How Does the Mortgage Meltdown Affect VCs?

I've heard today's frequently asked question multiple times this week as many colleagues, friends and family put all financial categories in the same mental bucket. Depending upon where you are in your fund cycle and the industries you back, the answer varies. Luckily, venture capital is a long-term business and private company valuations/fortunes don't fluctuate like public entities -- particularly when the mess has mortgage roots (little direct tech connection).  However, there are plenty of indirect effects on VCs and the portfolio companies.

In honor of the $700B bailout being considered, here's at least 7 ways the mortgage meltodwn affects VC funds.
1) Funds focused on financial technology investments are seeing customers disappear or cut technology spending.  However, companies with cost-saving products/ROI are still knocking down deals.
2) "Quant jocks" are on the market and smart tech companies are picking up the talent to squeeze ROI out of a microeconomic model, advertising arbitrage or customer value/acquisition. 
3) Portfolio debt from venture debt pure-plays (e.g. SVB, Square1) is calm, so far; but debt from diversified banks with mortgage exposure is nervous/gone -- watch those MAC clauses.  This is a very different bubble burst from the tech bubble, which left SVB licking their wounds for years.

4)  Alternative asset classes that relied heavily upon leverage/liquidity, like hedge funds, are getting creamed and regulation could change/kill many models.  That means venture capital gets a growing share of alternative asset allocations.

5) However, as public equities drop in value, the relative percentage of an LP's pool in venture capital grows even if VC valuations do not change -- putting some LPs over-allocated in venture capital.  Weird huh: as public securities perform poorly, LP allocation rules can actually discourage investing in a better performing category like VC.

6) "Mark to Market", one of the culprits behind the meltdown, is often derided by VCs who believe interim, illiquid valuations mean little compared to realized valuations.  Some bailout discussions include changing/removing mark to market -- could that simplify VC valuations/reporting going forward?

7) VC's in market for their next fund might as well hit the beach until all this blows over.  I've heard from at least one foundation friend that meetings with VC funds are being attended only as a courtesy right now.  LPs managing large pensions, foundations etc. are too busy ducking and moving money to really engage.

VC FAQ: Venture Capital Valuation

I received a couple more VC FAQ questions. This time from an entrepreneur and investment banker who saw Angie's List close a $35M round with Battery Ventures. That large funding, and others in the social media space, left her wondering how value is measured and created in online businesses.

Her site, roxiticusdh.blogspot.com, appears to be an early step towards a "Best of" site for various cities around New Jersey and elsewhere. I say "early step" with no details, because the name and domain are clearly ripe for improvement. Her questions were:

How do VC's value an online venture?
The "valuation question" is probably the most often asked question I hear directly from entrepreneurs or on venture capital panels. Entrepreneurs are either trying to understand how crazy high valuations in the news are justified or how crazy low valuations (in their eyes) offered by early-stage VCs are justified. I've been on the entrepreneur side of the table and now the VC side and I know the answer, but it's rarely satisfying for entrepreneurs to hear.

First, there is no one way to value a company. Different funds use different methods, and when you're talking about M&A time it's highly dependent upon the synergies a specific acquirer is trying to buy. Approaches also differ based upon the stage of a company. Because I focus on seed and early-stage companies, any suggestion by entrepreneurs of discounted cash flows makes me run the other way -- the future is way too uncertain for such calculations.

So, if there isn't one way, what can I expect on the fundraising trail? A mix of Art, Science and Voodoo. The Art of valuation takes into account your Market, Management, Magic and plenty of other soft factors to create a spectrum of investor excitement. The Science of valuation takes into account private and public comparables (what price are similar companies commanding in the marketplace), and some spreadsheet work with future revenue/income potentials. The Voodoo of valuation brings in such factors as fund size, typical/expected ownership % and the termsheet competition. At the end of the day, it comes down to getting multiple funding offers so you can actually reach a "market price" -- zero or one offer does not a market make.

I've even created a short presentation that reviews the Art, Science and Voodoo of Valuation and included it below:


Applying all of this to an online venture doesn't change the process much. One oddity in online ventures is the value placed on eyeballs (by some), with the potential of a freemium revenue model (most users are free, pro users pay). Because of these oddities, I'd put more weight on the Voodoo elements -- divide your round size by the typical ownership expectation of the fund you're speaking to, and you'll get pretty close to the valuation they will offer (if they offer anything).

Do you have any advice on short, medium, and long-term strategies to maximize the value of a blog or online business?
For a blog, I'd start with the First Commandment of blogging: frequent quality content = traffic. Frequent content isn't enough alone and quality content isn't enough alone. It may be heresy, but I'd suggest frequency is even more important than quality -- assuming some periodic quality a reader can expect. Readers aren't expecting every blogger to be a professional writer, but they are looking for unique access or unique perspectives on information.

I'd also say that pro blogging is a contact sport. It's hard to do it well if you don't live the blogosphere life of social networking, bookmarking and engaging your readers. Just reporting information isn't enough.

Then, assuming traffic comes, the question becomes how do you make a business from your efforts. There are thousands of get-rich-blogging pundits, but I'd focus on the networks or marketplaces that help you earn by doing what you already love. If your blogging has to change significantly for monetization then I'm not sure it's sustainable. Write the way you enjoy and find marketplaces that will bring advertisers to you, from a variety of topic/product areas so you and your readers don't tire of the sponsors.

Last, for blogs, I'd suggest setting your expectations appropriately. Getting rich blogging is unlikely. However, there are thousands of bloggers paying a mortgage, buying new cars or taking extra vacations with their earnings. Consider anything beyond that just icing on the cake.

For non-blog online businesses, it's hard for me to give one set of value-creating actions. It really depends upon the business. As an investor who has been around viral businesses since HotMail first pioneered the approach, I encourage every online business to 1) find ways for new customers to learn about your business specifically because current customers use it and 2) streamline your referral/signup process to remove every barrier to adoption.

So there you have it, valuation and value-creation in one handy-dandy blog post. I really only scratched the surface, but I hope you find a nugget of interest. If nothing else, I must have prompted another question...if so, blog me another VC FAQ.

VC FAQ: From Developer to VC and Back?

As SocialSpark was in private alpha I wanted to try out their Spark feature. Even if you aren't looking to monetize your blog, Sparks allow you to highlight a hot topic, pose a question or share a good cause -- providing a true "marketplace of ideas" for bloggers to pickup and blog about. I don't blog nearly as often as most bloggers and yet I sometimes get writer's block. Combine that with the fact that more posts equals more traffic, and Sparks can be a valuable firehose for blogging ideas.

I created one Spark for Tyler's Hope and another for VC Frequently Asked Questions. The VC FAQ Spark also tested SocialSpark's BlogUBack feature -- whereby I asked for posts I could blog about. Specifically, I asked people to share some common questions for VCs and/or specific questions they have for me as a VC. I really appreciate the questions I've received and my thoughts on the first few from caseyjenks.com are below:

How and why did you transition from being a developer into a venture capitalist?
While working at IBM's Networking Labs, I convinced management to allow me to pursue a dual MBA/JD degree from UNC Chapel Hill during the day -- fulfilling my operating responsibilities at night. I focused on entrepreneurship and new media at UNC, dove into venture capital topics pretty heavily and helped found/build some local startups. Via the Kauffmann Fellowship program I got introduced to Draper Fisher Jurvetson and was invited to help launch their first east coast fund. After building two funds with DFJ, I founded Inflexion with my current partners and Village Ventures. Breaking into VC was a combination of unique Engineering/MBA/JD education, technology operating experience, passion for startups/VC and a boatload of luck.

How does your experience as a developer help you with your current career?
Being a passionated developer taught me a crazy work ethic, especially on things I enjoyed working on. My VC efforts benefit from that drive. I also believe my background provides a unique view into technology investments and future strategy -- especially when initial prototypes don't show all that's possible and I can riff with entrepreneurs about what's possible. Last, I think developers (or engineers generally) learn the benefits of fixing problems once with well-thought solutions rather than applying patches. You'd be surprised how many times that perspective pays dividends in company building -- when quick fixes feel so easy.

If you were to go back to programming, would you want to go back to doing the networking research type stuff you did at IBM, or something new?
I still dabble in programming and have a blast with open source offerings -- makes it so easy to build something substantial quickly. I've got a notebook full of ideas and no time to pursue them. If I jumped back to the operator side, I'd focus more on quick-to-prototype applications with minimal adoption friction, simple/clean design and maximum viral potential -- with the potential for changing the world (e.g. not another bookmarking service)

What emerging technology excites you the most?
There are tons, but a couple I've been spending cycles on lately are open-source search (e.g. Nutch, Hadoop) and wireless power (e.g. WiPower, Witricity). Search feels like something that will eventually be open-source supplied with a combination of solid search algos, grid storage/computing and self-perfecting AI (to improve algos based upon user/community feedback). Wireless power has been a long-term obsession of mine and we're getting closer.

I hope these answers were helpful. If anyone else has questions for my VC FAQ, try out my Spark and I'll answer any here that make sense for FVB readers!

Connect the Dots for Your VCs and Board

I've been lucky in my venture career to typically lead deals as the local VC. This has allowed me to be very close and active with the entrepreneurs I back -- some may even suggest 'too active'.

There are many benefits from such a relationship, but one I particular appreciate is the opportunity to see both sides of typical entrepreneur/VC misunderstandings. The large majority of misunderstandings are about communication and little more. In particular, remote VCs/Directors either specifically yearn for more communication or, more often, they take issue with key business decisions that they don't completely understand because of poor entrepreneur communication.

Here's why it happens:
1) Entrepreneur lives their business 24/7, developing an intuitive sense for their market, customers, products and competitors -- and blindspots to what others don't already understand about their business;
2) Remote VC/Director focuses on the business at best one week per month, and more likely 2-3 days per month.

Now, if I'm right about this, think about how easy it is for an entrepreneur to forget to communicate 90% of what he/she has learned to inform their decisions. Likewise, think about how skewed/narrow a remote VC's perspective can be on the details -- some of which are critical to significant strategic decisions.

Given the realities of startups and funds, you're not going to change the typical time commitment of a remote VC board member. A couple things you can do is:
1) Make sure you have a local VC who can help you and remote VCs see the same things; and
2) Over-communicate by 'Connecting the Dots' for your VCs. Don't just share your vision, but share why it's your vision, how you plan to reach that vision and how you plan to track your progress/forks on the plan.

There are reasons you make the big decisions you do, and you need to share those reasons with your VCs. They may not agree with your conclusions, but at least everyone will have the same key datapoints in front of them. If you've done this well, your VCs will be happier, your VCs will provide better guidance and you'll have even greater trust in the guidance you receive.

Nice Idea, but How Will You Get Visitors?

I had another conversation today with an entrepreneur who had an interesting online destination site idea, but few answers for attracting visitors. In general, I'm not nearly as excited about destination/media properties as I am about horizontal online services. However, a well executed destination site can still make an interesting business.

The only problem is that the same pitches are happening today that happen in the late '90s -- focused on the big target/niche market and the interesting site functionality; with little discussion of how people will find out about the site and why they will visit. Responding to such questions with a reiteration of site function isn't sufficient, at least not for institutional capital.

A few of the tactical approaches for getting traffic to a destination are:
1) organic search
2) sponsored search
3) viral adoption
4) referral tools
5) affiliate marketing
6) display advertising
7) distribution relationships.
But, it's not enough to just reference this list or a subset. Entrepreneurs need to explain how their niche or target audience is uniquely accessible through one or more of these methods. I'd also recommend doing some small tests with one or more of these so you can speak from real data/ROI. It doesn't matter if you have the neatest idea with the best supplier relationships -- you need visitors or you die.

SBSS Week 2: 10 Reasons to Talk to Your Customers Early

We had another great week of the Success Breeds Success Series. This week covered Markets and Market Research -- with a focus on sizing your market and understanding what customers want.

Randy Scott, CEO of NovaMin, was the guest speaker and did a fantastic job of summarizing his efforts to select and size NovaMin's market. A defining characteristic of his market research was a focus on talking to customers instead of just relying on library/internet research (he did that too). As a result, his numbers and decisions were grounded in reality, not assumptions.

Entrepreneurs who talk to their customers early benefit in a multitude of ways:
1) Customers can provide primary data on market dynamics & size;
2) Customers often have/share secondary data (research reports etc.) on their markets;
3) Customers are typically more open to answer questions if the goal is reasearch instead of sales;
4) Customers can help prioritize product features;
5) Customers may provide early commitments for trials/sales;
6) Customers can be valuable references for funding diligence;
7) Customers could become early investors;
8) Customers can be a resource for more customers (e.g. trade associations);
9) Customers may know of good management candidates from their industry;
10) Customers that are included early, become long-term resources for information and guidance;

So...why are you reading this? Go talk to your customers...

SBSS Week 1: Entrepreneurs Need Passion

I'm helping facilitate the first FastTrac TechVenture program in North Florida, called Success Breeds Success Series (SBSS). It's an intensive 8-week bootcamp for entrepreneurs, including "secrets of success" from most of the top entrepreneurs in the area.

We have a fantastic group participating and our first week focused on the Characteristics of Entrepreneurs. Jamie Grooms, founder of Regeneration Technologies and AxoGen, was the speaker and we spent considerable time discussing the key traits of entrepreneurs. It was a wide-ranging discussion that I won't attempt to summarize here; however, there was one takeaway that was a mild surprise to me.

I'm a terribly passionate person and that has an impact on the type of people I back -- I'm drawn to others whose passion shows in their efforts and dedication to their companies. However, at SBSS I expected to hear diverse views on whether passion was a defining trait of entrepreneurs -- maybe from tech-heavy founders. Boy was I wrong.

Everyone felt passion was a defining trait of successful entrepreneurs. A commitment to do whatever it takes is critical to fight through all the inevitable "no's" heard when building a business. I believe this also shows itself in creativity -- passion makes an entrepreneur think of new ways to create success.

Are you ready to run through walls for your idea? If not, maybe it's not the right idea or the right time for you -- or you need to find co-founders with that core. The road to entrepreneurial success contains plenty of walls, will you stop or keep running?

Dry Powder = Venture Capital Reserves

Now that Inflexion Fund is well into it's life, I spent some time today reviewing how our reserve approach is working out across the portfolio (short answer: great). When I say reserves, I mean the amount of money or "dry powder" a fund mentally reserves for follow-on rounds in their companies. It's a concept that isn't immediately obvious to some entrepreneurs and even many investors.

As an early stage investor, I like to reserve at least $2 for every $1 of initial investment. Many funds focus on a $1 to $1 reserve and some funds may hold as much as $10 dry powder behind their initial $1 invested. Entrepreneurs would do well to ask potential investors about their reserve approach (as part of their overall investing strategy).

In particular, if an investor stumbles on the question or holds minimal reserves (or zero), consider it a big red flag. It typically means the investor hasn't done enough early-stage investing or they just sprinkle money around with a goal of heavying up in only one or two favorites. Their money is still green, but you might have mismatched expectations going forward -- especially when you need that extra little support that the investor never budgeted for. An investor that doesn't reserve properly can also impact your ability to raise future capital, because lack of insider reserves can signal weakness to new investors.

So, have you faced this issue before? What happened?