Honey, I Shrunk the Startups, Part II

A few comments about Dave McClure’s Sunday post encouraging entrepreneurs under 30 to sell at the earliest opportunity, from someone who was a founder under 30. I won’t go into the full rant, since I already wrote that last year, but can’t help but comment on a few of Dave’s claims. (Dave already knows I adore his writing style — Dave, I was just telling my twin brother this morning that I wished I had your voice — even if we disagree here.)

1. “Once you have a deal under your belt — whether it’s a $3M deal, a $30M deal, or a $300M deal, you are bankable.  People will bet on you again.” Ideas, not capital, are scarce. Selling a good company so that one you haven’t even thought of yet will be bankable — that is madness. Aaron Patzer — and anyone else in his position — was bankable well before he sold his company.

2. “And for the young entrepreneur — particularly those under 30 who’ve never done it before — the single best thing you can do to ensure your future success is TO GET A DEAL DONE.” Saying it is especially good for young entrepreneurs to sell their company is especially wrong. Entrepreneurs “who’ve never done it before” don’t need a farm system, or training wheels, or a practice run. Almost every great company (Amazon, Apple, Dell, Ebay, Google, Microsoft, Oracle, Yahoo!, PayPal, Facebook) was started by someone 30 or under. Your best idea usually comes before you’re 30.  Your ability to take risks is highest before you’re 30. In my experience, second-timers have a higher success rate because they are pragmatic and savvy about building a company for an exit, but the magnitude of success is highest among first-timers. If first-timers don’t create public companies, nobody will.

3. “Playing well sometimes means you take a single or a double instead of getting thrown out trying to steal home.” This talk of “swinging for the fences” and “striking out” or “getting thrown out at home” seems like a scare tactic. The difference between software and baseball is that you can swing for the fences and miss, and then just go back to second base. With the exception of Pointcast in 1997, which startup has gotten to the point where a lucrative acquisition is possible, decided to try building the business further, only to discover that there is no longer an exit at all? The company I co-founded, Plumtree Software, turned down seven acquisition offers before going public and accepting our eighth offer. What once made it hard for young people to hold out was their need for cash, but now most successful companies give the founders an opportunity to sell part of their stake early.

4. “Why is it that no one seems to think switching jobs every 3-5 years is a bad thing, but somehow think that selling your business to someone who really wants it and will grow it isn’t terrific?” Selling your business and switching jobs are totally different; anyone who has started a company knows that; you know that.  The idea that every entrepreneur is a serial entrepreneur, who can think of a new startup as easily as getting a gallon of milk from the store or finding a job at Kinkos, is a fiction we use to persuade ourselves that we’ll easily get another shot at greatness. It isn’t that simple. Ask Max Levchin, who seems to have gone through a Great Night of the Soul before founding a maker of Facebook applications, Slide. Just ask Aaron Patzer in five years. I don’t know Aaron and certainly wouldn’t want to bet against him, but if he makes as much money or has as much fun building his next startup as he did this one, he will have beaten some major odds. If I had been his adviser, I’d have helped him do whatever he wants — just as you did — but I also would have told him to keep having fun if he still believed in Mint. I think entrepreneurs need to hear that, too (for the record, I love Redfin as much as Plumtree, and Redfin may get bigger than Plumtree too, but this was a lucky break).

5. “More transactions of any kind or size help improve overall startup ecosystem health.” It is an interesting argument that small-scale transactions create liquidity and transparency, but surely public companies do that best. More to the point, Google, Microsoft and Amazon can’t buy every startup, particularly since many of their recent acquisitions haven’t been accretive. Without new venture-backed companies maturing into public companies, the total amount of capital available to fund innovation will decrease.

And the rest I agree with. It is outrageous baloney that anyone pressured Aaron Patzer to sell Mint. And there are plenty of startups that should sell when they can, for reasons both rational and admirable. But telling young entrepreneurs that they’re not ready to be a Jedi yet, just because they’re young — that just isn’t the Dave I know and love…

Update: a comment notes that the original Jason Fried essay never said that Aaron Patzer was pressured or forced into selling Mint. Jason just said that there’s an environment that made it easier for Aaron Patzer to sell, a point to which I am at least sympathetic. Jason, I just read your essay more carefully, and see that this comment is correct.  If you read what we’ve written earlier on the topic, you’ll see that we agree even more than I had originally realized.

It’s Silly to Judge Venture Capitalists Only By How Much They Spend

I was just about to go to bed when I saw Sarah Lacy on TechCrunch predicting that a 50% drop in venture capital investing last quarter signals the beginning of the end of the industry’s golden age. True to TechCrunch form, it was an eye-opener.

And we share some of her concerns. A few weeks ago, we wrote that “the money in the start-up economy today is like the water in a hose whose faucet was just turned off,” with investors in venture funds at one end of the hose, and startups at the other. Last September, we argued that what was really scary about the lack of public offerings or even accretive acquisitions was that nobody was scared.

But in some ways we are more hopeful now than Sarah. The 50% drop that Sarah takes as the starting point for her argument that venture capitalists are “falling off a cliff” is worrisome for startups looking for good valuations, but not necessarily worrisome for venture capitalists. The drop in dollars invested reflects a few trends that Sarah doesn’t account for:

1. Most startups this winter suffered a major dip in revenues as businesses and consumers stopped spending, and ad rates plummeted through the floor. As an entrepreneur, the last thing you want to do while your P&L is getting trashed is raise money. Every CEO I know who was considering raising a round put it off unless there was no way to avoid it. The only companies that were raising capital were the ones who had no choice.
2. Valuations were much lower, so dollars invested were lower too. But no venture capitalist objects to getting a good price. You don’t judge a trip to the grocery by what you spent, but by what you got. So a better measure of the VC industry would be the number of deals done, and the amount of equity purchased.

And this is where Sarah’s essay didn’t ring true, at least for me. The VCs I know are as interested as ever in deal flow, and eager for a big hit. They still have plenty of capital to deploy, and happily anticipate fire-sale valuations. (Update: Bernard Lunn at Read-Write-Web has the same observations based on first-hand interviews with VCs and entrepreneurs.)

The reason I write this is not to defend venture capitalists: there may well be too many venture firms, with bloated fund sizes driven by management fees rather than returns. But just as it was crazy for venture funds to measure themselves by the dollar volume of their funds rather than the amount of money they could really put to work, so now it’s crazy for Sarah to judge the venture industry by the dollar volume of its investments.

In fact, rather than seeing this decline as the problem in venture capital, I think it’s the solution. Less money more selectively invested into high-quality companies will lead to better returns.

So where are all the high-quality companies? That’s the real question behind Sarah’s essay. When she says there is “no obvious high-growth sector of the tech economy,” what she is really saying is not simply that there are too many venture capitalists but there’s nothing left for them to invest in.

Reading all the media coverage this week about Ashton Kutcher and Oprah Winfrey on Twitter, it would be easy to believe we’re at the end of our days. But last I checked, the global economy collapsed because we didn’t have the right information about what financial assets were worth. Doctors still have no way to know what treatments a patient received before showing up in their office, and the human genome has become too complicated for the current generation of computers to track. In our corner of the world, real estate is still pretty screwed up too. Business as usual won’t solve these problems. Startups armed with new technologies will.

The challenge will be focusing our time, energy and money on these important problems, which so far the Web 2.0 movement hasn’t always cared about as much as kicking the crap out of one moribund industry, newspapers, over and over again.

We talk about the dot-com era as our greatest folly in Silicon Valley. But at least back then, startups tried to do something big: criss-crossing the country with Internet fiber, putting a computer on every office desk and in every house, changing how consumer bought almost everything and how businesses manufactured almost everything, too.

If we get back to the big stuff, the world will be a lot better, and VCs will do just fine.

(Photo credit: Bikeracer on Flickr)

Begging and Choosing

Fred Wilson talked the other day about the importance of choosing a group of venture capitalists who like working together. It reminded me of how much I like our investors: Paul Goodrich from Madrona Capital, Marc Singer from BEV, Emily Melton from DFJ and Steve Hall from Vulcan.

When I first got involved in raising money for my last employer, Plumtree, I looked at a venture capitalist the way Wiley E. Coyote looked at the Roadrunner, as a mirage of drumsticks and chicken wings, garnished with a sprig of parsley. Assessing an investor for his advisory ability seemed like asking about a heart surgeon’s personality before getting a triple bypass; it was hard to think beyond the cash we needed for our survival.

Ten years later, raising money for Redfin has often still been a gambit — our last effort was in 2007, and it wasn’t as easy as we thought it would be — but what made it easier was that we had convinced ourselves we really were evaluating each investor too.

Of course, it isn’t always possible to choose your investors. Beggars can’t be choosers, and all of us unprofitable companies are beggars. But my point is that approaching money-raising as a choice actually makes you a better beggar. Nobody likes being sold to, but everybody likes being chosen.

I still read tweets and blogs about how to make a VC moan with pleasure or lose his mind or do whatever he is supposed to do, but a VC relationship is more of a marriage than a one-night stand. Yes, you need a mission statement that fits on the back of a business card, a snapshot of your financials and the blue-bottle magic of an insanely great demo — which I have to admit should have the intensity, the lack of antecedent, the awkardness and brevity of teenage sex.

But after that it seems obvious that you just want to have a conversation about the business. PowerPoint, an evil system of command and control that turns one person into an unstoppable bore and the rest of us into zombies, is responsible for billions of dollars in lost valuations.

And if you aren’t asking as many questions as the investors are, you can fall into becoming a performing monkey, skimpering down Sand Hill Road from one meeting to the next with the same song and dance. Ideally, raising money is more like traveling to alien planets in a densely clustered solar system, where you encounter very smart creatures who have no idea what your world is like, but ask you questions that make you wish it were better.

It has been so long since Redfin has raised money that I worry we’ve lost touch with an important source of ideas and information. I still remember the questions from last time: why doesn’t Redfin charge users for premium access? Have you looked at how Yelp encourages users to compliment one another’s reviews? Why aren’t you offering mortgages? I try to answer every question with “yes,” “no,” a number, or “I don’t know.” For the best questions, the answer is usually “I don’t know.”

But you also need to have questions of your own. Here are some of my faves:

1. How do you see our market changing over the next few years? Your investor has to develop her own ideas about your business sooner or later. At this early stage, this question is mostly an IQ test.
2. When times have gotten tough for your portfolio companies, how have you helped them out? Anybody can get lucky with an investment that takes off like a rocket; all you have to do is hang on for dear life. A VC’s true measure is how she gets all her other companies pointed in the right direction.
3. Who are your favorite entrepreneurs? Some people genuinely like entrepreneurs, notwithstanding their volatility and constant intellectual jousting. Most people fake it. If the investors’ fave five is composed of people she hasn’t worked with, she’s faking it.

It’s a fun process. Yes, when really smart people get to know everything about you in a very workmanlike way and then pass by the dozen, it becomes a self-esteem destruction machine. But mostly, it’s fun. Every entrepreneur I know secretly loves the WSoP-stakes game of raising money: the marbled lobbies and green courtyards, the bountiful assistants bearing glasses of ice-water are so much nicer than our grubby little offices.

What I don’t understand is why entrepreneurs only love venture capitalists until they give us money. As someone who always hated rich people and people in authority, I remember as a younger co-founder being shocked at how the grown-ups at Plumtree spoke respectfully of our board. I kept waiting for them to take off the rubber masks of their own faces and say, “just kidding, we hate them too.” So maybe now you’re waiting for me take off my rubber mask.

But back then, I just wanted to build good software and market it straight down the world’s throat. Now that I feel responsibility for other parts of the business, I need more help. This fall, despondent about our layoff, I really needed help.

Sooner or later, you will too. You’ll feel all alone in whatever you’re trying to do, and you’ll need advice. If you’re really in a jam, you won’t even be able to ask normal people for advice, because the situation is so bad you don’t want anyone to know about it. Your friends will listen to your better-than-it-really-is situation assessment while browsing the web or yelling at their kids, and then tell you what you want to hear: that the situation is better than it really is, that your board is wrong and you are right. If you already know what to do and just haven’t done it yet, this feels great. If not, it makes you feel more alone.

This is why it’s a good idea to at least try to choose your VCs, instead of just begging to be chosen by them. I almost didn’t write anything about recruiting and choosing VCs because I am so bad at talking to them — at a climactic meeting with an entire firm a few years ago, I opened the presentation by asking if the firm had ever made any Seattle investments, whereupon a senior partner gently reminded me that he was the first venture capitalist to invest in Microsoft — but the one real lesson I’ve been able to glean from the whole experience is that being a better chooser makes you a better beggar.

(photo credit: D.James | Darren J. Ryan)

A Free Call Option on the American Economy

This is an essay arguing that some of the same forces driving Wall Street have affected Sand Hill Road, so that entrepreneurs try to make money without worrying about losing it.

From the backseat’s darkness, the hedge fund manager wasn’t talking to anyone in particular, and didn’t seem to notice no one could understand much of what he said. The Christmas party ended late, and we were giving him a ride to his hotel.

He wasn’t sure when the economy would recover. He wasn’t sure if America would recover. “But,” he said, “it has been a good ride. All these years I’ve basically had a free call option on the American economy.”

We Are All Hedge Fund Managers
I explained to my wife, a doctor, that a call option lets you profit from a stock if it goes up, without actually owning the stock if it drops: hedge fund managers share in the fund’s gains but not its losses. I looked at her as if this was quite a trick. “But,” she said, “aren’t all of you paid in options too?”

It took a moment to realize she was right. Venture capitalists take 20% or more of their fund’s gains, but few risk much of their own money in a loss. At startups, entrepreneurs and executives don’t usually own stock, at least not any they can sell, but options to profit from the stock if the company is bought or goes public. Little if any of the money invested in a startup comes from the entrepreneur.

The hedge fund manager, the venture capitalist, the entrepreneur, the executive are, in this respect, not so different: we are paid to make money, not to avoid losing money. Heads we win alongside the investor; tails, only the investor loses. Who wouldn’t keep raising the stakes in a game like that?

The Ownership Society Becomes The Risk Society
This may be the final irony of President Bush’s efforts to create “an ownership society”: that it often resulted in an ownership-free society, where the leverage to risk others’ assets was more powerful than owning the actual asset. The triumph of leverage over credit is a big reason why markets have become so much more volatile than they once were.

But it wasn’t always this way. Remember the rage of Wall Street’s Gordon Gekko – the symbol of a different era’s greed — when he lost millions on Bluestar Airlines? He smashed his coffee table. As he explained the first time he met Bud Fox, “nothing ruins my day like losses.” Now imagine what kind of unchained creature Gekko would be in the world we have now, where the money he lost wasn’t his own?

For Michael Lewis, the former Salomon trader who profiled a real-life Gekko in his 1989 book Liar’s Poker, today’s meltdown of the financial system is primarily the result of the major banks, all investor-owned by 1999, insulating management from their losses. “No investment bank owned by its employees,” Lewis wrote last month, “would have levered itself 35 to 1.”

We could ask a similar question of startups. If we were funded and controlled by employees, how many would take the risks – or the losses – most startups take today? Who would sign up to generate revenues of $100 million in 5 years?

But that is exactly what a company raising venture capital must do. The first pre-requisite for getting venture capital is a willingness to invest it in a way that must seem reckless to traditional businesses.

One Reckless Company Ruins the Whole Barrel
And once one company in an industry is reckless, we all have to be reckless. Just look at the world in which my company, Redfin, competes. The two startups that in 2005 launched map-driven real estate websites similar to Redfin’s have raised, between them, over $75 million more than Redfin’s $20 million. Whenever I worry about the crazy risks we’ll have to take to earn back our $20 million, I think, “But those guys, now they’re crazy.” (They’re also very good).

Without the pressure from other, better-funded startups, we wouldn’t open a new market until the last one was profitable. We would spend less on research & development so we could reach break-even sooner. We wouldn’t worry about marketing at all. We’d be more likely to survive, albeit on a more modest scale.

To the Pain
But the truth is, I’m not a very modest person, and neither are the many talented people we’ve assembled at Redfin. The VCs aren’t twisting our arms to take risks; they’re letting us do what we wanted to do anyway.

You can’t assemble an army of Turks without marching it out to a huge battle; the army gets restless. I should know: for two years, the dot-com crash left my last company struggling to grow beyond $1 or $2 million in quarterly profits and still waiting to go public.

My old friend and colleague John Hogan would see me in the hallways and ask, “To the death?” “No!” I’d say, in a reference to the prolonged, mutilated existence promised to a villain in Princess Bride. “To the pain.”

What we worried about wasn’t that our company would fail, but that it would take too long to succeed.

Every Startup is a Time Bomb
A lot of startups now find themselves in the same unwilling suspension of disbelief. Every startup is a time-bomb, where all the ingredients of hope, sacrifice and brains can mix for only so long before self-destructing. The best employees are gone well before the money runs out. Redfin, which raised money three years ago, has already used up half its time.

Now that a downturn has focused everyone on survival, everyone is criticizing the unnatural haste — the artificially stimulated appetite for risk — that characterized the way we were only a few months ago. In fact, the whole idea of venture capital – of using other people’s money to build a startup with highly uncertain prospects – has now come into question.

I’ve been on that bandwagon. In a recent essay on how to survive the downturn, my main advice was to act like an owner. And yesterday, while I was putting the finishing touches on this essay, Fred Wilson published a post on spending money like an owner. It was good advice.

But it stopped short of the conclusion I thought Fred was heading for: that entrepreneurs should, as much as possible, start a company with their own money. Because no matter what you tell yourself, there is a big difference between spending money like it’s your own and actually spending your own money.

Mammals and Reptiles
I’ve worked at self-funded companies, and sat on the board of a largely self-funded company. The difference in how it feels is as vast as the gulf between reptiles and mammals: the one with an untrammeled ability to survive, the other capable of long-term thinking.  Both of the self-funded companies were bought for a price that gave the founders a nice return but neither could ever bring itself to take the risks necessary to grow into a huge, stand-alone business.

(Much of the way I am now grew from watching a company smaller than my first employer, worse than us in many ways, grow into a billion-dollar business.)

So while ownership is an important virtue, the willingness to take risks on a big idea is too. The great irony of all this is that Silicon Valley seems in this case to have understood risk better than Wall Street: a college student with a good idea and the ability to develop it has turned out to be a safer investment than many Moody’s-rated securities.

We don’t realize what a temporary historical aberration it is that there is a place and a time where people are willing to fork over millions to a penniless student. That there exists within the world’s vast plutocracy such a fragile meritocracy is still hard for me to believe.

It’s one of the only reasons I think the hedge fund manager is wrong about the economy. The party isn’t completely over. America can keep winning, but only if we’re willing to take bigger risks than the rest of the world.

Fred Wilson, Failure, Success, Blogging, Negative Capability

Everyone has been forwarding around Union Square Ventures partner Fred Wilson’s posts about how often and why his investments have failed. They are remarkable for their candor, for their argument that success depends on being able to change course quickly, and for Fred’s low failure rate (20%).

It made me wonder if the characteristics that make Fred such a compelling blogger — his willingness to think out loud, his openness to the possibility of failure, his simple enthusiasm for a dialog about ideas — also account for his success as a venture capitalist?

Maybe the essential quality of an entrepreneur or venture investor is what John Keats once called “Negative Capability,” the capacity to be “in uncertainties, Mysteries, doubts,” rather than prematurely forcing a solution to a problem. In any event, what I really like about Fred’s blog — the first I ever subscribed to — is something like his Negative Capability.

It’s very easy to trace his thinking through problems, and he’s always thinking about important problems.