In their December 2010 articles for DealBook, Heidi Moore and Jenna Wortham raised an interesting question: Are we re-living the tech bubble? The "smart money" at the AlwaysOn Venture Summit would've answered, "It depends."
Venture Summit was the place to be for firsthand investigation of this question. Various panel speakers included 36+ CEO's of emerging startups as well as "VC Titans" such as Tim Draper (Managing Director, DFJ), Todd Chaffee (General Partner, Institutional Venture Partners), and John Simon (Managing Director, General Catalyst Partners).
There was a palpable feeling that—particularly for "break out" companies such as Groupon, Twitter, Zynga, and Facebook at estimated valuations around $6, $4, $5, and $50 billion, respectively—we are indeed in some sort of reemergence or "Wave". However, this upswing appears different, in substance as much as in attitude, when compared to the late 90's. Early stage startups will feel these differences the most. Here were 5 takeaways from a panel discussion with the "VC Titans".
1."Prove it to me"
In spite of tales of VCs writing checks without term sheets or proper due diligence, particularly in the early stages, many veteran VCs remain cautious about jumping into the fray. They expect entrepreneurs to demonstrate that their startups are viable with proven revenue flow, rapidly increasing traffic or customers, unique assets and intellectual property, and/or some combination of the aforementioned.
"We've gotten to the point where the VCs are saying, 'Prove it.' And that never used to be the case. We used to just sort of say, 'Hmmm ... .sounds like an interesting opportunity, what if this works. If it works, then great.'"
- Tim Draper
Unlike the tech darlings of bubble 1.0, today's startups at minimum must have validated customers or a proven revenue stream.
"What's a little different about now verses the bubble is that these companies that are garnering these huge valuations actually are immensely profitable. We missed Groupon, and I'm so mad we didn't see that one. But from what I understand, that's an intensely profitable business growing at an exceptional rate; so it might be worth $6 to 10 billion."
- Todd Chaffee
With the bar set high, it's not easy for early stage companies to raise seed capital. Journalists love to write about the sexy dotcom deals that are getting funded at wild valuations; but as the saying goes, for every 1 you hear about, there are hundreds who didn't make it through.
"I don't feel like there's that much competition [among VCs] in the early stage. When we see an entrepreneur, he's usually been to 14 or 15 VCs or he's about to go to 14 or 15 more. At the early stage, if the business isn't proven, it's a really tough sale."
- Tim Draper
The takeaway: If you're an entrepreneur, don't be misled by the sexy deals everyone's talking about. Validated customers and/or strong fundamentals are still a prerequisite. Unless you're on Dave McClure's friend-list, no one's going to eagerly fund your on-the-job training or "me-too" idea. Let me recommend that you check out Steve Blank's write-up on customer development.
2. Find really big problems to solve
At the bottom of the innovation barrel, you've got everyone and their grandmother with some offshoot idea for a dating site, video site, or some other form of social networking. That sort of "me-too" innovation is like a photocopy of a photocopy of a photocopy. In the late 90's, such business model inbreeding was rampant due to too much money chasing too few quality deals. Total venture capital under management grew by a whopping 6 times between 1995 ($38 billion) and 2000 ($233 billion). The cheap money fostered a sector-based buy-and-flip investment climate. Things are a little different today:
"I try to avoid sector-investing because you're reliant on flukes [and fads] to be the big winners. Instead, I'm looking for new technology that applies to an entirely new market. That is more interesting to me than 'hey, we've got a social network that's 2.0 and all those buzz words.' Those are the [buzz-driven] ones that are 'sector'. Instead, we're trying to find things that are way out there."
- Tim Draper
Investors today are looking for entrepreneurs who are building solid companies based on solving real problems, and building value and defensible competitive barriers over the long-term.
"If people are solving hard technical problems, or a hard problem with consumer engagement, if people are solving hard puzzles that don't look easily solvable by other people, that's where we find long-term value can be created."
- John Simon
Tim Draper sets the bar even higher. His challenge to entrepreneurs is to topple kingdoms.
"I look for monopolies. They get sloppy and lazy. Find businesses that have been kings for a very long time, such as Oracle in databases. Look at spaces where there's only 1 or 2 major players, such as in investment banking or trading, education, transportation."
The takeaway: Take on Tim's challenge and find a real problem you can sink your teeth into. Aim higher than "Dude, I've got an idea for a dating site for one-legged midgets who love to Twitter while sky diving."
3. Longer planning horizons
Businesses focused on solving bigger problems take longer to build. But the other reason for longer planning horizons is the fact that investors and founders can no longer count on IPOs as a short-term exit.
"If I fund [a startup], it's going to be 15-20 years before it's public. I might be more willing to fund him if he has an acquirer 3-4 years out, and that's not healthy. Because you really want to build great global companies of the world as opposed to being just a feature on Google."
- Tim Draper
The number of IPOs in the last 3 years are a fraction of what they were during bubble 1.0 (see chart below). In spite of expectations for a gradual ramp up in IPOs in the next few years, the majority of those deals will be in Asia. North America accounted for only 16% of the deals in the first half of 2010.
Global IPOs by number of deals and capital raised, by year
Source: Ernst & Young, 2010
VCs are seeing more and more founders looking at M&A and IPOs not as exits, but as additional financing for continued growth. Founders often stay on board to see their visions through.
"A company looks out over the next 2 years and asks, 'Can I get paid in an M&A situation now for what I'll do over those next 2 years?' In addition, they're looking at their own strengths within the business because going public or getting acquired is seldom a 'liquidity event', it's a 'financing event'. So you have to not just think about the IPO or acquisition, but what about the year or 2 afterwards. Can they deliver that growth?"
- John Simon
In many ways, these financing events are happening opportunistically rather than by design. Startups these days aren't created to be later sold and turned into a feature on Google.
"We've had successes in companies that didn't necessarily fit in a particular bucket, and we couldn't necessarily know for sure who the acquirer was going to be when the company was started. It's not like this was designed to be sold to Google or Microsoft.
"In the last 15 months, we've had about $2.5 billion of liquidity events in our portfolio, and all were M&A's. In almost no case was the acquirer that bought the company one of the ones that would be in our 4 or 5 potential acquirers at the time we made the investment. And that's because the startup operated in a unique space where the entrepreneur found a whitespace. Acquirers were distantly adjacent and later started to converge."
- John Simon
The takeaway: Ditch your get-rich-quick notions, and plan on sticking around for the long haul. And since you're going to be eating peanut butter sandwiches for a while, you may as well have fun and be passionate about your startup.
Perhaps what we should really be asking is "Where are the bubbles?" not "Are we in a bubble?" The latter question implies that we're in some broad-based bubble which, if popped, would have far-reaching impact. However, in spite of all the excitement about heated valuations hovering above 25 times revenues, it's still fairly contained within pockets or "microclimates" of a handful of well-known emerging startups.
"There are some microclimates where valuations are a little high, particularly those closer to the public offering. In fact, that's where they are getting a little crazy. That's because interest rates are so low that there aren't a lot of other alternatives for investments, and so companies like Groupon and Facebook are trading in the private exchange at crazy prices. Those in the seed level, there's nobody who'll fund you, so there's a big discrepancy. And those things swing back and forth."
- Tim Draper
John Simon added a datapoint that seemed to corroborate the idea of microclimates:
"The amount of consumer Internet companies that are worth more than a $1 billion is surprisingly small. Probably only between 10 or 20. Generally speaking, from a valuation standpoint, it's a relatively normal time at this point across most of the stages."
Todd Chaffee shared his candid thoughts on the challenge an investor faces—"the art" of the business—when dealing with hot startups.
"It's probably a little more heated in the later stage for the big franchise companies. It's also overheated for the 'breakout' companies. In our [IVP's] business, we're targeting the big franchise companies that everyone knows of, with between 50 to 100 million in revenues.
"The trickier part are the breakout companies—the very best companies coming out of the early stage portfolios, that suddenly get traction and start shooting up. With the velocity at which those companies are moving up, you have to move really fast as they're the deal of the week. And all the top VC firms are competing intensely for them, so the valuations are getting way ahead of themselves in terms of fundamentals. The hard part of the business is when you see a company breaking out, there are no fundamentals to support the valuations being paid, and you pass on it, and the damn thing keeps going up. That's the art. Knowing when you want to pay way beyond the fundamentals."
Todd later offered a contrarian investment approach which reminds me of a saying in Hong Kong about investing: "If the grandmas and cab drivers start talking about your stock, get out." So what do you do when you hear a lot of chatter about mobile, cloud, and green tech?
"We have a few bets in mobile infrastructure. Mobile content is overfunded and overhyped. A lot of VCs are targeting mobile entertainment, while enterprise IT is considered the least attractive. But that's one of the secrets: go where they ain't. I'd be much more interested in the next wave of enterprise solutions."
The takeaway: What we're experiencing isn't a bubble so much as "bubblettes" here and there (Wow, did I just coin a new term? I'm gonna put it on a T-shirt and sell it). If you're a startup operating in an unsexy space, don't be disheartened. Someone will eventually take notice.
5. SOX Sucks
That's another slogan I'm going to put on T-shirts and sell at Menlo Park. Of course, one of the byproducts a couple years after the bust was Sarbanes-Oxley, an attempt to hold executives accountable for what and how they report. The costs, in terms of financial and executive energy, are so high that it has implicitly raised the threshold for companies seeking to go public.
"The reason you don't want to go public unless you've hit at least a $100 million in revenue is because you've got to be earning at least $10 or $15 million a year to pay for Sarbanes Oxley [laughter in the room]. And that's a big problem. It's a lot of reporting, you deal with a lot of individual investors, lawsuits, and all that stuff."
- Tim Draper
SOX and the burden of hitting quarterly targets is a huge deterrent to the IPO route:
"The real litmus test of whether you should go public or not is 'do we have control of our business? Can we establish clear quarterly goals and hit them?' Because in the public market, if you miss your numbers, you're gonna get slammed."
- Todd Chafee
That's sending investors and founders to other alternatives (i.e., secondary markets) for liquidity.
"If you're a good company and you feel you're in a great place and you don't want to sell out (i.e. go public), you didn't have very many options. Either you go public, or some of these later stage VC firms will buy founder's shares; but they're paying wholesale not retail. Some time soon, there'll be an opportunity where we'll be able to go 'Prublic' and take an XPO rather than IPO. And you have high net worth individuals, and possibly qualified institutions, buying and trading your stock. That will become a fairly popularly option."
- Tim Draper<
To find out more about what it means to go "prublic", check out my other post.
So what's remained the same?
Well, what will never change is that you, the entrepreneur, are still the hero. And even the VCs and angels (at least the down-to-earth ones) will acknowledge that.
" At the end of the day, there's no such thing as a VC titan or VC rockstar. It's the CEO, the entrepreneur, the CEO. We're just a capital intermediary, trying to route capital to the most talented entrepreneurs and management team. Once we get that capital in with them, we really work hard to help them grow their business. That's the way to generate superior returns."
- Todd Chaffee
The recent movie "Social Network" may be perpetuating the myth that all startups are operated by bright twenty-somethings with big ideas and no operational experience. But to investors, anything less than an A-team is still a dealbreaker.
"A dealbreaker is somebody who is starting a business, but doesn't want to get the world's best people he/she possibly can get. If a company is going to be the best in the world at what it does, one of the things that gives us more comfort is if the team has gone out and found people who've built similar businesses to get involved as advisors, head of engineering, or whatever. If they're just friends, it's not the right approach in today's hypercompetitive world to building a phenomenal company."
Jeffery To is an NYC-based corporate entrepreneur and IBM Innovator Award Winner who covers hot topics in Silicon Valley and Silicon Alley.