Making the System Work For Everyone

When I was young, my dad used to tell me that there was a proverb in Greek that went something along the lines of: “there is a special shame in taking the last morsel of food.” The lesson was an admonition about not being piggish, or maybe showing restraint, or perhaps being gracious. Deep down, though, I always suspected that it was just a ploy to put the last slice of pizza in the fridge so that he could enjoy a late-night snack after I’d gone to bed.

When I came into the venture business 16 years ago, somebody told me something similar. Even though I forget who said it, I’ll ascribe it to Henry McCance, in my mind the font of all wisdom I picked up during that period (“when venture works well, capital is expensive and time is cheap.”) He said, “it’s important to leave something on the table for the next guy – that way the whole system can work for everyone.”

I used to think about that statement a lot. Individuals are incentivized to maximize, although optimization works better for the system. It’s kind of a Tragedy of the Commons problem, right?

I’d forgotten about both sayings in the intervening years, but recalled them again a couple of years ago when I started seeing overfunded rounds at vanity valuations and other cap table shenanigans. The apotheosis of some of the worrying trends seemed to come about 18 months ago. Back then, it seemed that companies were able to raise cheap and easy money at inflated valuations based on perfect execution of their coming two-year plans.

So here we are, almost two years later and some companies have executed and others haven’t – that’s the risk of venture – and a lot of companies that raised then are looking to come back for fresh cash. There’s definitely money still sloshing around and the trainwreck some of us were worrying about seems to be less imminent, to everyone’s relief. Although, I do expect some tensions as the era of easy markups may yield to a time in which “flat is the new up.”

Indeed, every dollar demands a return, especially those of the final investor, whether that might be someone in the public markets or an acquirer. If they stop getting value, they may stop buying what we’re selling; it’s the classic boom-bust dynamic of IPO windows. The anemic number of tech IPOs last year suggests that maybe the outside world has gotten wise to the fact that we’re leaving less for the next guy. The always-awesome Beezer Clarkson wrote a great outlook post at the outset of this year that talked about some of the ways in which the exit markets had evolved: “The market went from valuing growth to looking for sustainable business metrics, which not all VC-backed companies felt that they had to get the valuations they wanted.”

Which of course reminds me of Josh Kopelman’s seminal 2012 post about the JOBS Act that noted the post-SarbOx change in public and private market value creation in the past compared to that of recent years. The topic is a nuanced one, but Josh reminds us that among ten pre-SarbOx tech bellwethers, public investors were able to capture about 97% of the ultimate value creation.  Now that’s leaving something on the table for the next guy! Maybe too much; I’m not sure we need to return to those levels and the markets (both pubic and private) have changed in some meaningful ways, but there’s a happy medium somewhere between that and the dreaded “down IPO.

Over-Done Diligence

The best laugh I’ve ever had in a meeting came courtesy of my buddy Gordon Ritter. For those who don’t know Gordon, he’s got this awesome and disarming zany earnestness that would probably make him the perfect guy with whom to watch Russian Dash Cam videos: “Did you see those cows tumble out of the truck when it tipped over?!? AND WALK AWAY LIKE NOTHING HAPPENED?!?!?!”

But I digress . . . it was the spring of 2003 and I was meeting with Gordon and his partners as they were raising Emergence’s first fund.   As the meeting was wrapping up, Gordon slid a piece of paper across the conference table: “our reference list,” he said. I had been in the LP biz for a couple of years at that point and was feeling pretty clever. “Well, I like to do off-list references,” I quipped. Looking serious, Gordon started to rummage around in his bag. After a few moments, he said, “I’ve got an off-list list in here somewhere . . . “ I must have looked completely bewildered as I stammered, “but then the ‘off-list’ would be ‘on list’ and I’d have to go off-off-list . . .” At that point, Gordon couldn’t bear it anymore and broke into a wide grin that gave us all permission to crack up in hysterics at the absurdity of what I’d said . . .

I thought of this story the other day while hanging out with my buddy David Katzman. Over dinner, we mused that it’s possible to do too much due diligence. David reminded me that Fred Wilson wrote a great blog post on this subject a couple of years back. Fred is famous for his gut and has an amazing hit rate on his intuition. Kaztman and I observed that, in contrast, it seems that some outsource their thinking to others by doing endless research. Indeed, having sat in front of a thick diligence binder, I’ve often thought that there are a lot of heuristics that are the enemy of good decisions. Confirmation bias is probably the most insidious of these, but overgeneralization is also pretty sinister, too. Sometimes it can be easy to forget that data is not the plural of anecdote.

I’ve learned by watching some of the best investors around that having a well-formed thesis simplifies investing: if you don’t have a good sense for what you’re seeking, how will you ever find it without boiling the ocean? Pasteur famously said, “in fields of observation, chance favors the prepared mind.” And very practice of developing a thesis helps you figure out what questions to ask and where the data sources, especially the orthogonal ones, lie. Classically practiced diligence mainly helps one manage conventional risks as seen through the prism of other people’s biases.

In having a prepared mind, investors should strive to develop opinions, a scarce resource in a hurried, reactive business. Oftentimes, the more diligence you do under the guise of “getting smart,” the more your mosaic of facts will resemble everyone else’s. But I guess that’s ok when for people who think it’s better to fail conventionally than it is to succeed unconventionally.

Of course, some people are ok with being copycats and there are folks that distill diligence to one call: to their favorite bell cow. At Old Ivy, we had a few folks who simply tried to index our portfolio. The problem with that approach is that they often couldn’t access the things we were most excited about, not to mention the fact that we were pursuing a strategy specifically tailored to our needs. Specifically, we were exploiting some unfair advantages that we had, especially low liquidity needs and long, long, long time horizon. Confounding matters further, when people called me to find out what we at Princeton were doing, I only shared my second-best ideas. Should I feel guilty?

Probably not. Too many people are intoxicated by opiate-like embrace of the crowd.  Indeed, taking the time to develop an opinion and resist FOMO takes courage and an investigators eye while the easy path relies on unfocused and reactive probing that captures more noise than signal because of poorly tuned antennae.  Robust non-conformists with the courage of their convictions tread through the thickets of embarrassment and career risk that come from being wrong and alone in search of fortune and glory. We make the road by walking it. Which path will you take?



For the Moment Mellow . . .

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Since I too often bellyache on these pages, I thought I’d share something I wrote for a quarterly letter at the end of last year.  Ironically, the poem I reference is called Temporary Well Being. Comments and feedback encouraged, just don’t harsh my mellow, as the kiddos say . . .


Q4 Commentary:

A Kenneth Burke poem inscribed on a wall in New York’s Penn Station begins, “the pond is plenteous and the land is lush and having turned off the news, I am for the moment mellow . . .”

I’ve been thinking about this poem a lot recently, as Silicon Valley seems to be enjoying a sanguine moment. Although the tech world was consumed at the outset of the year by an unease that resulted from an investing pullback on the part of so-called Tourists – a cohort of large public market-focused investors who had become active in late stage private investing – the middle third of the year seems to have been marked buy a growing realization that the sky was not falling.   And by September, optimism engendered by a smattering of tech IPOs lifted spirits across the Valley.

Indeed, an uneasy truce between bulls and bears seems to have emerged as 2016 slouched to its conclusion. The headline of one of our favorite barometers, the Fenwick and West Venture Capital Survey, reported that, “valuation metrics were down modestly in the third quarter.” After all, the median round over round price increase among companies completing financings during the third quarter was 27%, down slightly from the second quarter’s 31%. While the Report noted that this was the lowest amount since Q4 of 2013, this rate of increase was right in line with the 10-year average calculated by the survey. Our conclusion, both from the data, as well as from our on the ground perspective, is that the entrepreneurial ecosystem seems relatively healthy; there are many great companies who are being rewarded by increased valuations for the progress they have made.

What has caused some consternation around the Bay Area, however, is the decline in mega-financings driven by the exit of the Tourists. The late-stage market, which had been defined by froth in recent years, has slowed. Financing used to be available to companies at levels that assumed perfect execution for the subsequent 18 to 24 months; there was a conceit that all of these companies would grow in to their valuations. Today, late stage investors are only paying for progress to date and acknowledging execution risk and uncertainty. As result, many venture capitalists to which we have spoken are suggesting to their companies that are fundraising to expect valuations that are 25 to 40% lower than they might have expected a mere 18 months ago.

This, of course, is good news for us. Buffet’s equation tells us that Opportunity equals Intrinsic Value minus Perception. As sentiment comes into line and folks acknowledge the reality of risk, prices should come down and our expected return should go up.

This new reality is being reflected in entrepreneur perceptions, as well. First Round Capital produces an annual survey of start-up founders and one of their typical questions is, “who has the power in fundraising negotiations?” In a 180° reversal of last years results, entrepreneurs this year’s survey said that power rests with investors by a two to one margin.

Of course, optimism is always empty without the prospect of healthy distributions. We are hopeful that the momentum of late 2016 will carry over into the new year and that both distributions and valuations will give us, the ultimate providers of the capital, reason for a continued excitement that we would have never thought possible at the outset of year.

As we look to 2017, the conclusion of that Kenneth Burke poem sums up our feelings nicely: “ . . . with my book in one hand and my drink in the other, what more could I want but fame, better health, and ten million dollars?”


In the Time of the Gatsbys

img_4393So this buddy of mine, Peter Stein, is one of the best hedge fund evaluators I know and I once asked him how he knew to steer far clear of Madoff?
“Sometimes, returns can be too good,” he replied sardonically.

But it’s never been that way in Silicon Valley, a sunny and magical land where risk-adjusted return is impossible to calculate since risk is perpetually dialed up to eleven.

And in a culture steeped in selling the impossible, sometimes things go a little too far, which reminds me of another thing Stein, a veteran of ‘80s Tokyo and ‘90s New York, once cautioned me about long-running bull markets:

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