VC’s, and particularly seed focused VC’s, pursue a variety of different strategies in their portfolio. Every firm thinks about things a bit differently. It probably doesn’t really matter too much to entrepreneurs, but after a couple conversations about this with founders recently, I thought I’d share how we tend to think about it.
The main parameters that VC’s tend to think about around portfolio strategy are:
1. Number of investments
2. Ownership percentage
3. Concentration and staging of capital (how much and what stage and how much of the fund in a given company)
I’m sure there are other things, but these are some of the main ones.
Here’s an interesting through experiment though. The single best venture capital firm in the world would take this strategy:
- Invest in only one company
- Put the entire fund entirely into the first round with the lowest cost basis
- Pick the best company
Of course, no one does this. But what does that say? Essentially, the further one strays from this strategy, the more one admits that there is luck and unpredictable risk in the market they are investing in. So funds diversify. Some diversify across many companies, some across stage, some across time to some degree. The downside to diversification, however, is that you dampen the impact of any one winner.
Put it simply, the bigger the portfolio, the more the investor thinks that luck and uncertainty is a factor.
The problem is that the overall market for VC is pretty crappy. You don’t want to buy the index. Funds that have very broad portfolios are making a very particular bet – that although the entire index sucks, their slice of the index will outperform. Time will tell how that works out.
FWIW, our strategy is that we invest in about 30 companies per fund. That’s 3-4/partner, probably more concentrated than the vast majority of seed funds out there. We think that our portfolio will work out roughly as follows:
10 companies will not make it beyond their seed round
10 companies will make it beyond see, but die anyway
10 companies will make money
Of those 10, 0-4 will be transformative. If it’s 0, we don’t do so well. If it’s 1-4, we win. How much we win by depends on how large those outcomes are.
We are a one product company – and that product is a highly engaged, meaningful seed investment. So with any luck, we don’t actually have to worry too much about whether those 1-4 are at a low cost basis, or if we have enough dollars in. The answer should be yes for every investment. At least that’s the model.
One mega trend that we’ve been excited about recently is around the ways that technology is allowing for a re-organization of labor markets. This has been a real trend since the first internet bubble (eLance, Kosmo), and is exploding at the moment.
What technology has done in these markets is streamline three things.
First, customer acquisition and ordering. Being able to find providers and transact more easily, faster, and with less friction.
Second, coordination of resources. Efficient routing and labor utilization. Managing complicated workflows with multiple parties.
Third, enhancing the end product or service. More on-demand. Cheaper. Faster. More convenient.
What I’ve found interesting is that these forces have caused some markets to become much more fragmented by empowering the individual worker (eg Custommade) while other markets have become much more centralized by increasing the importance of the enabling company (Uber).
This got me thinking about what forces drive certain types of market structures to emerge. At first, I thought the distinction would be skilled vs. unskilled labor. Skilled labor markets would lead themselves to technology enabled fragmentation while unskilled labor markets would lead to technology enabled centralization. But that didn’t seem quite right.
A conversation with my friend Aaron White led me to a slightly different take – that there is a distinction between craft labor and trained labor. Craft labor tends to differ quite a bit from provider to provider, and the buyers of craft labor are very discerning, and can easily tell the difference between different providers. Trained labor yields a service that is fairly similar from provider to provider, assuming that the provider is reasonably well trained. Trained labor can be quite skilled. Conversely, even unskilled labor can have elements of a craft-like market.
Some types of services fall in unexpected categories. Programming is skilled, but for a number of different types of projects, is more trained labor than craft labor. Hence the activity you see on elance where some low-end work can go to the lowest bidder. Craft labor arises at the higher end of that category, or in more specialized types of projects.
I’d argue that house-cleaning is more crafty than one would think. Don’t believe me? If you have a cleaner, haven’t you been able to immediately tell when a different person or crew did the job vs. your regular providers? Buyers are super discerning, and providers usually aren’t really trained, they just do their job the way they think it should be done.
On the other end, I’d argue that driving, while skilled, it totally trained labor. You can tell the difference between a crappy provider and a good one, but as long as a driver clears a certain threshold, you still get from point A to point B quite reliably.
That’s why I think personally think Uber makes more sense than Lyft. The ethos of Lyft is more crafty, and more about empowering the individual driver. Uber feels more like the consolidator – the common service layer that customers primarily interact with. They are using technology to consolidate their labor market.
This is also why I think the feedback against many of the cleaning services has been so negative. Just check out the Yelp reviews – many many 1 or 2-star reviews. Those companies are trying to consolidate a market for labor that is more craft-like that one would think. The only way to overcome this would be to spend a lot more time and effort to train and enforce standards of consistency and quaility, which would really hurt the scaleability of the model.
It’s not a perfect theory, but it’s a lens that I’m starting to apply more and more when I see companies that are disrupting labor markets. I think it’s a really exciting theme that is leading to two very different outcomes in different sorts of categories.
I got together with an entrepreneur the other day that was looking for some advice. He admitted that he had spoken to a number of angels and VC’s about the product he was working on, and their initial response was a fairly dismissive “I’ve seen this tried many times before”.
I’ve said those words before as well, both directly to entrepreneurs as well as in our internal conversations about companies. But I’m convinced that “it’s been tried before” is a terrible way to dismiss a startup idea.
The reason is that this statement allows you to be way too intellectually lazy. It essentially says “I’m not going to think deeply about the challenges of the problem or proposed solution, I’m just going to assume it won’t work because others before it failed.”
This is fundamentally flawed for a couple reasons.
First, things change. That’s the point of technology. What wasn’t possible before becomes possible now. Even if technologies themselves don’t change, industries are constantly shifting as technology changes the rules of the game. If you hope to invest in tech, or be as disruptor, it’s actually a great thing to go after an opportunity where no one has been successful in the past if the context surrounding the problem has changed significantly.
Second, almost all companies have been tried before, and almost all startup companies fail. The fact that others before you failed is probably true for more than half of all successful company. Great companies are the exceptions, so pointing to the norm doesn’t tell you much unless you go deeper.
The fact that many others have tried to tackle a problem in the past actually shows that there’s demand, and that others have cared enough about the problem to quit their jobs and try to solve it. Maybe they were wrong, but maybe they were very right about most things, just made some poor choices along the way.
This is not to say that you shouldn’t have respect for the past – I think we have a lot to learn from what came before us. Just as I’m disappointed when folks say “it’s been tried before”, I’m also surprised when founders are unable to articulate why “this time is different” when they are embarking on a well trodden path. Conversely, I am always impressed when I hear detailed, knowledgable commentary on a sector, and why other attempts to solve the same problem failed (plus what needs to happen to drive to a different, successful outcome). This Tweetstorm from Nathan Hubbard, former CEO of Ticketmaster on the challenges with Seatgeek (and also why Fansnap had challenges) is a good example.
So, for founders that are starting companies in spaces where “it’s been tried before”, my advice is to acknowledge that this true, and focus on either
a) what has changed to make now the right time for this company (apparently the #1 question asked by investors at Sequoia) and/or
b) what you are doing better or different than those that came before you
Usually, the answer isn’t a laundry list, but one of two critical things that set the company apart from what has failed in the past. And if investors don’t want to engage in an intelligent conversation about these things, then move on.
I think it’s sometimes a good exercise for companies to take a step back and think about the big external threats to their businesses. This forces some level of intellectual honestly about one’s position in the market, and can push you to try to see around corners and respond.
Given that, I thought I’d write a post on the threats to my own business. There are five in particular, and I’ll give some commentary on each one. Perhaps in a future post, I’ll go deeper into how we are approaching these.
1. New Competition. When we started NextView, there were relatively few seed focused venture capital funds in the country, even fewer on the east coast, and almost none in the Boston area. Today, the landscape is very different. There are many more funds today than there were four years ago, and although a few have bubbled to the top in various sectors or geographies, many more are striving to get to the top of the heap. This creates competition, and competition makes it tougher to see and win deals and drives up pricing. Unlike large funds with hundreds of missions of dollars in each fund, it doesn’t take a huge amount of capital to getting going as a seed investor, so the barriers to entry are not as high.
2. Skipping Straight to A. Some founders are able to skip an institutional seed round and go straight to a multi-million dollar A-round where a larger VC puts in the lion’s share of the capital. This can happen either because the founder can bootstrap the company with her own resources to get further, or because the company and team is so compelling that a large fund can lead a series A out of the gates. As I’ve blogged about in the past, there are positives and negatives to this strategy, but it is a viable option to some founders.
3. Non-institutional Leads. I’ve seen a few cases now where a number of very high-quality institutional investors were interested in investing in a company at valuation, but a non-institutional investor was willing to set terms 1.5 – 2X higher than that valuation. The institutions walked, but the round got done. The founder sacrificed having potentially “smarter money” around the table, but got the same amount of dollars in the bank for less dilution. This happens because institutional investors tend to be more price and terms sensitive overall. With the advent of more open, standard financing documents, it’s also more possible for founders to just set terms themselves and have investors subscribe. In a frothy market, rounds can get done in this way at pretty high prices (or valuation caps for notes) albeit with less value-added investors involved.
4. Alternative funding sources. Related to 3, the potential to fill out rounds gets easier and easier with the rise of alternative financing sources like Angelist, FundersClub, and others. This is probably a good thing overall, because of the increased efficiency in the ecosystem. But if filling out a round becomes easier, then part of the value of having a strong lead to establish credibility goes away. Individual angels can lend their credibility to an investment through an Angelist syndicate, even if they are only investing a pretty small amount of capital themselves. Some specialized platforms like Kickstarter can garner so much interest from non-financial backers that founders can avoid dilutive financing at the seed stage altogether. These platforms are really interesting to seed funds because they are simultaneously a threat, a weapon, and a sourcing mechanism. It will be interesting to see how this all plays out.
5. Getting Crammed Down. The threat that always plagues seed funds is whether a very promising business hits a speed bump, and ends up going through a very dilutive financing. Many seed funds have significant follow-on capital, but not to the degree of traditional venture funds. This isn’t as much of an issue when times are good, but it becomes a problem when times are bad (and yes, this bull market will end at some point). There is no obvious solution to this. If the fund decides to reserve more capital for follow-ons, they either have to a) invest less in the seed and have less ownership to begin with or b) raise a larger fund. If a), you reduce the cram-down risk, but also reduce the fund’s upside because you own less of your portfolio companies to begin with. If b), the bar to return the fund is now higher because you have more capital. You either have to have bigger wins than before to get the same performance, or you have to own more of your portfolio companies, which puts you right back where you started.
So, these are the existential threats to my business. Most were the same threats that existed when we started NextView, just the 2014/2015 version.
Another way to summarize all of these is that in the seed stage VC market that I compete in:
- The barriers to entry are low
- The barriers to scale are higher, but seed funds shouldn’t scale
- The barriers to excellence are high, but sustained excellence is hard
In a market like this, success and market leadership are very fleeting. Sure, there is some brand benefit and network effect as you become known for investing in great companies. But those are short lived. Just like any startup, to stay successful, you need to stay inventive, stay hungry, and keep putting out the best product time and again.
All in all, this is good for entrepreneurs. It’s harder work for us, but it’s the business we’re in. I wouldn’t have it any other way.
Directr was founded on a mission to allow anyone with a smart phone to create great video. The realization of the founders is that while video is perhaps the most powerful mechanism for communication, very few people are able to use it effectively.
In a few short years, the team at Directr built an award winning product that democratized the creation of quality video for consumers and businesses alike. And earlier today, it was announced that the company looking to democratize video creation was successfully acquired by Youtube, the world’s leader in democratizing video distribution.
I’m excited to see where Google takes the company and how they integrate the product into their various offerings. It’s a win for all involved, but a bittersweet one for me because we loved working closely with Max, Eli, and the team.
Congrats guys, and good luck pursuing your same mission with a much much bigger platform. I hope we get to work together again.