VC Industry Posts

“The easiest way to become a millionaire is to start off a billionaire and go into the airline business.”

– Richard Branson

Summary: Every investor uses social proof to filter dealflow; Ron Conway has a fund that uses social proof as the sole investment criterion. Angels should almost do more homework than a professional VC would—VCs invest other people’s money while angels invest their own. We should all be thankful that we live in a world in which VCs exist. Finally, the accelerating returns on innovation means that all of the value in the public markets will be shrunk and put in the hands of startups.

I’m not an investor. And maybe that’s a good thing. Because it means I don’t have an investment philosophy.

Naval has a personal investment philosophy that he uses for his own investments—it’s focused and it has nothing to do with social proof. But there is no AngelList investment philosophy. The site helps startups and investors connect and the rest is up to them.

On Social Proof

Almost every investor uses social proof to filter dealflow. They just call it a “personal intro” or a “referral”. In fact, it’s usually the first filter they apply.

If social proof is a good filter, is it also a good investment strategy? Can I make my entire investment decision based solely on social proof? Will I make money if I invest in a company just because Warren Buffet invested in it, as long as I get the same price as him?

As in all investment matters, the answer is “who knows”. When I share a startup on AngelList, I consider the company’s traction, product, team, and social proof—in that order. If you do a great job with an early item on that list, it doesn’t really matter how bad the later items look.

But some interesting people are pursuing the social proof strategy. Yuri Milner, Ron Conway, and David Lee created Start Fund to “blindly” invest in every Y Combinator startup. And several VC funds are set up to provide follow-on capital to startups backed by Sequoia, Benchmark, Khosla, and other tippity-top-tier venture funds.

On Angels

If you’re going to invest your own money in private companies, as an angel or otherwise, get educated. Read Mark Suster‘s series on angel investing. Listen to our (old and somewhat out of date) podcast on the topic.

Angels should almost do more homework than a professional VC would—VCs invest other people’s money but angels invest their own!

And don’t invest in a startup if you can’t lose all that money tomorrow, with a smile on your face. Frankly, I wouldn’t invest in anything if it didn’t meet that criterion (except money markets and very broad, low-fee index funds).

On VCs

We’ve gotten about half a dozen Series A’s and B’s funded on AngelList, and we have 400 happy VCs on the site. I think Marc Andreessen put it best, well before he became a VC:

“Why we should be thankful that we live in a world in which VCs exist, even if they yell at us during board meetings, assuming they’ll fund our companies at all:

“Imagine living in a world in which professional venture capital didn’t exist.

“There’s no question that fewer new high-potential companies would be funded, fewer new technologies would be brought to market, and fewer medical cures would be invented.”

On Startups

Startup valuations are up. That’s because capital is flowing into the system and, therefore, there is more demand. That’s a cyclical trend: the amount of available capital will go up and down and so will valuations.

But there are some secular trends that are driving up valuations.

First, many investors believe that the vast majority of returns come from a few new companies every year and, therefore, those companies attract a disproportionate amount of investor interest.

Second, startups are getting better at creating a market for their shares and unbundling capital, control, and advice. This is where AngelList can help.

Third, startups have become a (bit of a) science. Entrepreneurs are much smarter about the art of building companies than they were even five years ago.

Fourth, the accelerating returns on innovation means that all of the value in the public markets will be shrunk and put in the hands of startups. The NYSE alone has $14 trillion of value. NASDAQ has almost a trillion dollars of volume every day. Today’s startups are the heirs to that value.

Of course, today’s startups will be disrupted by more startups. And on and on, with shorter and shorter time cycles. But I don’t think big companies will hold onto this value. The principal-agent problem is too pervasive, among many other reasons that big companies are considered “dumb”.

[Click the links in this post, they're all good.]

Angel investor Thomas McInerney:

“Take a look at all the innovation happening today — Tesla has produced a beautiful 100% electric car. The cost of mapping the human genome has gone from $3 billion ten years ago to thousands today. Moore’s Law continues unabated and the rate of innovation in smart phones is staggering. The computer has moved from the desktop to the pocket, this trend alone reminds me of the World Wide Web in 1994. Social networking is in its infancy, and Twitter and Facebook are growing explosively. IP traffic is growing so fast that it has stunned the pioneering people who helped create it.

Ray Kurzweil maps out an optimistic view of the future with a tremendous amount of data supporting his main thesis — that the rate of innovation is increasing on a geometric scale. This means that innovation is happening faster every day. So yes, there are macro-level concerns about the economy, but there is also a staggering amount of data that supports the case for being an optimist. The data supports the fact that we’ll see more innovation in the next ten years than we’ve seen in the last one hundred years.

“If you are an investor or entrepreneur, this is the best time in history to make a fortune and create a better world… So if you’ve run out of ideas, buy gold. But I argue this is the best time to find innovators and invest in the future. Fortune favors the bold.”

[Emphasis added.]

Read the full post. You can reach Thomas via AngelList.

If you’re a passionate entrepreneur, you can often see the vast potential for your product. In your head, the possibilities of the future branch out, with infinite forks and potential. When pitching to investors, you’ve learned to define your market as broadly as possible while remaining credible. So, it’s not surprising that you’re disappointed when investors don’t disclose a conflict, and you steer clear of investors who might already have an investment in the same space — dating, social gaming, compliance, security, etc.

If you’re an experienced investor, you’ve seen it all. How every startup thinks they can take over the world, but usually has to struggle to accomplish even its one core product or task. How three copycat business plans will arrive in the same week, and how each one thinks they’re unique and protectable. How domain knowledge and therefore your ability to help a startup accrue by having multiple investments in the same space.

Both points of view are pretty extreme, and the truths about conflicts of interest are highly contextual. Here’s how to think about it.

1. The idea

Firstly, the idea — it’s no big deal. If it’s any good, someone has had it before and someone will have it again. If you’re still convinced it’s that good, go file a patent first, and then go talk about it. Keep in mind that investors outside of big tech (cleantech, biotech…) automatically have a bias against “patented” ideas, and most brilliance seems obvious in hindsight. Ask an investor to sign an NDA, and you’ve just filtered out all but the most desperate investors.

2. The space

Secondly, the space — it’s tricky, but you have to define it as realistically narrow. There was a time when having an investment in “web” might have been considered a conflict for another “web” company. There was a time when the term “portal” was a competitive category. Unless it’s head-on competition, Foursquare v. Gowalla, Disqus v. IntenseDebate, Google v. Bing, it’s really, honestly, not competitive. If there’s room for multiple equal-sized players in the space, it’s not as competitive as you might think. Also, theories about where you might zig or zag don’t count — just compare on what you’re doing at this moment.

3. Angels vs. VCs

Thirdly, the type of investor matters — active angels have a lot more deals than active VCs and are more likely to have an investment in an adjacent space. This is not a big problem — angels invest in syndicates and usually only provide help in a contextual, on-demand way. Because VCs are likely to be on your board, have more money into the company, and have more control and information rights, it makes more sense to pay attention to conflicts VCs might have (Disclosure: I consider myself to be an angel investor).

4. Conflict checks

Fourthly, just ask the VC to disclose potential conflicts up front, but don’t be too broad-minded about what constitutes a conflict.

Lastly, beware the “entrepreneur check.” This is where the VC tells you that they like your company, want to do due-diligence, and then just have to check with the entrepreneur in one of their investments about whether this investment would be competitive or not. Since entrepreneurs tend to have an overly-broad view of what’s competitive, this check usually fails. Even in the rare case that it doesn’t, it’s used as an excuse by the investor to pass. Therefore, always insist that they run the “entrepreneur check” early in the process, before you’ve invested too much into this investor.

Your own biggest competition

Our flawed patent system aside, ideas do not have the merit that we were all raised believing. You do have to pick the right space, but after that, execution is everything. Here’s a quick confirmation test — go back to your classmates and pick out the smartest ones, and then the hardest working ones. Now look at who is successful. A certain base level of intellect and idea-formation capability is required, but beyond that are strongly diminishing or even negative returns.

Consequently, the best entrepreneurs display a lot of chutzpah. They aren’t fazed by the competition, nor do they see shadows in every corner. They are their own biggest competition.

Here are the latest videos from Venture Hacks TV (the best startup advice you can get while you’re folding the laundry). You can subscribe to VHTV via RSS, email, or Twitter.

1. John Doerr: The salesman for nerds

 


 

Video: Charlie Rose interviews John Doerr 

 

 

I’m going to keep my eyes on the videos coming out of TechCrunch Disrupt this week. The best talk on Monday was Charlie Rose’s interview of John Doerr.

I’ve always thought of John Doerr as a salesmen for nerds. And Doerr always looks at the big picture — I remember him talking about how the browser was going to be important again, well before Firefox emerged.

2. Gates convinces Jobs to give him 3 pre-release Macs

 

Video: Pirates of Silicon Valley

 

Watch how Gates manipulates Jobs hatred of IBM to get his way at 6:45.

Every entrepreneur should see Pirates of Silicon Valley. This made-for-TV movie from 1999 is amazingly well-done. It’s a dramatization of Steve Jobs and Steve Wozniak starting Apple; Bill Gates and Paul Allen starting Microsoft; and how Jobs and Gates collided.

The script and acting ring true. Wozniak writes that “the personalities were very accurately portrayed.” Steve Jobs actually invited Noah Wyle, the actor who portrays Jobs, to impersonate him at Macworld. And the negotiations are pretty realistic.

Watch the clip above and rent the movie if you like it — it’s cheesy but good.

3. This Week in Venture Capital with Jason Calacanis

 

 

Video: This Week in Venture Capital Episode 6 (Download) 

This Week in Venture Capital is a combination of startup analysis and startup advice from Jason Calacanis’ burgeoning ThisWeekIn empire. Mark Suster is the host. Jump to 33:05 for a solid block of startup advice on:

  1. Your deck getting in the wrong hands @ 33:05.
  2. If this is your first time raising angel money… @ 38:13.
  3. “VCs—when we fund raise—never ever are raising money. We’re pre-marketing until the round’s closed.” – Mark Suster @ 44:34

If you’re into startup analysis, check out the deal of the week, Stack Overflow, @ 1:00. Jason’s Q&A expertise shines through here. And here’s Mark’s recap of the episode.

Subscribe to VHTV via RSS, email, or Twitter. Do so immediately and without hesitation. How else are you going to get startup advice while you do the dishes.

Thanks to George Zachary, a partner at Charles River Ventures, for sponsoring Venture Hacks this week. If you like this post, check out George’s blog and tweets @georgezachary. – Nivi

In my first post, A brief history of your investors (and their investors), I wrote about the history of venture capital. I described how the economy and stock market drives investments into venture capital and startups. I also covered how the basic incentive structures are affected by these drivers.

I ended with a suggestion that cash is gaining power relative to other assets and a suggestion that this will shift the balance of valuation and terms in favor of the root sources of capital (limited partners and above). In this second part, I’ll discuss why I think this is happening and what it means for venture investors and entrepreneurs.

Speculative returns are a major component of total returns

The coming decade is not going to be a bull like the 1980’s or 1990’s. Why is this important? Because it’s going to turn money into a “scarce” commodity and therefore drive down valuations, erode returns, remove under-performing venture funds, and reduce company exit valuations.

The 1980’s and 90’s were incredibly bullish. The annualized return from the public stock market was 16.8% from 1982-2000. That is huge. If you dive into the 16.8%, the fundamental return was 9.9% annualized.

What’s the remainder? I’ll call it speculative return. The speculative return was 6.9% between 1982-2000. And what is speculative return? It’s the expansion of the starting and ending P/E from 1982 to 2000. We started 1982 with a P/E of 8.0 and finished 2000 at 26.4!

As I wrote in part one, the increased supply of money drove these large returns. M3 money supply started its ballistic rise in the early 1980s. The total debt market went from $4T in 1980 to about $52T at the end of 2009. So the credit boom and decreasing interest rates fire-hosed cash into all markets. And that’s how a speculative return of 6.9% a year was driven. Other drivers included the baby boomer demographic, the technology boom, geopolitical stability, and the boom in international trade from globalization.

If we look back in time, the preceding time period of 1966 to 1981 had a total return of 5.9% (including dividends of course). However, the fundamental return was 11.1% and the speculative return was -5.2%! We started 1966 with a P/E of 17.8 and finished 1981 with a P/E of 8.0. And to add a little more color, the 1950-1965 post-WWII time period had a total return of 16.1%. That was comprised of a 10.0% fundamental return and a 6.1% speculative return. And, looking forward a bit, we can see the 2001-2005 time period had a total return of -1.3% with a -6.9% speculative return.

This data suggests that the speculative return component is a huge driver on total returns. And that it has a fairly long half-cycle time. It’s in the vicinity of 16-18 years if we do the analysis since the early 1900s. In a short 5 year period, speculative return can comprise 55% of the total return. And, over a 40 year period, speculative return drops to near 0%.

Benjamin Graham said it best when he said that the stock market worked like a voting machine, but in the long term like a weighing machine. If you are building a long term company, that is the good news. The not-so-good news is that the short term pain of being part of the voting machine could be very significant.

2001-2020 will have negative speculative returns

Okay, its 2010. Could the speculative return dynamics since 2001 have ended? Umm — probably not. Take a look at this table of important drivers that compare 1981 (the start of the mega 20 year bull period) to now.

1981 Today
CPI 8.9% -1.3%
30-year bond 13.65% 4.24%
Fed Funds rate 12.00% 0.25%
Highest marginal tax rate 69% 35%
Highest LT capital gains tax rate 28% 15%
Home ownership rate 65.2% 67.4%
Household debt as % of income 56.1% 114.4%
% of families with retirement accts 20.4% 52.6%
Personal savings rate 11.4% 3.0%
Mortgage debt as % of disposable inc 43.1% 95%
Baby Boomer age range 17-35 45-63
Federal Deficit as % of Nominal GFP 2.5% 11.2% est
PCE (consumer spend) as % of GDP 61.9% 70.7%
US debt as % of GDP 32.2% 85.8%
Household debt as % of GDP 47.2% 96.8%

To me, these are very sobering statistics. They paint a completely different picture than at the start of the last bull cycle of 1982-2000. My judgment is that these statistics are going to seriously suppress speculative return. The -6.9% of 2001-2005 will get worse and total returns will suffer. In 2021, statistics will show that the 2001-2020 time period had good fundamental returns. But horrific speculative returns.

Valuations go down and diligence goes up for startups and VCs

What will this mean for the U.S. entrepreneurs and investors? In short, we are not going to be “partying like its 1999” for quite awhile. (Who knew that the artist formerly known as Prince could forecast market peaks?)

The implications of negative speculative returns will be huge. The number of venture firms and their personnel will shrink. And probably hit bottom sometime this decade. Venture firms will be under significant pressure to outperform their peers and outperform their limited partners’ common benchmark indices like NASDAQ. Limited partners will feel the same type of pressure as they too source their capital from sources that will be under tremendous economic pressures. Angel firms (translation: angels who are institutionally backed) will feel the same pressure. Angel investors (individuals investing their own capital) will become more risk averse.

How will these pressures affect entrepreneurs? As a whole, valuations will stay suppressed and will probably come down further over the future years. Revenue multiples and “discount to public market multiples” will re-enter and dominate the late stage financing lexicon. Early stage companies will also feel this suppression with smaller venture rounds. Capital-intense startups that need to raise large initial Series A financing rounds will be particularly affected.

The amount of time spent in due diligence will go up and get more rigorous and detailed. Of course, there will always be companies that are exceptions. But as a rule, the suppressed return environment will force all parts of the money chain to spend way more time in diligence. Way more time and energy for limited partners to raise capital. And the same for venture investors. And the same for angel firms.

Startups will feel this diligence pressure next as they are the next stop on the money supply chain. My guess is that new service providers will emerge to help both investors and entrepreneurs with these diligence processes. How they will be paid is an open question.

Since individual angels use their own cash, they won’t be directly affected. But they will probably diversify their portfolio by making smaller investments on average. And put less of their total portfolio in startups so that they can have greater portfolio liquidity. In aggregate, they will put less money into startups.

Some startups and VCs are going to disappear

Okay, so valuations down and diligence up for every part of the money supply chain. We can all work through that.

Where matters are going to get tricky is that parts of the money supply chain will disappear. A venture investor or angel firm may run out of cash in a fund and need to raise a new fund. A startup company has a similar problem.

If you are a startup company, a pure non-dilutable asset is your time. Raising a new financing round requires time. Since we’ve already established that investor due diligence time will increase, the last thing an entrepreneur will want to do is spend that time talking with investors who don’t have cash to invest. Or who can only invest with particularly harsh terms because of their own liquidity needs.

In the next and final part of this series, I will detail the questions you should ask your potential investors. These questions will assist you in ensuring you are talking to the right investors for your company.

In closing, here’s the “New York Daily Investment News” front page from the early part of the Great Depression to remind us that history may not repeat exactly. But it does rhyme.

Ho Nam (@honam):

“The blockbusters are oftentimes the ‘ugly ducklings.’ Cisco is probably the best example in the VC world. Everyone passed except for Sequoia. In the book world, almost everyone passed on JK Rowling.

“It’s just hard to predict the future looking into the rear-view mirror, yet everyone wants to pile onto the brand names [VCs] and they in turn pile into the hot deals in droves pushing up valuations to unsustainable levels.

“It doesn’t help the poor entrepreneur who just wants a little capital to back his dream. He has no clue whether or not it will be another Google, yet in order to raise VC funding he has to make promises that only hucksters can make. The VCs in turn make those same promises to LPs and some LPs actually believe the nonsense. What a shame.”

Emphasis added. Read Ho’s full comment. Also see Simeon Simeonov’s How to raise money without lying to investors.

Thanks to George Zachary, a partner at Charles River Ventures, for sponsoring Venture Hacks this week. If you like this post, check out George’s blog and tweets @georgezachary. – Nivi

Why should you read this post? So you know what questions to ask your potential investors about their investors (their limited partners). You need to understand how your investors are compensated, how they’re motivated, and how they’ll act in critical situations — so you know if you and your investor’s commitments are well aligned.

By the end of this two-part post I’ll provide a list of questions to ask investors to help determine if they’re the right investors for you. This post focuses on the history of venture capital. The second post will focus on the present and future of venture capital and how it will affect startups.

Some say that startups should raise smart money but not dumb money. Others say all the money is green, so there’s no difference. The issue is more complex than that. And this complexity involves the capital sources that your investors use as well as the terms of their agreements with limited partners (LPs).

Angels invest their own money, VCs invest their LP’s

Venture capital firms have limited partners. These limited partners come in all shapes and sizes from all over the world. And in turn these limited partners are frequently entities that are funnels for other sources of money.

Traditionally, angel investors were individuals that would use their own personal capital to make an investment. Recently, “seed stage” venture firms have emerged that have between one to three partners. These seed stage firms are usually backed by institutional limited partners or even by venture firms. They are really small venture firms that present more like angels because there are usually one or two partners running the seed stage firm.

To understand how these angel and VCs roles came to be, we need to look back in history.

1960’s and 1970’s: LPs realize they can seek alpha in VC

Let’s go all the way back to the 1960’s and 1970’s — early days in technology angel and venture investing. There were very few venture firms at the time. Most of them were formed by former technology executives who had had enough of operating but wanted to stay involved in startups. So they took some of the cash they made during their operating careers and started investing in companies that were in their work or social domain. And soon, corporate financial services and university endowments realized that these former execs-turned-angel investors had good instincts about which companies to invest in.

Meanwhile, these corporate financial services and university endowments started to apply financial asset allocation theories to their portfolio. It’s well known in financial theory that the allocation of capital in a fund across asset classes is the single most important decision that affects the fund’s return and volatility. In addition to having investments in liquid public equities, they also had investments in oil & gas funds, real estate, commodities, and other asset classes. These endowments (the early limited partners) started looking for “alpha” so they could outperform other limited-partner managers. So they created a new asset class with the highly descriptive name of “Alternative Assets.”

The LPs saw that angel investors and early venture firms made some spectacular returns. For example, MCI and Amgen came out of early small funds like Charles River Ventures and Genentech came out of  Kleiner Perkins. So the LPs got smart and said, “Aha, let’s allocate some of our alternative investments to venture capital.” In a way, it became the asset they could invest in to differentiate their performance from their competition. And to also earn a healthy bonus for themselves for “winning.”

These financial services companies and endowments would back these angel investors in a firm structure that usually took the form of a limited partnership — which, not incidentally, is totally different than an operating company. A limited partnership has limited partners and general partners; the limited partners are the major sources of capital. Historically, the limited partners would get 80% of the fund’s returns and the general partners would get 20%. The funds were small — for example, Charles River Ventures was $5M in 1970 and Kleiner Perkins was $7M. Most of the capital came from the limited partners.

General partners would typically get a 2% annual management fee. At that time, venture firms had small headcounts and the 2% fee on the small fund was used to cover business expenses like rent, travel, administrative staff, and meals. The fees were not a way to earn a living. And through the 1970’s, venture capital marginally outperformed the horrific public market.

Early 1980’s: Weak public markets tighten VC money

In the early 1980s, the 15-year public equity disaster came to an end. The public market literally went sideways from 1966 to 1981. If you invested $1 in the public stock market in 1966, you would have $1 in 1981. Worse, if you accounted for inflation, you only had 70 cents!

Because of the weak public market, startup valuations were low and investment syndicates were a must. Founders looked for deep pockets, not just easy pockets. In short, money was tight, not a commodity.

Investors were concerned that there would be few exits and worried that, even if companies became cash flow-generating businesses, they wouldn’t necessarily become high margin, high value companies. A whole host of terms became important in the term sheet like redemption rights, dividends, and participating preferred.

1982: Low interest rates and successful technology companies lead LPs to invest even more in VC

Starting in 1982, interest rates fell from 15%+ to 5%, paving the way for a lot of available capital as well as a lot of profit generation. These profits fed back to limited partners, who, in turn, pumped the profits back into venture capital through their “alternative assets” allocation, which was now 5% of their manageable funds. So the terms of limited partner’s investments in venture firms loosened up a bit, which also permitted venture firms to loosen up the terms of their investments into startups.

At the same time, technology companies like Apple and Microsoft were printing money. It was in the air that technology companies would disrupt and create new industries. And our government was printing actual paper money and creating a lot of debt to fund the deficits spurred by high defense spending and other spending. So there was a lot of new liquid capital.

All this extra capital boosted the size of venture funds. There were serious and large limited partners that wanted to place a lot of capital into these well-performing venture funds. These limited partners were university endowments, insurance companies, charitable foundations, as well as “fund-of-funds,” which were channels that would pool the capital of small limited partners that didn’t have the capital base or reach to invest in these venture firms.

1982–2000: $120B goes into venture firms in 2000 alone

Meanwhile, the 1980s and 1990s marched on, with the public market taking off and seeing an annualized 18% return into 2000. Limited partners were also happy because they were getting good returns, and venture firms were growing and specializing by domain. By 1996, venture firms had total capital of $12B+ and the average venture fund was about $120M.

In the next four years, the public market went ballistic and became a huge bubble. This was partly a social phenomenon, but it was also because of the Fed, which provided easy money at low interest rates. Also, the Fed, fearing a market collapse caused by Y2K problems, was pumping the market with liquidity in 1999.

Valuations on the private market skyrocketed across all stages and private companies were raising capital at billion dollar valuations fairly early in their development. The time frame also accelerated: investments were made within days to weeks and diligence was measured in days.

By 2000, limited partner’s returns were turbocharged and top venture firms saw annualized returns of more than 200% — far in excess of the public market. In fact, from 1995 to 2000, a total of $180B was invested into venture capital and approximately $325B was returned to limited partners. And what did the limited partners do? They put in more money. In fact, they invested $120B into venture capital firms in 2000, a tenfold increase in five years.

Limited partners were very happy with their returns from venture firms and did whatever it took to place their capital into these firms. It was like a feeding frenzy to raise a fund. My partners and I raised a $300M fund in three weeks during that period. It was just really easy. Limited partner allowed select venture firms like CRV to have better carry (25%-30%) and terms between entrepreneurs and VCs loosened up again.

2002-2009: $205B goes into VC but only returns $220B to LPs

So far so good — until we hit the year 2000, when the public market cratered and limited partners and the broad populace scrambled to defend their portfolios. Cash liquidity decreased and limited partners got very concerned about how some venture firms were being run. They also began to worry about the ballooned size of most venture funds.

But that worry didn’t last long enough, as the Fed began pumping more money into the system to “save” the United States from a recession. The great housing bubble started to grow and the public market began a strong rise in 2003, a rise that buoyed the public market portion of the limiter partners’ funds. LPs began to feel and think more positively, resulting in more capital flowing back to venture capital with good terms intact. Limited partners also began to characterize the bubble as the result of macro forces that were then tamed by Alan Greenspan. As a result, the limited partners rationalized away their worry about venture firms and we soon found ourselves returning to $30B/year going into venture capital each year. This was more sane, but not totally sane.

As the public markets improved, limited partners (who are now both domestic and international capital sources) worried that too much of their portfolio was in the public market and started pumping more money into venture capital firms. From 2002 to 2009, a total of $205B was invested into venture capital, and approximately $220B was returned. You can do the math. That is not a good return for the whole asset class.

What happened? A big part of the problem was that the public market never really responded like it did in the 1990s. The stock market blowout left collective scars across retail and institutional public market investors. There was no crazy bubble period, which was a problem because the amount of venture capital in total was still way too high given the total return. And while venture capital returns did slightly outperform that public market over the decade ending in 2009, the public market returns and private venture capital returns diverged in terms of the median return per company.

LPs: “The fund I invest in better be investing in the next Google.”

Along the way, something interesting happened to the shape of the return curve. In the 1980s and 1990s, venture capital returns were usually Gaussian with respect to their portfolios. Yes, there was Benchmark’s investment in eBay and a couple of others that created 1000x returns. But most of the exits were shaped around $300M exits. A big exit was a 10x return.

In the 2000s, the middle of that curve got blown out, making a lot of portfolios look bipolar. Most portfolio companies returned less than the capital that was put in. And a few companies generated astronomical results: Google measured in the 1,000X to 10,000X multiple. Limited partner data showed that eight venture funded companies a year were generating the vast majority of venture firm profits, and that’s out of a universe of three to four thousand companies funded every year.

Pretty soon this was common knowledge across the limited partner community, and the top limited partners — in terms of size and longevity — were looking for these “return the fund” opportunities when venture firms talked about their investments with them. If you couldn’t speak about a potential “billion dollar opportunity,” limited partners thought you really weren’t in the game. This data started a conversation across the limited partner community, which usually included the words “the fund I invest in better be investing in the next Google.” And limited partners liked to bring that up in their conversation with venture firm’s partners, “Which one of these companies can return the whole fund?”

Additionally, a decade had passed since the 2000 blowout. The decade returns for venture capital in aggregate were weak and limited partners started to reassess how, who, and what venture firms to invest in. And then the savage bear market that started in late 2007 started to ravage the limited partners’ portfolios again. This was the start of limited partners asking tough questions and looking for proof of how returns would get generated over the next decade.

2010: The balance of power shifts to limited partners?

Limited partners face the issue of diminishing returns because they also have shareholders. Likewise, the venture firms and seed stage firms that are down the pipeline from these limited partners are also subject to these hard questions.

Today, we’re beginning to see a shift of money turning back into a commodity. But without the massive government bailouts, it turns out that money supplies like M2 are declining, indicating that the core economic environment is one of deflation. This means that cash is gathering more value than any asset, and this macro shift will shift the balance of valuation and terms in favor of the root sources of capital.

In the next post, I will review what this means for direct investors and what it means for portfolio companies. I’ll also include a list of questions to ask your potential investors to ensure that they’re the right investors for your company.

Thanks to FastIgnite, a startup advisory firm, for sponsoring Venture Hacks this month. This post is by Simeon Simeonov, the firm’s founder and CEO (and formerly a partner at Polaris Ventures). If you like it, check out Sim’s blog and tweets @simeons. – Nivi

“Prediction is very difficult, especially if it’s about the future.”

Niels Bohr, Nobel Prize winner

By penalizing entrepreneurs who are humble and honest about how their companies will grow, many investors cause entrepreneurs to over-promise (and later under-deliver) when they’re raising money.

The histories of some of the best-known technology companies demonstrate the power of luck, timing, the mistakes of incumbents, and solid execution.

Execution is the main tool under a startup’s control but it’s often under-valued by investors.

So it’s not surprising that most entrepreneurs come to pitch meetings armed with very precise statements about a very uncertain future and a list of proven strategies guaranteed to make their company successful. While sitting through these pitches, I sometimes wonder which is worse: the entrepreneurs who know they’re spinning tall tales or the ones who “got high on their own supply.”

VCs and entrepreneurs collaborate to lie about the future

Instead of bringing entrepreneurs back down to earth, some investors push them further into orbit. Some VCs ask a seed-stage, pre-product startup for a detailed five-year financial plan. When I was a partner at Polaris Ventures, I saw many of these spreadsheets built “for fundraising purposes.” We didn’t ask for these spreadsheets — entrepreneurs had usually built them after meeting other, less early-stage, investors.

I find the process of planning — and understanding how a founder thinks about a business — educational and valuable. But pushing the exercise to the point of assumptions layered upon assumptions is not just wasteful, but dangerous, because it sets the wrong expectations.

After a few pitches, entrepreneurs realize that the distant future is safer territory than the immediate. It’s easier to boast about 30 must-have features your product will have in three years, than to show the three must-have features in the current prototype. It’s easier to talk about how you’ll recruit world-class CXOs when you’re big and successful, than to show a detailed plan for bringing in an amazing inbound marketing specialist, when everyone on the team is getting paid below-market rates to conserve cash. The examples go on and on.

I’ve co-founded four companies. The two that most quickly and easily raised money did it with nothing but slide decks. Both were funded by Polaris, which has a lot of experience with very early stage investing. We didn’t waste time over-planning the future in those two companies.

And for good reason. Both startups ended up quite different than the fundraising presentations promised — for solid, market-based reasons that were invisible during diligence. Plinky acquired a new product line and became Thing Labs. 8th Ring failed quickly and cheaply, only seven months after funding. The CEO and I decided the execution risk was too high. And, in retrospect, we were right: our only competitor had an unexciting exit a few years later.

Over-promising causes startups to throw away money

Over-promising is not a problem when it comes with over-delivery. But the overwhelming majority of startups fail to meet the promises they’ve made during fundraising. After years of observing this pattern, I’ve come to believe that over-promising can actually cause under-delivery. Entrepreneurs over-promise to raise money easily and set themselves up for pain down the road.

How? The reasons have to do with information signals, expectation setting, and the psychological contracts between entrepreneurs and investors. It’s very hard to pitch one story today and then change it the day the money hits the bank, especially if you’ve drunk the Kool-Aid.

An overly rosy pitch leads to expectations and fateful commitments that downplay the variability of the future. Decisions are made based on assumptions rather than tested hypotheses. The burn goes up earlier. The sales team is hired much too soon. In venture funds, over-promising also spreads from the investing partner to the rest of the partnership. It can also spread from the company to its customers and partners, further extending the reality distortion field.

If you’re Apple and you’ve got Steve, that’s awesome. For everyone else, it can get rough. I saw this play out with one of my companies that was expanding internationally (the reason why the company had raised money). The world was going to be our oyster and, before the reality that our go-to-market strategy wasn’t as effective as everyone had hoped set in, we had burned through a good chunk of capital.

Find investors you don’t have to lie to

How should you choose between being honest (and hearing “no” a lot) vs. amping up the pitch and risking the anti-patterns above? I give two answers to the CEOs I work with at my startup advisory firm FastIgnite.

First, I strongly advise startups to go to venture firms where the decision process is more collaborative and less “salesy.” One of the main reasons a VC will push an entrepreneur to over-promise is his need to sell a deal internally.

Second, pitch investors with a track record of valuing a team’s ability to execute, over any specific strategy or execution plan. While most firms pay lip service to this cliché, few do many investments this way. Here are some examples from my experience in the past few months:

  • On the smaller side, Betaworks and First Round Capital get this. Their portfolios and their philosophy show it. I look forward to working with them some day.
  • Among VCs, General Catalyst has repeatedly backed companies like Brightcove, m-Qube, and Visible Measures very early — with the understanding that many important questions will have answers only after months of execution. I’m actively partnering with them at FastIgnite.
  • Surprisingly, at the very high end, a private equity firm like Warburg Pincus can be a great place for the right early-stage entrepreneur. Last year, a Warburg entrepreneur-in-residence incubated Better Advertising, a company where I’m a co-founder and acting CTO. Better Advertising’s market and business model required a backer with staying power that exceeds most other investors’.

The firms above practice a form of agile investing by (1) not forcing entrepreneurs to over-plan for an uncertain future and (2) following the principle of minimizing wasted effort. Ultimately, it’s the investors’ responsibility to reward honesty with trust and cash. And I think that’s a win-win. I’m looking forward to discussing this with you in the comments.

If you like this post, check out Sim’s blog and his tweets @simeons. And contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi

Thanks to Atlas Venture for supporting Venture Hacks this month. This post is by Fred Destin, one of Atlas’ general partners. If you like it, check out Fred’s blog and tweets @fdestin. – Nivi

In Part 1 of The Arrogant VC, I discussed 4 reasons why VCs are disliked by entrepreneurs:

  1. Poor first impressions
  2. Getting strung along or left at the altar
  3. Getting a raw deal
  4. Great (but misguided) Expectations

This post contains 4 more reasons why VCs are disliked by entrepreneurs. Both of these posts contain direct quotes from entrepreneurs with real, hands-on experience with (often prominent) VC’s, sometimes through multiple companies and fundraising.

5. Unwanted advice, poor communication, and lack of operational sense

“While VCs are always happy to dish out advice, this feels disingenuous from people who have never actually built a company or had a knockout success as an investor. Learning from mistakes is far less useful than emulating success.” One entrepreneur goes further in accusing VC’s of seeing everything through the lens of money: “Often times they have zero operational experience (how to launch a company/product or manage customers), don’t understand marketing beyond just building their own brand, and see money as their ticket for everything.”

VC’s are often ex-lawyers or bankers and some have a tendency to feel safe with “experienced suits” that sometimes do nothing but drive the burn rate up and compound cash-flows problems. Entrepreneurs are often “driven, creative types who want out of larger organizations,” whose traits map poorly to those of many VC’s. Ultimately, since many of them don’t understand the businesses deeply, they “try to make up [for] this particular information asymmetry with legal enforcement.”

Some VC’s are not that shy about it. One partner in a tier I fund described his role in this way: “Industry experience is not that important. I see my role on a board as to challenge every decision the management makes.” Here’s a variant on the same theme: “I don’t give a s**t about the company’s strategy, my job is to come here once a month and check what you are doing with my money.” QED.

6. Different objectives and time frames

“It takes patience and time to build a great business, and target returns and time frames (e.g. five times in five years) can get in the way. On the other side, entrepreneurs burn out and blow up all the time, so it’s tough to keep both sides aligned and together for a long time.”

Sigurd says “short investor time frames to meaningful exits means forcing businesses to scale too much and too fast (and offsetting this risk through a portfolio approach), whereas the entrepreneur must offset the market and product risk by slower movement and something akin to agile development.” David agrees on this natural misalignment of interests: “VCs need home runs, and entrepreneurs need singles at least on their first couple of companies.”

The going really gets tough when entrepreneurs lose their original sponsor. “The new guy is either too junior, does not know the business, or feels he has the right to wash his hands of the mess left by his departing partner.”

7. Arrogance and lack of empathy

At the end of the day, most entrepreneurs completely understand that objectives are not always aligned and that VC’s work for funds that need to return capital. What they have trouble with regardless, are “double standards“. One entrepreneur who has raised money multiple times says, “A lot of VCs do things no regular employee would dare to do but are largely unaccountable for those behaviors: forgetting about board meetings, showing up 20 minutes late, bullying the team or CEO, being generally unavailable, paying no attention in meetings because they are arranging a golf game on their BlackBerry, failing to read the board pack before the meeting, so the actual meeting is remedial in nature.” the message seems to be, “Don’t treat me the way I see fit to treat you.”

Net-net, VC’s are too often “out of touch with the reality of entrepreneurs.” “They are often times elitist, clashing with the very scrapiness of their entrepreneurs.” Arrogance is the word. “I was told forcefully ‘you will fail’ and that I should join another startup… funded by the very same VC.” “I spent 4 years in poverty ignoring my family and my friends to get the company to this point, and now they want me to vest my shares.” Yet another: “I have mortgaged my house, I have spent all my money, my family lives on pizza coupons and now you are telling me you want customers and a live product to boot? Why don’t I call you back when I have gone public, bozo. You call yourself a risk taker? You want 30% of my company when all the risk has been taken out?” (I added the pizza coupon piece for effect, but you get the idea).

Finally, entrepreneurs feel VC’s are “crap at sharing the wealth,” recognizing “how tough it is to create value” or “properly re-incentivising managers who gave up many years of their lives, effectively abusing a position of power and often manipulating entrepreneurs by threatening their reputation.”

Bottom line: “VC’s really don’t take any personal risk but expect everyone else to…”

Add to this some “dumb practices” such as demanding board remuneration and monitoring fees or “submitting ridiculous expenses” to complete a picture that betrays a complete lack of empathy.

8. Dark Side of the Force

Finally, some ugly business behaviour. A fairly common practice seems to be what you might call “slow strangulation”, whether by design or not. “An equity investor will knowingly under-capitalize your startup only to gain control of it once the opportunity manifests itself by use of a wash-out round; milestone financing and abusive board control are used for similar tactics. As a consequence, myself and others now prefer to bootstrap/self-fund rather than taking any amount of early-stage capital that will not *clearly* take the company to the next level.”

This is a common gripe with smaller funds, who have badly under-performing portfolios and little follow-on reserves, and who fall back on such slow strangulation of businesses they fund by trickling money, gradually washing every one else out, and hoping that 50% ownership for little money invested will somehow pay back for the rest of their portfolio. Smaller regional, government-backed funds get a particularly bad rep in this area. Lacking experience and confidence, they rely on punishing paperwork and self-anointed gurus to help them through the hard process of building successful companies.

Entrepreneurs have come forth with other dubious practices, including outright lying about the state of the business when refinancing, disclosing confidential information or personal confidences, negotiating on behalf of management and forcing deals through, making a mockery of governance rules. One systemic problem appears to be a failure to represent the interests of the company in board meetings, but rather short-term investor interests. “This is a plague on the industry and makes the board worse than useless to the company.”

Another entrepreneur identifies what he calls “classic VC tricks” such as “firing the team just before an acquisition, term sheet bombs, hiding or obscuring key information, manipulating the team to try to change ownership or board composition, changing deal terms just before closing.” He adds: “These destroy alignment and trust, and without some alignment and trust the necessary working relationship and motivation is destroyed.”

The worst I got related to VC’s pushing to recover shares from the heirs of a deceased co-founder under a reverse vesting provision. As the contributor put it, “it will take a lot of good karma from a lot of VC’s to make up for this one.” I was stunned.

Conclusion

Last words to entrepreneurs from Rory Bernard: “Choose your VC’s with care. Good ones transform your business, bad ones wreck it.”

And to VC’s: “tread softly, remember that in a position of power, you can do many sensible things but a few stupid ones and end up with a ‘George Bush’ problem, and as a result the approval rating of Dubya.”

If you like this post, check out Fred’s blog and his tweets @fdestin. If you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Finally, contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi

Thanks to Atlas Venture for supporting Venture Hacks this month. This post is by Fred Destin, one of Atlas’ general partners. If you like it, check out Fred’s blog and tweets @fdestin. I’ve also generated an MP3 version of this post. Let me know if it’s useful. – Nivi

Below is the summary of all the answers I received to my recent post, “Tell me why VCs are disliked by entrepreneurs”. There is a shorter and easier to stomach version on Xconomy if you prefer, here. I have tried to keep my role as editor limited to re-organising, so this remains true to the commentary. I would add that most or all of these entrepreneurs had real, hands-on experience with (often prominent) VC’s, sometimes through multiple companies and fundraising. And yes, I also plan on writing a feature about the “good side” soon…

The VC-Entrepeneur relationship seems damaged. Whilst business partnerships gone bad and company failure can lead to fallout, this is different. I wanted to find out why and used my blog to ping the entrepreneur community to try and understand this better, listen to my audience as it were, and share the feedback.

As with all articles of this kind, it is plagued by generalizations and simplifications. In trying to do justice to the sixty detailed and mostly confidential responses that I got, I probably lost some of the color and detail. But for anyone interested in rebuilding the social contract with entrepreneurs and getting our VC mojo back, the scale of the problem should be apparent.

Clearly as VC’s our job is not be loved but to contribute in building great business and return money to our shareholders. Read on regardless; as you will see, the status quo is not an option.

A common answer I got was “sour grapes”. As Richard Jordan put it, “failures breeds frustration” and there is a natural tendency to spray the blame around. Externalize guilt as resentment, combine it with some old fashioned finger pointing, and there you go.” Many VC’s excel at that too. Sometimes anger stems from the “sheer exhaustion from being told ‘no’ too many times”. Now let’s dig deeper.

Poor first impressions

Richard Jordan (read him) says: “probably more than half of the VC pitches I have done have involved participants on the VC side who have behaved in a rude and disrespectful manner“. Arriving late, cutting out early, reading their blackberry, constantly interrupting pitches, taking calls, you name it. Some of the pitching experiences border on the ridiculous, as evidenced by a young founder who got invited to pitch for fifteen (yes, fifteen) minutes with five minutes Q&A, only to find the meeting started ten minutes late and was not to be extended…

The absence of feedback loop is a common theme with entrepreneurs griping about “dozens of unanswered calls and mails, from people they met. If nothing else works, what are your PA’s for?” Another common gripe is the need to be dealing with an Associate who needs to sell his deal internally and is often insecure and not clear himself on his chances of getting the deal done.

Even in early meetings, the lack of “empathy with and experience of the startup and the sacrifices involved” can leave entrepreneurs fuming. Finally, many entrepreneurs complain about a lack of confidentiality with their pitches sometimes “landing on competitors’ desks days after the meeting”. In a recent example, a well known General Partner interrupts 50 minutes of cross questioning with this casual statement, “By the way, I am personally invested in a new startup that is targeting this segment”.

Getting strung along or left at the altar

“Raising capital depletes far more energy than investors realize”, says one entrepreneur. “Getting a ‘no’ is actually fine from an entrepreneur point of view (one has to be rejection-proof anyway), but to preserve their opportunities many VC’s tend to string along entrepreneurs forever, blatantly lying about deal status only to let it fall apart at the last minute, wasting an entrepreneur’s time and energy.”

Many investors appear to be “vague on their decision and engagement process, which tends to be liquid.” Some VC’s promise term-sheets that never come, others withdraw at closing (the worst I personally heard was an SMS turndown by a “tier one” VC followed by a competitive investment), others still don’t bother checking conflicts of interest. “VCs are too opportunistic in their behaviour,” says one experienced entrepreneur.

A common gripe concerns the lack of clarity (or absence) in the rules of the game. Some companies are forced to jump through endless hoops to get a tiny round done whilst others raise a ton of money at seed with no substance. VC’s pretend to do seed but then say no to everything that is early and want revenues, customers, a business model, and a team. Entrepreneurs are confused and sometimes angry about this, as they feel fundraising is like a marathon with no end, when the hills keep getting steeper along the course. “The whole process leaves me with this feeling that landing funding is nothing more than getting lucky with the right pitch on the right day with the right person in the room,” says D. It makes you feel like “a sort of magic and certain incantations and artistry is required,” yet despite that, “investors often still fail to ask the right questions, the hard questions”.

Getting a raw deal

“Taking capital does feel a bit like making a deal with the devil after all.” Entrepreneurs fundamentally want to change the world and dealing with the Money Men is often a compromise they would rather do without.

“The entrepreneur is a bit like a child who’s just learned the rules of chess — he’s studying the current move intently, but he’s rarely thinking far ahead. The VC is an old hand at this game — he knows its patterns intimately and can see how it’ll develop far into the future. The entrepreneur tries to play well, but the terms he fights for often turn out not to be important, while the terms he thinks are innocuous can surprise him in unexpected ways. Unless things at the company go astoundingly well, the entrepreneur comes away feeling like he was played — taken advantage of by someone far, far more experienced at this particular game.” Clauses like participative liquidation preferences, anti-dilution, aggressive reverse vesting, board control or simply shareholders’ rights come up frequently, with good reason.

“My own VC’s have been great. That said — like many entrepreneurs, I’ve only realized some of the longer-term implications of the documents I’ve signed well after the fact. This was enough to make me wary.”

Great (but misguided) Expectations

“Many entrepreneurs want an investor to fund the idea (equivalent to a TV production house looking for funds from a commissioning editor to make a show, and generate a profit from it). It often takes them a long time to realize that such VCs don’t exist. By which time they are bitter and tired and blame the VCs, rather than their own lack of understanding” of what it takes to get VC funding.

David Smuts believes there are two kinds of VC’s: “Careerists VC’s” and “Entrepreneur VC’s” and two kinds of Entrepreneurs: “Real Entrepreneurs” and “Wannabe Entrepreneurs”. “Entrepreneur VC’s behave in the best interests of the business they are investing in,” whereas “Careerist VC’s put their own career prospects first.” “Wannabe Entrepreneurs either hate all VC’s because they reject their business idea,” or “suck up to all VCs because they want their money.” Long story short: The goal is to match Real Entrepreneurs with Entrepreneur VC’s.

Continued in Part 2 with unwanted advice, arrogance, and the dark side of the force… (I’ve also generated an MP3 version of this post. Is it useful?)

If you like this post, check out Fred’s blog and his tweets @fdestin. If you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Finally, contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi