The right size VC fund

As the VC industry goes through a certain level of upheaval, one of the frequently cited issues is the growth in fund size over the last 5-10 years. All other factors aside, VCs themselves have an incentive to grow the size of funds (or raise add'l funds focused on other strategies) because of the potential for the partners to "get rich on management fees". People like Fred Wilson and Chris Duovos have highlighted the challenges associated with generating strong returns with an industry composed of many large funds, the "VC math problem" so to speak.

Many people in the VC ecosystem (including me) believe the industry as a whole will contract in the coming years. After years of seeing $20-30B committed annually to VC as an asset class, in the first half of 2009 LP commitments were half that much. But an open debate remains as to what size funds will compose a VC industry that's materially smaller than the recent past. There are a couple schools of thought regarding this issue.

1) The VC "Index" Fund --> These folks suggest that $1B+ funds may be large in absolute terms, but in reality these funds are often pursuing mutiple sectors, geographies, and/or stages of investment. So in essence, these funds often describe themselves to LPs not as one huge fund but as an "index" of reasonably-sized VC funds or a "basket" of different strategies. Invest in our billion (or multi-billion) dollar fund, and in reality it's like buying a $200-400M life sciences fund, a $200-400M IT fund, and a $200-400M cleantech fund all rolled in one. Or a US fund plus a China fund plus an Europe fund all in one. Or an early-stage plus late-stage or growth equity fund. You get the idea. Firms like NEA, Oak, and others which have organized themselves in this fashion and are investing out of $1B+ funds tend to advance this perspective.

2) "Back to Basics" Small Funds --> This group believes that virtually all VC funds have grown too large. The capital requirements for launching and operating a startup (at least in IT / digital media) have dropped precipitously. Similarly most of the recent exits for VC-backed companies have been through M&A rather than IPO, and on average they are $100M or less. Therefore, the future of VC will look a lot like the early days of VC (starting in the late '60s running thru much of the '80s), with small partnerships managing small funds (<$250M or so). These will often be focused early-stage VC investing and often with a specific sector or perhaps geographic focus. Long-time, highly successful VC Alan Patricof (who launched Greycroft, a small $75M fund, a few yrs ago) is firmly in this camp as well as many others.

3) "Big" Funds Still Where It's At --> This group believes that the reasonably big VC fund (say $400-600M) still makes a lot of sense. Launching a startup may have become a lot more capital efficient, but building a big company (exit value of hundreds of millions or billion+) still requires significant capital prior to exit (tens of millions). To those who say the days of $1B+ exits are behind us, look no further than recent examples like Data Domain (IPO then >$2B acquisition), Equalogic (>$1B acquisition), athenahealth (IPO), or YouTube (>$1B acquisition). Unsurprisingly VCs who have "big" funds currently and want to continue to raise "big" funds in the future typically advocate this view. Not to pick on him, but David Hornik (GP at August Capital, which just raised a $650M fund) is just one example.

Having reflected on this issue quite a bit recently, I've come to the conclusion that they're all right to some extent and the future of VC will involve at least some firms of all three types. I think there's a great opportunity for smaller funds managed by smaller partnerships (including my own firm). These firms can capitalize on the fact that many startups don't need a great deal of capital, and at inception may be unclear whether they can (or want to) become a $1B+ company someday or are more likely to be a $100M company. Modestly sized VC-funds can generate attractive returns in whichever of these outcomes might ultimately occur. We're also seeing some firms that grew to have fairly large funds in the recent past revert back to investing with smaller funds (CRV, Atlas, et al).

But by the same token, I think several "big" funds in the VC ecosystem will continue to be very sucessful. I tend to agree most that few startups can become very big companies without requiring tens of millions of capital (and I don't see this changing anytime soon). The future Google's, Skype's, eBay's, and Genentech's of the world will still be created in the coming years. The VCs that can source, select, and win these investments will generate many multiples of invested capital and hundreds of millions if not billions of proceeds. I don't think the $500M VC fund in and of itself is a problem... I think the proliferation of many $500M VC funds is what's unsustainable. Presumably if LPs truly do pursue a "flight to quality", the industry won't see 30+ firms with funds of this scale but perhaps a dozen or thereabouts.

So while the VC industry may contract by as much as 50% in the near future, there's probably a place for us all... the small funds, the big funds, the index funds. Every VC just wants to be sure they end up in the "right" 50% when it's all said and done.

The "capital invested" trap

A lot of startup pitches I see or hear often include a point something along the lines of:

"Over $X million has been invested to date in building our technology/product"

The supposed conclusion, either expressly stated or simply implied, is that by virtue of investing a significant amount of money in development the startup must have a winning product or at least one that would be expensive to replicate.

Whether X is $2M or $20M or more, this conclusion is largely a fallacy. It's a derivative of the "sunk costs" issue we learn from economics text books. The amount of capital invested in developing a product isn't necessarily correlated with it's commercial success or potential. eBay was built on a few hundred thousand in capital and was already breakeven when Benchmark invested. Google has obviously continued to invest heavily in search, but reportedly they never fully exhausted their one and only round of venture funding from Sequoia and Kleiner before reaching profitability. Similarly, just because one startup spent $X million building a product doesn't mean a smart team of motivated engineers couldn't build a better version for far less.

Whenever I hear the "capital invested" point about a product, I tend to see it as a red flag. My anecdotal evidence suggests that entrepreneurs who highlight this in their pitches do so to justify company progress which isn't commensurate with the amount of capital raised to date. Or it's to suggest a barrier to entry when the company has few other strong competitive advantages.

My suggestion? Focus a pitch on the true metrics of progress and future success of your product or technology. Show potential invesetors why your startup will win over the competitors, whether through product superiority or more cost effective customer acquisition or what have you. Smart investors rarely fall into the "capital invested" trap so it's not worth emphasizing in a pitch.

Real-time: Search or Discovery (or Something Else)?

There is an incredible amount of buzz about "real-time" search in the web ecosystem these days. And if the availability of real-time data makes possible more accurate prediction or inference of future events, than that will almost certainly be a catalyst for dramatic things.

Real-time search, now possible thanks to the continuously updated flow of information from Twitter and others, tends to be the focus of discussion. Venturebeat has a good analysis of some of the startups in this space, and it's an area big players like Google and Microsoft are looking at closely.

But is what we're calling "real-time search"in fact search as we typically know it? Many of the use cases folks cite are things like finding out about breaking news (Michael Jackson's death or US Air #1549 landing in the Hudson), identifying popular trends, or delving into the discussion about topical events (what are Iranian protesters saying right now). I'd argue that most of these use cases are really more "discovery" than "search".

Search is when you know basically what you're looking for in advance, discovery is when you want things to be revealed to you. Search experts talk about lots of different forms of search... recall or recovery search (when you know a name or a brand and are trying to locate it), research search (trying to learn more about a topic or concept), competitive or comparative search (seeking similar concepts or objects to one already known), etc. Most of the products we call real-time search today involve consumers and companies wanting to find out what's happening right now and perhaps explore the conversation or draw high level conclusions from it. That's discovery.

So is this different just semantic? The correct answer is probably it's too soon to say, but the differences might have implications for the business models around real-time data. Paid search advertising as we know it is valuable in large part because direct response marketers can see and measure the purchase intent embedded in many types of search. It's unclear if or how this might translate to real-time discovery of information. Perhaps sentiment analysis or trend mapping tools will prove better businesses from the rise of real-time data than the "search" engines themselves, at least for companies. Perhaps consumers will be monetized through display or other forms of non-search advertising, as they come to rely on real-time search products for their news.

I have very little doubt that the proliferation and availability of real-time data will have meaningful impact on the web. But it's entirely possible real-time will have a lot less to do with "search" than the current buzz suggests.

Making the illiquid, liquid

It's no secret the time from initial startup to exit is growing longer for VC-backed startups and other private companies. The latest data I've seen indicates the average time to exit (and thus shareholder liquidity) is now in the 7-8 yr range.

A number of companies including SharesPost, SecondMarket, Xchange, and InsideVenture have launched recently to try to address the illiquidty challenge. And players in the PE secondary market have been quietly purchasing individual company stakes, in addition to VC fund positions, for a number of years. Various stakeholders in a private company may have different perspectives on whether enabling some shareholders to receive liquidity is a good or bad thing. VC's investors holding preferred shares, co-founders holding common shares, employees potentially holding common shares from stock option exercise, CEOs and boards who have to deal w/ all of these shareholders.

I played around a little bit with SharesPost the other day and I have to say it seems like a pretty interesting platform for potential buyers or sellers of private company shares. They currently only deal in common shares typically held by co-founders or employees, but anticipate adding preferred shares in the future. Supposedly one private transaction, for shares of Tesla Motors, has already gone into contract and as of this writing there are offers to buy or sell shares for a variety of other companies including eHarmony, LinkedIn, Facebook, Solar City, and Linden Lab (Second Life). I also have to say that SharesPost seems to have done a very thorough job of thinking through the legal and logistical challenges surrounded with company shares (i.e. right of first refusal and other restrictions on transfer).

These sorts of secondary markets for private company shares are not without their challenges, but overall I think they make a lot of sense. But the biggest challenge to any marketplace model is building a critical mass of of buyers and sellers, i.e. reaching genuine liquidity. We're talking about trading assets that by definition are already highly illiquid, so I wonder if having 4+ platforms all vying to build liquidity in these early days will mean none can achieve critical mass. I hope not, but we'll see how things develop...

Why micropayments are (still) a terrible idea

Micropayments is a concept which has been like the proverbial pot of gold at the end of the rainbow... always just over the next hill, at least here in North America. Recently micropayments have received a lot of talk as a way to rejuvinate the newspaper industry or create massive revenue for companies like Facebook. It's certainly possible that may happen, but I wouldn't bet on it.

There's no commonly accepted definition of a micropayment, but typically people use the term to mean purchases <$1.00 and certainly I'd would consider anything over $2.50-3.00 a normal transaction not a micropayment (i.e. a Starbucks drink isn't a micropayment). Proponents of micropayments over the years have suggested that allowing consumers to buy in smaller increments might open up newer models for online content and services like pay-per-article, "tip" jars, or small virtual goods purchases. Supporters point to services like iTunes, where you can buy a song or some iPhone apps for $0.99, or virtual items which can be as small as a few cents.

But if you actually start to dig in to the "success" stories for micropayments, the data starts to look a little questionable. The average price of a ringtone in the U.S. is roughly $2.40... on the border of even my generous definition of a micropayment. Forrester did a study of iTunes a couple years ago and the purchasing behavior of consumers actually doesn't look like micropayments and starts to look like "fractional CD" buying. The average transaction value (ATV) of an iTunes purchase was acually $6.34 and even the median was still about $3 bucks. Similarly if you start to dig in to virtual goods models at micropayment scale (some virtual goods are rather expensive), which today are still predominantly in Asian markets and not common in the US, you see a similar tale. When measured at purchasing power parity the $0.25 or $0.50 USD virtual good bought by a Chinese consumer starts to look like a "normal" sized purchase, i.e. equivalent to >$1 txn for US consumer.

I spent a lot of time, along with numerous colleagues, back in my PayPal days thinking about the micropayments space. It ultimately proved a nut we couldn't figure out how to crack. This was a number of years ago now, but in looking at the challenges facing micropayments models I don't see that a great deal has changed such that micropayments are now poised to grow dramatically.

Transaction Costs are the most cited hurdle for micropayments. It's true that credit card processing costs can eat as much as 25-50% of the value of a <$1 payment. Well what about PayPal, you say? Services like PayPal haven't fundamentally altered this equation, since roughly half of the payments that flow thru their system are funded with a credit card. Batch billing, or aggregating a bunch of small purchases into one txn as iTunes does, can certainly help. And alternative payment schemes like cell phone billing theoretically could have lower txn costs, but in practice third parties still have to pay a lot to process small payments.

But believe it or not, transaction costs aren't the largest barrier for micropayments. Yes it makes profitabiliy harder for Apple, given their cost of goods for a $0.99 iTunes song is $0.60-70 in record company royalties. Apple's succeded because they sell hardware (iPods, iPhones, etc) at very high margins and can accept extremely low margins on the digital content. But for a virtual good with $0 marginal cost the high transaction processing costs associated with micropayments aren't as big a deal.

Consumer's Mental Accounting remains the greatest challenge for the widespread adoption of micropayments. Pyschologically, it's not hard for us as humans to evaluate a $3 purchase from a $30 one or a $300 one. But it takes giant mental leaps for us to go from doing something totally for free to having to pay anything for it. Our brains go thru completely different calculus for paying $0.01 for something than simply doing something we know has zero direct cost. This is the true barrier to adoption for micropayments.

It's for precisely because of this mental accounting that cell phone data plans had minimal adoption when priced as $0.xx / KB, but took off with flat rate monthly subscriptions. Similarly it's why virtual goods based gaming has seen the proliferation of prepaid cards in $10, 20, and larger increments. Consumers in essence make a single "large" purchase decision, and simply consumer incrementally over time. It's a workaround to make small purchases work, not the success of micropayments.

I don't know if online subscriptions can save the newspaper business or what might drive a quantum shift in monetization of social platforms. But I'm highly skeptical that micropayments will do the trick.

Would Be IPOs in IT / Internet / Digital Media

Folks in the VC industry are often asked about or end up talking about the current state of the IPO market and the prospects for recovery in the near to longer term.  At the NVCA's annual meeting last wk, they presented a plan to try to address both systemic and macro challenges faced by VC-backed companies with hopes of an IPO.  Others like Fred Wilson suggest an end to the IPO drought is nigh.

To be clear, we VCs clearly stand to benefit from a healthier IPO market.  And undoubtedly some of the blame for lackluster demand for newly public companies stems from the fact that VCs pushed (w/ help from some investment bankers, public market investors, and entreprenuers) too many "un" startups into the public markets in the late 90s... unprofitable, undifferentiated, unsustainable, etc.  

There's fairly broad agreement in the startup ecosystem that there a number of companies today who've achieved scale, profitability, and a sustainable growth model that under "normal" circumstances could have a successful public offering if they so chose.  Many might elect not to go public in the near term for a variety of reasons including inability to obtain the valuation they want, preference of existing management not to be subject to public market scrutiny, additional SARBOX technicalities to be ironed out, etc.  But these companies have the raw ingredients to be public.

In any event, I thought I'd start compiling a list of these "would be" IPOs in the IT / digital media space.  I am undoubtedly be missing lots of candidates here, so I would welcome other examples which should be on the list via comments section or email  (and thanks to those of you who informally contributed as I drafted this).  I've excluded companies like OpenTable which have already filed an S-1, and so I'm relying on "scuttlebutt" for data to validate these but trying to stick to fairly "reliable" scuttlebutt.  My rough criteria are as follows:  VC-backed startups w/at least $100M revenue (annualized run rate ok, if prior yr revenue >$50M), top line growth rate 20% or greater, cashflow breakeven (can be GAAP unprofitable, but not burning cash), sustainable product/service (loosely defined, but can keep high margins or growth rate for forseeable future).  It's not to say that companies that don't meet these criteria couldn't get public, but they'd be harder pressed.

Facebook

LinkedIn

Quinstreet

Vantage Media

GAIN Capital

Demand Media

Xoom

Yandex

Vente Privee

Zappos

Kayak

Endeca

Big Fish Games

Zynga

TheLadders

Why Google Profiles Won't Kill Facebook or LinkedIn

Google is now highlighting peoples' Google Profiles in search results when users search for a person's name. There's speculation that this change may impact services like Facebook, LinkedIn, Twitter, and others whose own profile pages have historically ranked high in natural search results for peoples' names.  Some have even gone so far as to call this a [insert popular social networking service here] "killer".  

This is an interesting change by Google to try to do more w/ Profiles.  To date most users' Google Profiles have been evolved from the variety of personalized services they use from Google (gmail, Blogger, gtalk, Google Finance, etc), rather than something they've intentionally created or curated.  But whatever you may think of Google giving preference to their own products in search results, this won't fundamentally "kill" Facebook, LinkedIn, or others even if a large number of Google users start populating their profiles someday.  It might put a small dent in organic search traffic for these services, but it's highly unlikely to put any of them out of business.

Why?  First search is a jumping off point not a destination.  Yes some searchers will now click on Google Profiles because Google has prioritized them over other results.  But often if a user is searching for a person's name, they might be trying to find their info on another SNS or their blog or whatever (i.e. a "recall" search).  They'll probably still click thru to another site if that's indeed what they're looking for.  

Secondly, context and content matter in how people present their personas.  If you google "Lee Hower" you'll come up with a bunch of things which might include this blog, my LinkedIn profile, my Facebook profile, my bio on the Point Judith Capital website, etc.  Each of those pages represents a different context, with some overlapping but mostly unique content.  Might most users somedate populate their Google Profiles to include all of this information?  Conceivably, but even if Google gets high user participation, it still probably won't be an end all be all profile simply because most people want to have somewhat different presentations of themselves in various online contexts.  

Third, for certain contexts the social graph will matter.  If you're trying to find out who we know in common or what my "influence" level is based on how many twitter followers I have, Google Profile probably won't be very useful.  

When Google started prioritizing it's own Google Maps/Local info of local businesses over a year ago, many speculated that it would be the end of services like Yelp particularly since Yelp's early growth was driven in large part by SEO.  Yelp's growth hasn't exactly been killed by this move, at least in part for the reasons above.  Plus... as much as we all love Google, there are a non-trivial number of consumers out there who don't want to rely on them for everything.