Portfolio Math

There has been a great deal of discussion about the viability of the venture capital industry.


What types of returns are required to justify the asset class' risk? Are such returns available in today's market? How much risk does an early stage venture capitalist need to take to justify the premise of the business?

To find out, I constructed a simple model of a portfolio with the following characteristics:

1. # of companies in portfolio
1. 10


2. $ per company ($m)
1. $10


3. management fee
1. $0 (to keep this simple:))
   
4. Probability of Success
1. 40%


5. Probability of Failure
1. 60%


6. Definition of Success
1. 5x money


7. Definition of Failure
1. 0x money

The table below illustrates the probability of N successes, the value of the Nth success, and the expected value of the Nth success:









For example, in a portfolio of 10 companies:

• the probability of 4 successful outcomes is 25%
• or, 10!/4!6!*(.4)^4*(.6)^6
• the value of 4 successes is $200m, or 4x5x10
• the expected value (prob * value) of the fund, the sum of the total distribution of expected values, is also $200m
  

To 3x a fund, one would need:

• $300m,
• given a 40% success rate, and 7.5x your money/success

To 5x a fund, one would need:

• $500m, or
• given a 40% hit rate, 12.5x your money/success

To 8x a fund, one would need:

• $800m, or
• given a 40% hit rate, 20x your money/success

Now, if the hit rate falls to 20%, to 3x a fund, one would need:

• $300m, and
• 15x your money/success

If you hold 5x money/success, each 1% improvement in the hit rate is worth $5m.

If you hold the hit rate constant at 40%, each .5x money/success is worth $20m.

In summary, given that early stage venture capital often experiences binary outcomes, individual firms should look to ensure that deals support the possibility, if not the probability, of a 10x or better outcome.

Furthermore, LPs should diversify across multiple partnerships and look for firms that look to create large winners, not incremental winners. Conventional wisdom holds that 10x returns are required for Series A investors, however, the math exercise helps illustrate why that is the case.

Back to the original question...The early stage very capitalist appears to only be able to justify the risk involved in the asset class if they can either

• materially increase the hit rate, ie reduce probability of failure per deal
• create deals with 10x+ returns on invested capital
  

Are there 10x or greater deals in the market? Of course, however, great funds will need to find quite a few in order to justify their existence.

Hitting doubles or triples, in the face of a high mortality rate, will not cut it.

Note: thank you to Hunter Hancock for his valuable feedback and help on this post.

Six Filters for Business Evaluation

I am currently reading, Seeking Wisdom: From Darwin to Munger. The book seeks to provide guidelines for better thinking, explain what influences our thinking, and delves into the psychology of misjudgments. All topics of real interest to investors.

The book leans heavily on the writing and speeches of Warren Buffet and Charlie Munger. It reads like a reference book - with each chapter full of terrific nuggets of wisdom and quotes to remember.

The book includes a useful checklist for business evaluation. All investors, like pilots, need to have a checklist to ensure consistent best practices in decision making. At Hummer Winblad, we put together a checklist for every deal.

The book's checklist follows. While perhaps the book's list is not perfectly suited for early stage investing....like many frameworks, the real value lies not in the specific framework itself, but in the consistent application of a mental model that ensures diligent analysis and carefully weighed decision making.

Filter 1: Can I understand the business - predictability?
Reasons for demand - how certain am I that people are likely to buy this type of product or service? why will they buy? what are the benefits?
Return characteristics - Industry and company return characteristics and change over the last five years? Is there a business model comparable that has made real money for its investors and management team and proven the operating model's economic value?
Industry structure - (a la Michael Porter), no of competitors and size? Who dictates terms in this industry? Do I know who is going to make the money in this market and why?
Real customer - who decides what to buy and what are his decision criteria?

Filter 2: Does it look the business has some kind of sustainable competitive advantage?
Competitive advantage - can I explain why the customer is likely to buy from this company as opposed to others in the market? what is the basis of the advantage - market knowledge, execution strength, or technology?
Value - how strong is this advantage, does the advantage benefit from network effects or scale that will make it stronger and more durable over the years?
Profitability - can the advantage be translated into profitability and why?

Filter 3: Able and honest management?
Is the team competent and honest? Do they understand the market and are they focused on value creation for the owners of the business?

Filter 4: Is the price right?
Can I buy at a price that provides a good rate of return with an adequate margin of safety?

Filter 5: Disprove
How can the business get killed?
Who could kill it?
If it failed, what are the likely internal and external causes?

Filter 6: What are the consequences if I am wrong?

At Hummer Winblad, we add:
Filter 7 - what disruption will aid the company is driving growth?
What wave will the company ride that rewrites the operating dynamics of the industry and drives the reallocation of capital away from old models and technologies to new players in the market?

The book is a fun read and one to have on your desk.

Rich Price - Playing on Sept 25th in SF

My brother, Rich, is a wonderfully talented recording artist.

His new band, RGB, will be playing in SF on Sept 25th.

Below is a note from Rich and I hope some of you can make it!

Hi Bay Area friends, I hope all's well. I'm excited to announce I'll be bringing my new trio, RGB (Rich Price/Greg Naughton/Brian Chartrand) to San Francisco a week from this coming Tuesday.

I'm thrilled to be performing with two of my favorite songwriters, and the trio has been great fun. It's like Crosby, Stills and Nash had a one night stand with Paul Simon, The Police, David Gray, Martin Sexton and that short guy from Fantasy Island and somehow managed to produce a three-headed singing beast...that's RGB.

If you're free on Sept 25th, we'd love to see you! Thanks for all the support and for helping to spread the word!! All the best, Rich

RGB (feat. Rich Price)
Tues, Sept 25th at 8pm (sharp)
Red Devil Lounge
1695 Polk St (at Clay)
San Francisco, CA

link to purchase $10 ticket





p.s. I'll be performing in SF in late Oct with my old band. More details to follow.

What is a Brand?

I recently heard a very succinct and compelling answer to the question, "how do you define the concept of a brand?"

The answer, from the CEO of E&J Gallo Winery,...

"A brand is a promise to a customer of quality, image, and differentiation."

The definition elegantly boils down a complex concept to five key elements:

1. a promise...a commitment from the company.
   
1. Employees across the organization need to internalize that promise and live up to the commitment that is at the heart of the company/customer relationship
2. a customer
   
1. the company needs to understand the interests, demographic profile, characteristics, motivations of the customer. What makes them tick? Who are they?
   
2. A clear picture of the target customer helps align the product, sales and marketing strategy, and positioning with the customer's interests and needs
   
3. quality
   
1. a value...be it an experience, physical good, or relationship
   
4. an image
   
1. a set of mental associations that complement the interests and self-image of the customer
   
5. a differentiation
   
1. a clearly unique proposition that is effectively communicated to and understood by the customer

I think all five elements are worthy of thought and reflection.

• what is your brand's promise?
• who is your brand's customer?
• what is your brand's quality?
• what is your brand's image, mental associations, characteristics?
• what is your brand's differentiation?

Simple questions with surprisingly hard answers.

Chad Ruble, Reuters Vlogger, is Funny

Chad Ruble is funny.

(Full disclosure - Chad is one of my great friends)

Chad hosts a weekly internet video show, And Finally, on Reuters.com highlighting wild and wacky news stories from around the world.

On this week's episode, Chad visits a professional stunt school in NYC.

The show reminds me of Keith Olberman's Countdown segment "Let's Play Oddball" and it is well worth subscribing to via RSS.

The Psychology of SaaS and Web 2.0 Persuasion (and Selling)

One of the cool things about blogging is that it fosters the cross-pollination of ideas. Often, moreover, the derivative idea is much better then its source.

Bob Warfield's post, The Psychology of SaaS and Web 2.0 Persuasion (and Selling), is a great example.

He picked up on my post regarding Cialdini and the psychology of compliance and wrote a very thoughtful piece on how Cialdini's work can be applied to SaaS and Web companies.

It is well worth reading.

Beginner's Mind

"In the beginner's mind there are many possibilities, but in the expert's there are few."

-Shunryo Suzuki-Roshi

I am coming to believe that the comfort to say "I don't know" is fundamental to being a good investor. Intellectual curiosity, being open to new ideas, and the willingness to momentarily suspend disbelief in the face of unorthodox approaches are vital preconditions to being able to reward disruption.

Ideas, opinions, and expertise get in the way of knowing what we don't know. Given that venture is premised on funding innovation, refusal to admit ignorance, unwillingness to ask for clarification, to avoid learning can blind one to the clarity and creativity that exist in a beginner's mind. "Knowing" does not allow us anything new, no surprises, no insights, no discoveries.

When I worked for Art Samberg, a brilliant investor and founder of Pequot Capital, I was consistently impressed by his ability to listen and to learn. He would often ask people for their views; the chance to showcase knowledge to a billionaire investor would drive people into long monologues. When then asked what he thought, he would often say "I don't know enough about it to comment" and walk out of the room. The lesson: there is no shame in admitting you don't know, rather, the real shame lies in making your "intelligence" so much a part of your identity that you are afraid to ask or admit a lack of knowledge.

The concept of beginner's mind is not limited to Buddhism. Frank Herbert said, "“The beginning of knowledge is the discovery of something we do not understand.” While Proust wrote, "“The real voyage of discovery consists not in seeking new landscapes but in having new eyes.”

Our learnings and experiences often help us process a complex world, however, I believe that it is important that we work to maintain beginner's mind over and over again in order to not let "knowledge" trap us from seeing innovation and possibilities.

Oracle buys Bridgestream

Oracle's acquisition spree continued this month with the purchase of Bridgestream, the leading provider of business role automation solutions.

Role-based access to systems and information is a well understood security paradigm. Importantly, Bridgestream extended the ability of identity access management (IDAM) solutions to map to the complex, ever-changing business relationships that exist within a department, within a division and across the extended enterprise.

Role based automation enables fast, accurate and real-time information about role-based authorizations and enables organizational changes to seamlessly flow through to production IDAM solutions. Modeling complex, ever-changing enterprises via the Bridgestream solution enhances security, improves compliance, and reduces IT costs. The acquisition complements the earlier purchase of Oblix and further pushes Oracle into the security market.

Hummer Winblad's Mitchell Kertzman co-led Bridgestream's A round and congratulations to Mark Tice, CEO, the Bridgestream team, and the Board on a great outcome.

Starmine Acquired by Reuters

Congratulations to Joe Gatto, CEO and founder, and the Starmine team on their sale to Reuters.

Hummer Winblad led Starmine's A round in 1999 with John Hummer serving on the Board.

Starmine is a powerful example of actionable analytics adding value on top of readily available data- the company's algorithms provide independent ratings of securities analysts around the globe by measuring their stock-picking performance and the accuracy of their earnings forecasts.

StarMine helps professional investors extract more value from broker research and fundamental equity data in less time by identifying the analysts that add value, forecasting potential earnings surprises and shortfalls, evaluating earnings quality, and alerting investors to the most important developments on stocks they follow.

Given the Wall St research shenanigans uncovered in the dot com bust and the recent failing of the credit rating agencies in the sub prime mess, it is more important than ever that effective analytics exist as a check and balance against either incompetence and/or malfeasance.

Congratulations to Reuters and Starmine on a great deal.

Influence - The Psychology of Persuasion

I recently read Robert Cialdini's wonderful book, Influence, The Psychology of Persuasion.

Cialdini is an experimental psychologist who studies the psychology of compliance, or why people say yes. In the book, he identifies six universal principles of influence, the psychology behind their effectiveness, and how we are eerily hardwired to succumb to their effect.

The six principles are:

1. reciprocation
1. securing compliance from people can be greatly increased by doing them a "favor," whether they ask for it, like it, etc or not...the simple act of a gift triggers an obligation to comply, within reason, to the gift giver's request
   
2. commitment and consistency
1. we have a nearly obsessive desire to be and to appear to be consistent with what we have already committed to. Once we have taken a stand and made a choice, we behave in ways that justify our earlier decision and commitment.
2. The desire to be seen as consistent holds even when the cost, value, state of the original commitment evolves or changes
3. Public verbal or written commitments drive intense desires to comply
   
3. social proof
1. we tend to determine what is correct, or not, by what other people think is correct
2. this proof is most powerful with people of our own age and background
4. liking
1. we tend to say yes to people we like
2. research shows we say yes to people who are good looking, feed us, who we are friends with, are famous, etc
   
3. Tupperware uses friends to sell to other friends --the success rate is amazing as people simply cannot say no to people they are close to
   
4. this is also why referrals from friends work - think about the difference in efficacy in trying to set up a sales call or pitch through a friend of the target rather than directly
5. authority
1. we feel a deep-seated sense of duty to authority figures
2. see Milgram's reserach which measured the willingness of study participants to obey an authority figure who instructed them to perform acts that conflicted with their personal conscience
3. titles, uniforms, clothes, offices reinforce authority and lead to almost universal compliance, even to requests that conflict with our values and conscience
   
6. scarcity
1. opportunities seem more valuable to us when their availability is limited
2. people appear to be more motivated by the thought of losing something than by the thought of gaining something of equal value - stressing loss versus gain is instrumental in positive response rate and compliance
3. deadlines, limited supplies, the cost of being left out
   

A core thesis of the book is that we rely on automated cues and heuristics to make decisions in a world too complex, busy, and fast to ever truly think through every decision.

Smart marketers and con men know that we leverage rules of decision making to streamline our choices and actions - by understanding the core principles of compliance and the psychology that drives automated responses we can vastly improve response rates.

While we all "know" these principles exist and none are radically new, the level of his analysis in understanding why they work is powerful indeed. It is definitely worth reading - both to apply in life and to use in order to defend yourself from marketers and others who are masters in using them to get you to OBEY!

Company Culture and Politics - Survival of the Savvy

Business school alums often come back to campus and tell students that Organizational behavior proved to be the most valuable course(s) they took. When I studied at Kellogg, I never understood why.

I often meet with people who ruefully state, "my company is too political;" "there is no transparency where I work, things happen, people come and go, and no one knows why;" "I don't understand how decisions get made, things seem so random."

Politics, as we all know, is not something that just happens in Washington DC. All companies, be they start-ups or GM, are political. Politics are informal, unofficial, and sometimes behind-the-scenes efforts to sell ideas, influence an organization, increase power, and achieve other targeted objectives.

Politics have a truly pejorative connotation and being accused of being a political animal is most often meant to be an insult. Since I left business school in 1999, however, I have come to appreciate the fact that to ignore the realities of organizational life and decision making is certain to reduce your effectiveness and influence at work. I believe people often join start-ups to escape the crushing politics of large companies. The reality is that organizational politics are a constant, while start-ups may be lower on the political spectrum/continuum than larger companies, they remain organizations populated by people.

I recently read a book that provided a model with respect to understanding the organizational political continuum. The book, Survival of the Savvy, argues there are two contrasting styles and hence models of people and companies.

The first model is idea-centric. Idea-centric people and companies are driven by the power of an idea. They view power as residing in facts, logic, analysis, and innovation. These companies are often flat, meritocracies where the best ideas win and the way to win is to make the most cogent, objectively correct arguments. These people believe in substance, in doing the right (logically speaking) thing, open agendas and transparency, and the belief that ideas speak for themselves. Ie, if the ideas are well stated, why wouldn't someone agree? I fall into this camp and often believe that if I make a logically consistent argument (ie axiomatic) then it should be clear what to do.

The second model is person-centric. Person-centric people and companies are driven by the power of hierarchy. The merit of an idea is not driven by the cogency of the logic but by the power, position, and political support for the speaker. In this world, ideas definitely do not speak for themselves, but rather image and the perception of support (who supports this, what does the VP/CEO, etc think about it).

In these companies, people often don't do what's right but rather what works. Decisions, given they are not based on logic, are far from transparent and meetings are fait accomplis rather than opportunities for genuine discussion and feedback. Relationships drive support, not ideas and merit appears to lose out to coalitions and sponsorship. Loyalty, alliances, and working the system outweigh doing whats right and trusting the system to pick the "best" outcome.

In my experience, companies land somewhere along a continuum of the two models. The challenge for all of us is to understand the type of company we work in and what style we will need to adopt to be successful, or rather to quit and leave. Often the most frustrated people are idea-centric people working in people-centric companies who simply don't realize it and cannot understand why their brilliant ideas find no support or traction.

We owe it to ourselves to be self-aware. I believe this is the message the alums were bringing to students - don't be naive, calibrate your company's culture and style, and recognize that merit alone, unfortunately, is often not enough to get things done. The key is to always maintain integrity, avoid ugly ethical compromises, while working within the political constraints of your employer.

Star Analytics Raises Series A

Last week, Lightspeed Venture Partners and Hummer Winblad announced the Series A funding of Star Analytics, a provider of financial data management solutions.

Star provides ETL software designed to bridge multi-dimensional and relational data and applications.

The company boasts 16 enterprise customers across key verticals and the A round represents the first paid-in-capital. The team is led by early members of the Hyperion team, also backed by Hummer Winblad.

The investment thesis is clear and the product offering unique relative a large pain point.

Pain Point in Market

1) Fortune 500 companies deploy OLAP-based planning and reporting applications (Hyperion, Cognos, and Business Objects)

2) Data in cubes is A) in proprietary data formats and B) is often largely dynamic (i.e. not persisted)

3) Access to the data requires the use of native client applications from said vendors

4) Corporate America is deploying standard, relational reporting and analytics applications for KPI, BPM, and financial reporting

5) Currently, these applications (Crystal, MicroStrategy, ORCL, SAP, MSFT) are not able to query or view the data trapped in cubes

6) Current solution involves professional services dollars to map OLAP to star schema data structures

Core Product

1) Extracts OLAP data into standard tables (data, metadata, security access controls)

2) Captures dynamic (non persisted) data

3) Manages synchronization – delta’s flagged and continuously exported to maintain consistency between source (OLAP) and target (RDBMS)

As enterprises seek to break data silos and ensure corporate wide access to unified and accurate data, barriers such as data structure, data source, and proprietary interfaces frustrate that goal.

Star breaks the shackles of proprietary data formats, connectivity, and unshared calculations and consolidations and allows for key financial data to by syndicated to business users and processes across the enterprise.

Congratulations to the team.

Competitive Strategy: Play to Your Strengths

Fighting battles that leverage your assets and competitive position rather than your competitors is common sense.

Too often, however, underdogs choose to compete with the market leader on the leader's terms; ie mimicking their strategy and business practices. Rather than seeking to shift the terms of the battle, companies seek to match the products, pricing, and delivery best practices of the industry leader. Think MSFT's current strategy vs Google - ie let's out Google them by focusing on search and text advertising.

The WSJ recently ran a great article on HP's PC business and its battle with Dell.

The article focuses on HP's new PC chief, Todd Bradley, and his decision to change the battlefield and basis of competition.

Prior to Bradley's arrival, HP took on Dell at their own game; HP focused its efforts on battling Dell in direct sales over the Internet and phone.

Bradley's epiphany was to realize that fighting Dell on their terms put HP at a disadvantage and that the HP should instead focus on its core assets, namely the retail channel and retail stores.

A quick inventory found that HP's obsession with Dell's online advantage had left the core retail channel under served and under utilized. Bradley's audit of the channel found HP lacking in on-time shipments to retail, shoddy retail and wholesale account management, and poor supply chain controls.

He actively courted large retailers and committed HP to on-time channel shipments, improved account management, and marketing and product design campaigns to help retailers market the in-store buying experience and custom product offerings.

In one year, HP's market share grew from 14.9% to 17.6%, while Dell from 16.4% to 13.9%. In-store PC purchases went from 54% to 61% over two years.

I found the article compelling and an excellent reminder that head-on competition with market leaders will likely lead to large losses and that it pays to play to your strengths rather than theirs.

You Owe it to Yourself

This summer buy and read Woody Allen's The Insanity Defense: The Complete Prose.

You will laugh out loud at least once a page.

The Insanity Defense: The Complete Prose

Be careful reading it on a plane. The passengers may start to worry.

Widgetbox and Forbes.com

Widgetbox, a Humwin portfolio company, announced today a partnership with Forbes.com

Widgetbox will distribute Forbes content and advertising via eight initial widgets all sponsored by Visa.

The atomization of the web is underway and media companies and advertisers are looking to distribute content, application functionality, and advertising to social media and web site end points. The Forbes widgets are a powerful example of a major advertiser, Visa, and content publisher, Forbes, recognizing the power of widgets to reach a distributed audience.

The widgets can be found here and I include an example below.

Congratulations to Widgetbox and Forbes.com on a great launch.

3M: Six Sigma vs Innovation

Innovation is the lifeblood of Silicon Valley. Technological and business model disruptions drive the cycle of category, company, and wealth creation.

Innovation often leads to high growth and growth often demands the introduction of processes to ensure quality and scale.

There is, however, an obvious tension between innovation and process, between standardization and disruption. How does a company best manage that tension and avoid the extremes of creative anarchy vs bureaucratic and rigid process?

Companies that optimize for scale often begin to look like eBay - a monolithic app that is always up but still looks the same five years later. While companies that optimize for creativity, like Handspring, stumble with quality and return issues.

BusinessWeek recently profiled the impact of process, via Six Sigma, on innovation in an article on 3M. In 2000, 3M hired Jim McNerney from GE and introduced a total quality management initiative designed to lower costs and drive efficiencies. The company cut 8,000 jobs, operating margins grew from 17 to 23%, and thousands of Six Sigma black belts were trained and turned loose on the company. The short term gains proved popular with Wall St, however, longer term cracks began to appear.

Historically, 3M prided itself of delivering 1/3 of its sales from products introduced over the last five years. Under the Six Sigma regime, however, the ratio of revenue from new products fell to 1/4 and the company lost its creative edge.

The article notes, "while process excellence demands precision, consistency, and repetition, innovation calls for variation, failure, and serendipity."

At Hummer Winblad, we believe that founders are the key creative sparks that drive innovation and vision.

A business school framework defines three classes of company: operational excellence, customer intimacy, and product leadership. VC-backed companies typically succeed via a focus on either customer intimacy or product leadership. Senior executive hires that seek to optimize operational excellence too early in the company's development tend to lead to frustrated engineers and a rigidity that eliminates the chance to innovate. The absence of innovation in a company with few customers or product offerings is an almost certain predictor of failure.

Ideally, our founder-CEOs add a wrapper of operational excellence to their core focus on product leadership and innovation. Rather than move founders to CTO roles and bring in "grey" hair CEOs to drive process-led execution, we would rather see the founder as CEO, infusing the culture and product with their passion and creativity while learning the "tools" of the management trade.

Process, moreover, can be brought in at the VP level to compliment innovation and to help institute best practices that help with visibility and predictability while working to avoid hindering creativity and a culture of trial and iteration.

In summary, it is hard to balance innovation and process, however, in early stage companies innovation is a prerequisite to success. Accordingly, it is often very dangerous to move company founders to staff roles and to hire senior executives with operational depth but little emotional or intrinsic connection to the product market and problem.

Just as it is hard to Six Sigma your way to innovation, it is hard to execute your way to disruption.

Food for Thought: Target Post Money Valuations and Capital Structure

Jeremy and Josh's thoughts on valuation are well worth reading.

Not only should founders be mindful of valuation issues, but also need to be thoughtful about capital structure and shareholder mix.

Venture capital is often described as a business of pattern recognition - experienced investors pick up on market patterns, management team dynamics, and seemingly random data points to draw powerful insights. While I am still relatively new to the industry, I am struck by a few capital structure patterns that are generally bad omens.

The Too Large "A" Round
Ideal company formation reminds me of agile programming - small teams driving quick, iterative cycles that allow for the most insights, appropriate changes in strategy, and, ultimately, the highest quality "product."

I often say that genius is a function of context, and until a company is fully immersed in the context of the given problem set the best insights and strategies are often not apparent.

Too much money too early and too many people too early interferes with the productive process of iteration. Large teams with lots of resources and a very uncertain sense of direction or purpose are a bad combination.

Too High "A" Round Post-Money Valuations
While a self-serving argument, an equally challenging problem is a too high "A" round post-money. High "A" round valuations are often Pyrrhic victories.

High posts and middling execution often leaves a company in a grey zone whereby objective value creating milestones have not been clearly met, yet some qualitative progress has been made. A common result of such a financing is a bridge round that extends the runway and is designed to allow the company a quarter or two to "grow" into its post-money "A" round valuation. More often than not, the bridge becomes a pier and the company and founders suffer from a post-money that proved you can win the battle and lose the war because of it.

"A" round financing strategies should be tied to discrete logic tests and proofs and the goal should be to optimize the validation/dollars ratio. Can we validate the technology and business model on as little as capital as possible? The ratio forces founders to think through the material questions that need to be answered with the use of proceeds. Will the product work? Will customers buy it? Can we sell it? If so, how? How much do we need, with a slight cushion, to answer these questions? Given all the noise in a start-up, what are the real issues and risks we need to manage?

The validation/dollars ratio is a measure of efficiency and a quasi measure of return on equity. Start-ups that maximize the ratio are generally rewarded for it.

A reasonable Series "A" raise and post-money combined with realized value-creating milestones generally leaves a company in an enviable position when raising the Series " B". The key hypotheses have been validated and a reasonable mark-up is possible.

To that end, Fewnwick's recent report on trends in venture capital reported that the median valuations for A-D rounds were $5m, $12m, $23.5m, and $41.71m respectively.

Patterns and data suggest that for software companies an $8-10m "A" post appears to maximize the probability of a healthy B round and good optics and pattern recognition.

Debtor Nation

This month's Harvard Magazine includes a great article on the implications of America's current account deficit and negative savings rate.

The article addresses a key question - how much longer can the US continue to consume more than it earns? And equally importantly, how much longer will other nations continue to provide the US access to cheap capital by buying US Treasuries and holding US dollar reserves?

The long term fear is that a move away from US dollar reserves, ex. to Euros, will lead to a depreciated dollar, negative impact on US consumer purchasing power, and a rise in interest rates to attract capital back to the US.

The opening paragraph outlines the scope of the problem:

"In 2006, the infusion of foreign cash required to close the gap between American incomes and consumption reached nearly 7 percent of gross domestic product (GDP), leaving the United States with a deficit in its current account (an annual measure of capital flows to and from the rest of the world) of more than $850 billion. In other words, the quantity of goods and services that Americans consumed last year in excess of what we produced was close to the entire annual output of Brazil. “Brazil is the tenth largest economy on the planet,” points out Laura Alfaro, an associate professor of business administration who teaches a class on the current account deficit at Harvard Business School (HBS). “That is what the U.S. is eating up every year—a Brazil or a Mexico.”

As investors, entrepreneurs, and technologists, we have a vital interest in positive net savings rates that allow for investment in the future rather than debt service payments to cover historical obligations and spending.

If Gross Domestic Investment = Private Saving + Government Saving + Foreign Saving, then the low rate of private and government savings demands that we import capital. Future growth is conditional on investment in infrastructure, education, and health care. However, we as a nation are no longer saving; thereby forcing us to borrow abroad to fund our consumption and investment.

The key concerns are

1) that the debt service associated with the current borrowings drowns out the ability for net new investment or
2) foreigners stop providing us cheap capital and dollars available for investment (and hence growth) are limited.

It will be interesting to see how quickly the current account deficit becomes part of the public policy discourse and how politicians will wrestle with the enormity of the problem and complexity of the issues involved.

JavaScript-Enabled Services, SaaS, and Open Source: Friction Free Models that Drive the Reallocation of Capital

What do JavaScript-enabled services, SaaS, and Open Source all have in common?

They are product delivery models that dramatically reduce the cost, time, and resource requirements to test products and their purported value.

The risk to trial is mitigated and individual users can experiment and validate value in isolation of the broader enterprise.

More than ever, companies that focus on reducing the risk and resources required to trial their product or service are outperforming "heavy" footprint product companies.

The capital markets are highly efficient and dollars quickly flow to the highest yielding assets. IT markets, however, are characterized by high degrees of friction that artificially limit capital reallocation and flow.

Typical IT frictions include: required asset requisitions, proprietary interfaces, multi-department decision making, multi-level budget approvals, lack of connectivity, lack of resource and expertise, and behavioral inertia.

It truly pays to ask what are the exogenous barriers that artificially limit value testing and access.

Today's fastest growing companies seek to optimize two core things:

1) friction free adoption and
2) hard "value per unit" analysis; such as price per click, price per CPU, price per seat.

Capital flows to the highest yielding assets.

Once economic actors are able to validate the "value per unit," the dollars will flow:

• at a rate proportional to the relative increase in yield (value/cost) from product A to product B and
  
• at a rate inversely proportionate to the number of barriers that limit the free flow of capital to product B (the higher the # of frictions, the slower the reallocation to the economically advantaged unit of value).

In summary:

• market are efficient and capital flows to the highest yield assets
• products that provide a higher yield (value/cost) will attract capital
• ex. cost per action, cost per seat, cost per CPU
• product delivery models that reduce frictions will see faster capital allocation
• efficient product test, validation, and delivery mechanisms stimulate capital flows
• equity value creation is a function of the amount of total capital at risk and the rate of reallocation from one class of assets to the next
• ex. total capital at risk = total ad spend market
• ex. "value unit" = cost per sale
• ex. "yield" comparison = $100 sale/$2 cost per click= 50x vs $100 sale/$15 per telesales call = 6.66x, or 7.5x differential in yield
  
• ex. "friction" = JavaScript implementation of AdSense vs setting up telesales trial

In designing a start-up's strategy, outline:

• the targeted pool of capital
• the economic unit of value in question
• the differential in yield from model A to model B per given unit of value
• barriers to capital reallocation from model A to model B
• barriers that protect model B from replication
  

IRR Multiplication Table

The attached IRR Multiplication Table is a very useful reference tool.

The data table calculates IRR by years (x-axis) and multiple (y-axis).

Dan O'Keefe, who I worked with at Pequot Ventures is the brains behind the spreadsheet. I suggest printing it out and keeping it by your desk.

When you are on the phone you can impress your friends/boss by quickly reeling off the IRR on a 5x over 5 years (38%), 10x over 6 years (46.8%), 3x over 3 years (44.2%) etc.