Taking Portfolio Theory One Level Further

Peter Rip, a General Partner at Crosslink Capital, wrote a thought provoking post on his blog on Sunday.  The post was initially sent to me by one of my Partners, and I in turn distributed it to the fledgling community of B2C or consumer oriented tech entrepreneurs here in Austin.

(One of the most rewarding parts of my job is meeting the best and the brightest, and I especially enjoy the enthusiasm and energy of my generational peers or those even younger than I.  So I am doing what I can to make sure that all in Austin who are committed to building a landmark B2C or consumer oriented tech success story at least have the support of each other.)

My e-mail started a very interesting thread that reveals the perspectives of both an investor (or at least, an Entrepreneur in Residence ("EIR") type at a large (greater than $1B total Assets Under Management ("AUM") VC firm) and of a set of consumer oriented startup founders.  Struck me that a blog is really the more appropriate medium for a thread-type conversation, so with everyone's permission, am reposting the entire thread here.  Specific names and firms are mentioned only when the entrepreneur gave me his approval.  When I have time, I am going to add a Comment with my thoughts as well.  (Although this post's title should hint at what I think ...)

Original Piece: Fail Fast, Fail Often
link to original blog / post here

There was an article last week in the Wall Street Journal talking about an apparent change in the entrepreneurship/VC funding model.  Riya, Meebo, and others were cited as poster children for the new restraint.  The core idea was that entrepreneurs are taking advantage of the availability of capital to fund for long periods, often several years, rather than the traditional 12-18 months.  So why does this make sense? Why raise a bucket of money when a thimbleful will do?

The classic venture model has been to fund to milestones 12-18 months out.  In consumer web services, there are only two meaningful milestones --  (1) are you getting a lot of users and (2) have you figured out how to make money?  We use other metrics in other sectors (like management, product, etc.)  as proxies for real economic progress.  We also use them because (we believe) they would have residual value in an asset sale or merger.

None of this is true in consumer web services. You're either hot or not. Second place generally sucks.

The problem is that it is hard for entrepreneurs and VCs to know a priori if something is going to be a hit. The only way to know is to try, and trying takes time and money.  So here's the real rationale for what it makes sense for these companies to raise "a lot of money" and not blow it.  They have to run lots of experiments.

By now we are all well-acquainted with the observation that software is cheaper than ever to produce.  But that is only half the story.  The other half is that it takes several iterations -- several trials -- to hit it big.   

Imagine you have a low-burn consumer internet company and you think you can do your next build for $2M (offshore, open source, etc.)  Imagine further that there is a 1 in 20 chance that you could be the next [insert fantasy outcome here]. Angels are lining up with $2M in hand.  VCs are waving $5-20M checks at you.  Everyone says this is a $10M pre-money company and you own 50% today.

Assume you have a 5% chance of Being Big on the $2M raise, and a 95% chance of nothing.  The chance of Being Big if you raise $4M is 9.75% (1-.95*.95).  This is because you can iterate twice at 5% probability each.  The chance of Being Big after raising $20M is 40.1%.

Of course, each $2M has a dilution to you as the Founder. As the graph below illustrates for this hypothetical example, the risk-adjusted ownership (diluted ownership x probability of success) increases as you raise more money.  (This conclusion is not universally true in all situations.)   

The key to this thinking is to resist the temptation to spend like a lottery winner. Raising the big VC round isn't winning the lottery; it is the purchase of a deck of weekly lottery tickets.

This is how Munjal Shah described the move to Riya 2.0 in the WSJ article.  It was the realization that the first experiment, while a success by many measures, wasn't enough of a success relative to other options.

The larger-than-expected VC rounds in consumer internet deals are perfectly rational outcomes, for the entrepreneurs who understand the trials of consumer marketing.  Failure is baked into the calculus of the opportunity.  The key is to fail fast.  Set metrics ahead of time and be decisive. Because time is money -- literally.

Entrepreneurs who practice this discipline are just doing what VCs do every day.  Venture Capital is a hits business, too.  Companies often fail.  Time is money here, too.  Failure is part of the process.  We, too, are looking to fail fast and expect to fail often.  That's why funds are getting bigger, too.

Feedback From Austin Entrepreneurs and Investors
in chronological order

CEO/Founder of VC-Backed B2B (Consumer Oriented)

Great read, thanks for sending.

It is true that an entrepreneur gets few chances at the bat and that more capital helps them fail fast and recover with a new angle on the business.  The trick is that there are very few VCs that I know that will back companies in this way.  I wish there were more - but VCs are risk adverse and saying you are going to try 10 different business models with $15 million in funding won't fly.   If anything, it seems like some VCs are moving to seed models where they can test out a bunch of concepts without putting a lot of capital at risk.

How do you reconcile these two?

Consumer Oriented EIR at Large (>$1B AUM) VC

I’m fairly new to Austin and haven’t met all of you yet (actually, I think I’ve only met [Class V's author] and Ryan).

I completely agree it would be nearly impossible to raise $15M from VC’s on the premise of trying 10 different models. I think in part the VC community would see it as their job to handle diversification rather than the entrepreneur. That said, I hear often the VC business is all about banking on people and what bolder way to make that statement than to invest X million in an entrepreneur.

While I’m hopeful of getting my own startup going here in the near future, I’ve been fortunate to attend the [large VC firm] weekly partner meetings and see some of the world through their lens. I think giving an entrepreneur X million and letting him innovate wouldn’t work for them given the uncertainty of where it might end up. It could end up competing with an existing portfolio company. It could end up in an industry their limiteds don’t want them investing in. from what I’ve heard so far, the partners don’t seem overly distraught when they invest $250-$500K in a seed deal and it doesn’t work. That’s a sharp contrast to how VC’s feel when a Series A or B of millions doesn’t work. I infer from that (but haven’t got to witness it) that [large VC firm] would be fine with betting on an entrepreneur in $500K chunks and having some of them not work out – but only within the constraints of the seed financing model.

Ryan Pitylak, CEO/Founder of Excellent Suggestion

Thanks for sending this along!

This truly highlights the B2C investment dilemma for start-ups and VCs.  As both [Large VC EIR] and [CEO/Founder of VC-Backed B2B] mentioned, there is not a lot of experiment money floating around.  So, there is an expectation to have it all figured out beforehand or with the seed investment.  However, predicting consumer behavior patterns can be tricky.

I think an important question is:  Why do certain big angels and VCs invest big dollars to get it right?  Is it the team?  Is it the market?  Is it an expected repeat success from an adjacent market?  Is it the 5% who didn’t fail after the seed investment? 

Regardless, this is an interesting topic that directly affects every VC and entrepreneur in the B2C space.  Thanks for starting the dialog.

Jason Reneau, CEO/Founder of MindBites

I reconcile the two this way.  The media likes to glamorize startups and they do some crazy investing in California.  $19M for a photo site that then becomes a comparison shopping site???  Wow.  I want the guy who sold that deal.

Some VC's seem to have started looking at small seed rounds and I think its because a lot of early startups can get a beta up with a small amount of funding and they either don't want more, or the team isn't strong enough to warrant the big bet.  In general, though I think VCs are happy to leave the seed stage to Angels.  They have too much cash to invest and they'd rather wait and see what gets early traction.  In the end though, venture investing is like any high-risk investment -- take a portfolio approach with the smallest bet possible to get the option value for the big potential win.  Other high-risk industries like video games and movie studios, are like this, and Cisco followed this strategy in terms of acquiring winning network technologies as they emerged. 

Once you move away from the ridiculousness of raising $19M for a photo site that becomes a shopping comparison site, I think the key message are:
-  Determine how much $$$ you think you need and double it
-  Raise money like a visionary with the big plan to justify the cash
-  Implement like a bootstrap entrepreneur to make it last
-  Be ready to change directions and/or clamp down on spending if things start to go awry

In the words of one of my business school profs, no one wants to give you money when you really need it (and you will need it at some point). 

That all being said, if any of you would like to give me $19M on a say $50M pre, I'd consider it.

Thanks for the article.

CEO/Founder of a Consumer Oriented Online Business

Here's my attempt to reconcile the two based on my recent fundraising experiences:

There are two kinds of "seed/early stage/angel/first round" investments that seem to be going on right now:

#1 investments in companies with customer traction

#2 investments in proven entrepreneurs

#1 these are typically bootstrapped companies that figure out how to build a user base of raving fans and get customer traction (and pay their own way for product development and early sales)

#2 follow Peter's advice and get big early funding and fail carefully quickly so they can find success

The folks in group #2 are basically handed a set of lottery tickets to figure out the business and then execute.  The folks in group #1 are the lottery ticket.

So my take is that you CAN get an investment after you figure out how to build customer traction, get raving fans, have a defensible business, etc... BUT you're being paid to execute and scale.  Until that point the job is to get customers.  Which in a sense gives you infinite iterations to figure it out depending on your own patience, burn rate, savings, and spouse's tolerance.

So to me, this suggests there are two distinct early stage investing strategies at play:

#1 pick a portfolio of companies that are ready to scale

#2 pick a technician to manage experiments within certain boundaries

PS: In my opinion the drawback to all of this is that there are probably some worthy bootstrap companies that require funding to get sales channels that work, but cannot get funded because they lack customers because the sales channels that deliver the requisite CPA are cost prohibitive.

Consumer Oriented EIR at Large (>$1B AUM) VC

Profitability definitely isn’t the goal of a seed round. The goal is to prove out a few key milestones and then raise a Series A VC round. Charles River has recently formalized their seed process (publicly). As with [large VC firm], the goal of the seed is to prove out a handful of assumptions and then invest more $$. The way the larger funds are organized makes it difficult (impossible?) for them to invest a small amount (like a $500K seed) without a view towards a total investment of $5-$10 million. 

Technorati Tags: Peter Rip, venture captial, startup, seed funding, Austin

Comments

[Arj C]

I guess this really depends on your definition of success. Per the post, raising $20mm may increase your chances of becoming 'big' (which I do not agree with, btw), but the returns seen by the entrepreneur in the gig quickly begin to tend to zero, unless 'big' is 'real big', 'real quick'. Take the case of the recent Yahoo acquisition of mybloglog for $10mm. Not bad for a 6 mth old company w/ 5 employees. Assuming they had spent time and money raising a large vc round, they might have been forced to reject the offer and hold out for more, which in this market, with their type of product, might never have come.

Mike Maples said it best - $500k is the new $5mm. Prove your model with a small round and see if you get even a few nibbles in the market.

When factoring partner carry in the deals - a fraction of the typical 20% carry on the fund - the incentives to hold out for a larger exit are much greater for a VC than the entrepreneur (not that all VCs would let it cloud their judgement on when to hold and when to fold/cash out)

So, the real question is - what is the entrepreneur's definition of success, and how does that align with the investor's definition, and how that that relate to exits currently being enjoyed in the fat of the consumer-internet market exits bell-curve's sweet spot of $10-$40mm.

[robbey]

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[robbey]

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