Wednesday, October 30, 2013

VC vs S&P 500? The public markets continue to win!

The Cambridge Associates Benchmarks provide a regular health check on the overall Venture Capital industry - it doesn't make for a great story! (In recent years anyway.) My optimistic conclusion continues to be that Angel Investors, being devoid of VC level fees, have a better chance of capturing additional returns to risk ... the data seems to bear that hypothesis out on the average, although with the winners being asymmetrically distributed to those with great skill, more likely a lot of luck and certainly a well diversified portfolio!

The 2Q VC 2013 data provides a reminder that, at least for LPs and in aggregate, investors in venture capital funds are not compensated for the additional risk they assume be it operational or liquidity related.

My three high level take on this latest data is as follows:

1. VCs collectively haven't beaten the S&P 500 for a decade:
The data shows 1, 3 and 5 year net to LP returns lag the public markets while the 10 year record is roughly a wash.

2. The glory days are decades back:
For any early VC investor lucky enough to be reviewing 15-30 year returns the picture is dramatically better with substantial out performance by VC vs the public markets over that much longer time frame. This likely reflects a period when these early stage markets were considerably less "efficient" then they are now.

3. Late/expansion stage funds have delivered better results than early stage funds of late:
Over the last decade to a modest or greater degree late/expansion stage funds have continued to outperform early stage funds and indeed over 5 and 10 year time horizons the S&P. (This is an inversion of the early years of VC as revealed in this data ... looking back over all of the 15/20/25/30 horizons early stage trounced late/expansion stage and indeed crushed the performance of the broader public market indicies!)

As I noted in two prior posts:
1. Gross VC returns are better than the Cambridge Associates net of fees numbers:
Obviously this is because of the 2/20% feee structure which, on the face of its, has eaten up all VC excess returns in recent years.
2. As a set of pooled investment vehicles VC has some similar disappointing return characteristics to Hedge Funds and Mutual Funds:
The point being that all in aggregate have struggled to beat public benchmarks in recent years, keeping at least Nobel prize winner Eugene Fama happy. 

PS VC size does matter, smaller is better: As an important footnote to the aggregate VC returns discussion, John Frankel of ff Venture Capital reminded me of the Kauffman findings pointing to the concentration of higher returns amongst smaller VC funds. Again this parallels the Hedge Fund experience. ie the larger asset under management funds are holding the overall averages "down" and you are more likely to find VC funds that deliver returns that look respectable, after fees, that are sub $500mn or so.

Tuesday, October 22, 2013

Early Stage Investor Due Diligence: A More Detailed Take On What Matters

After "Due Diligence - The Philosophy Part" and "Early Stage Investor Due Diligence: A High Level Take on What Matters" here is a a more detailed take early stage investor due diligence based on my Big Three and Then Three More breakdown:


As you research an investment opportunity it seems to me that it is essential to put a lot of weight on the people, more so than I ever did in my public equity investment research career. Startups are by definition doing something no one has done before, or certainly doing it differently. Hence predicting success is hard - and is highly dependent on the vision, energy, determination, flexibility, creativity, persistence and down right crazy obsession to succeed of the founders.

Qualitative factors matter including:
- How do they present?  
- Why are they doing this?
- What is the genesis of their idea? 
- Are they the right people to be doing this?  
- Are they persistent and passionate?  
As you explore these things one thing will become clear ... do you "like" the entrepreneur. (And vice versa.) I don't mean that you are set to be buddies, rather that you have the basis for a good (long term) working relationship.

Getting a handle on the people stuff also involves some combination of factual/accessible stuff like:

-       Resumes (and social profile) 
-       References, talk to a few if you can since these add important color to the resume - especially prior employees if they ran a start up before
-       Assess team chemistry – visit the office, do they get on
-       If it’s a co-founded team are the roles clear or could there be friction
-       Is there a CEO, you need clarity
-       Do they have a strong understanding of their business and market opportunity
-       Are they well organized and responsive
-       Do they have a grip on their numbers – crucially costs
-       Does their compensation (if any) make sense
-       Has anyone left for less than friendly reasons
-       Credentials and contribution of the BoA/BoD, if any

And you need based on your dialog and reference to judge a crucial intangible - integrity:

-       Have they met prior obligations
-       Do they have unpaid bills
-    Are they candid

Final point here is something my friend Elizabeth Crowell described to me as "observation mode". How does an entrepreneur handle a request? How enthusiastic are they when they respond? ie it's not just the answers that matter. Form is important too - observe the way an entrepreneur conducts her/himself. Elizabeth's point rightly being, this is an important human capital due diligence data point of itself.

You need to assess:

-       Is there a convincing pain point/need ... making for something that it a "must have", not just a "nice to have" solution. The point being Enterprises usually have too many other priorities for nice to have and Consumers are faced with so much noise that your prospective investee really does need to have a solid product/market fit to have a chance of success.
-       Do they have a technology platform/MVP that delivers a solution to the pain point - so ideally spend time with the engineering team too
-     What more needs to be done to commercialize the product
-    Is it truly differentiated from competitors and is there some kind of advantage that will prevent other people entering market and dominating it.


The Market is the opportunity in the long term, customers are the reality in the here and now.  More customers in the here and now, aka traction, validates the longer term opportunity. 

So for the here and now if relevant:

- Review the customer list and customer pipeline
- Interview some actual customers – does the product deliver real value
- Do the contract terms make sense
- What does it cost to acquire customers

And for the future market opportunity:

- What is the size of the market – it really needs to be $1bn +
- Is the go to market strategy credible. This is a major stumbling block for many start ups in my experience
- How does the sales strategy scale over time and what needs to be done to achieve that
- Crucially can the CEO sell the company and the product ... because she/he initially is sales person #1, #2 and #3!


1) Financials

As a former financial analyst you might be surprised to hear me argue that these are not a first order decision criteria – not ahead of People, Product and Market anyway. Let's face it, any start up can hire a decent outsourced CFO to make its models better and what the excel shows in Y5 may look nice but is still ... a work of fiction! My experience is that multi year projections are so hard to make that they just aren’t worth spending a lot of time on. 

Still, the financial model is valuable as a window on the business model as opposed to the specific numbers. i.e. how do the people and product create value from the market they are address. 

As an aside here I note that some people get this from a formal Business Plan. Personally I don't ask for them and don't expect to see them. A good deck with supporting materials, yes. But a full on business plan, no. It's just not a good use of the entrepreneur's time in my view. Although, back to the point about conveying the sense of the business model ... a business model canvas can be helpful. 

On the numbers, it is important in my view to reality check the balance sheet and historic figures. This means assessing these issues:

- Does the company have basic book keeping disciplines in place aka quickbooks in most cases.

- Is there any debt or other bad stuff outstanding (look at payables and aging if possible)

- Do they have a good handle on cash (ie what is in the bank end of each and every day) and cash levers (what can be quickly dialed up or down as conditions change)

Key Question: Why do startups die?
Answer: They run out of money!’

So I think you need to be comfortable that the CEO has a handle on cash flow and can flex things as necessary as stuff happens - it always does.

2) Exit

As Brian Cohen of the New York Angels likes to say, Angels are in the Exit Business, not the Investing Business. Without the exit your illiquid private equity investment has no realizable value.

Question: What is by far the most likely exit for a start up?

Answer: M&A ie an acquisition by a larger entity usually for cash.

So as part of your due diligence it is important to establish that the entrepreneurs who you are going to have a relationship with for quite some time have "an exit mentality". That does not mean, are they building to flip. As the driving purpose that is not healthy. You want to be supporting entrepreneurs with vision and drive to create a big business ... it's just that if they make it clear they will "never sell" then that's fine. Just don't give them your money ... because you won't get it back.

I like to assess whether the CEO have a good handle on acquirers. Partly for the obvious reason but also because I see it as a corollary of thoughtful competitive analysis. Combining those two means that the CEO can build towards "acquirer value". Again since the most likely exit is M&A value maximization comes from making you business optimally attractive to specific acquirers which can involve different strategic choices than might otherwise be the case in a standalone case.

3)  IP/Patents
In life sciences the patent behind a new molecule is crucial to value. But in most mainstream tech startups patentable ideas tend to be limited and where they do exist are not a meaningful source of protection because in a software context work arounds are all too easy.

That said IP is worth getting right for future value protection, it's just not for the here and now. Some Big Tech Co infringes your patent ... but let's face it ... you don’t have the resources to defend the patent infringement anyway. I think Paul Singh at 500 StartUps has it right when he says: “Traction is the new Intellectual Property” (See p12 of his presentation.)

Unless you are a patent attorney yourself, or have a friend who is, you need will need to engage one to review existing  patents. A no cost proxy, although hardly as robust, is making sure your potential investee's patents have been filed by a well qualified person at a reputable law firm.

Early Stage Investor Due Diligence: A High Level Take on What Matters

As I described in my recent post, Due Diligence - The Philosophy Part, I  recently gave a talk to Empire Angels on the subject of early stage investor due diligence, courtesy of Graham Gullans and Christina Bechhold. I followed up with another at The Hatchery on the invitation of Yao Huang. (And will be on a panel focused on this topic next month hosted by Angela Lee for 37 Angels.)

I spent a fair amount of time at the two past sessions framing the issue of "what to do" rather than getting straight into a "traditional" check list of steps to things "to do". My key line was:

"You need to recognize who is taking the real risk here and treat them [the entrepreneurs] with commensurate respect."

High Level Process Thoughts for Investors

Respect, and to be honest good use of your own time, translate into these three high level process guidelines:

1) Be sensitive to the context and the risks the entrepreneurs are taking and protect their time
- What can you do via desk research, talking to 3rd parties, not to them!?
- Don’t keep going back again and again for stuff. Have a few focused meetings, know what you want, and keep it to that
- Be aware that there is an 80:20 rule in most things … you will likely get 80% of the answer from 20% of the due diligence effort. Gathering the remaining 20% of the info but taking a lot more time ... will likely not change your answer!

2) Focus on the key issues for the given company

- What the biggest risks? 
- Biggest opportunities? 
ie Don't get lost in the weeds.

3) Try and set a deadline and stick to it
In the end know that this is decision making under extreme uncertainty. You need to make an informed but largely gut decision. For example Charlie O'Donnell recently spoke to the fact that he makes a decision in three weeks.

Getting to the detail: The Big Three, Then Three more ...

I break the due diligence to dos into what I called the three big categories and then three more. However there are many different approaches so what follows is just a personal perspective. By way of example Brian Cohen (read more at "What Every Angel Investor Wants You to Know") separates his "do diligence" into what he calls traditional build a better mousetrap and gee wiz "lottery" plays. He focuses on identifying viable innovation and disruption. And he says his "spidey sense" is key for lottery play. i.e. gut feel on steroids!

Anyway, back to my three own plus three more. These are:

The Big Three

1) The people

2) The product (or service)

3) The market & customers

Then Three More

1) Financials – which might surprise you but I will explain in due course

2) The Exit

3) Intellectual Property (IP)
I will dive into detail on all of these in my next post.

Monday, October 7, 2013

General (Solicitation) Confusion!

General (Solicitation) Confusion!

There is, and I think will continue to be for some time, enormous confusion about the JOBS Act General Solicitation rules. I have had multiple lengthy discussions about it recently with entrepreneurs and others. Some but not all venues where startups showcase themselves are changing the way they operate. And everyone seems to be getting pretty anxious. I am not a lawyer but I, and I know many many other investors, still get asked by early stage entrepreneurs: "So, what am I to do!?"

In my view each and every entrepreneur needs to talk to their own company lawyer about this and get comfortable with what they can and can not do/say while fund raising. Armed with advice specific to them, they can assess what they need to do depending on whether they go down the General Solicitation (rule 506c) vs non General Solicitation (rule 506b) routes. And to make matters worse although General Solicitation is now legal (since 9/23) there are multiple rules pending finalization that could make General Solicitation much more onerous. So it's a moving target.

In the past two weeks I have been to Demo Day/pitch events with multiple formats where each has taken a different approach. This highlights the fact that entrepreneurs can't assume they can look to third parties for concrete "... the right way to do it is ..." guidance.

1. At one event the presenting companies had no financing related slides or discussion in their decks. So presented their businesses pure and simple.

2. At another event the hosts had suggested that financing info be removed from pitch decks ... some entrepreneurs did that in their materials, some didn't.

3. And at another event all the entrepreneurs pitched with what might call the "traditional" manner. So a full investor deck ... with a slide on their financing. 

For those organizing these types of events Trent Dykes sets out the options in a very comprehensive manner.

The SEC has never explicitly defined what amounts to general solicitation - which is not helpful. Rather they rely on a facts and circumstances test. As they did in the case of Angel list syndicates they will respond to specific clear asks for a No Action letter. But their decisions on any individual situation seem likely to stay dependent on the specific facts and circumstances. Still, based on guidelines and precedent, attorneys have some sense of the "rules" but there are many grey areas that are open to interpretation and more or less conservative legal opinions can be found. 

Entrepreneurs should, in my view, not just ask: "What am I to do?" but also "And what are the risks?". Knowing the risks attached to various options, when bright lines are lacking, allows a business judgement to be made. (As a colleague once pointed out to me: "You always want a lawyer on the bus. But you never want a lawyer driving the bus.")

There are some basics you can work with: I recently came across this simple two side cheat sheet, prepared by seedinvest with input from Cooley. It seems a pretty helpful guide to have on hand. Including, at the risk of belaboring the point, to have on hand when you talk to your own lawyer. 500 Start Ups have also provided a good take thanks to Greg Raiten, their General Counsel. For a longer audio and visual run through The ACA (Angel Capital Association) and Global Accelerator Network (GAN) have posted a 1h5 15mn webinar giving many detailed insights and recommendations. (There is a good section starting at minute 50 where Peggy Wallace from Golden Seeds addresses the questions entrepreneurs should ask their attorney.)

There seems to be one way out of the confusion. Namely to default to using general solicitation working on the basis that since you don't know for sure when you are going to cross a grey line you might as well go straight to the other side. VentureDocs pointed out that arguably many things entrepreneurs have done to date amount to general solicitation. Including for example: a) using third party platforms even if they are open only to accredited investors or b) presenting at any event that is announced on a public website. They conclude:

"It may be virtually impossible for startups to avoid general solicitation when selling preferred stock, convertible notes or common stock. Many activities that companies are already doing constitute general solicitation."

Where this all ends up seems likely to hinge on whether the SEC interprets general solicitation closely in accordance with past guidance and practice ... or not. We shall see.

Whether you like all this or not (I am guessing not!) as an entrepreneur in my view you do need to get informed. As a friend thoughtfully noted to me: "Entrepreneurs aren't expected to know everything, but they are expected to be able to figure it out." The point being that as an entrepreneur you will appear smarter and more on the case to investors if you are on top of the key issues and clearly have experts on speed dial (yes, that would be your attorney again) for more detail as and when needed.

Final thought: For a close to real time take on all this I find Joe Wallin's blog very helpful. He comments regularly, and thoughtfully, on this General Solicitation mess (and other legal matters that impact startups too!) 


Wednesday, October 2, 2013

Rapt Wisdom: 10 Tips for New StartUps

10 Tips for Start Ups from Erika Trautman CEO of Rapt Media

Rapt Media is an exciting (and fun) company based in Boulder, CO. Full disclosure - I invested in Rapt Media (then Flixmaster) at the end of summer 2012 and then added to that through a Series A round led by Golden Seeds in 2013. 

CEO and Co-founder Erika Trautman and her team are pioneering the use of interactive online video for brands and media companies to dramatically increase user engagement and provide powerful analytics. 

Erika has taken advantage of multiple great opportunities and learning like crazy along the wayIn addition to working closely with Golden Seeds Erika previously benefited from taking the company through the Boulder Techstars program and also the Fall 2012 Astia Silicon valley bootcamp. In April 2013 year Erika participated in the Springboard Enterprises SPROCKIT program at the NAB Show in Las VegasAs a result, learning still of course, she has definitely completed a real life Start Up MBA - making good calls and some bad ones, recalibrating and always moving forwards. Most recently Rapt Media closed a $3.1mn Series B round led by Boulder Ventures.

So Erika is well placed to pay it forward for other entrepreneurs. She did so through a start up veteran's (you soak up a lot in just a couple of years!) Top Ten Tips list. I like the focus, from multiple angles, on the team (including your external network) and the lean startup mindset around getting product out asap, validated and measured.

Erika's Top Ten Tips 

  1. Honest Feedback – Get your product in front of beta testers as soon as possible. Move beyond sharing with friends and family so you can get honest feedback from people who don’t care about hurting your feelings.
  2. Diverse Perspective – Build your founding team with people who have different backgrounds and perspectives.
  3. Speak Their Language – Spend time talking to other founders, investors, and entrepreneurs to learn the lingo of the community. You need to be able to communicate your idea in a language that everyone understands.
  4. Find Key Metrics – Everyone knows this is important, but it’s critical to identify what your key metrics are and measure, measure, measure.
  5. All About the Team – Every startup needs to build a team that is full of great, multi-talented people. As hard as it is, if someone isn’t working out, you need to fire them quickly.
  6. Build your Network – As the founder of a startup, you need a network so get out there and meet people. Build your network. Your connections are invaluable as you navigate the first couple of years of founding a company.
  7. Quit Your Day Job – I’m sorry to say, but you have to quit your job to found a company. You need to make the startup the priority in your professional life.
  8. Don’t Get Too Big Too Soon – Startups need to validate each business goal and review metrics along the way to ensure that growth is sustainable. You don’t want to start spending money that you have from investors without the validation that you’re meeting milestones.
  9. Play to Strengths – Within your team of employees, identify the right person for the right job and make sure that everyone is playing to their strengths.
  10. Support Network – It’s not easy to start a new company. There are a lot of ups and downs and, as the founder, you’re going to need a strong support system. Your friends and family can help you get through the tough times and celebrate the milestones.
You can watch Erika deliver her Top Ten message HERE.

Be sure to follow her on twitter @trautmanerika and via @raptmedia