriver better still!)
So we conceived of (what has been provisionally named) CiRX – the corporate director and investor relations information exchange:
CiRX is a purpose-built platform enabling private companies, directors and investors to communicate and collaborate more efficiently saving time, money and effort. By streamlining processes and connecting stakeholders in an intuitive and context-rich environment, CiRX offers a tailored yet consistent solution to the challenge of managing information and documentation flows, reducing administrative burdens and creating opportunities for a richer, more dynamic and flexible approach to corporate governance and strategic management.
Over the past few months, we have been developing the concept, the business model and have done a significant amount of macro research to identify the potential size of the market opportunity and now have started to take the next step and ‘talk/think details’ as they say. In order to support this next stage of development, as we are poised to start ‘cutting code’, we wanted to get more direct feedback from the community – of company executives and founders, non-executives, angel and institutional investors – to better understand how their experiences and perceptions were both similar and different to our own. To do so we created a short(ish) survey and have sent it to a number of our contacts across all these communities, but if we missed you and you are a company founder or non-exec director or investor in one or more private companies and you are interested in contributing your views, you can find the survey by clicking here. (We’ll leave the survey open for a couple weeks probably but if you are so inclined to complete it, we are excited to be presenting CiRX at mini-seedcamp London next week so would be great to have as much feedback as possible before then.) Of course you are also welcome to share your views – good, bad and ugly – in the comments below.
* That e-bookbuilding (generic) never gained acceptance in the US (at least not while I was still in the market) is in my opinion a telling manifestation of the oligopoly of Wall Street (which gives us things like 7% IPO fees with the spooky consistency of North Korean election results) which absent the pressure of competition, allowed the dominant underwriters to resist this change tooth and nail. It was even more glaringly apparent when these same US firms operating in Europe adopted e-bookbuilding as strongly as everyone else once it was obvious it was an evolutionary winner…
Where is Goldilocks when you need her? On the one hand you have high frequency and algorithmic trading dominating the world of listed companies with market shares often exceeding 50% of all volumes traded and with increasing instances of unstable trading and extreme volatility in liquidity as these machines enter and exit the market creating a complex, unstable chaotic system where long term investors who aren’t careful can literally be run over in both directions like Wile E. Coyote on an Arizona desert highway… On the other hand, in the world of private investments – in particular in the broad category known as venture capital – liquidity remains elusive with (too) many practitioners having a disfunctional and often irrational set of beliefs as to how and when liquidity is acceptable and when it is not, with the end result making naturally illiquid investments even more so. And yet, wouldn’t it be nice (for investors and companies) to have a long term capital market where liquidity was “just right?”
So what would just right liquidity look like? Can you have your cake (all the typically enormous strategic advantages that accrue to a private company) and eat it too (the advantages of being listed, afforded by having a periodic mark-to-market and the ability to use your equity as a real currency)? I think you (mostly) can and am very encouraged to see this sweet spot slowly emerging and gaining traction outside of a handful of what previously would have been considered exceptions to the rule. In my opinion, the answer (as I have mentioned before) lies in further developing secondary markets in private company equity.
The two most successful companies I have had the privilege of investing in – Markit and Betfair – despite being multi-billion dollar companies and market leaders, are still today private companies and have provided liquidity to investors, management and employee shareholders (in different ways) which has gone a long way to allowing them to remain private and reap the associated benefits. The flexibility of Facebook’s management to run their company for the long term optimal outcome has I suspect been a direct function of the liquidity that secondary investments (from DST) and a relatively active secondary market in Facebook shares on platforms like Second Market and SharesPost have provided to early investors and employees. And it’s not just about cashing out – at least half the value of these secondary markets comes from providing a credible mark-to-market and the reasonable expectation that – if needed – an investor could access liquidity. Perhaps paradoxically, with these two factors in hand, more often than not, investors will actually have a higher propensity to hold on too their investment, not lower.
Another benefit of secondary markets would be to improve the health of the overall venture investment ecosystem which while evolving in fits and starts, most recently with the rise and rise of “super-angels” and “seed funds” still mostly remains in the eyes of this industry outsider, static and prone to herding around the notion that one-size-fits-all in terms of capital structure and financing paradigms is somehow optimal and should not be questioned. In particular, I fail to understand why the received wisdom of the venture capital community seems firmly stuck on the concept of “nobody exits until everybody exits”. It’s a dumb concept and worse, quite frankly is at odds with the interests of the various investors and stakeholders in a private company, including later stage investors (aka mainstream venture capital funds.) I believe much of the angst surrounding seed stage investing and (traditional) venture capital investing, arises as a result of a dysfunctional transition mechanism. (ie There isn’t really one.)
What I would like to see – and quite frankly have never heard a good counter-argument against – is a more dynamic and flexible financing chain, one that pragmatically combines both primary and secondary elements. Practically speaking, what would this mean? At its simplest, it would mean that at any given funding round, the possibility of existing investors exiting part or all of their holding is considered objectively and without undue emotion. Having participated in many such transitions in companies going from “seed” funding to “series A”, or “series A” to “series B”, etc. the relationship between existing shareholders and the new shareholders is far to often one of conflict – to the extent that this is often seen as just the normal way of things – when there is no reason that this ever need be the case. Venture capital firms often talk of “needing” to invest a minimum amount of capital and/or “needing” to own a certain minimum stake in the companies they invest in. While I think the case is sometimes overstated, if you understand the dynamics of their business model, their attitude is easily understandable and basically rational. And yet, I have never yet seen a venture capital fund offer to buy-out the early stage investors in whole or in part when more often than not this would be an ideal outcome for everyone:
- the company: not needing to raise more new capital than strictly necessary
- the early stage investors: (whether professional angels or seed funds or friends and family) allowing them to reduce risk, recycle capital and retain focus on the market segment (early stage) they know best and which corresponds to their capital base
- the venture capital funds: allowing them to simplify the capital structure, deploy more capital and ease negotiations
If this became the norm, I think it would drive a massive downstream benefit which would be to create a more dynamic, focused and intelligent early stage investment paradigm as investors in this ecosystem niche could really focus on funding two types of companies:
- companies that have a plausible case to become successful but modestly sized businesses worth $10-40 million; and
- companies that have a plausible case to become “VC fundable” where the goal is to exit in a series A or series B at $10-40 million
This would considerably improve both the availability but also the quality of early-stage capital as the risk / return dynamics would become much less random and the impact and velocity of the best investors in this space would increase considerably, providing more, cheaper and easier access to capital to entrepreneurs while at the same time providing a fantastic “farm-system” of talent and corporate development to later stage VC’s, perhaps even allowing (the best amongst) them to deploy their hundreds of millions or billions of capital efficiently as their ecological niche becomes better defined. I am absolutely convinced that this paradigm would create a much healthier, more vibrant capital market for innovation and disruption, improving returns for everyone in the ecosystem.
What I am not saying is that buying out seed investors would be appropriate in every situation. Nor that all seed investors would always be happy to sell all or even part of any individual investment. Nor that later stage investors should always look to buy out early stage investors. What I am saying is that this discussion should always be a part of the financing tool-kit, this option should always be on the table, and dismissed only when and where it is objectively inappropriate. Let’s get rid of the dogma and let markets work. Liquidity: not too much, not too little, let’s get it right!
Ten days ago, an irresponsible and unthinking young man crashed into me from behind at great speed while I was skiing with my children. The force of the impact broke two things: my right ski and the top of my right arm. There were multiple fractures and (the shoulder being full of many nerves, tendons, muscles) I was advised that I would need surgery to ensure proper healing and that I should entrust this only to an expert specialist surgeon. Fortunately, via my network I was able to identify just such a doctor quickly but it meant that my surgery could not be scheduled until Wednesday last week. I think it is fair to say that I totally underestimated the seriousness of the injury and surgery and somehow thought I’d be patched up and good to go in a day or so. Today is Tuesday and only now am I “back at my desk” feeling pretty good, although without the use of my right hand for typing. So, other than some limited iphone-based twitter and email scanning, a couple calls and starting some “to-do triage” over the last couple days, this totally random accident has cost me nine days “offline” (in the broader getting-things-done sense) and will continue to impact my productivity – in particular my ability to travel and type – for at least the next 4-6 weeks. While I am confident that I’ll be able to adapt somewhat (my left-hand only typing is already 5-10x faster than a couple days ago, although still not close to my usual 60+ wpm and I can now actually get the curser to the right spot in under a minute using a mouse), it would be ridiculous not to acknowledge this as a unwelcome setback.
But why am I explaining this here? And no, it is not to generate an outpouring of sympathy 
(which however I must acknowledge as very nice as I have been fortunate enough to have been reminded of over the past week.) No, there are effectively two distinct reasons I thought it would be worth telling this story.
The first is from a strictly practical standpoint: to get the word out to all the people I “work with” on a day-to-day basis without needing to write dozens or hundreds of emails (never much fun at the best of times but even less appealing with one-hand…) I suspect not all the people that I’d like to have this information are readers, and clearly for many of you this is probably unnecessary information, but while clearly not perfect, the broadcast mechanism of a blog I felt was the best option available to me. So for those of you waiting for an email or call to be returned, or an appointment to be confirmed, now you know what has happened and I would ask your indulgence and patience. If you have heard nothing back from me in the next few days or so, or if it is more urgent than that, please follow-up with a nudge. Otherwise, give me a couple weeks and I’m sure I can get back on top of things (at least as much as I ever do!)
The second reason is hopefully more interesting to a wider audience and is about addressing one of the risks that seems to me to be less discussed in the vibrant “start-up commons” that many other issues venture entrepreneurs and investors face. This is the risk to founders health from exogenous, unanticipated events.
In particular, I’m interested in risks not readily addressable by traditional key-man life insurance. This of course is a standard requirement when raising outside investment and insofar as it protects investor capital (if not their opportunity cost) from the worst-case result of a catastrophic injury or death of one or more of the founders (ie winding up of company), it probably doesn’t help in the more probable situation of a significant productivity loss due to severe illness or accidental injury. Thinking through our portfolio of early stage companies, I dare say none of them has thought much about this except for one, and if I am honest, this was only because we had to manage just such a risk in the early days of the company (which I’m happy to report was successfully done, helped of course by the individual’s recovery proceeding as expected.) If you are a start-up founder or investor, have you given this much thought? If so what sort of solutions or contingencies have you put in place to mitigate this risk? Are any insurance companies writing policies that pay out (to companies, quickly) in the case of non-critical short term health issues with key personnel? If so is the pricing reasonable?
I’ve obviously had a few days and a good reason to think about this, and just to be clear, have been considering the question in the first instance from the point of view of a founder. (For while we are also investors, my company is in fact a start-up and I am reliant upon it for my livelihood.) And in terms of protecting my family, I have life insurance, but this accident underlined that in the event I were temporarily incapacitated and unable to work, mitigating the financial risk arising is potentially much more problematic, and that this is a problem (most acutely) faced by start-ups and small businesses. Indeed, were I still working for an established (big) company or organization, I have a very nice letter from my doctor stating I cannot work for the next 4 weeks and so I would sit at home collecting my salary and healing. But even more importantly, the business of the company would go on (even if I were Steve Jobs); and while (one would hope that!) some opportunity cost would be incurred, the larger and more established the company or organization, the more marginal it would be. ie The problem (for founders and their investors) isn’t insuring the loss of a month’s salary/revenues/burn per se (which is I’m sure a tractable actuarial problem.) Rather, it is insuring the opportunity loss of a month of foregone productivity or progress. And because the “value” of this lost opportunity is subject to so many internal, external and temporal/situational variables unique to each founder/company pair, I suspect this is probably an uninsurable risk, at least in the sense of financial insurance. Indeed, I think the solution to mitigating this risk if one exists lies more in ‘operational engineering” admitting that in some cases even this will be impossible.
And so my (highly tentative) conclusions are that:
- founders should probably think about a “Plan B” to manage their personal risk (eg this could be cash savings, support from family, returning to traditional employment, etc.)
- investors need to consider the value of portfolio diversification in this context and perhaps, insofar as possible, think about what critical skills may be replaceable on a temporary basis should a founder be incapacitated for a few weeks or months and ideally build a network of people who have or have access to these skill sets; my thinking here is not to suggest that founders are replaceable but that it may in some cases be possible to soften the impact should the unexpected happen.
I would be very interested in the community’s thoughts on this and in particular whether they think it is a risk that can and should be acknowledged and managed in early-stage (and/or later-stage) companies, or if on the contrary they believe this is an intractable risk and so just needs to be “accepted” without wasting any time, energy or money trying to manage it.
So having spent 90 minutes on this post (sooo slow…) I better get down to work, and so while I’ve a dozen posts up my sling, I probably won’t be back here for a week or so as I work my way through a daunting (but mostly exciting) to do list. Oh, and for the next few weeks at least, you can just call me Lefty.
I’m not sure what the venture community makes of Right Side Capital Management, but I think their novel approach to early stage investing is really interesting:
Yes, we do love fledgling startups. They may not have finished products, marquis customers, or proven markets. But every one has “Black Swan” potential.
Given the opportunity they represent, seed-stage startups are badly underserved. The chances of finding funding are so low that many qualified entrepreneurs sit on the sidelines. It takes so long to put together a decent-sized angel round that many promising companies miss their market window. The transaction costs are so high that a good chunk of investment capital evaporates instantly.
We’re going to change that. We’re planning to fund 100-200 seed-stage startups each year and give founders a yes-no decision in two weeks. It’s a win-win. Lots of entrepreneurs get a chance to innovate. We get a well-diversified portfolio.
I think this approach is very clever and (in a slightly different context) in fact a couple years ago worked on a business model focused on improving angel funding process / environment (for both investors and entrepreneurs) that very much relied on a similar systemization of process. While I’m not sure we are ready for a fully algorithmic early stage investment process (black box VC anyone?), it seems clear that there is certainly a lot of room for a more robust (technology-enabled, data-driven) process, lowering costs and improving efficiency. I hope RSCM succeeds and in so doing helps move the market towards this vision which I think would be a win for both investors and entrepreneurs.
I particularly like the way they have clearly articulated one of the key factors involved in early stage investing – chance – and how their high-volume, process-driven approach addresses this issue head-on and seeks to mitigate the impact of luck (good or bad) on portfolio returns:
However, we also understand that the probability of a particular young startup succeeding is relatively small. Many things are beyond its control. Many things can change. Many things have to go right. Probability compounds and there are literally thousands of factors that can significantly affect a young startup. So there’s a tremendous amount of uncertainty. We do not believe anyone has a model with much skill in picking winners at the seed stage. Therefore, the only reasonable strategy is to diversify away the idiosyncratic risk as much as possible by constructing as large a portfolio as is practical.
No one can claim to ever be able to fully remove risk from any process, but by bringing talent and a deliberate process to bear, I do believe one can improve the odds of any given outcome considerably. A top professional golfer cannot guarantee a hole-in-one, and indeed it is possible that a 36 handicap weekend warrior could get one. Black swans etc. But if the competition consists of hitting 100 balls to a par 3 green and scoring 10,000 points for a hole in one, 100 points for any ball within 3 feet and 10 points for any ball on the green, I know I’d much rather back the professional golfer, even though there is a non-zero chance that the hacker could get lucky and win. I think venture – and especially early stage – investing is similar. I can’t guarantee any investor that I will get a hole-in-one. But I think I can make a credible case that most of the investments I make will be ‘on the green’ and a fair number will be ‘inside the leather.’ It seems that RSCM have taken this view and put it explicitly at the heart of their approach.
However, I would be curious as to the reaction of their potential investors/LPs to this kind of approach. It is entirely anecdotal and quite possibly an unrepresentative sample, but we have found most investors to be very cautious with respect to any new approach and/or structure, preferring standardized and ‘traditional’ ways of doing business with innovation a domain to be restricted to the companies we invest in. This of course may be particular to our circumstances, but given the extremely high homogeneity in fund structures and investing approaches we have observed across the venture capital (and private equity) universe, it would indeed seem that limited partners have little or no appetite for (as RSCM puts it) “innovation in the business of innovation.”
So if there are any LPs out there reading, I would encourage you to comment on both RSCM’s model specifically, and especially on innovation in fund structures and/or investment methodologies more generally.
Today Kublax
announced that it was closing down:
The race the create the Mint.com for the UK has claimed its first victim. Kublax, a Seedcamp 2007 winner which launched in August 2008, has now gone into administration, saying it was unable to secure a further funding round.
I’m pretty disappointed to tell the truth. Not so much because we held a small stake (via our investment in seedcamp) although this is unfortunate, but mainly because I think their business proposition is valid and although they certainly made mistakes along the way, these mistakes were probably avoidable and actually more to do with raising capital and managing a start-up than anything specific to Kublax. Of course to be fair, in any new venture all aspects of execution are at least as important as the idea and/or market opportunity and a two-legged stool won’t stand. Debating which leg is missing or broken and why is ultimately a somewhat irrelevant exercise. The reality is they didn’t make it happen. Nonetheless I feel badly for Tom and Sri, who I know put a lot of passion and effort into building Kublax and stayed focused and pragmatic to the end.
The general (ie non Kublax-specific) lesson that I would put at the heart of a case-study on Kublax is that capital is important. Now that might sound blindingly obvious – and of course it is – but stay with me. The lesson I see is that not all (‘tech’) start-ups can succeed bootstrapping a few hundred thousand pounds into a sustainable business model. As a relative outsider, I have and remained perplexed by the ‘one-size-fits-all’ capital model that seems pervasive in European venture capital, which often in reality turns into a feast or famine of capital for individual start-ups. Kublax was built on a shoestring and quite frankly it showed. The chicken never laid the egg and so the end became an inevitability. But I wonder if it could have been different.
You might be wondering why we didn’t invest in Kublax.* It really came down to one thing: we did not have the capital resources required to allow Kublax to hit ‘escape velocity’. I have looked very closely at Kublax over the last 18 months, and indeed we wanted to invest. However as a result of our analysis, we believed that the best risk/reward scenario would have required them to raise at least £2 million pounds and possibly as much as £5 million. Upfront. Not being in a position to provide this quantum of finance at the time, it would have been foolhardy to commit capital only to be ultimately at the mercy of other people’s investment committees. Further – and accuse me of hubris if you like – we felt strongly that our specific skills, knowledge and networks would be able to materially help the company successfully address some of it’s key strategic and operational challenges. However it would not have been economically rational for us to deploy these resources against only a modest investment. So we were confined to waiting on the touch line for others to drive the process. In the event, none did.
Lack of capital was not the only problem at Kublax, but I think the other key issues that the company faced could all have been addressed given sufficient capital. I will highlight four examples:
- capital structure (specifically who owned how much and why)
- management depth and experience (in particular in financial services)
- product and user experience (never evolved beyond alpha quality); and
- marketing and brand awareness
All of these issues could possibly have been solved with an appropriate infusion of capital from a serious and domain-knowledgeable investor. A cynic might point out that these four factors are pretty much the only four factors that matter so saying you would invest subject to being able to improve these is tantamount to saying you would invest if the company was ‘good.’ Well yes. Sort of. I think in the case of Kublax, the investment decision would have boiled down to a ‘build vs buy’ logic. Starting from scratch is hard and for all its faults, Kublax had done a lot of the basic plumbing (hard, unrewarding but necessary) and didn’t get a chance to start laying the tiles (hard but rewarding.) I find it hard to believe that asset is of no value.
In any event, given Kublax’s seedcamp pedigree, I imagine that most or all of the establishment London venture capital firms had the opportunity to look at Kublax. I think it would be very interesting and helpful to the broader UK/European start-up ecosystem to understand the key factors that informed their decisions to pass. Ask your favorite London VC to comment below.
So would we have invested if we had been in a position to underwrite a £2-5 million investment? Quite possibly. And indeed we would have made a determination on each of the four points above to really understand if these issues could be addressed, and the execution risk reduced accordingly. Alternatively we might have decided (and still might in the future) to incubate something similar ourselves.
In any event I wish Tom, Sri and the rest of the team at Kublax all the best for the future and hope they take away as many positives as possible from what must be a very disappointing outcome.
* I am referring here to what I call “Kublax Mark II” – in the early stages of the company’s life there were some clear management issues and dynamics that overshadowed the business and market opportunity. However seen from the outside, the company and it’s shareholders eventually addressed these issues and seemed to have a fresh start with some new investors coming on board and importantly a new CEO (Tom Symonds) early last year. It’s at this point we became interested (having explicitly passed a year earlier due to our lack of confidence in how the company was being managed.) Unfortunately one of the lessons is that it seems in the world of capital raising you often really do only get one chance to make a first impression…
AMEE announced today that they had closed a new round of financing. I think this is a fascinating company and compelling opportunity. Given the chance, would I have for certain chosen to invest? Based on what I know of the company and its management, I would like to say yes. Probably. I’m forced to hedge my opinion because I just don’t know enough, especially with respect to the financials and the attractiveness of the valuation given the opportunity. But given what I do know, I would have loved to have them in our portfolio. And I’m certainly more than a little disappointed that we weren’t in a position to throw our hat in the ring, do our homework and at least make an offer…
Which brings me to an idea I’ve been toying with for the past several months. I’ve been contemplating publishing a virtual portfolio of venture and private equity investments – ie the investments we would likely have made (and would make) had we the capital available. A sort of an analogous take on Covestor or Marketocracy but for private investments.* There are however a number of reasons I have not taken the plunge. Perhaps most obviously is the issue of proprietary knowledge. After all, the heart of the value proposition we make to prospective investors is that we have a unique and robust investment thesis and that based on this foundation, we have identified (and will continue to identify) exciting young companies who are naturally adapted to grow and prosper in the coming years. If we tell everyone who these companies are, why would anyone need to pay us a fee? Why wouldn’t they just invest directly. Or more likely, why wouldn’t competing investors just ‘free-ride’ on our research and analysis, using our list as a filter or more? And what if the companies we listed failed (see below)? What benefit would there be to publishing such a list?
Further, there are a number of structural factors at work that mean that the ‘Covestor’ metaphor is imperfect at best and fundamentally inappropriate at worst. Investing in private companies involves a number of challenges that are different/additional to those faced by a public company investor. A number of these factors are interrelated but for the sake of clarity I’ll try to enumerate a few:
- deep information deficit: for most of the companies that would appear on such a list, our information is significantly limited, especially with respect to financial aspects (budgets, sales, valuation, etc.) As a practical matter it is usually not possible to obtain this level of detailed information unless one is actively engaged with the company in view of a potential investment. Obviously it would be completely disingenuous for us to misrepresent our capacity and intentions simply in order to be able to put our slide-rule over the financial model. Further, without the potential pay-off of being able to follow through and invest in companies that pass due diligence and valuation muster, quite frankly we don’t have the luxury of doing such a deep analysis even if the company was happy to provide us the data.
- price (valuation): while perhaps less important (within reason of course) the earlier you are in the life-cycle of a company, it is obviously a key input that is quite often unavailable. To be fair, one could possibly – at least for the purposes of such a list – assume that if respected investors participated in a given financing round that we would have been ok with the pricing too.
- value enhancement: call it hubris if you like, but one of the key inputs in our investment process is understanding to what extent our participation as an investor can help reduce risk and accelerate success. Elements of this analysis can be done from ‘outside’ but without a deeper understanding of the business and in particular a personal relationship with the management team, it is hard to properly assess what value, if any, we can bring to the table. Some companies that look great to us from afar might just not be a good fit.
- managing destiny: (a variation/specific case of the point above) particularly for seed and very early stage companies, one of the biggest risks they face is securing follow-on finance. In this context, a theoretical investment and a real investment are fundamentally different: there are many ways a company can fail. Failure is failure of course but I suspect there is a risk that some of the companies on our wish list might indeed fail to raise follow-on capital, whereas had we invested for real, we would be prepared to follow-on in most cases, mitigating if not eliminating this risk. Of course it’s probably impossible – even ex-post – to definitely identify companies whose failure was ultimately unavoidable (market driven) from those whose failure was only due to a financing gap.
The case for publishing such a list – assuming you can overcome some of the structural limitations outlined above – really boils down to building reputation and trust, both with potential investors and existing and aspiring entrepreneurs in particular and within the wider venture capital / private equity ecosystem in general. Part of me also likes to think that there is less risk, in terms of ‘giving away’ intellectual property, than would be the case for say a hedge fund manager focused on public equities: anyone can buy a public security, the same is not true of private companies. Wanting to invest is not sufficient to allow one to invest. Further, let’s be realistic: for better or worse, I’m not Warren Buffett or John Doerr or anyone really…will the fact that I say AMEE is a must own company really make a difference to anyone? More importantly (to me!), will it make it more or less likely that I will be able to use my skills to make a living identifying and investing in great young companies?
Basically the only potential downside to publishing a virtual or ‘wish-list’ portfolio I can see is the fact that one would have to assume that any nuance and qualifying information attached to such a list would ultimately get lost and that for better or worse, the companies would be inextricably linked to me without qualification. I was thinking that a list constructed as ‘Probables’ and ‘Possibles’ might just allow some useful qualification without diluting the impact. And yet, I hesitate. And I’m not sure why. So I thought I’d ask you.
- Why should I not publish such a list?
- What (if any) qualifications should I include, were I to publish such a list?
- Why don’t other investors publish lists of deals they would like to or would have liked to have done? (before outcome is known of course!) (Or if any do, please tell me who/where.)
* Is there a business idea in here somewhere? Sort of a Covestor meets seedcamp for aspiring new private equity managers? A set of tools and a community to help LPs identify new talent and spread their investments in this asset class more widely (and intelligently) without the limitations of the existing fund of funds business model…
This week NEA announced the close of their latest fund at $2.5 billion. That seems like a lot of money for one venture fund, although perhaps if the intention is to focus on (highly capital intensive) clean tech and/or biotech they will be able to deploy this amount effectively. Of course NEA, founded in 1978, has a long and successful track record, with I imagine many long-standing relationships with LPs and excellent ‘brand recognition’ within the universe of potential LPs, and so it is hardly surprising that they are able to raise such large funds. After all – especially with respect to institutional investors – the analog to the ‘nobody-ever-got-fired-for-buying-IBM” paradigm operates in their favor.
A couple years ago, when I first started thinking about what would become Nauiokas Park, a good friend told me that private equity was all about raising capital, not investing it. Of course I understood what he
…private equity is about raising money, not investing it.
was saying, but thought he was using hyperbole to make the point that raising capital was more important than just a means to an end (investing.)
Now I understand that however cynical it may sound, he wasn’t trying to be clever: the way the institutional marketplace for private equity (including venture capital) is structured is all about raising capital and only incidently about investing that capital.
For better or worse, the year-end is typically a time to step back and take stock, to reflect on the year that was and the year to come. And indeed I have been thinking about what we could have done better or differently last year and what we need to focus on in this new year. And the short answer is we need to spend less time thinking about the economic and industrial landscape, developing our investment framework, sourcing potential investments and nurturing our existing investments, and more time soliciting potential investors: pitching our skills, our approach and the opportunity we believe exists to people and institutions that will determine whether or not we can turn our vision into reality. And like any start-up, we are going to have to be hard-headed about how we approach this as the proverbial runway is running out. As they say, there is a fine line between tenacity and obstinacy. I want to try to stay on the right side of that line.
Of course, once the lightbulb goes on it becomes obvious that raising money would be the most important talent of any prospective private investment firm: your LP’s, shareholders, investors are your customers (and not your portfolio companies.) They are they ones that ‘pay the rent’. They consume your service which is to invest their capital. Ah but the better the service, the more customers you have and the more successful you will be, right?
Well not exactly. In investment management generally it is very hard to determine a priori the quality of service one is likely to receive, which is why so often prospective investors – be they retail or institutional – fall back on historical performance to make their judgements. This reliance on historical data is clearly imperfect. However, when considering (many types of) hedge fund or mutual fund, given the typical investment horizon and liquidity profile, a consumer of these services can at least adjust relatively dynamically if they make a mistake. The effect of this is to reduce the psychological barrier to ‘taking a risk’ on any particular investment manager in these asset classes. But given the long time horizons and relative illiquidity in private equity, investors cannot exit a decision easily and so are (even more) inclined to stick with well-established firms and are less open to considering newcomers.
Basically “track record” is the box that needs to be ticked. And is much more important than having a coherent, well-researched and plausible investment thesis. After all, if you have the money, the deals come to you. But a track record in private equity is hard to come by quickly. (And it needs to be the ‘right’ kind: the first time I was told (by a prospective investor) that having been a founding investor in two multi-billion dollar companies didn’t ‘count’ because I wasn’t “a professional investor” when I made the investments was frustrating and somewhat irritating I have to admit.)
Given our domain specialization and investment framework, we are very interested in understanding the dynamics of two-sided markets. Companies that successfully position themselves at the nexus of these markets are typically very, very valuable. There are many examples – credit cards, advertising, computer operating systems – and I suspect the number of such markets will continue to grow as the economy becomes increasingly digitized.
A company active in a two-sided market provides it’s services to two distinct constituencies. Often times, they provide those services for free to one side of the market, in order to increase the value of the services they provide to the other side of the market. For example, Visa provides consumers a free payments service (and actually often pays consumers to use their service via loyalty programs, cash back, etc.); in so doing they can charge merchants to use their services which have value to the merchants because of the number of consumers who use their platform. In effect, Visa sells ‘access to consumers’ to merchants. In a different context but the same vein, Google sells access to consumers to advertisers.
Successful private equity and venture capital firms “sell” access to dealflow to their investors and limited partners. It is a two-sided market. And so it is natural that network effects apply and rational for investors to be pre-disposed to the biggest, most established players. It is reasonable to think that NEA (and KPCB, Index, etc.) or Blackstone (and KKR, Carlyle, etc.) will see a high proportion of the best deals. So far, so true. But unlike electronic payments or algorithmic online advertising, investing (in private companies) does not scale and so unlike these markets, the law of diminishing returns kicks in much, much earlier. The industry (well, much of it) admits as much: I suspect if you offered the GPs of NEA a $10 billion fund, they would probably demur. Indeed I suspect if you offered USV a $500mn fund, they would probably turn it down. The key point is that for any given private investment strategy (sector, stage, etc.) there is clearly a maximum optimal fund size. For a company like Visa or Google, this is not the case – more customers, more merchants, more searches, more advertisers – it’s all good.
Jeff Bussgang recently estimated that the (US?) population of active VC partners was approximately 1000. I don’t know how many mutual and hedge fund managers there are but I suspect it is at least an order of magnitude higher than this. This seems intuitively wrong: investing in a private company is more work and there are more of them. You have a thousand investors looking at a universe of tens of thousands (or more) of investable private companies and tens of thousands of investors looking at investing in a universe of thousands of public companies…
Paul Kedrosky (and others) have written extensively and intelligently on how the venture capital industry needs to shrink. How too much money, chasing too few opportunities has destroyed returns. The logic is compelling. However I would posit that the problem is not too much money per se, but too much money with too few and homogeneous investors.
Let’s look at these two constraints sequentially (although they are co-dependent to a large extent.) If you double the number of GPs but provide ten times more investment capital, on average the valuations of the investments they make will go up five times (thus significantly compromising their future returns.) Ah but this logic assumes a closed system – ie that both the number and types of investments are held constant, and so increasing the ‘money supply’ drives inflation (and lower real returns.)
Well in a world where the number of GPs is constrained, and most of them come from similar geographic, educational and professional backgrounds, this assumption is likely to be more right than wrong. Indeed it is embedded in the initial conditions above – ten times more capital allocated to the asset class does not result in ten times the number of GPs. And yet the number of investments any GP can effectively manage is by definition bounded (at a reasonably small number.) (Which is of course why firms like Apax eventually exited venture capital and ‘graduated’ to private equity.) Perhaps an even more important gating factor however is the number of potential investments a GP can seriously analyze and consider each year (dozens? a hundred or two?)
And we uncover the Achilles Heel of the (otherwise extremely successful) ‘Silicon Valley’ model: the relative homogeneity of the environment leads inevitably to a collective narrowing of the universe of potential investments that is considered and amongst these, an additional narrowing in the way they are evaluated and considered. ie Everyone sees the same deals and runs the same slide rule over them. And so more capital simply means valuation inflation and ultimately, lower returns.
But what if we were able to disrupt this state of affairs? Having spent the past two years intensively researching the markets we are interested in, I simply don’t accept that the ‘problem with venture capital’ is a bounded set of investment opportunities. I’m sure there is some limit to the number of good entrepreneurs, viable business models and attractive market opportunities but we are nowhere close to reaching it. In fact, it is so far away we can’t even see it yet.
No, the problem is a failure of market design. (The irony being of course if this market design failure were in any other industry, venture capitalists would be aggressively investing in companies and business models designed to correct and take advantage of this failure.) The problem simply stated is too small a number of too many similar venture capital and private equity investors. The solution is more, and more diversity. The question is how?
I’m sure you won’t be surprised to hear that I have a few ideas on the subject, and for my first (and only) New Year’s resolution, I will endeavor to articulate these in a multi-part series I will call ‘Saving Private Equity’. Some earlier thoughts on the subject can be found here.
The more cynical amongst you might accuse me of simply ‘talking my book.’ Perhaps. Probably. A more flattering way to look at it is that I am living my convictions. And the lesson I’ve learned is that we need to focus almost exclusively on fund raising for now even if that means disappointing some of our portfolio companies or missing out on a great investment opportunity in the short term. It’s not fun or particularly interesting but like almost any other startup, without capital the rest is just theory. Time to stop thinking and start pitching!
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