AGILEVC My idle thoughts on tech startups

They say the small stuff you do to accomplish a big goal is often the most important, even if a lot of isn’t glamorous or produces very small incremental benefit.  The football analogy is blocking by the offensive line and tackling by the defense, as opposed to the more sensational touchdown pass or or diving interception or 90-yd punt return.

I generally think this is true.  A lot of successfully achieved goals are mainly the product of working hard on the “fundamentals” and nailing the small stuff.  Occasionally though there are objectives which can’t be achieved by laying a single brick at a time, over and over.  There’s some critical mass which much be achieved or other large scale gating factor that makes or breaks the outcome.

When you see these kinds of goals that can’t be accomplished by small incremental effort, it sometimes makes you question the importance of blocking & tackling.  If a Big Bang type event (e.g. spontaneous, unpredictable, and largely out of one’s control) is the only way to accomplish those goals, why bother?

But even for these, I think the small stuff still really matters.  The blocking and tackling may not be a sufficient condition, but it’s probably a necessary one.  Even if outside forces or luck or whatever is the driver behind that step function goal, you still have to put yourself in the position for it to happen.  So without doing the blocking and tackling and small incremental stuff, you’d probably never get there.

The VC industry is a competitive business.  So are most disciplines within the investing world, but the fundamental framework and manner in which we compete in VC is pretty different.

In the modern age public market investors, whether they be focused on equities (stocks), fixed income (bonds), currencies, commodities, or derivatives of these, all have access to essentially the same investment choices and the same body of information.  Even new innovations, like advanced trading systems and low-latency infrastructure deployed by high frequency traders, get diffused and democratized pretty quickly eliminating the arbitrage in the long run.  So ultimately whatever alpha exists must be generated by analysis, foresight, and clear thinking.

Even other forms of private investing (growth equity, buyouts, real estate, distressed, etc) have a pretty different competitive framework.  There are more similarities with early-stage VC than public investing, but in these asset classes you still see somewhat more uniform access to investment opportunities and less information asymmetry.  That’s because intermediaries like bankers/brokers, and even internal cold-call sourcing operations, create more standardized access to and information about potential deals.  Also these are typically more mature assets that can be analyzed and understood in broader ways than a de novo startup.

Success in early-stage VC ultimately comes down to investors’ ability to source, select, and win the best investment opportunities.

Sourcing is critical because each VC firm’s investment opportunity set is inherently unique.  Every mutual fund in the world can buy stock in any publicly traded company, but even the most respected VCs don’t see all of the “best” opportunities.  A lot of times you hear VCs talk about their sourcing in raw numbers… “we saw X opportunities in 2011 and invested in [small fraction of X]“.  But ultimately “good” dealflow is about signals – large amplitude, high signal to noise ratio, and enough strong signals on an absolute basis to build a portfolio.  You’d rather have a lot of high quality dealflow that’s relevant to your strategy (stage, sector, geography, etc) than simply winning the “we got the most business plans” award.

To illustrate what great sourcing means, let me give an analogy from the academic world.  Harvard gets more applications than pretty much any undergraduate program in the US, and they accept a small fraction (7.2%) of those folks.  Harvey Mudd on the other hand gets far fewer applicants (Harvard gets >10x more) and is less “selective” in the sense that they admit about 25% of the students that apply.  Yet Harvey Mudd’s students are incredible, and the school produces the best paid graduates of any undergrad program in the country.  College is obviously about more than just landing a well-paid job, and I’m not saying Harvey Mudd is inherently better than Harvard… they’re both great.  But sourcing the best VC deals or college applicants isn’t merely a numbers exercise.

It turns out selecting is arguably the least important of the three.  Returns in venture are driven primarily by outlier outcomes, so being a great stock-picker or paying the lowest valuations does you little good if you’re selecting from a pool of mediocre opportunities or if you’re consistently unable to win great opportunities.  As Peter Thiel used to say, there is no subprime model for VC.  I’m not saying selecting doesn’t matter… Facebook’s investors and MySpace’s investors each did well, but we all know one group did a little “more” well.  So being good at selecting is as much about having an effective process as a firm for making decisions and a well-functioning partnership to do it.

Finally, even if you source and select great opportunities you usually have to win the right to invest against other good investors.  At the end of the day, all VCs are selling expensive equity capital and despite the ongoing contraction in the industry there’s still a lot of capital out there.  How do you win?  It obviously depends who you’re competing against… at the seed stage where NextView plays, there’s a range of different types of investors (large lifecycle VC funds, seed/micro VC funds, angels, etc) so sometimes it’s an apples vs oranges choice by the entrepreneur.  Brand, both firm brand and individual partner brand, clearly matters.  Ultimately though like any selling process, enthusiastic and respected reference customers (e.g. other entrepreneurs you’ve backed) are usually the best tool for the job.

You’ll notice I didn’t include “add value post investment” in the source, select, win factors of success.  This is clearly important and something I think the best venture investors do well.   Also because the VC business is a multi-turn game, in the long run being a helpful investor in the eyes of entrepreneurs directly increases a VCs ability to source and win opportunities.  But ultimately I don’t believe it’s the key determinant of success in the same way as the others.

Source, select, win.  We think about it every day at NextView, and are continuously refining how we can get better at each of them.

Those of you who’ve visited the NextView website may have seen a Ethos section where we describe five tenets of how we approach things… Golazo, Authentic, Blank Canvas, Invited Guest, and Tribe.  I wanted to touch on ‘golazo’ as it’s my fault we use this strange verbiage, but also a critical element we look for in all the startups we invest in.

Golazo is a slang word in Spanish used to describe truly special goals scored in a soccer match.  Watch enough soccer on Telemundo or Univision and you’ll occasionally hear the commentators shout it at the top of their lungs, or just search on YouTube and you’ll get some examples.  There’s no literal translation of golazo into English, but the characteristics which distinguish a golazo from a run of the mill goal are that it’s amazing, colossal, and/or improbable in nature.

These are the same qualities we’re looking for in terms of ambition and potential scale of the startups we invest in.  As a seed-focused VC fund we invest comparatively small sums of capital at the very beginning of a startup’s life.  But everything we invest in has to have the potential to be a large, transformative business someday.  A company that in time can generate $100M+ in revenue and have an enterprise value measured in the hundreds of millions or more (what some VCs refer to as a “venture scale” outcome).  Simply put… startups that have golazo potential.

Obviously not every startup we invest in will become a golazo.  The potential for outsized investment return only comes with taking significant risk, especially when investing at the seed stage, so many of the companies we invest in will ultimately be unsuccessful.  Some may end up having more modest outcomes that product a decent return on investment, which we fully understand and are supportive of.  But for us that can’t be the goal at the outset and we try to be up front with entrepreneurs that we meet that we’re not the right investment partner if that’s what they’re looking for.

When we started NextView we wanted to describe our ethos in our own words.  Some of the elements we chose are less common concepts among VCs, but in two cases we have to tip our hats to other firms where we adopted an existing best practice.  One is striving to be an “invited guest” at the entrepreneur’s table, a notion that Greylock has both espoused and practiced for decades.  Also our ethos of golazo is conceptually similar to what Venrock describes as a “glimmer of greatness” that David picked up during his time there.

But as I said, we had to put NextView’s ethos in our own words.  I’m a complete nut about soccer… I played in my youth and have been an avid fan for many years.  I’ve been to a World Cup (South Korea 2002), gold medal Olympic soccer matches (men & women Beijing 2008), English Premier League, MLS, heck even AYSO.  Proof in point is my license plate:

So it always had to be golazo…

The interminable wait is over, and Facebook’s S-1 was filed yesterday afternoon.

I recently wrote a post noting that while the growth cycle of startups has clearly accelerated in the last 5 years, the number of truly monster new businesses (a company ultimately worth $75-100B) remains about the same… it’s a once in a decade sort of thing.  My partner Rob also wondered if Facebook is the next Yahoo!, or the next Google.  No matter what you think of Facebook’s future prospects, what Zuckerberg & Co. have built in 8 years is truly incredible.

Here’s my first look at Facebook viewed through the lens of their IPO filing.  I’ll focus for now on the business itself, there’s plenty of other info on the web if you care to understand the equity ownership or financing history of Facebook and frankly this has been fairly well known for awhile.

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Facebook, Inc.

Filing Date:  February 1, 2012

Founded:  Spring 2004, incorporated July 2004

Headquarters:  Palo Alto, CA

What They Do: Enable users to connect and share content with friends online

How They Do It: Operate a social network at Facebook.com, through Facebook’s mobile apps, and the Facebook Platform which lets other websites extend Facebook’s tools for authentication and social sharing

How They Make Money:  Facebook’s primary revenue stream is of course selling advertising on Facebook.com, which in total accounts for 85% of revenue.  The next chunk comes from Facebook’s platform, in essence “taxing” the revenues of app developers like Zynga, which represents 15% of revenue.

Financial Snapshot:

• 2011 Revenue: $3.71 billion
• 2011 YoY Revenue Growth: 88%
• 2011 Gross Profit Margin:  77%
• 2011 Net Income: $1.00 billion
• 2011 US Revenue = 56% of total, ROW = 44% of total

 

Notable Aspects of Facebook’s Business:

1) Facebook’s Revenue is “Cleaner” Than Google or Yahoo! – All of Facebook’s ad revenue comes from the Facebook.com website.  They don’t even run ads in the FB mobile apps.  This is different from companies like Google and Yahoo! who derive a meaningful chunk of their revenue from operating ad networks.  These companies report gross ad revenue but then subtract out “TAC” (Traffic Acquisition Costs) which is basically accounting-speak for the revenue share they pay to the partner sites where the ads actually appear.  Facebook’s ad revenue is pure… after the cost of running the site is factored in, the rest just drops straight to the bottom line.

Also if you haven’t read it Bill Gurley had an excellent post grading Facebook in the 10x Revenue multiple club, a continuation of his thoughts from before on this topic.

2) Facebook’s Growth is Robust But Lumpy – Facebook’s top-line growth is slowing, but it’s still incredibly high (88% from 2010 to 2011) especially when you consider it’s growing a multi-billion dollar revenue base.  This is what Facebook’s quarterly revenue looks like:

The Payments/Other business essentially had step function growth as Facebook phased in the 30% tax on apps.  The Advertising business is growing slower (69% YoY in 2011) than the whole company and if you dive in to the quarterly growth rates, you can see that it’s fairly lumpy.  Facebook admits as much that the ad business, which again accounts for the vast majority of revenues (85%), has seasonality in line with the media industry generally with a strong Q4 and weak Q1.  In fact Facebook’s ad revenue dropped in absolute terms slightly (about -3%) from Q4 2010 to Q1 2011.

Again, let me be perfectly clear… Facebook’s revenues are still growing very robustly, even the advertising business.  The overall growth in Payments clearly helps smooth out some of the ad revenue seasonality.  But it’ll be interesting to see how public market investors react when Facebook files an amended S-1 pre-IPO with Q1 2012 numbers, particularly if there’s similar Q1 slowdown in ad revenue.

3) Employee Stock Purchases Are a Near-Term ATM - Facebook has issued a combination of stock options and more recently restricted stock units (RSUs) as compensation to employees.  Obviously depending when an employee was granted equity, the exercise price they’d have to pay to actually purchase and own these shares outright could be quite high since Facebook’s company valuation grew rapidly.  As a result, the amount these employees pay the company for these exercises is non-trivial… in 2011 these common stock purchases generated about $1 billion in cash for Facebook.  To put that in perspective, Facebook’s overall operations (which are highly profitable) generated about $1.5 billion in cash profit last year.

Without knowing more details about the employee equity plans, it’s unclear how much more cash of this nature could come in during 2012 or 2013.  Plus Facebook has ample cash on hand today and will get a huge slug more from the IPO.

4) $600M Buys a Lot of Data Centers - It’s widely known that Facebook invests heavily in it’s technical infrastructure and operates it’s own data centers.  We didn’t know exactly how much that was but it turns out Facebook invested over $600M in data center infrastructure last year.  That’s the capex (e.g. new stuff they built or bought), the operating cost of staffing and running these things is on top of that (that’s baked into cost of revenue).

5) Zynga/Games Revenue Concentration - Other folks have already written about the fact that Zynga accounts for 12% of Facebook’s total revenue, which would be about $450M in 2011.  That’s actually a combination of Payments (the 30% share Facebook takes from app developer revenues) and advertising spend for ads Zynga buys on FB to acquire customers.  Back of the envelope, Zynga did just under $1B in revenue in 2011 so 30% of that is something like $330-340M.  So presumably they spent about $100M give or take on FB ads on top of that.

Facebook disclosed in the S-1 that games (as opposed to other kinds of apps) account for substantially all of the Payments revenue and Zynga accounts for most of that.

6) US Usage Slowing, OUS Still Accelerating - Facebook has a lot of users, and their users are on Facebook a lot… no shocker there.  The headline stats have been out in the public domain for awhile – >800M users, more than 50% log in daily, around 50% access on mobile devices at least some, etc.  If you want to dig in yourself there’s a bunch of charts in the S-1 starting on pg. 44 but I’ll give you the headline view because that’s probably why you’re reading this post.

US user base is still growing, but it’s clearly slowing as Facebook approaches saturation.  Facebook estimates they already have 60% of addressable US internet users.  Internationally Facebook’s user growth is still accelerating, but there are clear regional differences.  In fact penetration in Chile, Turkey, and Venezuela is estimated at >80% which is astonishing.  But places like Brazil and India are estimated at 20-30% and Japan and South Korea at <15%.  The big gaping whole is of course China where Facebook has “near 0% penetration”.

 

Note: None of this should be construed as investment advice to buy or sell any stock.

 

Something has clearly changed within the last 5-6 years in terms of the speed with which monster startups are created in the software and internet space.  As a result of a convergence of many factors (lean startup methodology, broadband & smartphone penetration, social web, cloud computing, etc), breakout startups are clearly getting scale faster than they used to.

There’s lot of anecdotal evidence for this:

• Seed stage investors (including NextView and many of our peers) are seeing more startups progress from seed to Series A stage in 6-9 months rather than 12-18
• Revenue ramp of Groupon and Zynga –> Kleiner famously said Zynga was the fastest growing company they’d ever invested in, no mean feat for the original backers of Google, Amazon, Netscape, etc, and Groupon might be the fastest ever startup to reach $1B in revenue
• Multi-billion dollar valuations for late stage startups like Dropbox, et al

There’s one school of thought that the paradigm has changed, and startups that achieve a market value of tens of billions or more will be more frequent than in decades past.

I’m not so sure that’s the case.  What if the new paradigm is simply that software and internet startups accelerate much faster than before, but terminal velocity so to speak remains the same?  It’s the difference between Google-scale outcomes being a once in a decade event or something that happens much more frequently.

The table above highlights some of the most significant VC-backed startups of the last 25 years.  I know Cisco’s really more of a hardware company than software, but I think it’s still relevant to this question.  You could throw companies like VMware in here too (~$38B mkt cap) but that was a spinout of EMC rather than a pure startup.  It’s also worth noting that in the last 5-10 years breakout startups have remained private much longer than in decades past, so more of the equity appreciation has been captured by private investors than public market investors.

In looking at the table, you see that startups reaching the rarefied air of a $75-100B+ market value (either as a private or public company) are extremely few and far between.  This list is hardly exhaustive, but I could only think of CSCO in the ’80s and AMZN in the ’90s and GOOG in the ’00s, and again none of them reached this value until years after IPO.

Facebook will pretty clearly achieve this here in this decade, and undoubtedly there will be more massive standalone companies that are built in the coming years and decades.  And to be clear, I take nothing away from the likes of Zynga, Groupon, LinkedIn, Salesforce, Yandex, and other companies which have achieved multi-billion dollar values in recent years… it’s an incredible achievement.  I’m obviously biased but LinkedIn’s revenue growth is actually accelerating now (>100% year over year) so I think it’s market value will grow commensurately in the years ahead.  But one would be hard pressed to say that other than Facebook, there will clearly be a company out of this crop that will be worth $100B in the foreseeable future.

To me, the new paradigm is one in which companies can often start with less capital than and can grow at a markedly faster pace than before.  For everyone in the startup ecosystem this is a pretty incredible state of affairs.  But I think we must be cautious is letting ourselves believe that as a result, there will be another Google or Amazon every year.