Current fundraising climate & metaphors for VC rounds (addendum)

It's interesting observing the current fundraising climate for startups, both as a VC myself and just as a general market observer familiar with the goings on of other firms and startup.  For the record, I am very much actively looking at new investments now as well as helping existing companies in the portfolio who are considering raising add'l funds in the near to intermediate term. 

Virtually all fundraising right now is harder than it was 12mo ago, but there are subtle differences that I've noticed.  Based on both direct and indirect data points, it seems that raising a Ser A round is only moderately more difficult than say 12mo ago.  All the entrepreneurs out there raising a Ser A round right now may disagree, as early stage VCs are being a little more discriminate and also strongly encouraging capital efficient budgets.  But at the end of the day if you're investing in a pre-revenue or even pre-product startup, by definition you're expecting it to grow over the next 5-8 years.  I have no idea how long or steep the current down turn will ultimately be (nobody does), but it's a virtual certainty we will return to a growth period at some point within the next 5-8 years.  And so Ser A companies are still getting funded at a decent rate.

At the other end of the spectrum, significant late stage VC/growth rounds are getting closed.  A company with $100M+ in revenue that's profitable and still growing rapidly is very valuable.  Yes, investors might have a difficult time exiting via IPO or acquisition in the next 12-18 mo but such companies are likely to only increase in value from here and in most cases these late stage investors have very modest downside risk (due to liquidation preferences).

So who's getting squeezed?  Basically every startup in the middle of those two points, as far as I can tell.  If Ser A and Ser D+ (i.e. late stage) rounds are 10-20% harder to close than a year ago, then Ser B, C, etc rounds are probably twice as hard or more in the current climate.  Potential new investors want to see more traction that business models are working.  Having not been involved with the companies for the last several years, new investors require longer track records of growth than they used to in order to be "convinced".   Expect to see a larger portion of follow-on rounds being done by existing investors ("inside" rounds) in the coming months.

The most challenged companies I've seen are those that raised their first or second VC round at extremely high valuations during more optimistic times.  To the extent they're still unprofitable, their valuation "overhang" acts as a major drag in raising new funds.  These startups face a handful of options, none of which are pleasant:  a down round at a significantly lower valuation than the last (diluting existing shareholders), drastically cutting burn to reach breakeven quickly, or at worst winding down operations.  Those that are acting decisively with either of the first two options significantly increase survival chances in the long run.

Also an addendum to my last post covered some metaphors for various rounds of VC funding that a startup raises.    FWIW, I believe that things certainly change based on the fundraising climate (Rafer... you're right).

My take is that the metaphors themselves largely hold true no matter the market climate and it's really the measuring stick that moves about.  In dour fundraising markets, like we're experiencing right now, the definition of "Ser B:  proof of concept" isn't just that you have a product live with 10K unique visitors or a single customer.  The bar is raised such that a company raising a Ser B must have several customers and demonstrated revenue.  But fundamentally it's still proving the base concept is working, rather than demonstrating signifcant historical growth or even profitability.  

Similarly the bar may have been raised on how plausible the future success of a Series A startup is.  But companies today that are closing Ser A rounds are, by and large, still doing it by demonstrating high[er] plausibility.  It's not as though pre-revenue startups simply aren't getting initial funding today, even if a handful of VCs are slowing their investment pace.  And during more bubblicious times, entrepreneurs may have an easier time raising a Ser A and may command higher valuations but typically are still pitching the "high plausibility" I described.

Btw... I promised a follow-up from the other side of the table, how VC mindsets can vary based on the stage they typically invest.  Noodling on this one, but something I'm still planning to post on.

Metaphors for successive VC funding rounds

I've heard several very good pitches within the last several weeks, which prompted me to think about the differences between pitching companies at various stages of development.  The bulk of my personal experience, both in pitching and being pitched, comes at the earlier stages of Series A and B stage companies though I'm plenty familiar with later stages as well.

I decided to breakdown various stages of funding into the central theme of which entrepreneurs must convince potential VC investors.  I use the labels "Series X" simply as a guidepost here for stage of development.  We've all seen companies that might be raising their "Series A" round that have been boostrapped to a much later stage of development (post-revenue, etc).  Similarly there are plenty of startups that raise a small seed/angel Series A such that their B round is more akin to most companies Series A.  And once you get into much later rounds of funding it all becomes a blur... how do you distinguish a Series F from Series G?

But overall, both entrepreneurs and VCs often describe a startup's stage of development to an approximate round of funding.  I find it striking how closely successful fundraising correlates to successfully communicating the central themes below.  Without further ado, here's the framework as best I see it:

Series A:  High Plausability

Entrepreneurs who succeed in raising a first round of VC funding have essentially established plausability of three things:  suitable market opportunity, some ability to differentiate, and a core team's ability to get it launched.  The suitable market includes all the parameters that VCs want to see:  large addressable size, mkt dynamics which permit new entrants, etc.  Differentiation is the "special sauce" that a startup's innovative technology, product, and/or business model provide.  And the founding team has to establish why they have a reasonably high chance of getting the startup off the ground (based on prior entrepreneurial experience, domain expertise, etc).  

The point here is that the standard of "proof" is a high degree of plausability on all these dimensions... not proven beyond all reasonable doubt.  And what I mean by plausability is a relatively high standard of potential, rather than a 1 in 1,000,000 chance of "if all possible stars align we might have a chance of succeeding".  Startups that are unable to raise a first VC round have generally failed to establish high plausability along one or more of the market, differentiation, and team issues above.  

Series B:  Proof of Concept

Proving a concept means different things in different sorts of industry sectors.  For a consumer-facing company it generally means product launch with some compelling, if early data on usage and often even initial revenue.  For companies with B2B software business models, it usually means an initial set of customer wins.  It might be design milestones for a semiconductor startup, or clinical trial data for a life sciences startup.  The point is that raising a 2nd round of VC financing almost always means that a company had proven it's vision at least on a limited scale.

When you see startups raise "inside" Series B rounds from their existing investors, it could mean that the Ser A VC(s) are so overwhelmingly thrilled with the progress that they want to "keep" the round to themselves.  But more often than not, it means that the company may have progressed but either not to a full proof of concept or that the proof cannot easily be validated by an oustide investor.

Series C:  Certainty at Moderate Scale

Starups raising a 3rd round of instutitional funding have generally demonstrated certainty in their business at moderate scale.  This could mean a clear track record of revenue growth, possibly even reaching breakeven or beyond.  It might mean other things in other sectors, but ultimately it's clearly more than proof at a conceptual level.  On the continuum between experimentation <----> growth, a Series C startup is clearly closer to the latter than the former.  We're talking pour gas on the fire, not keep striking the flints and praying.  

Series D+:  Historical Growth

A majority of startups raising a Series D round could quite probably get away with not doing it if they absolutely had to.  They might have reached profitability in their core business, or even if they're still funding burn they're often sufficiently developed to have legitimate opportunities to be acquired.    You often hear of companies raising a later stage round (Ser D, E, etc) on an "opportunistic" basis... to pursue international expansion, acquisitions, entry into adjacent product categories, etc.  Late stage investors who play in these rounds typically emphasize historical growth metrics as much as the other facets (team, mkt oppty, etc).  

Like any framework, there's always plenty of exceptions that fall outside this construct.  But it's been my experience as both an entrepreneur and VC investor that the startups that do well in fundraising do so because they've honed their pitches to fit these broad themes.  

For what it's worth, I believe the converse holds true for VC investors.  I'll do a follow-up post on this sometime soon, but investors who focus on Series A companies typically have a different mindset and approach than those focused on Series D startups.  To do either well, VC investors have to be clear with themselves what they should be looking for in a startup at a given stage.

There are only co-founders

In my day job as a VC, I have the privilege of constantly interacting with founding entrepreneurs.  And before this I worked in two startups myself, including one as part of the founding group.

Throughout my experiences, I've come to hold the following belief with deep conviction... there is no such thing as a "founder", there are only "co-founders".  Conceiving, launching, and building a de novo company requires a broad range of talents and extraordinarily few people possess them all.  And even those rare few who do can almost always augment with others more capable than themselves in a particular area.

Think of the truly great startups of the last several decades and virtually all had at least two initial co-founders involved at inception.  Most famously in Silicon Valley were the Traitorious Eight, who departed Shockley Lab en masse to start Fairchild Semiconductor.  Two members of the eight left again a few years later to start Intel.  Similar examples of co-founding are endless:  Larry Page & Sergey Brin, Bill Gates & Paul Allen, Steve Jobs & Steve Wozniak, Jerry Yang & David Filo, Sandy Lerner & Len Bosack.  The great east coast tech startups are no different... Dick Egan & Roger Marino (EMC), Ken Olsen & Harlan Anderson (DEC), Mitch Kapor & Jonathan Sachs (Lotus).

There are of course exceptions like Amazon with Jeff Bezos.  But even those companies we often identify with a single founding personality have a deeper story.  Larry Ellison generally takes/gets credit for Oracle, but Ed Oates and Bob Miner helped start the company.  Pierre Omidyar started eBay as part of his personal website, but Jeff Skoll helped turn it into a standalone company.  For what it's worth, the overwhelming majority of VC firms were "co-founded" too.  Tom Perkins & Eugene Kleiner of KPCB.  Frank Bonsal, Dick Kramlich, and Chuck Newhall of NEA.  The only notable exception I can think of is Sequoia Capital, launched single handedly by Don Valentine.

I'm not suggesting all co-founders are necessarily created equal.  Job titles, organizational responsibilities & power, founders equity... these are all frequently divided in an unequal fashion.  But at the end of the day, almost nobody succeeds in launching and building a great company without co-founders.  And everybody can dramatically increase the probability of success of their startup with great co-founders.  Organizations like Y Combinator only accept groups of co-founders (not individuals) with good reason.

Just as I think it's more important to pick your boss than to pick your specific job title/function, similarly it's more important to carefully pick your co-founders as it is to write your first line of code or the first draft of a business plan.

Consumer web & black magic

This post had me laughing out loud today:

"One of the nice things about being in an industry [consumer web] that traditionally doesn't produce revenue and relies heavily on the advertising industry, venture capital, and black magic to keep it afloat..."

-Steve Spalding via HowToSplitAnAtom.com

I'm obviously enmeshed in the consumer web as a VC investor and former entrepreneur.  But even in a somber time for lots of folks, life is too short not to be able to laugh at yourself occasionally.

The state of our financial system

I'd be remiss if I let this week pass without noting the current state of our financial system and the furor this has caused among nearly everybody.

In my humble opinion, it is unfortunate that the remedy which has been proposed by the Treasury Department has become embroiled in politics from all points along the political spectrum. I personally have limited interest at the present time to try to apportion blame for the politization of this process.

Similarly I have limited interest in the present moment for attempting to discern who is "at fault" for our current crisis (Note #1). Objectively speaking some element of the blame can be laid at a wide swath of participants in our economic and political system including:

• Certain consumers - who took mortgages and other loans that in their heart of hearts, they knew they couldn't really afford.
  
• Certain real estate agents - who told consumers that home prices almost never go down and encouraged them to buy more home than they could afford (if not outright speculate and buy lots of homes), yet knew in their heart of hearts that the fun couldn't last forever.
• Certain mortgage brokers - who employed shoddy lending and underwriting procedures knowing in their heart of hearts they were simply gaming the securitization process.
• Certain investment banks - who created securities of such complexity that they knew in their heart of hearts could not properly be valued or understood by their buyers.   Compounding this problem is that in some cases these banks ended up buying some of these securities either on their own balance sheet or through opaque off-balance sheet vehicles, exposing themselves to the complexity and risk of their own creations.
• Certain investment rating agencies and bond insurers - who improperly gave higher ratings of creditworthiness to various mortgage-backed securities, but in their heart of hearts were more interested in the fees they got from the investment banks than their fiduciary duty to objectivity.
• Certain institutional investors - like banks, pension funds, and others who in many cases bought investments they didn't understand.  They were motivated to get a little extra return versus safer alternatives, even though they knew in their heart of hearts they were taking on additional risk (risk they didn't understand and underpriced) with these investments.
• Certain government sponsered enterprises (GSEs) - like Freddie Mac and Fannie Mae who were ostensibly "private" companies, but who knew in their heart of hearts they had an implicit guarantee from the Federal gov't.  The management of these GSEs took a plethora of risks and used the companies profits to heavily lobby lawmakers on both sides of the aisle to ensure this guarantee never went away and expand the purview of their risk-taking behavior.
• The accounting standards board (FASB) -  who in the wake of the Enron collapse imposed "mark to market" accounting without fully appreciating its unintended consequences when markets freeze, but in their heart of hearts didn't care so long as their SARBOX business kept growing and we didn't have another Arthur Andersen type implosion.
• Federal & state regulators - who in many cases where outgunned from the start, but ultimately failed to grasp the gravity of the escalating credit crisis which began over a year ago.
• Politicians of all stripes - who in most cases take lobbying dollars from any variety of the parties above who will provide them.  Who in most cases lack the perspective and depth of understanding of our current situation to be able to opine cogently on it.  Who in their heart  of hearts should know that the right thing to do now is figure out a solution, but instead spend most of their cycles blaming each other or some combination of the groups above.
• Anybody from one of the groups above who broke the law - and incontrovertibly there were folks in virtually every group above who have.  But in reality there are not singular bad actors you can point to and the number of people in any of the groups above who actually violated laws is probably a small minority of the total.  Virtually everybody in the food chain here benefited from inflating this bubble, which became self-sustaining as it drove real estate prices higher, so almostly nobody had incentive to try to stop it.

There's plenty of blame to go around and plenty of time to spend apportioning it.  However, this should not be the focus of our collective energies at present.  The question at hand should not be "How did we get into this mess?" as some have suggested, rather it should be what are the steps we should take right now to prevent this mess in the financial industry from getting even worse thereby causing greater challenges in the broader economy.

Regardless of whether it is "fair" for the CEOs of investment banks or GSEs to receive severance compensation, whether they do so or not will not inherently fix our current plight.  Whether the Treasury proposal smacks of socialism or not, no one with a true grasp of our financial markets has put forth a serious alternative with dramatically lower costs (note #2).  Regardless of whether $700B is many multiples of the budget of [insert your favoriate govt program / department here] is irrelevant on two fronts.  For one, spending more on any given project won't address the financial crisis we face.  For two, $700B is not the cost of this program... nobody on the planet knows how much this program will ultimately cost.  The $700B figure is a ceiling on expenditure, and obviously a non-trivial one.  But the ultimate cost of this effort is likely to be only a portion of that total, possibly a small portion and conceivably even a profitable outcome for the federal govt.  

For those who doubt the gravity of the current situation, I urge you to study the history of the Great Depression.  Many talking heads in the last two wks have compared our current plight as the worst crisis since then.  The Depression was not caused by fundamental economic weakness which then precipitated a financial crisis in the form of the October 1929 stock market crash.  Instead, a downward spiral in bank lending markets (itself precipitated by government tightening of interest rates, precisely when they should have been relaxed) essentially brought our credit system to a hault.   This constricting (and utimately virtually complete seizure) of the credit markets is what led delfation, 25% unemployment, 50% foreclosure rates (in some areas), and a decade of misery for most Americans.

Let's get to fixing first.  If we do succed in fixing it, we will have ample time for scoring political points (on either side) and apportioning blame.  Sadly if we fail to address the situation, we will all have far too much time on our hands to attend to these tasks.

Note #1:  I want to publicly give credit to Peter Thiel who was right about this sooo long before the rest of us.  He seems to have a habit of doing that, profitably.

Note #2:  The only serious alternative I've heard propsed, put forth by Paul Krugman and others, is to inject equity capital into the financial institutions still standing.  But the scale of an equity infusion that would be large enough to inspire confidence by banks themselves and among themselves as counterparties would surely be massive.  The two remaining investment banks (and they were essentially converted to conventional banks earlier this wk), Goldman Sachs and Morgan Stanley, each have balance sheets in excess of $1 trillion on equity capital bases of <$50B each.  Troubled banks/thrifts like Washington Mutual (insolvent and seized by the government yesterday) and Wachovia (looking rocky as of this afternoon) have balance sheets in excess of $300B and $700B respectively and each with equity capital <10%>

Platforms and developers, part three: What platforms like Facebook can do to expand the developer ecosystem

This is the final installment of a three-part series which is also being featured as a guest column on VentureBeat.

My first two posts in this series examined the fragmented nature of the development community that has evolved around Facebook and other platforms, and then addressed the implications for platform owners, users, and developers. In this last post I wanted to touch upon what Facebook might do to foster larger scale developers and how things might evolve in the future. My focus on Facebook here isn’t so much to pick on them… platforms like the iPhone, perhaps Twitter, and others may face similar issues someday. But Facebook is the clear leader at present among emerging software platforms (Google hasn’t counted as “emerging” for a long time), and Facebook has the stated ambition of becoming an “operating system” for the internet it’s worth focusing on them.

One idea would be for Facebook to take algorithmic-based approaches to the promotion of various applications, whereby those apps that end up with the most usage are highlighted in app directories or news feeds, instead of simply selecting “Great Apps” by whatever process is used today. Most usage could be measured in a lot of different ways (active daily users, installs, time spent interacting with app, growth rates, etc) and it’s reasonable to debate which might be most appropriate. Google has obviously taken this approach to search… the collective input of users is algorithmically processed for everything from PageRank (links users create on the broader web) to AdWords placement (which ads users click on most frequently). Of course Facebook app developers might try to game algorithms just like web developers try to game Google through search engine optimization techniques. But it would seem that an algorithmic approach would be both fairer and more importantly would ensure that the best apps (in the eyes of users) rise to the top.

Facebook could work with large developers differently than smaller ones. Again, I’m not “anti small developer” but Microsoft doesn’t treat very large Windows developers in the same way it treats very small ones. In many cases large developers enjoy greater access to new technology, more integrated marketing support for new products, and other benefits. Microsoft still spends resources on both large and small developers and more importantly lays out its various programs with reasonable transparency. Mature as the Windows platform may be, there are still thousands of small developers today right alongside the large ones. So while they encouraging large scale developers that are critical to the success of Windows platform, they still support a vibrant network across developers of different sizes.

There is one key difference worth noting between platforms like Facebook versus software operating systems or gaming consoles. Both OSs and console revenue models were built largely (if not solely) on software licensing revenues as opposed to being ad-based. In the case of OSs, the fact that people bought apps from Intuit, Adobe, et. al. meant that in the long run more Windows licenses would be sold. For gaming consoles, the console owners receive a cut of every game license sold.

In a world where both the platform and the app developer generate revenue primarily from advertising directed at the same set of users, the issue is less clear. Yes, virtual goods and commerce type models are growing, but these still remain the minority within the broader Facebook ecosystem. Surely the pot of potential revenue is vast enough to split somehow — assuming Facebook emerges as a huge platform (that they are a huge social network and destination website isn’t in question). Microsoft developed the biggest game franchise for Xbox internally, including the Halo series, after acquiring Bungee in 2000. Yet, there’s still ample room for EA, Take 2, Activision, and others to still exist. In my opinion, Facebook should at least permit larger scale developers to flourish if not actively encouraging them given the symbiotic relationship. It’s the trade-off we as venture capitalists often discuss with entrepreneurs around the tough issue of dilution… the choice between owning virtually all of a small pie versus owning a smaller (though still very substantial) piece of an immense pie.

Speaking of venture capitalist, a handful have launched specific pools of capital focused on Facebook developers (parallels can be drawn to Kleiner’s iPhone fund). Only time will tell obviously how these investments play out, but certainly Accel, Founders Fund, and Bay Partners are all successful firms and should be applauded for forwarding the thinking here. But if Facebook truly succeeds as a platform in five or ten years we won’t be talking about specialized funds allocated to Facebook app developers. Instead, this will cease to be a novel investing approach and virtually every venture capitalist who focuses on the internet and software sectors will simply have companies in their portfolio developing in part or maybe even exclusively for Facebook. That will be one of many true benchmarks of the evolution beyond cottage industry.

While I may have raised some critical questions in this series of posts, let’s take a step back for a second and acknowledge the success Facebook has achieved with its platform. Within three months of launching it, nearly 2/3rds of users on the site interacted with at least one app, and the usage has only scaled dramatically since then. You can’t draw a direct analogy of course, but Microsoft spent years and billions on the Xbox platform to achieve comparable user adoption. Yet extraordinarily few startups in our lifetime will have the opportunity to become a dominant platform in the way Facebook might. I truly hope they seize that unique opportunity and play a important part in evolving their developer ecosystem beyond a cottage industry.

Platforms and developers, part two: What have the new platforms learned from the old ones?

This is part #2 of a three-part series which is also being featured as a guest column on VentureBeat.

In my first post, I explored the question of whether a fragmented developer ecosystem is ultimately in the best interests of both developers and platforms like Facebook. I wanted to follow-up with some of the implications of a cottage industry-like development community for all parties involved (platform owners, users, developers), as well as a deeper exploration of the evolution of other software platforms.

What’s in the best interest of platform owners like Facebook (f8), Apple (iPhone App Store), and MySpace (based on OpenSocial)? The short and simple answer is presumably “that which maximizes the value of their platforms.” The long and more complicated answer is… well, complicated. One consequence of a largely fragmented developer ecosystem is that platforms have to better police the applications themselves for potential issues of privacy or perceived suitability. Obviously the more fragmented, the harder to police effectively.

Perhaps the most critical implication of cottage industry development for platforms is attracting investment in applications. It seems ludicrous, perhaps, to suggest that Facebook isn’t attracting investment in its platform when companies like Slide, RockYou, and Zynga have raised tens of millions in venture capital funding at significant valuations. And certainly in aggregate, the investment in both financial and human capital in Facebook applications is nontrivial. But the investment in any given Facebook application, whether measured in dollars or software engineers, is fairly small today.

I don’t think the value or success of a given application is based solely on how much was spent to develop it. But if you look at other types of platforms, their success was typically predicated not on how many applications are available for it but rather is there a critical mass of great applications for it. Look no further than the game console realm, where new console generations succeed not because there are hundreds of games available but because of a handful of wildly popular launch titles. And as anyone who follows the gaming business knows, big games that wow users require significant investment to development (example: EA’s development budget for Spore is estimated at $35M).

The aggregate investment in third party applications also matters, to the extent it stagnates or shrinks over time. Whereas Microsoft let lots of large independent software vendors flourish from the Windows platform, Apple often thwarted the efforts of Mac focused developers in the late 80’s and early 90’s. Joel Spolsky has blogged about this, and others, like Randy Komisar, have written about the experience of companies such as Claris that failed on Mac. It obviously took many years for Apple to recover, and ultimately they failed as a personal computing OS and succeeded (wildly so) instead as a multi-product company based upon their design leadership. Windows didn’t become indispensible because of applications from developers we’ve never heard of… it did so because companies like Intuit, Adobe, EA, Symantec, Autodesk, et al built applications lots of people wanted to use. Without a clear opportunity for large independent developers to exist, platforms themselves can fail.

How much do users care whether development ecosystems for the platforms they use are fragmented or concentrated? Directly, not much. But they undoubtedly feel the effects. Consistency of experience across applications certainly impacts users… there’s a reason that if you use Quicken you can usually pickup TurboTax’s user interface pretty quickly. All of us have experienced the effects of cottage industry development on Facebook, whether it’s apps that don’t scale (let’s just say that when I gave up my modem more than 10 years ago, my patience for 30 second page loads decreased) or message spam of various forms. Anything that contributes to a user feeling “application fatigue” can’t be a good thing.

What about developers? Well both large and small ultimately share many objectives: The long run growth and health of the platforms they develop for, transparency between platforms and developers, and the ability to build a business for themselves on a given platform. All want access to and support from platform owners, and obviously the bigger the platform owner gets the more resources they can potentially devote to developers.

It’s interesting to note that most of the companies doing large scale development on Facebook have direct or indirect ties to the company. There are of course exceptions like RockYou, but companies like Slide (Peter Thiel is a board director of both Slide & FB), Zynga (chief executive Marc Pincus is an individual investor in Facebook), Project Agape / Causes (Sean Parker was an early Facebook exec, Joseph Green was Mark Zuckerberg’s former roommate), SGN (backed by Facebook investors Founders Fund and Greylock), and Buddy Media (Pincus and Thiel are investors) all have some form of tie back to Facebook. I’m not trying to be critical here… many of the folks involved in these companies are my friends, former colleagues, or current collaborators — and smart people congregate around exciting ideas. My point is simply that if there were true transparency and encouragement of larger scale development, you’d think there would be more big developers that were wholly unconnected to Facebook. We’re still in the relatively early days of platforms like Facebook, so perhaps in time more large independent developers will emerge.

It seems to me that few parts of the platform ecosystem really benefit from a largely fragmented community of developers. Which begs the question of how could things be different? I’ll address that in my third and final post in the series, tomorrow.