The word “annex” is a loaded one for me. You see, junior year in college my buddies and I had a terrible room draw and the seven of us got sent to our dorm’s annex space on the freshman quad. While I’d like to say that hilarity ensued – and, indeed, it did – living among an battalion of guileless freshmen and a platoon of fretful Senior Counselors sometimes made us feel like merry pranksters exiled to the Nanny State.
Late one evening, one of our buddies found a box of circular fluorescent lights in an unlocked maintenance closet. Inspired by a then-popular David Letterman skit that involved throwing things off of roofs, we found that GE Circlines made spectacular explosions when hitting the flagstone four stories below. Needless to say, our Wanton Disregard for Souls and Property summoned our entryway’s Counselor, an earnest Midwestern pre-med major in late-night cold cream and pig tails. Surveying our room with dismay, she turned to John Moussach (names changed to protect the guilty) and barked, “What the heck are you doing?” His reply caused us grief in the hours and weeks ahead: “We’re drunk. Care to join us?” The post-midnight cleanup crew and subsequent work details to which we were conscripted combined with the ensuing stint on Double-Secret Probation to teach a valuable lesson: good times have limits.
And indeed, when I think about the current trend for small funds to raise Annex – or Opportunity – funds, the same thought crosses my mind: good times always have limits.
For those who haven’t followed this trend, a bunch of smaller funds have raised annexes to provide capital to companies that are showing breakout potential. An early and classically transparent one of these efforts was Union Square’s Opportunity Fund. Another thoughtful effort was Foundry’s Select Fund. Indeed, as both Fred Wilson and Brad Feld had discussed in their respective blog posts, there are many very good reasons for raising such a fund.
Yet, there are reasons for LPs to be circumspect, as well. It takes a lot of discipline for any kind of investor (but especially those in echo chambers) to not fall into a common trap: an opportunistic investment here or there can become a gateway drug to a full-blown addiction to capital-intensive late stage deals. After all, many of the small funds that now are raising more money for larger follow-on, or later-stage investments once sang from the Capital Efficiency songbook and now risk contradicting the tune they sang for others since one of the greatest hits in that canon is, “Give an Entrepreneur a Dollar and They’ll Spend It.” It’s the lyrical version of the Maples Rule: “a B-round will last a start-up 18 months, no matter how much or how little the investors put in.”
Then there’s the valuation question: throughout history, many investors have convinced themselves that some company was worth an outrageous price simply because a high-flying comp commanded a higher price. I remember one of the first portfolio companies I met when I became an LP in 2001 – we’ll call them Spacely Sprockets – had just raised a monster round at a ten-figure valuation. A few years later, after the assets and intellectual property had been sold off for pennies to Cogswell Cogs, the VC backer justified the once reasonable, but obscene-in-retrospect valuation by saying that a large public comp was trading at a $60 billion valuation at the time and that the start-up’s post-money seemed reasonable in that context. I’m sometimes prone to feeling like a value investor lost in the Valley, but I’m often reminded of the words of a mentor of mine from my pre-B-school hedge fund days: “it’s ok to fall in love with companies,” he admonished. “Just don’t fall in love with the pieces of paper that represent ownership stakes in those companies, as the love those pieces of paper offer in return tends to be inversely correlated with price.” It’s a lesson often forgotten during heady times. Remember, good times have limits.
Lastly, there’s the Stephen Bochco Effect. Just as Union Square Ventures and Foundry Group pioneered new areas, Bochco changed television. He made dramas more gritty and real. These shows had visceral impact because they showed real life in raw formats; in the service of art, Bochco was unafraid to show a buttock or drop a swear word. The censors looked askance at such boundary pushing, but eventually acquiesced because the troubling content was consistent with the entirety of the tableau. But once the floodgates opened, artless imitators picked up the standard and pushed boundaries for shock and effect, not art. Thus, there’s a straight line from Hill Street Blues and NYPD Blue to Jersey Shore and Naked Dating. Financial markets have seen their fair share of “pioneering art” devolve into base commercialism with some regularity, so in the words of one of Bochco's most loved characters, Hill Street's Seargeant Phil Esterhaus, "Let's be careful out there!"