Boulder Open Angel Forum #6

We’ve rallied together and the crew has decided to host the next Boulder Open Angel Forum (OAF) on Thursday, September 20th. For those of you who aren’t familiar with the OAF, it’s a pitch event that’s FREE for both entrepreneurs and angel investors to attend. The purpose of the event is to connect angels and entrepreneur. We hope this event can help grow the entrepreneurial ecosystem by providing qualified angels with some pre-screened deal flow and exposure/funding for the selected startups.

To qualify as an entrepreneur you should be raising your angel round which will be the first outside capital your startup has raised (a friends and family round isn’t considered “outside capital”). Ideally, your round is partially committed and you will be using the event to it close out. In order to be considered as a presenting startup you need to apply here. Please note the application deadline is on 9/4 at midnight. Our team typically receives 50 to 60 presenter applications and we are sure to get some great quality companies applying. From these companies we will choose, what we feel, are the top six teams to present at the 9/20 event. In order to increase your chances of success we urge you to apply to the event prior to the deadline, this will allow an OAF team member to reach out to you and get that extra layer of understanding regarding your business.

To be eligible to apply as an angel investor you should have made three or more investments in the past year. But even if you haven’t made three investments we encourage you to apply as we usually reserve 1 or 2 spots for up and coming angels. Although we strive to make sure that only the best angels attend the event we are also trying to grow the regional ecosystem and want to provide a window of opportunity for new, serious, angel investors. If you are interested in applying as an angel investor you can do so here.

Our last event, OAF 5, was a great success. Of the presenting companies we had two get into TechStars Boulder (Pivot Desk and Ubooly) and others who received funding. You can also see results from OAF 1-4 here.

In addition to the original OAF team which includes David Cohen, Tim Falls and myself, we’ve added a few new members to help with operations and the selection process. Please welcome Alex Newmann and Rob Foss who are both CU Leeds MBA students, and members of the Deming Center Venture Fund.

I’m looking forward to hosting another great event that supports the regional entrepreneurial ecosystem by helping startups raise so much needed capital.

Presenters Apply Here

Angel Investors Apply Here

The Need for Seed VC

Yesterday, Founders Fund partner Brian Singerman, wrote a post called The Paradox of VC Seed Investing which referred to the risks of large VCs buying options in the Angel/Seed round. While I do agree with Brian’s position on large VC firms, I think his post oversimplifies the investment landscape and the players within it. More notably he seems to infer that a “VC” is a large fund, $400mm+ in size. I believe that this is an inaccurate definition, rather, a VC can be defined as an investor who manages capital on behalf of a group of limited partners. I also believe that the investing ecosystem has adjusted to accomodate specialists for each round of financing. The prime example of this is Super Angels/Micro VCs model that came in existence only few years ago and is growing at an unprecedented rate.

We can get some insight to the growth of each specialized sector using the NVCA data. According to the NVCA Q2 report 14 of the 38 new venture funds were less than $10.5mm in size which implies that these are Super Angel Funds. On the other side of the spectrum the top five new funds accounted for 80% of the funds raised. What’s left is a gap in the Seed VC stage. But before I explain further I’d like to outline each investment specialist and their role in the market.

The Players

Angels: Wealthy individuals who contribute $25 to $100k per deal. These investors are unlikely to participate in future rounds

Super Angels/Micro VC/Seed Funds: This is a professional investor or small team of investors who raise between $5mm and $20mm from LPs and use these funds to make passive investments in a large number of companies. Their investment size is $50 to $100k in the Angel Round and will often participate in the Seed and Series A round. Think 500 Startups, Bullet Time, Soft Tech VC.

Seed VC: These are institutional investors who raise between $25 and $200mm to active seed investments leading a $800k to $1.5mm round. Although the Seed VC has the right to participate in future rounds, their strategy isn’t to purchase an option. Rather, these companies do extensive due diligence on the founding team because they are establishing a partnership with portfolio company and have plans to follow-on throughout the lifecycle of the company. Our fund, High Country Venture, follows this model. Other Seed VCs are True Ventures and First Round Capital.

Early Stage VC: These are larger firms, usually between $100mm and $500mm in capital who lead the Series A through C rounds by writing $3 to $10mm checks. These firms will also be active investors, taking a board seat, and will have plans to invest throughout the lifecycle of the company. These VC firms follow the traditional VC model. Examples are Founders Fund, Union Square Ventures and Foundry Group.

Growth Stage Equity: These investment firms come in late stage and right big checks.  They will lead a $20mm+ round in a company that has mitigated the majority of their risk, they simply need to put fuel on the fire. One could argue that the companies under consideration are companies, not startups. Growth stage investors also command a board seat and take an active role in helping the company go public or recruit potential suitors for acquisition. Examples of Growth Equity are Index Ventures, DCM and General Atlantic.

The Investment Ecosystem

I’d like to make the argument that there is a need for more Seed VC funds. According to the NVCA data, the percentage of seed funding has dropped relative to the total amount of investment dollars in the ecosystem. In 2009 seed funding was $1.8B representing 8.97% of the total dollars invested, while in 2011 this number fell to $1B which equates to  3.55% of the total market.

Now let’s compare this to the Angel Market. UNH Center for Venture research reported that the Angel Market in 2011 was $22.5B with 66,220 deals. This is over 22X greater than the size of the seed market.

In 2011, Fenwick and West released the results from a 2010 Seed Financing Survey focused on Internet and Digital Media. The survey results indicated that 74% of companies raised seed rounds from Angels/Seed Funds (not Seed VCs) who are unlikely to participate in the Series A. Only 45% of companies who raised seed funding went on the raise a Series A, a percentage which I fully expect to decrease as the angel market grows (28% since 2009) and the seed market declines (-42% since 2009).

What does all this mean?

It means there is a lack of specialists in the Seed Round. There is a need for the Seed VC. As previously mentioned, the NVCA data indicates that the funds being raised today are either Super Angels/Seed Funds or large Early/Growth Stage funds. How are companies going to raise the $1mm round which enables them to hit milestones and prove out their business model? Today their options are limited. As Barry Kramer, partner at Fenwick and West, puts it; “there is a non-trivial hurdle to get to Series B.”

The final point I would like to make is that Barry Singerman’s comment that “VC meddling is potentially very detrimental to a company’s early success” is preposterous. Is Josh Kopelman from FirstRound Capital “meddling” with a company’s success? Do you think the addition of True Ventures‘ network and partner input is detrimental? I would like to argue that a good Seed VC will add strategic value to an early stage company. At HCV we’ve made seed stage investments in 14 companies, 13 which are still operating today.

The bottom line is that the investment ecosystem needs more Seed Stage VCs to take an active role in helping young startups raise the next round and ultimately achieve their full potential. A startup is a process, and most young companies can’t afford to skip the achievements made in the Seed Round.

We Are All Gamers. We Just Don’t Know It.

I went climbing this morning at Movement Gym in Boulder. I was doing some bouldering and looked over at this super smooth climber who was making V10s look like V2s. When he jumped down I noticed it was free soloist, Alex Honnold, who has been featured on 60 minutes. It was fun to watch someone so good at the sport, you could almost see the hours of practice it took Alex to hone his skills and become the climber he is today. If you’re familiar with the climbing culture, you’ll know that serious climbers are slightly obsessed with the sport. It’s a bit like golf, where athletes catch “the bug” and all they want to do is be on the course or up on the wall. What triggers this obsession? I think has to do with the pursuit of mastery.

Daniel Pink’s book, Drive, analyzes what motivates people. As it turns out it isn’t about money, rather it’s our desire to seek mastery. We like to get better at stuff because it’s inherently satisfying. Yesterday, CNN Money posted How to Win The Tech Talent War, which stated that “the companies best able to land the most gifted coders are those with interesting challenges to offer them… What’s most important to people is the amount of impact they can have — that’s personal impact and also being part of something that is bigger than themselves”

Game developer, Jane McGonigal, has coined the term “Happiness Hacking” which she defines as: “the experimental design practice of translating positive-psychology research findings into game mechanics. It’s a way to make happiness activities feel significantly less hokey, and to put them in a bigger social context.” Her blog goes on to illustrate the ideas (she calls them fixes) necessary to “hack” happiness. The four fixes that resonate with me the most are: we must opt into unnecessary obstacles/pursuit of mastery, we have a clear mission or goal that we wholeheartedly participate in and we receive meaningful rewards when we need them the most. Lastly, we long for affirmation from our peers, and the social connectivity or social currency gained through mastery makes our pursuit even more enticing, McGonical terms this “pro-social emotions.”

When Jane McGonigal is explaining her theories she is using them in reference to the positive benefits of games, more notably video games. While I’m an advocate of video games, I would like to argue that being a “Gamer” is part of our everyday life. If being a Gamer means I’m striving towards a pursuit of mastery, that I have clear goals, work with peers to achieve these goals and receive meaningful rewards when they are accomplished, then I’m a Gamer everyday, all day. I would bet that you are too.

FullContact Is Solving The World’s Contact Information Problem

Innovation begins with divergence. As entrepreneurs develop new products they challenge the status quo by diverging from the old business model. While this iterative process is positive it can also lead to fragmentation, ultimately, causing confusion for the user. Every once in a while a product will diverge from the old business model and invent something that makes the user’s life simpler, converging the fragmented landscape. Evernote is a great example. Before Evernote my notes were scattered in various places and were in different formats.Today, my notes are located in one place, tagged with meta data and accessible on any platform.

I now have my notes are in order, but my contacts are a complete mess. I have different groups of friends/contacts on my various social networks, contacts on my phone, gmail contacts, work contacts, personal contacts, family contacts. In addition to these being inaccessible across networks my contacts have out of date information, mislabeled, duplicated and more. FullContact is solving the world’s contact information problem. They are building a web app which will allow me to take back the ownership of my contacts through convergence, making my life simple and organized. I love it. But the team isn’t only building an organizational tool. They have much, much, bigger plans. They have plans to build the technical infrastructure that changes the game.

I met Bart, Dan and Travis in early 2011. They were pitching Who Sent it, an email enrichment that relied on identity resolution. Chris Marks and I liked the idea but we had no idea of the technical difficulty involved in building the infrastructure. Bart often talks about the problem as “schlep blindness”. We really liked the founding team, they had a complementary yet diverse skill set combined with a passion to solve a really hard problem. Fast forward 6 months, the passionate trio was nearing TechStars graduation and had recruited a handful of School of Mines talent to build some solid core technology. In addition they were able to clearly express their business model and the disruption it brought to the market. The team re-branded the company to FullContact, raised their Series A (or series API as Bart likes to call it) with HCV as the lead, and didn’t look back. Over the next year the FullContact team has gone on to build some pretty impressive, cutting edge, technology that has the capability to replace the contacts app on our phones, desktops and CRMs. The API offering went live in January and the team learned a ton from the customers. In a few weeks, FullContact will launch the web app which will provide a viable solution to anyone with a contact management problem (aka. everyone). sign up for beta!

In short, the FullContact team has hit several product and business milestones which resulted in closing a Series B round led by Foundry Group. I’m excited announce our participation in this financing and would also like to welcome Foundry Group as an investment partner. We’ve co-invested with Foundry before, and we are excited to continue the relationship.

Congratulations to Full Contact team on raising the Series B round! I look forward to continuing the journey.

How Clean-Tech Innovation Differs From Software Innovation

This past Friday I drove up to Ft. Collins to check out the entrepreneurial scene in Northern Colorado. I did a quick tour of the Rocky Mountain Innosphere, which is a non-profit formed to accelerate the success of startups in the region. The Innosphere has hired new leadership and will be a meaningful resource to the entrepreneurs in the area. I plan to keep in touch.

The hidden gem of the trip was the tour of the CSU Engines Lab. Lab Co-Director Dr. Morgan DeFoot gave us a fascinating tour of the lab and showed us some of the intellectual property that was developed at the facility. More specifically, it was interesting to see how innovation in clean-tech differed from that in the software world.

Incremental Efficiencies vs. Market Disruption

As someone who invests primarily in software, I’m always looking for the product and team that is going to change the market. Market-changers are few and far between, and most of the time I get pitches focused on building a slightly different, yet better mouse trap: “Foursquare with automatic check-ins”, “Pinterest for pet lovers” or whatever other improvement you can think of. At High Country Venture we try and steer clear of software with incremental technology.

On the other hand, the CSU Engines Lab is all about creating efficiencies to the current infrastructure. A slight change in the efficiency of a disel engine can be worth billions in cost savings and have a significant environmental impact. Unlike software engineers who start from a blank slate these engineers are improving the current system. While this may not work in software, it’s a great model for clean-tech.

Why Does Incremental Innovation Work in Clean-Tech? 

It really comes down to distribution and switching cost.

The massive distribution of the energy markets makes an incremental changes extremely powerful. The folks at CSU Engine Lab are laser focused on use cases with large existing network, ultimately making a huge impact with one modification.

When it comes to physical infrastructure it is more efficient to improve vs replace. Financially speaking, physical infrastructure has already been recorded under capex and amortized over a set of years. What this means is that there is a specific lifecycle for things like engines, and most companies will elect to repair over replace. This means that retrofitting the existing infrastructure will have more of an immediate impact than attempting to build a new network. We’re talking about the switching cost. This is very different from the software world, where the switching cost from Sugar CRM to Salesforce only takes a few man hours.

A Clearly Defined Problem

Unlike software development the engine has baseline metrics and the sole purpose of the engineer is to improve upon these metrics. This requires a lab like atmosphere where you tweak, test, find a new solution, test, improve, test, change and test some more. Although software is becoming more data driven through Agile methodologies and A/B testing, the problem is less direct and it can often be interpreted differently. When seeking increased efficiency the mission is straight forward and success is almost binary. An engineer at the CSU Engines Lab needs to ask themselves “Have I improved efficiency by 10X?” If the answer is no, keep working.

CSU Engine Lab

Dr.DeFoot and his crew are an impressive bunch. They’ve made modifications to the large engines used to pump natural gas that had cost savings worth a billion dollars. They are researching the use of lasers in engines to increase efficiency. They’ve designed a low cost stove to reduce harmful emissions in the 3rd world and distributed it to millions across the world. They’ve built a test electrical grid used for simulating different power sources and so much more. The Engines Lab is arguably the state’s most impressive research facility for clean-tech innovation. Congratulations to the team and the progress.

The CSU Engines and Energy Conversion Lab‘s mission is to create innovative energy solutions and entrepreneurial models which benefit the human condition and achieve global impact.

Don’t Panic, Software is Still Eating the World. Time to Rethink Everything.

Facebook is $11.50 down from it’s opening price of $38.00. Fred Wilson wrote a great post with some perspective on the enterprise value of FB and how it’s value is appropriate based on the revenue and EBITA multiples. Paul Graham has also written a memo on the Facebook Fallout, which states that the Facebook IPO will lead to a difficult fundraising environment. I don’t disagree that the FB could have an impact on valuations in the later stage and secondary markets (per Fred Wilson), and I also believe that the effect will trickle through the market and have the biggest impact in the very early stages. The market has been frothy for some time, and a correction is expected. On the other hand, the “Facebook Fallout” will have next to no effect on the capital allocated in institutional rounds. Here’s why:

VCs invest consistently over time.

VCs worth their salt don’t try to time the market. The “flippers” who are looking to make  investment and sell quick aren’t real VCs and won’t be around for long. A true VC will take an active role in it’s portfolio companies and help build it into a company of value over. It takes several YEARS of value creation before an exit is feasible, making it impossible to time the markets. Fred Wilson has written a good deal about a consistent investment strategy.

VC dollars are close to equilibrium

VC fundraising is also up. In 2011, 181 funds raised $18.8B, compared to 2010, where 170 funds raised $13.8B. These VC firms will be looking to allocate this new capital over a 3 to 5 year period. It’s arguable but there is some indication that the equilibrium number for VC dollars raised and allocated is just under $20B/yr. Given the current level of activity I don’t foresee a huge disruption in the amount of dollars raised and allocated by institutional firms.

Why will there be lower valuations? And what is Paul Graham talking about? 

Valuations in the IPO and secondary market may be adjusted based on the Facebook market value. These lower values will force down values in the prior round which will eventually trickle down to the early stages. But it will be the angel round that takes the biggest blow as the number of active angel decreases.

Angels invest their own money, usually on a part time basis. Unlike a VC, who must allocate capital within a specific time frame, an Angel has no requirement to make an investment. When the market is “hot” and angels are getting big mark ups on subsequent rounds they invest more. The increase in activity has been prevalent over the last few years. Accoring to Jeffery Sohl, director of UNH Center for Venture Research “The significant increase in total dollars, coupled with the rise in the number of investments resulted in a larger deal size for 2011.“ The cycle of angel investment activity unravels fairly quickly when a catalytic event occurs that resets market prices. This what Graham means when he says the markets are going to tighten up.

What should you do?

If you’ve raised money at a valuation higher than the upper end of normal, or skipped a step in the start up process, shame on you. There isn’t much you can do, you can’t control the market. But this doesn’t mean you should give up, it simply means you need to continue to build a company of value. The price of Facebook isn’t going to affect the execution of your startup or the happiness you deliver to your customers. Focus on building your business, hit your milestones, acquire new customers and prove out your business model. There is no need to panic, software is still eating the world, time to rethink everything.

Leading To A Drink From The Cup

It’s a great time of year, summer is around the corner and we are within a game of the Stanley Cup finals. This year’s playoff story is the LA Kings. In the first round of the playoffs the Kings crushed the league leading Vancouver Canucks. Next, they destroyed the St. Louis Blues, who finished 2nd overall. Most recently they earned the right to the Stanley Cup playoff by beating 3rd seed, Phoenix Coyotes, in 5 games. How can the last seed in the Western Division dominate the top teams in the sport? Some may say great goaltending from Johnathan Quick, or a strong performance by Dustin Brown, but I think the majority of the credit goes to the guy behind the bench, Darryl Sutter.

Sutter has coached 11 seasons in the NHL and has only missed the playoffs once. He took the head coaching job with the Kings on December 17th and was 25-13-11 in the regular season. If you include his playoff record, Sutter’s Kings are 37-15-11. Prior to Sutter’s arrival to LA the Kings were a mediocre 15-14-4. The point here is that a good coach in the NHL is worth his weight in gold. To prove this isn’t an isolated incident I’d like to reference the legendary coach, Scotty Bowman, who had 28 playoff appearances and 9 Stanley Cup victories over the course of his career. How can someone who doesn’t touch the ice have such a profound effect on the results?

The role of a Coach is not unlike that of a CEO. A CEO is a strong willed leader that commands respect. He* stands behind his team with a composure that is unfazed by the unexpected outcomes of the game. He’s the author of the strategic plan and has inspired unwavering confidence in its execution. He’s the first and biggest believer in the team’s ability, and his words inspire others to believe in the mission and the importance of their role. This seed of inspiration glues together the group of individuals to become a single unit, which ultimately becomes greater than the sum of it’s parts. It’s at this point where the team exceeds expectations and surpasses the unthinkable.

A CEO is a leader who has the ability to forge through adversity and take ownership of the business. He cannot afford to show self-doubt or dispair during the difficult times. Imagine the opposition scores two quick goals, if Sutter panics and says “this will never work, we can’t win”, the entire Kings squad would crumble. The mood and the culture of the leader radiates across the entire company. A great leader will keep his composure and hold the line during difficult times, but will also bring the team down from the clouds during times of prosperity.

The role of a CEO comes with a massive amount of pressure and is extremely difficult. The employees, the board and all other stakeholders look at the CEO for direction and answers to the hard questions. It’s not that the other founders don’t have a say in the business, but rather it’s the CEO who is the frontman, the leader, and is responsible for the team’s  successes and failures. The role of CEO is not the glamorous position that society makes it out to be, and hiring for it should not be taken lightly. Not everyone has the composure and leadership skills to be a CEO, and that’s okay. While it takes a full team to build something great, it also requires a great leader. Hopefully you’re company has the person who will lead you to a drink from The Cup.

* There are many great Women CEOs and there will be many more in the coming years. The pronoun “He” is used for simplicity and is thought of as a generic pronoun for both genders.

Startup Evolution; Early-Stage vs Growth-Stage Companies

It’s the first week of TechStars Boulder 2012 and excitement is in the air. The founders are fresh with enthusiasm and ecstatic  about the opportunity that the next three months will bring. It’s great atmosphere and a fun time of year. Chris Marks and I spent Wednesday and Tuesday afternoon meeting founders and listening to what they want to get accomplished this summer. As expected, most responses had something to do with figuring out product-market-fit and the go-to-market strategy.

I’d like to compare the TechStars meetings with a meeting we had earlier in the week with Andy Grolnick, CEO of LogRhythm. LogRhythm is one of our more mature portfolio companies and has become recognized as a market leader in the SIEM space (they will be featured as a leader in Gartner’s Magic Quadrant). What I find fascinating about this comparison is how the focal point of the meeting differed from that of an early stage company.

An early-stage company must be laser focused on product-market-fit. What is the value proposition to the user? What is the customer’s willingness to pay? How big is the market for our product offering? Who is the competition and how do we differ from them? Once the product hypothesis has been developed the early stage entrepreneurs will focus on go-to-market strategy, namely distribution. How can you cut out the noise and get customers to try/buy your product? Can you capture their mindshare? What is the frequency of use? The product and strategy of an early stage company are constantly being tweaked as the founders assemble the pieces of the puzzle.

Compare the early-stage process to a growth-stage company who has fully built their core offering and have an established product and brand in the marketplace. In the growth-stage the company is puts the majority of their effort on growing the top line; marketing and positioning, lead generation, converting customers in the pipeline, win rates, lowering churn rate. Don’t get me wrong, any company is only as good as it’s product offering, it’s just that the puzzle pieces have been assembled and the focus has shifted from product road map and development cycles to sales growth and revenues.

Observing the different stages of a startup and the risks associated with each stage is a fascinating topic. I feel privileged to have regular interactions with a set of companies at different stages of the entrepreneurial process. My hope is that I can learn something new from each company we work with and pass this new found knowledge to portfolio companies who face similar challenges.

Is VC really broken? Thoughts on the Kauffman White Paper “We Have Met The Enemy… And He Is Us”

Last week the Kauffman Foundation published a white paper about the lackluster returns of their venture portfolio and titled it “We Have Met The Enemy… And He Is Us” Lessons From Twenty Years of the Kauffman Foundations’ Investments in Venture Capital Funds and The Triumph of Hope Over Experience. The paper lists a set of assumptions and recommendations on capital allocation in the venture industry. The paper’s thesis is that the Kauffman Foundation’s own Limited Partners (LP) are at fault for accepting the various  performance metrics used to market a venture fund and the investment structure that favors the General Partners (GP).

The appropriate standardized performance metric is a difficult infer. Kauffman suggests that using a public market index, such as the Russell 2000 or the S&P 500, as a benchmark is the solution to problem. I see two problems with this approach.

  1. The value of an early stage company’s future cash flows is largely unknown and unpredictable with the bulk of the value created at the end of the fund’s lifecycle. While the lifecycle of a fund might not form a J-Curve, as the report suggests, comparing the value creation in the 1st half of the fund’s lifecycle to a public index would be an “apples to oranges” comparison.
  2. The venture industry is largely uncorrelated from public markets. Isn’t this the primary idea behind the portable alpha? Why would one use a public index as a benchmark when the whole purpose of the strategy is to de-risk the portfolio beta by investing in an alternative asset that has the potential to achieve a high return? I do understand that there is an opportunity cost of investment, but the public market benchmark strategy completely dismisses the concept of a diversified portfolio.

I agree that measuring performance on an IRR only basis has some problems, and the large unknowns in future cash flows virtually eliminates the discounted cash flow method. But if the LP takes into account both the cash on cash and the IRR they should get a clear indication of fund performance, and thus have sufficient information to make a investment decision.

There is no question that the 2/20 fund structure incentivizes GPs to raise larger funds. The problem is that VC firms don’t scale (which is somewhat ironic given the VC focuses on investing in business that scale). The Kauffman Report states that big VC funds fail to deliver big returns, and the point of inflection, where the fund size achieves diminishing returns, is at $500mm. The problem is easiest to understand if we look at issue from a “cause and effect” perspective.

Cause: With a 2% management fee a bigger fund earns more money, but it doesn’t usually grow it’s partnership by the same increment as the increase in fees. The result is more guaranteed money per partner, a nice deal for GPs.

Effect: With a larger fund size VCs must allocate more capital in the same time frame. These VCs have two choices: 1) allocate capital in bigger chunks, which means later stage investments 2) make more early stage investments. Larger investments could force a change of scope, but also additional risk, as large failures hurt the return more than small failures. If the VC elects to make more early stage investments, they have more portfolio companies, which in-turn, requires more partner time. Since time is finite, more investments per partner means less time per portfolio company and ultimately a lower contribution, which in theory decreases the portfolio’s chance of success (assuming a VCs active role increase’s the firms chance of success).

Although the 2/20 structure does have some misalignment I don’t think the industry will change. The reason is the polarity of returns between the top VC firms and the bottom VC firms. This makes for a fierce competitive environment, where LPs fight to invest in the top firms (supply exceeds demand). Since the to GPs are oversubscribed, they hold all the leverage and command the fee structure. On the other hand, a GP that offers anything less than the standard 2/20 is signaling inferiority and will actually be questioned by  LPs for the lower fee structure. Dan Primack’s May 11th Term Sheet post highlights Bain’s 1/30 offering.

I don’t agree that that Venture Industry as a whole is broken, with the top firms providing stellar returns (see slides 7 through 11). While the Kauffan Foundation has illustrated some compelling assumptions, I would argue that every industry has its share of top performers and losers. LPs need to use their best judgement to find VCs who are following a sound investment strategy; VCs who are passionate about investing in the most promising and innovative early stage companies, who are working with the most talented entrepreneurs to foster growth, and who are transforming markets and creating long-term value. The idea of building a successful organization is best said by NY Mets GM, Sandy Alderson, in his interview Behind in the Count:

“It’s a cliché, but the enjoyment I get out of this job isn’t the destination, it’s the journey. We won the World Series in Oakland, but that’s not what I remember most about my time there. It’s about building an organization. It’s about following a process you believe in. It’s about identifying good people and then finding ways to keep them motivated and retaining them. It’s about the camaraderie you establish in the organization, whether that’s with the owners or the equipment managers or the clubhouse boys.”

The VC model is not broken, it’s just that some LPs are funding firms that are breaking the mold.

Peer To Peer Is Here To Serve You

2012 is said to be The Year of the Peer to Peer, and we are off to a great start. Every week I see a new peer-to-peer startup that is trying to capture the overcapacity in market via the “Airbnb business model” (also known as The Sharing Economy or Collaborative Consumption). This new breed of startups consists of everything from loaning money to purchasing imported candy. Why have these sites been created? Why now? And what are the attributes that make a good one?

Efficiency and social are at the heart of the sharing economy. If I have a fixed cost for something (empty office space or an empty seat in my car), I can receive incremental benefits by using the excess capacity. Since we are all socially connected on the marketplace, it’s much easier to find buyers for our offering. The peer-to-peer model is ingenious and works great for certain transactions, but is prohibitively difficult for others. Here is a list of the core components to launch a peer-to-peer marketplace.

  • Third Party Product and Economies of Scale
  • User Reputation
  • User Acquisition: Both Supply and Demand Side
  • User Experience
  • Physical Hurdles to a Transaction

From a technical aspect, standing up a marketplace is as easy as ever. This is primarily due to the vast number of third party technology services that lower the barrier to entry. In addition to the infrastructure as a service companies (AWSSoftlayer etc), services like Legal Zoom and Stripe make it easy and affordable to have professional solutions without getting too deep into the details. In addition to the low startup cost, your marketplace will standardizing the transaction process, bringing economies of scale and the burden of startup costs down to pennies per transaction.

eBayCraigslist and Amazon have paved the way with the consumer. People feel comfortable buying from strangers online, especially if there are some positive reviews or a reputation score. I realize that this crowd-sourced information is far from flawless, but I do believe that it solves the “Craiglist effect”, where every 2nd person is a scammer. If the marketplace owner adds some additional policing/guarantees in addition to the reputation score they will solve for the majority of the bad players.

Acquiring the critical mass of users is the hardest hurdle to overcome in the early stages. How does one ignite the supply side without any demand side and vice versa? How can one build a market that is dense enough to attract new users? Various tactics can be used depending on the offering, but it usually involves some type of viral game mechanic (credit for friends), geo-fencing (only available in Boulder/Denver) and/or seeding inventory.

Your success and the low technical barriers to entry will cause co-evolution in the space, aka. the rise of the copy-cats. These new entrants are trying to steal your market share and will create a lot of noise, confusing the consumer. Sure, you have the user today, but the new entrant is touting lower fees or some other incremental benefit. Basically, your offering has become commoditized, and it’s going to be hard to increasingly hard to differentiate. The best way to combat the copy-cats is through User Experience. This is the end-to-end customer experience. In the business model canvas it’s the customer relationship square. This is where most marketplaces fail because they don’t put in the hard work to understand the details of the transaction. Brian Chesky says it best in his interview, Airbnb.com: Necessity Begets Creativity:

I think that industrial design is all about user experience. You become a user, you become your own guinea pig, you learn to observe the world. It’s important that you put yourself in the shoes of the user and really use the product. I literally live in Airbnb.com…. Understanding nuances and learning how to empathize with our users. Also, improving the UX of site. As an industrial designer, you just have to consume it, you have to live it.

Since the marketplace is facilitating a peer-to-peer transaction, part of the customer experience is beyond your control. If a transaction in your marketplace has significant physical hurdles it’s going to difficult to succeed. An example of a physical hurdle is the transaction size: if an item is priced too low, it’s not worth the physical requirements (shipping cost, meet up, pickup etc.). Most of us have experienced a Craigslist sale where the buyer shows up 1hr late to buy a $10 item then he haggles you down to $8, or the hassle of packing and shipping a book on eBay for a whopping net gain of $3. Precise timing is another example of a physical hurdle that can hurt the user’s willingness to transact. In a ride-sharing marketplace people are very sensitive to the physical coordination required to fulfill the transaction, a 30min wait makes the ride share an inconvenient option.

When you get into to the details of the marketplace you begin to understand that excess capacity doesn’t always equal a market need. You can leverage third party services, seed the marketplace and be off and running in a few weeks. In the long run the difference maker is going to be the customer experience. It requires detailed planning and tight internal processes that enable your company to execute on the offering. The winning company will create raving fans. This involves thinking about everything from site design to the transaction process. It’s hard work and nearly impossible to replicate.

Before you launch your new a marketplace ask yourself if you want to build customer service company. Are you willing you willing to live it?