You Don’t Have to Tweet to Twitter

Posted on November 15, 2011. Filed under: advertising, Facebook, Internet, IPO, social networking, Twitter, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , |

Frequent comparisons to Facebook leave many confused about the true value of Twitter.

[Follow Me on Twitter]

“In a brand new direction
A change of perception
On a brand new trajection”

[Disclosure: Benchmark Capital is a major investor in Twitter, and my partner Peter Fenton sits on the Twitter BOD.]

Twitter is having a remarkable year. Active users have soared to over 100 million per month, with daily actives now above 50 million. Tweets per day are over 250 million. Most top actors, athletes, and artists are all active on Twitter. Every news and sports program proudly advertises its Twitter account handle. No one would consider running for public office without a strong Twitter presence. Global news in any region breaks first and spreads fast on Twitter. Even uber-socialist Hugo Chavez of Venezuela has 2.24 million followers (which puts him slightly behind Mandy Moore, but just ahead of Queen Latifah).

So, Twitter’s traffic has been growing in leaps and bounds. It has become an indispensable tool for managing personal and corporate brands. And Twitter, along with its verb form “tweet”, have become words in everyday usage all over the world. Yet despite these impressive strides, Twitter’s upside is far, far greater and its user base will expand by an order of magnitude – as soon as the service can overcome a major perception problem.

Twitter suffers from two key misperceptions that need to be resolved before the business can reach its true potential. The first misperception is that Twitter is simply another social network, like Facebook. People commonly think of Twitter as a variant of Facebook. The press frequently positions the two together as “leaders in social networking.” This pairing erroneously implies that the two services are used for the exact same thing, even though the two platforms are very different. Facebook is a few-to-few communication network designed for sharing information and life events with friends. Twitter, on the other hand, is a one-to-many information broadcast network. The only way magic happens on Facebook is through reciprocity: I friend you and you friend me back – then information flows. But on Twitter, I can get something out of following Shaquile O’Neil who has no social obligation to follow me back.

As its roots are in communication, a key part of the Facebook value proposition is sharing information. Any potential anxiety with regards to Facebook sharing is reduced by the fact that these communications are generally seen only by one’s friends. In fact, users react quite negatively when this information is unknowingly shared more broadly. For the people who view Twitter as a Facebook variant, they immediately assume the platform’s core purpose is for the user to broadcast his or her own thoughts and personal information (like Facebook), but to a much broader public audience. For those with this perception, the notion of potentially exposing their own private thoughts to the broad public Internet is overwhelming and uninteresting.

The second, and more critical, Twitter misperception is that you need to tweet, to have something to say and broadcast, for the service to be meaningful to you. For many non-Twitter users, Twitter is an intimidating proposition. “Why would I tweet?,” and “…but I don’t want to tweet” are two common refrains from the non-adopter that highlight this key misperception. But this completely misses the point as to why Twitter has become such an amazingly powerful Internet destination for 100 million others. For the vast majority of Twitter’s next 900 million users, the core usage modality will have very little to do with “tweeting,” and everything to do with “listening” or “hearing.”

Twitter is an innovative and remarkable information service. While it is amazingly democratic and allows literally anyone to broadcast publicly as a “tweeter,” the core value in today’s Twitter is the amazing flow of curated and customized information that emanates from its crowd-sourced user feeds. Other Internet networks like to keep the user “inside.” Much like Google, Twitter points out to the world. It’s a “discovery engine” and an “information utility” rolled into one. With Twitter, you get news faster, you see updates from your favorite artists, you hear directly from key politicians, and gain insights from influencers in a wide variety of specializations. Just as Facebook is symmetric in terms of its poster-reader relationship, Twitter is highly asymmetric. The majority of the tweets on Twitter are posted by a small sub-set of the users. And the majority of the users get value from “reading” or “listening” to the tweets from these core influencers. Once again, for most users it’s more about what you hear, learn, and find than the fact that you can tweet.

In many ways, Twitter is much more of a competitor to other “discovery tools” and “information sources” than it is to Facebook. Facebook is unquestionably the number one resource for “sharing with the people in your life.” From this perspective, Facebook competes (extremely well) with email, instant messengers, and certainly other symmetric social networks like MySpace. Twitter, on the other hand, competes most directly with other tools that help you find important links, news, and information. It is in this broad, non-friend based crowd-sourcing and speed of discovery where Twitter truly shines. A recent Tweet by famed sci-fi author William Gibson highlights this point. Having become accustomed to the non-linear speed of information flow on Twitter, Gibson grew frustrated watching news of the Osama bin Laden killing on TV: “Network news feels like trying to suck cold tar through a milkshake straw.

Some who understand this point have suggested that Twitter is merely a “Better RSS reader.” While this analogy is directionally more accurate than the Facebook comparison, it greatly underestimates the power and value of Twitter. RSS feeds are simply computerized information “routers” that require complex setup, initialization, and maintenance. Twitter has three breakthroughs that make it dramatically more powerful than simple RSS. First and foremost, your personalized Twitter feed is human-curated by a potential universe of millions of curators. When you “check Twitter” you are looking at the specific articles and links purposefully chosen by people you have chosen to follow. That is powerful leverage. Second, it is easily extensible. Due primarily to the concept of “retweeting,” the simple act of using Twitter exposes you to new and interesting sources to follow. It evolves into a richer and more customized offering over time. You discover new people as well as new information. Lastly, Twitter’s unique handles and follower networks create a strong-form network effect that has high lock-in and high switching costs. Twitter and its top tweeters have a deeply symbiotic relationship.

So what can Twitter do to solve this misperception problem? The first thing they can fix is the new user registration flow, a process that has already begun. Earlier this year, a new user would be encouraged to “tweet” very early in the registration process, basically reinforcing the perception problem. Today’s “first 60-second” Twitter experience is quite different and revolves around choosing the influencers you will follow. You should expect even more evolution in this direction in the future. Next, Twitter must make it crystal clear to the press and prospective user that there is an amazingly powerful value proposition for non-broadcasting users. This will not be easy, as it requires a reprogramming of perception across a broad audience. Not only will this aid in incremental adoption, but it will also help subdue the confusion with respect to Facebook.

Twitter is on an amazing trajectory and will continue to increase in usage and influence.  However, the power of this discovery platform is much more about the tweets themselves, and not simply about every single user having the ability to tweet.

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Silicon Valley’s IPO Anxiety

Posted on November 15, 2010. Filed under: Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , |

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“Living in the limelight
The universal dream
For those who wish to seem.
Those who wish to be
Must put aside the alienation,
Get on with the fascination…”
— Limelight from Moving Pictures, Rush

If you could travel back in time to the early 1990’s and ask Silicon Valley’s top entrepreneurs and private company executives about their long-term career ambitions, you would hear a constant theme – they all wanted to be part of an Initial Public Offering (IPO). Back then, taking a company public, either as a CEO, CFO, or founder, held an allure similar to that of a young athlete dreaming of making it in the major leagues. Clearly, not everyone was able to go public, but that of course added to appeal. Everyone still wanted to go public. They all dreamed of playing on the business world’s biggest business stage.

A great deal has changed since then. First, we lived through the peculiar time now known as the Dot-com bubble, where the elite requirements for going public were greatly reduced. This was followed by a period of heavy regulation where many aspiring startups felt as if they were absorbing the burden of sins committed by the likes of Enron and WorldCom, two companies that are far away from Silicon Valley. If you believe what you read, we now live in a world where young entrepreneurs have a more cynical view of the IPO and being public in general. It is common today to read a phrase like “You don’t have to go public early to provide liquidity to early investors or employees.” It is critical to consider just how far away “don’t have to” is from “want to” or “dream of”.

How Did It Get This Bad?

There are many potential causes of this widespread pessimism. First and foremost, going public and being public are not nearly as much fun as they once were. The combination of a rise of ambulance-chaser shareholder lawsuits, Sarbanes-Oxley, the requirement for CEO and CFO signatures on financial filings, and limited personal trading flexibility has unquestionably made being public less enjoyable for executives. Increased bureaucracy and red-tape almost never lead to increased enthusiasm.

We may also have a perturbed notion of what a “healthy” IPO market looks like. For many, the go-go days of the late 1990’s stick in their mind as the definition of a strong IPO market. Unfortunately, the IPO market of 1999 was a myth, a façade, a once-in-a-lifetime mirage that you will never see again. While that period was economically fruitful, it was clearly manic and a long, long way from being healthy. Moreover, it was completely and utterly unsustainable. It also may have “cheapened” our view of the IPO. If anyone and everyone can go, it is no longer a heroic accomplishment.

One recent argument knocking the IPO is as follows: Wall Street is too short-term focused, and that if you want to run your company for the long-term you should remain private. There are three great reasons that this “can’t focus on the long term” argument falls short — Jeff Bezos, Marc Benioff, and Reed Hastings. All three of these amazing entrepreneurs turned CEOs took their company public on a standard IPO time frame. They also all three conveyed to Wall Street that they would postpone short-term earnings results in order to chase a greater long-term objectives and ambitions. The intelligent mutual fund investors that were swayed by their convincing arguments (there were many) were handsomely rewarded. Furthermore, Bezos, Benioff, and Hastings all three used “being public” as a bully-pulpit to tell their version of their industry’s story, thereby aiding their advantage. If you are unconvinced go ask Steve Riggio, Tom Siebel, or Blockbuster CEO Jim Keyes.

Certainly one contributor to the negativity surrounding the Silicon Valley view of the IPO market is the negative perception of the local press echoing off the hillsides of the Santa Cruz mountain peaks. Over the past several years, it has become quite common to read Silicon Valley articles and blog-post offering near-eulogies of the high-tech IPO. TechCrunch refers not to simply the “IPO” but to the “dreaded IPO,” or the “Poor, Pilloried, Tech IPO.” Famed early stage investor and typically glass-half-full blogger Fred Wilson recently penned “IPOs Just Aren’t What They Used To Be.” The San Francisco Chronicle stated that the “market for initial public offerings remains badly broken,” and the ecosystem “..has been destroyed.” And despite the numerous successful IPOs in the last two years that have supposedly put an “end to the IPO drought,” the only thing that doesn’t seem to go away is the use of the phrase “IPO drought.” If that were not enough, the NVCA (National Venture Capital Association) argues the situation is so dire that we need a Four Pillar Plan To Restore Liquidity. The pessimism is consistent and deafening. The glass isn’t simply half-empty; everyone seems to think there is a hole in the bottom of it.

How Bad Is It Really?

A more optimistic eye can see that the IPO data is actually improving. This quote from the NVCA’s second quarter update is rather straightforward:

Venture-backed company exit activity showed continued momentum during the second quarter of 2010, with the best quarterly total for venture-backed Initial Public Offerings (IPOs) since the fourth quarter of 2007, according to the Exit Poll report by Thomson Reuters and the National Venture Capital Association (NVCA). The quarter ended with 17 venture-backed IPOs, marking the third consecutive quarter for increased offerings, by number and by dollar amount.

Looking at the Q3-2010 NVCA data included above, you can see that 2010 is markedly improved over 2009. We have already tripled all of last year in the first three quarters of this year. Moreover, with a healthy Q4, we could meet or beat the annual numbers from 2005 and 2006. If you limit the data to VC backed companies in the U.S. in high technology (leaving out Pharma and bio med; which is different from the above), there were five in 2008, twelve in 2009, and 25 year-to-date in 2010. These data points are clearly up and to the right. And while they may not hit the bar we are looking from for a cyclical market high point, it surely makes it hard to say the IPO market is fatally flawed. And it unquestionably not “closed.”

The Majority of Recent IPOs Are Outside of Silicon Valley

U.S. High Technology / VC Backed IPOs Since the Beginning of 2008 (XLS)

The Excel spreadsheet embedded above contains a detailed look at all of the high-tech VC backed U.S. IPOs since the beginning of 2008. There is some very surprising data in this table. First, these IPOs have performed relatively well since their initial offering. On average, these IPOs have averaged 55.9% in price appreciation since their IPO date. This represents almost $14B of post IPO value creation as a group. Moreover, 19 of the 42 companies are worth over $1B. A full nineteen VC-backed companies with recent IPOs are now worth over $1b!  The press that keeps yearning for the next “big” IPO in Silicon Valley and complaining about the health of the IPO market, doesn’t spend much time talking about RackSpace ($3.3B market cap), RealPage ($1.8B market cap), GreenDot ($2.2B), or Ancestry ($1.1B) – all recent IPOs that have traded up quite nicely since they went public. Maybe there is a reason for this.

Is there any chance that the negative IPO sentiment that is reverberating through Silicon Valley is actually having an impact on the local IPO volume? One might expect, that as the epicenter of innovation, Silicon Valley would warrant more than its fair share of IPOs. But the data shows the exact opposite (see table below). In this same spreadsheet of recent IPOs, we have highlighted whether each company has its headquarters here in Silicon Valley or elsewhere in the United States. The shocking reality is that only 11 of the 42 high-tech, venture backed IPOs since 2008 reside in Silicon Valley. In other words, 74% of these IPOs hail from outside of the SV echo chamber.  If you look at the data in terms of initial IPO value, 78% of the overall value is from outside SV. In terms of value today its 73.5% (SV IPOS have outperformed those outside SV).  Perhaps these out-of-market IPOs aren’t well covered within Silicon Valley, and perhaps the negative IPO sentiment isn’t well heard outside of it. Our pessimism may have led to a self-fulfilling prophecy.

Demand or Supply Problem?

There is an interesting commentary at the end of the San Francisco Chronicle article that we previously discussed. “Brent Gledhill, with William Blair & Co., a small investment bank in Chicago, said he has buyers for small IPOs, but can’t get sellers.”  This argument, which was also supported by Paul Deninger of Jefferies, suggests that we have a “supply” problem, not a demand problem. He has BUYERS but not SELLERS. The problem is not that Wall Street doesn’t want product, it is the opposite; that we are not offering them enough of it. While it is clearly a chicken-egg argument, you simply cannot have a healthy IPO market if the leading high-quality companies are unwilling to file. The problem may be attitudinal, not structural.

To this point, and perhaps ironically to some, most of the people I know that work in high tech mutual funds and hedge funds would like to see more IPOs not less. They are tired of trading the same large technology names that are showing limited equity returns over the past 10 years, and have very low growth opportunities/ambitions. If you look at the the forward revenue growth estimates for technology bellwether stocks you may be surprised: Intel (3.5%), HP (5.6%), Microsoft (6.8%), Cisco (11.1%),Ebay (11.4%), and Yahoo (3.3%). And many of these stocks are flat to down for the past decade! Even Google, the youngest of the large cap tech plays has a go forward growth estimate of below 20%. As you can imagine, these traditional “must have” technology names are not contributing to mutual fund outperformance the way they once did. Fund managers desperately need more exposure to growth. They also crave exposure to new trends like social networking and mobile computing, but with limited IPOs they have limited ways to invest in these new innovative trends. They simply need more “quality” product.

Valuations Are “Higher” in the Public Market

As a result of this scarcity of growth across the broader set of public companies, strong category leaders like OpenTable, GreenDot, Realpage and are seeing healthy valuations in the public market. These high growth Internet leaders trade at PE multiples (30-50x) that are roughly twice that of Internet leaders Microsoft, Yahoo, Ebay, and even Google. The IPO market is currently paying a substantial premium over the M&A market (the exact opposite of what you read). The same large companies that are struggling to find growth have reduced valuation multiples (P/E, P/S). This in turn makes it hard for them to pay strategically high prices in an acquisition. Therefore, entrepreneurs that follow the advice from the San Francisco Chronicle, and are “looking to be acquired” may be leaving ample money on the table.

As an example, drill down on RealPage, a Dallas based leader in SAAS solutions for property management companies. It is currently trading at $1.86B after a successful August IPO. They currently trade at about 8.7X annualized Q2 revenue. Which potential acquirer would pay this valuation for a private vertical industry specific SAAS play? Do you think Salesforce, who has never done a large acquisition, would? Do you think Oracle (who trades at 3.5x sales would)? What about SAP (3.8X sales)? IBM (1.7x sales)? Or consider GreenDot which went public in July and currently trades at a $2.2B market capitalization. This valuation equates to roughly 6 times 2010 revenues. Do you think American Express (currently trades at 2X revenues) would have offered that in a private transaction?  What about  This recent Internet IPO is currently trading at a market capitalization of $1.17B. Which large Internet company would have paid close to $1B for Ancestry? None is my answer.

We should also consider DataDomain, 3Par, and Arcsight, all companies with remarkable sell-side M&A transactions who went public BEFORE engaging in an M&A transaction. Being public is a wonderful way to establish a baseline valuation in an eventual corporate sale. There is no chance someone would make an offer at or below the current market price, as the expectation is to pay a market premium. And because the BOD has a very high duty in terms of maximizing shareholder value, these deals are often seen by multiple bidders and therefore more likely to be competitive than a private transaction. Lastly, and not to be ignored, public company sales have zero escrow provisions. These escrows typically put at risk 10-15% of the transaction value when a private company is acquired. Being public before you get acquired can be extremely valuable.

Your Company Is Not Facebook

A large contributor to the negative IPO press is Facebook’s definitive view that it prefers to postpone its IPO well into the future. Recent comments suggest an IPO may be put off until 2012. As a top three worldwide Internet site, the press is obviously interested in what Facebook wants to do. Also, because of its huge impact, and the emerging trend of social networking, the buy-side is quite interested in owning Facebook. The demand for an IPO, were one to happen, would be enormous. And that is probably an understatement. However, it is critical to put this in perspective relative to everyone else.

Facebook is the exception not the rule. They can do what they want when they want. They can raise money privately at any time if they feel the need to do a cash acquisition. There are literally firms willing to wait in line to give them money. They can hold a press events and everyone comes, so they certainly do not need to be public to broadcast their message. However, they are also a miserable proxy for the average private company CEO and BOD to consider. Your company is not like Facebook, and it should not build its IPO plans based on what Facebook does or does not do.

Things Are Looking Up

This entire problem may be self-correcting. The BOD and executives from the companies that have not gone public have certainly noticed the successful offerings, post-market performance, and valuations of the IPOs mentioned herein. As such many of these executives are now marshalling the forces for their own IPO. As an example, Betfair, a long awaited IPO in the UK (congrats @jdh) just went public and had strong results. Skype and ZipCar have filed, and all indications are that LinkedIn is working on its own filing. There is also a good chance that companies like AutoTrader and eHarmony will come public soon, and there have been multiple rumors of IPOs at companies such as Hulu and Pandora.

In addition, the very recent press seems to also be singing a different tune than the dire press from this summer.  Check out the following headlines from the last few weeks:

I recently had the opportunity to hear the story of how Tim Sullivan, the former leader of, went into five years ago as CEO.  At the time, the company’s growth had slowed and many had assumed it had seen its better days. Tim and his team and began a multi-year turn-around that would eventually lead to last year’s respectable IPO. Last week, the company completed a successful secondary offering. Tim shared with me all of the amazing work that went into reigniting this market leader (a very impressive story), but I was most surprised when he talked about the IPO process. His face broke out into this huge grin as he described watching the stock trade that first day. You could clearly see the type of IPO enthusiasm that once reigned supreme in Silicon Valley. For Tim, the dream was still alive, and more importantly he was able to turn his dream into reality.

Waves of pessimistic analysis can become self-reinforcing and began to influence rather than just inform. That appears to be the case with respect to local attitudes towards high-tech IPOs. Next time you hear someone talking about how broken the IPO market is, please let him or her know that despite what you read, many great companies are going public and are having remarkable success. And if they still doubt you, tell them reach out to Steven Streit at GreenDot, Zorik Gordon at ReachLocal, Doug Valenti at QuinStreet, or any of the 38 other CEOs who recently stood up and walked through the door that everyone else says isn’t open. Their story should be at least as compelling as focusing on the few companies that don’t seem all that interested.

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What Is Really Happening to the Venture Capital Industry?

Posted on August 24, 2009. Filed under: Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , , , |


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Many are speculating that the year two thousand and nine represents a fundamental turning point for the venture capital industry. Some are arguing that the industry is in dire straits after years of poor performance. Others have argued that the math simply does not work for the industry’s current size. Another theory suggests that permanent challenges with the IPO market call into question the fundamental economics of the VC industry. Lastly, some credible authors have suggested that things are so bad that a federal bailout may be in order.

What is really happening in the venture capital industry? It is indeed quite likely that the venture industry is in the process of a very substantial reduction in size, perhaps the first in the history of the industry. However, the specific catalyst for this reduction is not directly related to the issues just mentioned. In order to fully understand what is happening, one must look upstream from the venture capitalists to the source of funds, for that is where the wheels of change are in motion.

Venture capital funds receive the majority of their funds from large pension funds, endowments, and foundations which represent some of the largest pools of capital in the world. This “institutional capital” is typically managed by active fund managers who invest with the objective of earning an optimal return in order to meet the needs of the specific institution and/or to grow the size of their overall fund. These fund managers have one primary tool in their search for optimal returns: deciding which investment categories (referred to as “asset classes”) should receive which percentage of the overall capital allocation. This process is known in the financial field as “asset allocation.”

Asset allocation is the strategy an investor uses to choose specifically how to divide up capital amongst asset classes such as stocks, bonds, international stocks, international bonds, real-estate funds, leveraged buys-outs (LBOs), venture capital, as well as other obscure classes such as timber funds.  Some of these asset classes, such as stocks and bonds, are known as “liquid assets,” because these instruments trade on a daily basis on exchanges around the world. For these assets, investors can be quite sure of the exact value of their holdings, as the price is set continuously in the market. Also, if they need to sell, there is a ready market to accept the trade. Illiquid assets, also known as alternative assets, include all the other investment classes that do not trade on a daily exchange. These “private” investments (as compared to “public” liquid investments) are considered higher risk due to their illiquidity, but also are expected to earn a higher return. Some hedge funds are included in alternative assets either because they themselves invest in illiquid investments or because they put strict limitations on the trading capability of the institutional investors, rendering themselves “illiquid”.

graphAsset allocation is a well-studied area within the field of finance. A prototypical U.S.-based asset allocation model might allocate 25% to U.S. stocks, 30% to U.S. debt, 25% to international equity and debt, and let’s say 20% to all alternative assets. Within alternative assets, LBOs might be 60%, and venture capital could be as low as 10% (of the 20%). As a result, venture capital could be as low as 2% of a institutional fund’s overall capital allocation. Most people fail to realize just how small venture capital is in the overall scheme of things.

Very generally speaking, experts and academicians have considered it “conservative” to have a smaller allocation to all alternative assets reflecting the risks of illiquidity, the inability to ascertain price, and the higher difficulty in analyzing the non-standard vehicles. It is a fairly straightforward, conservative investment approach to favor liquidity and certainty over absolute potential upside (this is the same argument for holding bonds over stocks).

Over the past decade or so, a large number of very influential institutional funds have substantially increased their allocation in alternative assets. In some extreme cases, these investors have taken this allocation from a conservative amount of say 15-20% to well over 50% of their fund. Many people suggest that David Swensen at Yale was the original architect of a strategy to adopt a much higher allocation to alternative assets. Regardless of whether he was the leader or not, several funds simultaneously adopted this higher-risk, higher-return model. (For a more detailed look at how this evolved and why, see Ivy League Schools Learn a Lesson in Liquidity and How Harvard Investing Superstars Crashed. For an even deeper dive including comparative asset allocation models see Tough Lessons for Harvard and Yale.)

lbo_dataContributing to this dynamic on the field, the early movers to this model were able to post above-average returns.* Also, due to the high disclosure policy of most universities, these above average performances were often touted in press releases. This “public benchmarking” put further pressure on competing fund managers who were not seeing equal returns, which as you might guess, led to them mimicking the same strategy. As a result, alternative assets have grown quite substantially over the past ten years. This is perhaps best seen in the size of the overall LBO market. The included chart shows the money raised in the LBO market over the past 30 years. As you can see, the amount of dollars pouring into this category over the past five years is nothing short of breathtaking.

The market contraction of late 2008 and early 2009 severely compromised the high-alternative asset allocation strategy. The liquid portion of  average portfolio contracted as much as 30-40%, which had two resulting impacts. Initially, this resulted in most fund managers having an even higher portion of their funds in illiquid investments. Ironically this was largely an accounting issue. Most likely, the illiquid pieces of their portfolio had declined just as much, but as illiquid investments are not valued on a day-to-day basis, they simply were not properly discounted at this point (over time they “would” and “are” eventually coming down). But with one’s fund already down 30% or so, no one is eager to further decrement the value. Despite that this may have only been an “accounting” issue, it presented a problem nonetheless, as many fund managers have triggers that force them to reallocate capital if they go above or below a certain asset allocation. This is one of those policies that encouraged selling at a point that may be the exact wrong time, contributing to further declines.

A second and more complicated problem also emerged. It turns out that when an institutional investor “invests” in an LBO fund they don’t actually invest the dollars all at once, rather they commit to an investment over time, which is “drawn down” by the LBO manager (venture capital works in the same way, but once again is a much smaller category). As these funds substantially increased their commitment to the LBO category, they were de facto increasing a guaranteed negative cash flow in the future to meet these draw-downs. Now, with portfolios out of balance, and lack of new liquidity events from the M&A and IPO markets, these funds have cash needs (to meet the draw-downs) that are not offset by cash availability. If anything, the universities and endowments these managers represent want more cash now to deal with the difficult overall economic environment.

To meet these new liquidity needs an institutional investor could:

  1. Sell more of it’s liquid securities. This is problematic because it further compromises the target asset allocation.
  2. Try to sell the LBO commitments on the secondary market. As you might suspect the secondary market is extremely depressed. Some have even suggested that due to the forward cash need on an early LBO fund, an institution might have to “pay” to get out of the position, and to encourage someone else take on the future cash commitment.
  3. Default on the commitment. While this does have penalties in most cases, it would not be out of the realm of possibilities for this to occur if the investor has lost faith in the manager, and it is early in the fund (with more cash needs in the future).
  4. Try to raise more capital. Not surprisingly, donations to foundations and universities are down dramatically due to the overall decline in the capital markets. This makes this strategy unlikely.

As you can see, none of these options are overly compelling.

If this is not bad enough, many institutional fund managers and the groups to whom they report (such as a board of trustees) are now second-guessing the high-alternative asset allocation model. As a result, they may desire to return to the more conservative and more traditional asset allocation of 10-20% allocated to alternative assets. Ironically, they are in no position to rebalance their portfolio precisely because they lack incremental liquidity. Think about it this way – it is very easy to shift a portfolio from liquid assets to illiquid. You simply sell positions in highly liquid securities, and buy or commit to illiquid ones. Going the other way is not so simple, as there is no ability to conveniently exit the illiquid positions.

This is a very long explanation, but the punch line is that as these large institutions adjust their portfolios and potentially abandon these more aggressive strategies, the amount of overall capital committed to alternative assets will undoubtedly shrink. As this happens, the VC industry will shrink in kind. How much will it go down? It is very hard to say. It would not be surprising for many of these funds to cut their allocation in the category in half, and as a result, it shouldn’t be surprising for the VC industry to get cut in half also.

One could argue that poor returns in the VC industry is the primary reason the category will shrink and that, as a result, the VC industry could be cut even further – or perhaps even go away. There are two key reasons that this is highly unlikely. First, one of the key tenets of finance theory is the Capital Asset Pricing Model (CAPM). The CAPM model argues that each investment has a risk, measured as Beta, which is correlated with return vs. that of the risk-free return. Venture Capital is obviously a high-Beta investment category. As of August 3rd, 2009, the S&P 500 has a negative 10-year return. As a higher-Beta category, no rational investor could reasonably expect the VC industry as a whole to outperform in a catastrophic overall equity market. In fact, the expectation would be for lower returns than the equity benchmark. This multiplicative correlation with traditional equity markets is the exact same reason that venture capital outperformed traditional equities in the late 1990’s. The bottom line is that no institutional investor should be surprised by the recent below-average performance of the entire category, all things being equal.

The second reason the category will not be abandoned is contrarianism. Most students of financial history have read the famous quote attributed to Warren Buffet, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” One of the biggest fears of any investor is to abandon an investment at its low point, and then miss the corresponding recovery that would have helped offset previous poor returns. While this mindset will not guarantee the 100-year viability of the venture capital category, it should act as a governor on any mass exodus of the category. The more people that exit, the more the true believers will want to double-down.

So when will this happen? One thing for sure is it will not happen quickly. The VC industry has low barriers to entry and high barriers to exit. Theoretically, a fund raised in 2008, where all the LPs have no plans to commit to their next fund, may still be doing business in 2018. VC funds have long lives, and the point at which they decide to “not continue” is usually when they go to raise a new fund. This would typically be 3-5 years after they raised their last fund, but could be expanded to 5-7 years in a tough market. In some ways the process has already started. Stories are starting to pop up about VC funds that were unable to raise their next fund. Also, some entrepreneurs are starting to discuss favoring VCs of which they can be confident of their longevity. All in all, one should expect a large number of VC firms to call it quits over the next five years.

How should Silicon Valley think about these changes? It is important to realize that there are approximately 900 active VC firms in the U.S. alone. If that number fell to 450, it is not clear that the average Silicon Valley resident would take much notice. Another interesting data point can be found in the NVCA data outlining how much money VCs are investing in startups (as opposed to LP’s committing to VC firms). VC firms invested about $3.7B in the second quarter of 2009. Interestingly, this number is about half of the recent peak of around $8B/quarter. It is also quite similar to the investment level in the mid 1990s, prior to both the Internet bubble, and the rise of the aggressive asset allocation model. So from that perspective, this, meaning the investment level we see right now in Q2 of 2009, may be what it is going to be like in the future.

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future. This is not simply because less supply of dollars will give VCs more pricing leverage. We have seen over and over again how excess capital can lead to crowded emerging markets with as many as 5-6 VC backed competitors. Reducing this to 2-3 players will result in less cutthroat behavior and much healthier returns for all companies and entrepreneurs in the market. Additionally, at a stabilized market size of well over $15B a year, there should be plenty of capital to fund the next Microsoft, Ebay, or Google.  

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* To date, it is unclear if these “above-average” returns were a result of the liquid half of these portfolios or the illiquid half. As we mentioned earlier, it is extremely difficult to ascertain the actual value of an illiquid investment. In many cases, the institutional fund manager relies on the investment manager of the asset in which they invested to prescribe a value to the investment, even though they may be highly biased. If it turns out a large portion of the “above-average” returns of these early adopters of this more aggressive strategy were on the illiquid side, we may have yet again another example of the dangers of mark-to-market accounting.

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Note To Timothy Geithner: Do Startups & Venture Capitalists Really Need More Regulation?

Posted on March 26, 2009. Filed under: Internet, Regulation, Uncategorized, Venture Capital | Tags: , , , , |

Mr. Geithner:

In the late 1990’s, in response to the obvious financial shenanigans of large companies like Enron, Tyco, and WorldCom, Washington handed us the Sarbanes-Oxley Act.  I have no idea how effective Sarbanes has been at reducing fraud (it obviously did not prevent our current economic malaise), but I do know one thing.  Sarbox created a significant burden and tax on small companies that desired to tap into America’s public capital markets, and one that could have long-lasting negative impact on the long-term success of startups and innovation in America.  It’s pretty simple, Sarbanes-Oxley can costs $2-3mm to implement, and also is a huge burden on your IT and development staff (taking away from feature expansion and product improvement).  For a company doing $50mm in revenue with a 10% pre-tax operating margin, you only have say $3mm in after-tax earnings to report.  These new Sarbox costs effectively eliminate your profitability, which has a huge impact on valuation.  Of course, what this in fact causes is companies to feel the need to be much, much larger before they even try to go public.  Notably, IPOs have been systematically reduced post-Sarbox, and we are still significantly below 1991-1992 pre-bubble levels.  As David Weild notes for PEHub, “I submit that there is no question that accounting costs and Sarbanes-Oxley costs are a primary (maybe not the only) factor in the diminution of initial public offerings in the United States.”

So today we get news that in light of the recent financial crisis, you want to impose new regulations on hedge funds that will also sweep in venture capitalists (and by association their private companies). Depending on the regulation, this could require VCs to disclose specific metrics about the private companies in which they have invested, robbing these companies of one of the key benefits of being private.  Now it is fairly obvious that venture capitalists and the small venture backed companies in which they invest had nothing to do with the mortgage crisis, Fannie Mae, Fredie Mac, AIG, or anyone of the 8 major TARP recipients.   Yet despite this, your sweeping recommended legislation will impose more undue costs and disclosures on entities that had absolutely nothing to do with the problem you are solving.  

Washington already has given us one overly burdensome legislation (in Sarbox) for a previous problem we did not create.  Please do not do it to us again.  And remember that the largest companies in America that were created in the last 35 years (MSFT, GOOG, AAPL, CSCO, INTC) were all small venture-backed companies at one point in time.  Do we really want to inappropriately restrain or throttle the future pipeline of such companies in America?

I am all for you solving the problems you need to solve, but please be careful of the effects of unintended consequences for others.

Bill Gurley, Benchmark Capital

Added note:  Some have pointed out that VCs should not be the only class “exempted” from the regulation.  First and foremost, why would they be included?  What did they do to contribute to the current situation? However, if you insist on this viewpoint, then let us instead focus on the specific instruments that caused the harm – leverage and derivatives.  If any limited partnership uses these instruments, they are subject to the regulation.  If not, no regulation.  That is pretty simple and clean.

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Just Say No to a VC Bailout – Part 2

Posted on February 22, 2009. Filed under: government stimulus, Green, Internet, Uncategorized, Venture Capital | Tags: , , , |

While I attempted to bury this issue last week, this Sunday, Thomas Friedman again used his pulpit in the New York Times Opinion section to beg for a VC Bailout.  Last week he merely suggested that the government invest along side venture firms.  This week, he went even further astray and suggested that the government “Call up the top 20 venture capital firms in America, which are short of cash today because their partners — university endowments and pension funds — are tapped out, and make them this offer: The U.S. Treasury will give you each up to $1 billion to fund the best venture capital ideas that have come your way.”  As a practicing venture capitalist, I must say that this borders on silliness.

 1) The top 20 VC firms are simply not “short on cash today”.  Based on all of the knowledge I have as a VC, this is simply a false statement.  Last week he asserted that the hottest sector in the VC industry (green tech) was desperate, and now he is begging empathy for the top 20 VC firms.  I am bewildered by the objective of these statements.

2) The average VC firm collects fees of 2% on the total investment amount each year over 10 years, equating to fees of 20% of the total raise.  As a result, Friedman is suggesting the government “create” $4 billion dollars in partner fees for already well-compensated venture capitalists.  At a time when the New York Times is arguing for claw-backs on investment banker pay, he wants to load up the VC community with $4 billion in tax payer dollars for fees?

3) As we said last week, if you want to help the green technology sector focus on the demand side, not the supply side.  There is already an excess of venture capital dollars focused on green.  The key is to create an ROI positive investment for the end customer through subsidies.  Ethanol isn’t falling to succeed because of a lack of capital — it’s a problem with customer ROI.  Invest through subsidies in making the market huge and ROI positive.  Capital alone will not solve the problem as the ethanol case proves.

It is peculiar to me why Friedman is hell-bent on a VC subsidy/bailout.  The only thing this plan is certain to accomplish is to dramatically increase the annual salary of the top venture capitalists; an odd goal for today’s environment.

More from the web:

1) Fred Wilson at Union Square Ventures:  A Stimulus Plan for Venture Capital?  No Thanks

2) Earth2Tech: Why the Government Should Not Be a Green VC

3) Sarah Lacy at TechCrunch: Friedman Misses the Point and Economic Reality of Silicon Valley

4) Lots of Views in the Twittersphere

5) PE Hub’s Take

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Just Say No to a VC Bailout: A Green Government Venture Fund Is a Flawed Idea

Posted on February 18, 2009. Filed under: Green, Internet, Web/Tech | Tags: , , , , , , , |

[Note: Update to this post, posted 2/22/09]

A few weeks back, a friend mentioned an idea he had heard suggesting that the government consider entering the VC (venture capital) business as part of the overall stimulus plan.  Specifically, the argument was made for the government to provide excess venture capital funding to the green sector.  At first, I assumed this was just one individual’s idea, but the noise level has risen to the point where it is reasonable to assume there is a group pushing or lobbying for this outcome.  Last week, Thomas Friedman jumped on the bandwagon in a New York Times article titled Open Door Bailout.  Friedman noted: “I would have loved to have seen the stimulus package include a government-funded venture capital bank to help finance all the start-ups that are clearly not starting up today — in the clean-energy space they’re dying like flies — because of a lack of liquidity from traditional lending sources.”

Clearly, there is a group of individuals that believes the government should enter the venture business.  With all due respect to Mr. Friedman – and by the way I am a huge fan of The World Is Flat — this is a remarkably flawed idea.  Startups and VCs simply do NOT need bailout dollars.  Allow me to provide more detail:

1) No Lack of Venture Capital.  Simply put, there is no shortage of venture capital dollars.  In fact, if you talk to anyone in the business, or perhaps even the limited partners who provide capital to VCs, they all believe the industry has been substantially over-funded for the past fifteen years.  According to the NVCA, the venture capital industry has averaged approximately $30 billion in investments each of the past three years.  Even in Q4 of 2008, when everyone was supposedly hiding under a rock, venture capitalists invested $5.4 billion in 818 deals.  Most interestingly the NVCA notes, “The Clean Technology sector, which represented seven of the ten largest deals of the year, experienced significant growth in 2008 with $4.1 billion invested in 277 deals.  This investment level represents a 52 percent growth in dollars and a 16 percent growth in deal volume over 2007 when $2.7 billion was invested in 238 companies.”  The remarkable disconnect between Friedman’s cry of desperation (“dying like flies”) and the indisputable fact that is the hottest sector in venture capital is both confusing and curious.

2) VCs Don’t Deserve a Bailout.  It’s hard to imagine that venture capitalists or startup executives are eager to submit themselves to the scrutiny and the compensation restrictions that are now part and parcel of any stimulus package.  If American citizens were truly appalled with John Thain’s bathroom and the GM executive’s private plane, then they should find plenty to abhor in the well-compensated VC community.  One could only assume that any potential venture fund package would include similar restrictions on any venture capitalists whose investments are “buoyed” by this kind of stimulus.

3) Lender of Last Resort.  Warren Buffet is noted for saying, “There is a fool in every market, and if you don’t know who it is, it is probably you.”  The government will undoubtedly find its way into deals where every single player in the already over-funded VC community has said “no.”  This is not because these VCs are sitting on their hands as Friedman implies (once again VCs put out $5b in Q4 alone).  Any companies that are not getting funded are simply failing to meet the basic requirements of a rather open-minded green investment community.  Separately, it is quite unclear how the government would attract the talent needed to separate the good deals from the bad (remember quality VCs are handsomely paid).  The more likely scenario is that a government VC would invest behind the companies and investors with the best lobbyists and Washington networkers.

4) Excess Capital Hurts Markets.  One thing that has become particularly evident over the past fifteen years is that excess capital in any market has a consequential and negative impact.  First and foremost, excess capital keeps third-tier competitors in the market longer.  This has a subsequent negative effect on pricing and, as a result, makes it harder for the first-tier players to reach profitability and sustainability – a falling tide lowers all ships.  It is healthy and a requirement for the less competitive companies to fail in an emerging market.  Second, when an overfunded market comes crashing down, the result is a negative self-reinforcing spiral.  The press jumps on the broad-based failure and then capital really does dry up in the industry.  Skepticism weighs on the effectiveness of the market leaders and the whole industry – and therefore the general mandate – suffers.

5) Good Companies Do Not Lack for Capital.  This seems brain-dead simple, but great companies do not have a hard time raising capital, especially in an over-funded venture market.  If you have a great team, a compelling idea, and a demonstrable probability of success, then you simply will not go unfunded.  Just because a company may have an inspirational goal, does not mean that it deserves unfettered funding.  An anti-gravity machine would be a nice thing to have, but it doesn’t demand venture investment.

6) Do Not Reinvent the Wheel.  If you want to ensure that green technologies are successful, use the government dollars to employ subsidies rather than wasting them on third tier venture investments.  Japan and Germany are the clear world leaders when it comes to solar, and they both achieved this leadership status through customer subsidies.  What solar needs in the U.S. is not more dollars for companies producing a product which is then exported, but a fair, predictable, and profitable local market.  A viable customer subsidy would create a market that is suitable to attract any amount of private investment dollars into the companies that are seeking to serve it.  And this approach would not favor VC backed companies over large established, high-employment participants.  This form of market approach is proven and dependable (Japan and German).  Why would the U.S. try something different?

Great ideas have never suffered from a lack of capital availability.  Bringing extra government dollars to the investment side will only ensure that marginal and sub-par companies get more funding dollars, which historically has had a perverse and negative effect on the overall market.  Put aside whether the government wastes money or not – if you want to see these green technologies successful in the marketplace, it would be a disservice to support a government venture fund.  It simply will not work.

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Benchmark Capital: Open For Business

Posted on December 1, 2008. Filed under: Internet, Uncategorized, Web/Tech | Tags: , , , , |


“People see you having fun
Just a-lying in the sun
Tell them that you like it this way”
     – BTO, Takin’ Care of Business

The seemingly chronic state of our economy, combined with the thundering sound of dire financial news has left many in a state of shock.  This unprecedented moment in time has resulted in unprecedented questions, such as, “Do you think California Municipal bonds are safe investments?”  Hard to imagine in the past, but with the country’s richest state begging for a federal bail-out, who knows? 

There have been similar questions raised about the VC industry, and perhaps many of them are equally unprecedented.  Do VCs have money to invest?  Are they pulling back?   Do they have access to their money?  Do they have enough capital for follow-on investments?  Are the LPs pulling back for their own liquidity?  The list goes on and on, and if you read the popular press you might think we are all under our desks dreaming of 1999.

I can’t speak for other firms, but make no mistake about…Benchmark Capital is wide open for business and we are eager to invest new capital behind great entrepreneurs.  Right now.  In this environment.  Today. 

You may wonder why I feel the need to make this pronouncement, and you many even consider this a stunt.  It is not.   We have made fourteen new investments this year, and are actively considering new investments each and every day.

What is driving our enthusiasm to be optimistic while the general perception is that we should be “scared”?  Here are four answers on a roll:

1)   We make money investing, not sitting on our money.  Innovation and disruption are constant and not subject to the whims of the overall economy.

2)   We believe that environments like this tend to sort out the true entrepreneurs from the pretenders.  When money is easy in Silicon Valley, it tends to attract short-term opportunists looking to make a fast-buck rather than build a lasting company.  Only the best entrepreneurs set sail in rough seas like this.

3)   We like the probability for startups (especially Series A deals) in this environment.  Consider that people are easier to hire and rent is cheap.  Incumbents are cutting their R&D budgets, and there will be fewer startups in each space, all of which means less competition.  These are good things. 

4)   Graham and Dodd said it first and best, but one “… should try to be fearful when others are greedy and greedy when others are fearful.”  Pretty clear what time it is.

If you hear anyone asking if VCs are “puling back” and unwilling to invest, please tell them to call us.  We are open for business.

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    …focusing on the evolution and economics of high technology business and strategy. By day, I am a venture capitalist at Benchmark Capital.


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