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Sunk Costs

July 26th, 2010
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Today on MBA Mondays we are going to talk about another form of costs; Sunk Costs.

Sunk Costs are time and money (and other resources) you have already spent on a project, investment, or some other effort. They have been sunk into the effort and most likely you cannot get them back.

The important thing about sunk costs is when it comes time to make a decision about the project or investment, you should NOT factor in the sunk costs in that decision. You should treat them as gone already and make the decision based on what is in front of you in terms of costs and opportunities.

Let's make this a bit more tangible. Let's say you have been funding a new product effort at your company. To date, you've spent six months of effort, the full-time costs of three software developers, one product manager, and much of your time and your senior team's time. Let's say all-in, you've spent $300,000 on this new product. Those costs are sunk. You've spent them and there is no easy way to get that cash back in your bank account.

Now let's say this product effort is troubled. You aren't happy with the product in its current incarnation. You don't think it will work as currently constructed and envisioned. You think you can fix it, but that will take another six months with the same team and same effort of the senior team. In making the decision about going forward or killing this effort, you should not consider the $300,000 you have already sunk into the project. You should only consider the additional $300,000 you are thinking about spending going forward. The reason is that first $300,000 has been spent whether or not you kill the project. It is immaterial to the going forward decision.

This is a hard thing to do. It is human nature to want to recover the sunk costs. We face this all the time in our business. When we have invested $500,000 or $5mm into a company, it is really easy to get into the mindset that we need to stick with the investment so we can get our money back. If we stop funding, then we write off the investment almost all of the time. If we keep putting money in, there is a chance the investment will work out and we'll get our money back or even a return on it.

Even though I was taught about sunk costs in business school twenty-five years ago, I have had to learn this lesson the hard way. Most of the time that we make a follow-on investment defensively, to protect the capital we have already invested, that follow-on investment is marginal or outright bad. I have seen this again and again. And so we try really hard to look at every investment based on the return on the new money and not include the capital we have already invested in the decision.

This ties back to the discussion about seed investing and treating seed investments as "options." Every investor, if they are rational, will look at the follow-on round on its own merits and not based on the capital they already have invested. But the venture capital business is a relatively small world and reputation matters as well. Those investors who make one follow-on for every ten seeds they make will get a reputation and may not see many high quality seed opportunities going forward. Our firm has followed every single seed investment we have made with another round. In most cases, those investments have been good ones. But we have made a few marginal or outright bad follow-ons. We do that for reputation value as much as anything else. We measure that value and understand that is what we are doing and we keep those reputation driven follow-ons small on purpose.

When it is time to commit additional capital to an ongoing project or investment, you need to isolate the incremental investment and assess the return on that capital investment. You should not include the costs you have already sunk into the project in your math. When you do that, you make bad investment decisions.

blog, MBA Mondays, Venture Capital and Technology

Terms, Term Sheets, and Terminal Value

July 23rd, 2010
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Mark Suster has a great post on calculating valuation and the things that VCs can throw at you to make the deal better for them (I guess I should say us) than it actually looks. Go read it. It's complicated stuff but you should try to wrap your head around it. I've written a bunch about this as has Brad Feld and other VC bloggers have too. The VC world is changing. We are talking about this stuff, explaining it, and discussing it. That's progress.

But here is the thing. Terms and term sheets are a necessary evil of the venture business but most venture returns don't come from terms. They come from terminal values. Meaning the size of the exit. One deal often returns the entire fund. The next three to four deals return it again. The rest of the portfolio might return it again and if you can do 3x gross, you'll raise another fund, and another, and another.

In my talk with John Battelle yesterday at Geo Loco, where I said some controversial and partly tongue in cheek things that were widely reported, I did talk about this. And I wish it was as widely reported as the sound bites. What I said was that there are only a few things that really matter in a venture investment. The first is the amount being raised, the second is the dilution to the entrepreneur and the ownership the investors are buying (largely the same thing), and the third is the relationship between the investor and the entrepreneur. Everything else is pretty much noise.

I do care about and want a plain vanilla one times liquidation preference because I think it is fair. If the company is sold for less than the valuation that we invest at, I think it is fair that the investors get their money back in that scenario. Any multiple of liquidation or participation should be avoided at all costs by both sides. VCs often use those tricks to bridge valuation gaps but I have come to believe you should resolve valuation gaps with compromise or just don't do the deal if the gap is unbridgeable.

I think the VC business is changing in many ways and one good way is that more and more VCs are thinking less about terms and more about terminal values. And that is best for everyone.

blog, Venture Capital and Technology

Ten Characteristics of Great Companies

September 3rd, 2009
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Yesterday I got to do one of my favorite things. Our portfolio company Etsy invited me out to their new offices in Dumbo to talk to the entire team. Since they didn't ask me to talk about anything in specific, I picked a topic and composed some thoughts on the F'd train ride out to Brooklyn.

The topic I picked was "What Makes A Great Company?"  I picked that topic because I think Etsy can be a great company and in fact is already well on its way to becoming one. I thought it would be good to share with the team some traits I see in many "great companies."

So here are the ten characteristics that I jotted down on my blackberry on the subway. This is not meant to be a comprehensive list. It is the ten traits that came to me on a 15 minute subway ride. And it is also true that great companies don't hit every single one of these traits. But they hit most of them. And some do hit all of them.

So with that caveat, here is my list of ten traits I see in great companies. This is aimed at web/tech companies but I believe it can and should be applicable to all companies.

1) Great companies are constantly innovating and delighting their customers/users with new products and services.

2) Great companies are built to last and be independent and sustainable. Great companies don't sell out.

3) Great companies make lots of money but leave even more money on the table for their users and partners.

4) Great companies don't look elsewhere for ideas. They develop their ideas internally and are copied by others.

5) Great companies infect their users/customers with their brand. They turn their users and customers into marketing/salesforces.

6) Great companies are led by entrepreneurs who own a meaningful piece of the business. As such, they make decisions based on long term business needs and objectives not short term goals.

7) Great companies have a global mindset. They treat every person in the world as a potential customer/user.

8) Great companies are attempting to change the world in addition to making money.

9) Great companies are not reliant on any one person to deliver their value proposition.

10) Great companies put the customer/user first above any other priority.

So there it is. The Q&A session after the talk was quite stimulating and I expect the comment thread here will be equally so.

blog, Venture Capital and Technology

Use The Public Channel For Better Customer Service

May 5th, 2009
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One of Mike Bloomberg's greatest achievements is the creation of the 311 service here in New York City. These 311 services operate in many large cities in the US and Canada. The first one was in Baltimore in the mid 90s.

Apparently Bloomberg is a huge user of 311 himself and he calls all the time as he is driving around the city, reporting potholes and such.

We had a pothole in our neighborhood that I passed every day on my way to the subway. It was a big one and I'd watch car after car pound the hell out of their undercarriage as they made their way from Hudson onto Bethune street.  One day I stopped and snapped this photo with my Blackberry and posted it to Flickr (and then automatically to Twitter):

It would be great if you could twitter these in like: @potholenyc corner of bethune and hudson

I added the following to the Flickr headline which became the tweet:

It would be great if you could twitter these in like: @potholenyc corner of bethune and hudson

Of course I could have called 311, like our Mayor does, and reported the pothole. But doing it this way does a bunch of things;

1) It saves the cost of staffing large call centers because computers can handle most of the processing of messages like this. There will still need to be humans at some part of this process, but the front end can certainly be automated.

2) You get an image of the pothole which should help the crews who fix them evaluate the worst ones and prioritize.

3) The photo and the twitter message is out there for anyone to see. Ideally this message would get routed, via something like our portfolio company outside.in, to the various local media in the neighborhood. If the messages have enough metadata in them, you could even create pages of local media based on the most common neighborhood issues (crime, infrastructure, schools, parks, etc)

4) The public discussion about the photo and related posts could be aggregated to create even more metadata and further identify the highest priority issues.

We see this "public channel" in action already with services like Comcast Cares on Twitter. Anyone can pick up the phone and call Comcast and tell them that their cable service isn't working. But the only people who know about that are the person making the call and call center rep taking it. When someone posts on Twitter that their cable service isn't working and directs the message to Comcast Cares, many people see that. Some of them may be other Comcast customers who might find out that their cable isn't working either. And as Comcast Cares elevates the issue, gets it fixed, and reports back, everyone gets to see that too. It's a huge win for Comcast. Anything that can make a cable company look better is a great thing and the use of the public channel is exactly that.

The public channel is just developing. It's in its infancy. Services like Twitter and Facebook are building key elements of it. But we need a lot more infrastructure to make this happen. I do not believe that the way this will happen is the creation of "enterprise services" that will be sold to local governments. I think we'll see things like GetSatisfaction and Uservoice develop that are consumer facing first and foremost that governments will be forced to adopt.

My friend John Geraci, co-founder of Outside.in, is developing a non-profit called DIYcity that is attempting to spearhead a movement along this idea. If you are interested in working on projects in this area, you should join DIYcity and start collaborating with others who are working in this space.

The public channel is the right channel for business and government. Most "customer support" issues are not confined to one person (just look at the comments on my American Express post for proof of that). So we should be using a public channel to talk to companies and institutions. They'll benefit and so will we.

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blog, NYC, Venture Capital and Technology, Web/Tech

The Three Terms You Must Have In A Venture Investmemt

April 10th, 2009
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Many years ago, when I was still in my 20s, the managing partner of my first venture firm, Milt Pappas, told me that he felt there were three terms that really mattered in a venture deal (other than price of course). They are:

1) The liquidation preference
 2) The right to participate pro-rata in future rounds
3) The right to a board seat

I listened intently and have been practicing what Milt preached ever since. In recent years, I've gotten comfortable doing a few deals without the board seat in very specific circumstances. But I've mostly followed Milt's advice to me and I have been well served by it.

There are many other provisions in venture term sheets that can, at times, come in handy. There are the protective provisions, the blocking rights, the rights of first refusal and co-sale, the anti-dilution protections, redemption rights, etc, etc

I've seen some of these provisions invoked and they have been useful to have. But there are several typical venture terms that I have never seen invoked in almost 23 years in this business. That doesn't mean they aren't useful or even best practices to have them. But it does mean that some things matter more than others.

And in a negotiation, it is critical to know what you must have, what you should have, and what you can live without.

When it comes to venture terms, I believe Milt was spot on. The three things that have saved my investment and kept people honest more than any others are the three I listed up front.

The liquidation preference matters because without it, if you invest $1mm for 10pcnt of a business and the next day the entrepreneur gets an offer to sell the business for $5mm, he or she might choose to take it and get $4.5mm while you only get $500k. Sure you could negotiate for a blocking right on a sale, but getting in between an entrepreneur and an exit they want to do is not a recipe for success in the venture business It's much better to say, "give me the option to get my investment back or my negotiated ownership, whichever is more". And that's what a liquidation preference is, plain and simple.

The right to purchase your pro-rata share of future rounds is possibly the most important term of all. In early stage VC, a few investments generally deliver the vast majority of the returns in a fund. When you are in one of those deals, you need to be able to invest in the subsequent rounds (to go "all in" in poker parlance). The pro-rata right is equally critical in down rounds to protect you from getting wiped out in a highly dilutive financing.

The board seat is not something all VCs care about. But you cannot have real impact on an investment without one. Its the best way to make sure the investment is going well and when it is not, the board seat gives you the right to have a say in what is needed to fix the investment.

I am sure there are many opinions on this topic. There's a link at the end of this post that says "comment" on it. Please click on it and tell us what you think.

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blog, Venture Capital and Technology