Market Share

The National Venture Capital Association (NVCA) and PricewaterhouseCoopers (PWC) Moneytree put out some data at the beginning of the 2014. It looked at venture dollars and deals by year by state.

numbers

With some simple division I was able to figure out that between 2008 and 2013 New York went from 5 percent of total venture capital deployed in the US to nearly 10%. That is a 5-year CAGR of 13.5 percent and a net dollar increase of 89 percent.

As I look around at New York, I’m not surprised at these growth numbers. Certainly the development of the NY ecosystem bears that out. And by the way, I’ve seen numbers that are a little higher in other studies, but not much, so I believe this in general.

All at once I’m disappointed and enthused. I’m disappointed that with all the work, development, press and hoopla, when the rubber meets the road NY is only 10%. Maybe I’m deluded, but it just feels like it should be more. After all NY is growing twice as fast as the rest of the country in terms of both deals and dollars deployed. I’m enthused because, hey, NY is only 10%. With all the cool things that are going on here in terms of talent development, capital access, municipal support, it would not surprise me if NY went from 10% to 20% of US VC dollars deployed (a double) in the next 8 or 10 years. How great would that be?

Now, I realize that venture is cyclical and we have been enjoying a pretty nice little run, for the last couple years. The tide will inevitably go out. As I have mentioned, in other posts – NY is much better equipped to handle that then in past down cycles. And whereas many other up and coming ‘innovation centers’ might not be as well prepared (or have the critical mass to endure), the market leaders would take the opportunity to gain market share.

Enterprise Venture on the East Coast

In 2011 there were 58 enterprise seed deals done in New York and Boston representing $21 million of capital being put to work. Two years later those numbers were up to 73 enterprise seed deals and $33 million. Deals up 26% and dollars up 57%.

The numbers are more impressive for Series A deals. In 2013 enterprise deals rose 73% to 57 from 33 in 2011 and enterprise dollars rose 159% to $342 million from $132m in 2011.

It’s safe to say the upward trend is continuing into 2014. So far there have been $243 million dollars invested in 85 deals (combined Seed and A) in New York and Boston through Q2.

Contained in that sample are companies I’ve come in contact with like:

  • Datadog which Crunchbase reports has raised $22.4 million from 9 investors.
  • Hadapt which Crunchbase reports has raised $16.2 million from 2 investors and was acquired for around $50 million.
  • WorkFusion which Crunchbase reports has raised $22.3 million from 4 investors.
  • Evergage which Crunchbase reports has raised $6.3 million from 8 investors
  • MortarData which Crunchbase reports has raised $3.2 million from 5 investors.
  • VisualRevenue which Crunchbase reports has raised $2.2 million from 7 investors and was acquired for around $10 million.

Just in this small sample there are couple nice mark ups and a couple exits at decent multiples. And of course there are many more successful companies I didn’t mention and plenty of time for them to be wildly successful.

I expect a couple things to happen:

  • I expect some of these founders and other senior guys to build other enterprise companies here on the east coast.
  • I expect some larger enterprise tech companies that have engineers here on the east coast to break out and do their own thing here on the east coast.
  • I expect some of the entrepreneurs from Cornell and Columbia and NYU and MIT and Harvard to decide that they would rather be closer to their customers and not move to the valley to start their companies.
  • I expect the support ecosystem that nurtures these types of companies to grow.
  • I expect the support ecosystem that nurtures these types of companies to grow.

In short, I expect the trends we are seeing in enterprise tech startups on the east coast to continue. And I look forward to being part of it.

Hire Slow, Fire Fast

When a seed stage startup shows me their cash burn projections (believe it or not) I often think they can’t possible spend the money this fast. The reason is hiring. At the very beginning, most of the burn is in salaries and employee related costs. Often forecasts have unrealistic hiring expectations. The CEO is sure that she/he can hire 4 this quarter, 5 next quarter and 6 the quarter after that and there will be no turnover.

That pretty much never turns out to be the case. There are a couple reasons why.

As an investor, I’m starting with the premise that I will help make sure the initial hires are disciplined hires. There will be no CFOs. There will be no Senior Vice Presidents or worse Executive Vice Presidents. Each person hired will be evaluated against needed skill set and ability to contribute to the vision. It seems obvious, but it is easy to veer from the path.

And talent, as everybody knows is scarce. It takes time to find people who are great and who fit with the company chemistry. If a company starts out by being absurdly selective in hiring (which they should), than it takes even longer than normal.

The final reason is attrition and bad hires. Sometimes the person hired isn’t getting what they bargained for. Sometimes the company isn’t.

As I may have mentioned before in the seed stage, my belief is that a startup gets two small mistakes or one medium mistake. More than that and there could be trouble raising the next funding round. It should be a surprise to nobody that hiring is among the most common mistakes.

If a company brings on an engineer who is not contributing or isn’t as talented as advertised, that person needs to go – quickly. If the new bus. dev. person isn’t making things happen. The founder should waste no time. There just isn’t the capital to wait and see.

So… if a company does what it should, which is to hire slowly and fire quickly, then building the right team takes time. The interesting side effect is slower cash burn.

The trick of course is to not sacrifice growth.

Deal Flow

Deal flow seems to be this nebulous thing to some people, especially outside of venture capital. I’m frequently asked where does it come from? What is the quality? How do I know it’s enough?

I recently had the opportunity to evaluate my deal flow. So I figured I would answer the question as it stands today. Now the key thing to put up front is this is that my deal flow is just a small subset of RTP Ventures (my employer). I contribute my deal flow to RTP, when it makes sense, but sometimes it doesn’t because of sector or stage, or other reasons and I simply don’t want to waste their time. This is my slice from outside sources in the enterprise seed and early stage space. So take this analysis with a grain of salt and don’t expect too many follow on answers.

In the past full year, I looked at slightly over 300 deals. That’s a key number for an early stage investor because of the following:

A committed investor should be thinking about doing 2% of the deals that get looked at or less. So 300 deals means 5 or 6 deals a year. In order to get the asset class return I think it makes sense to do 18 or 20 deals, so the investment horizon is about 3 years plus. My thinking on this is my own, and only loosely based on Harry Markowitz, modern portfolio theory. Additionally, if an investor kept to these numbers, I think it would mimic what might be a typical seed stage fund (at perhaps a smaller scale).

Some high level stats as it relates to my deal flow – I received about 75, unsolicited inbound deals this past year (about 1 every 5 days). Most people know that I’m an enterprise investor so about 75% of the deals I was shown were enterprise b2b, but there were still pretty many outside my focus area. I think that is improving over time as sources get more acquainted with what I like to see. 70-plus deals per year come from proactive searching – meaning reaching out and talking to companies in the spaces I’m interested. The other deals come from the following sources:

  • Accelerators / Incubators / Co-working spaces
  • Venture Capitalists
  • Corporate lawyers
  • Startup CEOs / Corp Dev. Execs
  • Investment bankers / analysts
  • Universities
  • Angel Networks
  • Cloud Providers

This list is actually in order of percent contribution. So the second least deals come from Angel Networks and the least come from Cloud Providers. The other interesting thing is there is not ‘customer concentration’, meaning no single source is more than low teens in terms of percentage.

Quality is likely a function of source. In general, the better networked the source is, the higher the quality typically is. Each has source their different quirks. Deals from founders are usually very high quality. Deals from universities are usually great tech, but missing other key components that make for a great company. When I look at deals, I try to keep track of who actually ends up doing the deal, what their track record is and how well the company goes on to do.

Enterprise Technology

When I started as a technology analyst (over a decade ago), enterprise technology meant products for datacenters. I’m talking about rooms full of servers and network equipment running applications to help large companies with sales, marketing and accounting. The B2B sales model was characterized by long sales cycles for high ticket, large-scale purchases. The deals were closed by fast talking, deeply tanned men who seem to be perpetually in their middle 30s with good haircuts and golf shirts.

Today that definition of enterprise technology is quickly becoming antiquated. Even virtualization is becoming passé. More and more, enterprises compute in the cloud. It be might be a public, private or hybrid cloud depending on scale, privacy concerns and internal stubbornness. Progressive enterprises often find it more economical to spin up a server and rent the IO. They migrate their data. Their applications are constructed to be multi-tenant. Applications these days help us communicate, collaborate and innovate. And then there is the mobility piece – all these things we do, we need to push out to someplace else. In order to do that we need to secure data – both in flight and at rest. Enterprise is no longer confined to a datacenter (or even the cloud). The deal sizes are often subscriptions designed to scale with usage. The sales model is ‘inbound’ and hopefully frictionless. Sales are often closed over the phone by geeky, mole-boys in dark rooms that you will never actually meet or shake hands with.

What else? Data is now a commodity (like oil). Our formerly worthless data now has value. We need to save it, mine it, visualize it, gain intelligence from it. Leadership is now data driven. Data scientists are a scare resource and worth their weight in data. Open source is now okay. We are learning to trust it a little more. Dev/ops is a cooler crowd with more pull inside the organization than before.

This is why ‘enterprise technology’ has become a really great place to invest. It is not slow moving and stodgy as it was in former definitions. It costs less to build enterprise products than it used to and it has gotten easier to sell them as well. The value of an enterprise startup (meaning the IP) is a little more tangible than in Internet or eCommerce startups, and the iteration cycle is fast enough now that course correction can be made before a product veers too far off course. All this leads to a decent understanding of the startups chance for success before too much capital is sunk into the business.

I think west coast investors have a better idea of what enterprise is. While enterprise startups are becoming ever more common here in the east, they are still pretty rare. Sometimes we east coast investors wedge companies into the ‘enterprise’ category that aren’t quite enterprise. Way to often I hear, “yes, we are an enterprise company our model is B2B2C”. I shake my head. And I believe that will change.

As an east coast enterprise investor the types of companies I’m particularly interested today are…

  • Database / Big Data
  • Analytics and visualization
  • Security
  • Next generation BI, CRM, ERP
  • Backup / disaster recovery / data migration
  • Systems management
  • Natural language processing
  • Financial services applications
  • Healthcare applications

Investment Proximity

Depending on which funding round a company is going for there will be different investor skill sets that are requirements.  For example, seed stage enterprise companies (that are still working on product) might benefit more from investors with good technical expertise.  By the time the company hits it Series B, and revenue becomes the priority, preferred investors are the ones that know how to build a sales force and can connect a company to potential customers.  And in the growth round, investors that know how to deepen a management bench and scale a company are probably most helpful.

For seed stage companies I think the two most important investor qualities are technical understanding and proximity.  By proximity I mean an investor who is close by and in close contact with the company. Here’s my logic…

Let us say you are a highly technical founder (and if you are building an enterprise startup you should be highly technical). In fact, you have focused so keenly on developing your technical ability that you may have done so to the detriment of other skills that are common in building a business.  The net result may be that you have the skills to build a fantastic product, but don’t have all the skills to build a great company around it.

When the time comes for you to pick your investors you will need to decide what you are looking for.  You will probably want someone who understands why the product really is fantastic.  You will probably also realize that you are building a business and you could use some help.  If you were to ask me, I would agree that you want at least a semi-technical guy who has experience building businesses.

Of course the thing about building businesses is it happens day-by-day, brick by brick, decision by decision.  It most definitely doesn’t happen only on a monthly basis (and at the seed stage you should be on a monthly board meeting schedule) when the board meets.

A founder needs to be face-to-face with his investors, talk to his investors, and even hang out with his investors.  Consideration regarding closeness should be part of the due diligence process on both sides of the investment.  The question ‘can I work closely with this person’ should be asked and answered in the affirmative by both sides.

Experience tells me that a founder in the seed stage should have a planned conversation with his investors at least once a week and expect an unplanned chat, once or twice more.  The founder spends the time to avoid making any operational mistakes that could doom the business. The investor spends the time to be a good custodian of the company during the time that the seed capital is being deployed.

I would argue that a good seed investor (especially the lead) should be looking to make investments close to home where there can be an impact on the day-to-day and as a result investment proximity is an important factor in the success of seed stage investing.

Impacts on Seed Stage Returns

Let us say you gave an angel/seed stage investor $100 to invest in 100 different companies in $1 increments.  The odds are that fifty of those investments will yield a return of less than $1 each – meaning you won’t even get all (or possibly any of) your money back.  This is according to a Kauffman Foundation survey done a couple of years ago.  It’s not to say that the returns from the asset class are bad.  In fact, the study found that the average return from the asset class is 2.6x the investment in 3.5 years or about a 27% IRR.

So what are we make of the above facts?  Well… investors need to offset the negative IRR investments with investments that have really high IRRs.  Seven of those 100 investments are likely to return more than 10 times the original dollar.  That’s the offset.

In order to do better than average ideally you want to do two things to improve your returns: decrease the number less than 1x returns and increase the number of >10x returns. Luckily Kauffman provides a blueprint for that as well.  According to their survey, the 3 factors that positively impact angel/seed stage returns are:

  1. a rigorous due diligence process (to weed out bad outcomes from the start),
  2. a high level of experience and expertise in the investment sector (to lend any investment context to the environment) and
  3. being a helpful mentor once you do invest in the company (to help the company avoid operational errors that can be especially dooming as a company is first started).

As I look at my process, there are a couple of things I do to keep my thinking on track and aligned with this guidance.

First of all, I only invest in what I know.  I know enterprise technology.  I covered it as a buy side analyst, I covered it as a sell side analyst, I worked with it when I ran corporate development for a public company and my current employer RTP Ventures, invests in enterprise almost exclusively.  I often see what I think are amazing deals in Internet or eCommerce or B2C spaces and regardless I pass.  For one thing, I don’t know what I don’t know and could easily miss something when evaluating a deal.  For another, since I probably know little, I can’t be very helpful to the company as they go through their stages of development.  And finally, I don’t have very many good connections to ‘follow on’ investors in most other tech sectors.  So I agree with Kauffman.org when they say stick to your knitting.

The second important part of the process for me (and the first for Kauffman) is diligence.  Everybody should have their own diligence list and process that they go through methodically for every deal they do.  Certainly it is harder at the angel/seed stage because ether is just not as much to diligence.  However, when I’m first looking at a company I think through a decision tree that looks something like this:

decision treeThis is to just make sure that I’m weeding out deals that have high level issues.

The next thing I do is put the company/deal through a rating system.  This is a way to compare deals that might otherwise be like apples and oranges.  It is also a way to dig in on some things that might otherwise be intangible.  And finally it is a good record in case you need to look back on deals.  Skyler Fernandes at Simon Venture Group was the first to share his document here.  I modified his document for my own use.

And then of course I do proper diligence, which means compiling documents, talking to employees and customers and industry experts on the finer points.

The purpose of diligence should be to uncover all the issues that define the risks.  If you know what those are you can then decide if you are comfortable with them.

And once the investment is made, that’s when the real work starts.  By my estimation a seed stage company can make maybe two small mistakes or one medium mistake in the 12 to 18 months that the seed stage money is meant to last.  Any more than that and the next funding round becomes difficult.

That’s why proximity to the investment is important.  An investor should want to stay in contact with the teams that have been invested in and see what is going on.  It’s best if you can grab a coffee or a breakfast with the entrepreneur and talk.  Talking about obstacles, pitfalls, best practices and experiences is the best way to help prevent early mistakes. That’s one of the biggest parts of mentoring.

Mentoring is the third important factor in successful seed stage investing.  Hopefully in your career you have helped to build a business and have some operational, product and financial experience that you can bring to bear.  In the beginning getting things on track and keeping things on track is the most helpful thing you can do.

The Kauffman can be found at: http://sites.kauffman.org/pdf/angel_groups_111207.pdf

Classic VC vs ‘New’ Model

The prevailing notion in venture capital today is that the funding model, which has been in place for the past 20 or 30 years, is being forced to evolve as a result of changes in startup recipe for success.

Classic venture – defined as traditional risk capital deployed by an entrepreneur who does the bulk of the work building the business and makes the bulk of the decisions taking the occasional VC suggestion or intro – is on it’s way out.

The new model is a platform, which provides services like PR, marketing, and recruiting. The thinking is that capital is a commodity and in order to 1) win competitive deals and 2) reduce business risk, the VC needs to do more to help ensure startup success.

What’s changed is that the cost to start a company has been driven down from the millions in the 90s to the double digit or even single digit thousands today. Meanwhile the number of funded seed deals has gone up proportionately.

Funding alternatives including super angels, accelerators and crowd-sourced projects have become viable to entrepreneurs seeking to get over a much lower barrier to entry.

The competitive advantage VCs enjoyed of being one of the few sources with enough capital to get a company off the ground along with proprietary deal flow is diminished if not totally negated.

The venture capital response is fairly predictable. In order to reestablish a competitive advantage, they offer scale and services to entrepreneurs that lesser funded, lesser-established entities aren’t able to. This is the ‘new’ model.

There are two valuable side effects of this strategy as well. First, the VCs can scale their time more efficiently. They can spend their hours with startups and winning deals instead of interviewing operations folks, solving back office issues or marketing. The second is the founders that VCs fund can be more narrowly focused. They can be either highly technical or have narrow industry expertise. This is because on the platform, the VC can simply build the company around that skill set. The founder does not need to be a jack-of-all-trades as in the past.

That is the argument.

Personally, I don’t believe this argument it in its entirety. A VC who can’t win deals against new funding sources based on experience, track record and force of personality probably won’t do much better with a platform. Sarah Lacy, of Pando Daily summarizes the sentiment well in saying, “You know what works in venture capital? A group of incredibly smart, connected people who have the financial wherewithal and risk appetite to make multi-million dollar bets on unproven ideas and inexperienced founders. People who can make decisions quickly, and who spend their time trying to help entrepreneurs make the most of that cash.”

Yeah. I think this is the better way to look at it.

Now I’m not saying that a VC platform is not an innovation or has no value. What I’m saying is that 1) it’s a response to a change in environment and 2) a platform won’t make a mediocre VC or their returns any better.

The core of venture capital is the same. Strong entrepreneurs, with good ideas backed by helpful, knowledgeable investors have the best chance of success and superior returns.

VC Services (NAMCE #4)

Fourth post in the series of blogs about what entrepreneurs should look for in a VC (besides the money).  This post is focused on the post funding interaction that a company’s management team has with its VCs/Board.

In general, early-stage CEOs tend to think of VCs/Board members as “pigeons” because they fly in, shit all over everything, and fly back out.  They focus on what is at hand.  They don’t give too much advice on how to:

  • Strengthen an internal weakness.
  • Step by step fix what is wrong.
  • Position the company better than competitors.
  • Plan ahead both 30 days and 6 months.
  • Get ready to raise the next round until there are 4 months of cash left.

I’ve heard the complaint that, VCs are not as long on process as they should be. And they are not as hands on outside of board meeting as some would like.

So let’s break that down.  How much should you expect of your VC if he is sitting on between 15 and 20 boards? Did you ask about her/his process in guiding companies when you were considering signing the term sheet?  Did you talk about the VC process with other entrepreneurs that this VC has mentored?  Hmmm… maybe you’ve gotten what you deserve?

They way it should be…

  • A VC, for an early stage company, should be like another team member.  By signing the term sheet the VC is committing to having the time to devote
  • Expect to talk via Skype or face-to-face for 40 minutes weekly.
  • Expect to be trading emails constantly on every aspect of your business.
  • Expect your VC to know your business thoroughly without a slide deck in from of her/him.
  • Expect to schedule all day strategy sessions with your VC where you can discuss 1) go-to-market 2) competitive positioning 3) technology/architecture 4) product development schedules 5) hiring 6) cash burn 7) etc.
  • Expect hands on involvement in the next fund raising round including pitch decks, mock sessions, pitching strategy, deeply personal intros ordered in a thoughtful way.
  • Expect someone who will tell you when they think you are doing something wrong or executing poorly.
  • Expect someone who will want to interview your key hires.
  • Expect more.

Of course this changes as a company grows and matures and needs less hands on.  But if you are not getting this type of service out of the gate from your VC, you are at a disadvantage versus other companies in your space.

The interesting thing is it is so obvious.  If a VC gets in the trenches and brings his/her experience to bear, then the chance of being successful rise.  And makes everyone a lot of money.  But… it’s not always happening.  And it’s your job as CEO to make sure it does!

VC Services (NAMCE #3)

Third post in the series of blogs about some of the things to look for in a VC.  This one is about a VCs network and Rolodex…

An omniscient entrepreneur I know recently declared that the adage, “It’s not what you know, but who you know” is dead.  His argument was that an in an information economy an entrepreneur can build something that is really great and users/customers will gravitate to it.  Everything will flow from there.

Okay.  If you manage to bootstrap a truly original product for the next generation Internet or datacenter – you might get enough buzz or traction or whatever to get the resources you need.

But… you may not, and if you do not, your company may starve in time without capital, customers or talent.  And you will wish you had someone you could call that would introduce you to the head of business development at company XYZ or an amazing Data Scientist or the right investors to take your company to the next level.

It’s not just knowing Larry Ellison or Marc Andreesen.  They are going to funnel and filter and pawn off all the thousands of requests on their lieutenants and gatekeepers.  If you choose the right VC, someone who is in the trenches with you, they will be able to know what you need and plug you in at the right level with people who can help you move forward.

What you need probably depends on your stage as a company.  If you are Series A, you might need technical talent, or outsourced back office or some initial beta customers.  If you are Series B, you might need to hire a business development person or a controller.  If you are a Series C, you might need a good COO or an experienced head of sales.  And what about if you are raising a Series B or a Series C?  You will want someone who can help you decide which investors are the right fit for your particular type of company and then make you a personal introduction at the partner level.

That’s a lot of different people and a lot of different ecosystems.  An early stage VC I know recently told me he spends nearly 20% of his time recruiting for his portfolio companies.  One needs to be pretty plugged in to do that.

So how, as an entrepreneur, do you find out if the VC that you are interviewing is connected to the people you care about?  The best way is to walk through examples of situations with your perspective VC.  Ask questions like the following:

  • What process do you go through when you companies are fund raising?
  • Who is the last executive that you brought into one of your portfolio companies?
  • How do you suggest I set up my accounting and legal functions?
  • As a technical founder, in what ways do you like to help on the business side?

You will get a pretty good idea right away what the VCs approach is and who she/he knows.  And if you don’t… talk to the CEOs of some past or present portfolio companies and ask them point blank, “Is this person well connected?” “What are the strengths and weaknesses of her/his rolodex?”

I personally think that this gets back to the argument I made in an earlier post.  VCs with operating experience probably are more tied into operators and other business folks than VCs with financial backgrounds.  This is a generalization, but it matches with my experience.

Back to the topic: not all money is created equal (NAMCE) because not all VCs have the right connections to be successful.  Of the things a VC can add, connections are probably the most obvious and important.