I was having breakfast this morning from someone I know from the LP world. We were talking about what’s “working” in the broader VC ecosystem and this person expressed their enthusiasm that today there are a range of different models that are producing attractive returns for LPs.
Historically there was just one model… VCs had to invest in the Series A or B round of a startup, own 20%+ of the company, and be one of the primary capital supporters of it through exit. That model still works for quite a few firms, but now there are also some different models producing attractive returns. One example is seed/micro VCs who own far less than 20% (often <10%) of companies but are typically investing at the earliest stages and out of smaller funds, both of which can produce superior returns on a cash on cash multiple if done well.
There’s also select late stage VC investors, either as a dedicated late stage fund or as part of a broadly diversified large fund, again who often own far less than 10% of the companies they invest in but where they can still produce good multiples in shorter time frame again if executed well. Neither of these models is brand new, but they have emerged more distinctly in the last 5-7 years meaning there’s now realized returns to support the attractiveness of these seed or late-stage models in addition to the “traditional” own 20% early stage model.
But while there’s multiple models working in the VC ecosystem, it remains acutely true that there is no subprime model for VC. I’m fond of saying this phrase though I must give credit to Peter Thiel who coined it back in the early PayPal days 10+ years ago. The point is that unlike various consumer credit markets where subprime lending does indeed work, trying to apply a comparable model to VC is typically disastrous because startup outcomes follow a power-law distribution rather than a normal distribution.
In consumer credit (credit cards, mortgages, car loans, etc) a subprime approach works. You could argue some forms of subprime consumer credit are predatory or usurious in nature (e.g. payday lending). But while lending to borrowers who are less desirable (from a creditworthiness and ability to repay standpoint) will result in greater loan losses than lending to “prime” customers, as long as you price this credit accordingly (higher interest rates, fees, etc) and do a good job underwriting and managing the portfolio it can be a rather profitable enterprise. There are both specialty lenders and large banks that have built big, successful businesses in subprime lending. [see Note 1 below re: subprime crisis of 2008-9]
So why doesn’t the same model work in VC? The subprime analogy for venture would be to invest in the somewhat less desirable startups (in terms of team, mkt oppty, product, etc) but to price one’s investment capital appropriately. Put plainly, the subprime model of VC would be to invest in the mediocre startups at a low valuation. Or to focus solely on getting the lowest valuation as an investor, which by definition will price you out of the most desirable companies which typically have substantial demand for their equity. Or to invest in mediocre startups at a low valuation but hope to “manage” this portfolio to better than expected outcomes.
In theory this would work if the ok, not great startups had good, not great positive outcomes. But we all know that is in fact false… the power law distribution holds. The great startups produce 10X+ returns for their VC investors, the mediocre ones struggle to return capital or minimize losses. Even if you get a super low valuation, investing in a company that raises $20M in VC capital and sells for around that much doesn’t produce a good return. That’s what the middle of the startup outcome distribution tends to look like.
So if there is no subprime model for VC, is the corollary that valuation doesn’t matter or as some have said there are only 5-10 startups per year that “matter”? Well in a way investing in the best companies is in fact more important than valuation, though valuation still matters in certain respects as I’ve discussed before. And the answer to the second corollary in fact depends on the definition of what “matters”.
I can’t speak for Marc Andreessen but I suspect when he said only 5-10 startups a year matter, he was looking at it through the lens of a very large “platform” VC fund like AH or others that are several billion dollars in size. Indeed for groups like these to produce a good fund level return, they by definition must be investing in the companies that are ultimately worth $5-10B or more in enterprise value and there are only perhaps 5-10 of those per year (maybe less). But for a traditional early-stage VC with a $200-300M fund a single exit of $500M-1B really “matters” in terms of returning a huge portion of the fund. For a seed VC fund it might be even smaller depending on size and strategy. So “matters” is relative and while there aren’t hundreds of startup outcomes per year that “matter” there are probably many dozens. But there still is no subprime model that works in venture…
Note 1: Readers may feel that the subprime mortgage collapse which led to the financial crisis of 2008-2009 implies that subprime lending does not indeed work. The subprime mortgage collapse had many interrelated factors at work – easy monetary policy, lax underwriting standards, misleading credit ratings, fraud (at all levels from consumer to originators to securitization), uninformed investors buying MBSs & CDOs – all of which became self-reinforcing in a vicious cycle to inflate a credit bubble. This produced an obviously bad outcome. But the fundamental premise of subprime lending (lend to the less creditworthy but demanding higher interest rates to compensate for defaults) remains sound and is working today, just as the bursting of the Dutch tulip bubble doesn’t mean that tulips are valueless.
I’ve been doing some thinking about the future of cars and the impact of the internet. A large part of this is just some idle thoughts, a small part is driven by my love of cars, and a small part is thinking about what potential opportunities for innovation & investment might stem from this. I started jotting this down about a month ago but Google’s acquisition of Waze was a good prompt to finish off this post.
When people talk about “internet” and “cars” people usually think of internet-connected automobiles for the purposes of infotainment. Connected cars arguably started with GM’s launch of the OnStar telematics service in the mid-late ’90s, though in essence this remains a private network which was originally run over analog cellular and satellites rather than open internet. Today you can buy an Audi or a Dodge Ram pickup with a wifi hotspot (connected via mobile broadband) and you’ll see similar capabilities from other manufacturers in the next 1-2 years. Internet & software giants like Google (Google Maps now powers Audi nav systems) and Microsoft (Sync infotainment created in conjunction with Ford) have been hard at work to remain at the leading edge of innovation here.
But to me infotainment is really just a small part of the internet connected car story. We’ve had internet in our cars since the rise of smartphones, and arguably it’s been as much a safety hazard (distracted driving while texting, emailing, etc) as a positive transformation (navigation, music, etc). And outside the confines of the chassis, the internet has had more of an impact on the car industry from the basic (internet research is the most influential component of car buying today) to the transformative (ZipCar, Uber, etc).
So what will ubiquitous connected computing mean for the 100+ year old automobile? My thoughts here are still at the 60,000ft, macro-economic level and not at the micro startup opportunity level but here are a few.
Diagnostics & Maintenance – The computerization of cars is several decades old at this point and was driven by a multitude of factors, mainly safety and environmental concerns (reduced emissions from electronic control of combustion). With chips running large parts of cars came basic diagnostic tools like the “check engine” light to OBD ports. This has led to a broad transition away from many consumers doing their own maintenance and repair work to few doing it. With internet connectivity integrated by the OEMs, you’re going to see real-time monitoring and diagnostics which should favor franchise dealers or factory-owned service centers (e.g. Tesla) even more for repair work. The independent shop won’t go away just as do-it-yourself repair didn’t disappear with electronic fuel injection, but franchise dealers & factory service centers will take an increasing share of the maintenance market.
Driverless Cars Change Definition of Car “Owners” – We’ve all heard of or seen Google’s driverless cars and forward-thinking manufacturers are already planning for this day whether it’s 5 or 20 years in the future. And to be fair ubiquitous connected computing is but one of the enabling technologies for driverless cars (computer vision, AI, etc). But in a world of driverless cars, the notion of who “owns” or can “drive” an automobile can change dramatically. I don’t just mean that people are going to share cars, though that will undoubtedly be true in densely populated areas.
Driverless cars could actually increase the number of cars on the road, both because the safe density of cars on the road can be increased, but also because of expanding the universe of drivers and societal preferences. In a world where a human isn’t the primary operator, you will have more visually impaired or physically handicapped persons driving themselves or more elderly persons or even children. A 9 year old could hop in a driverless car and drive themselves to school for example. Also if driving wasn’t time-consuming or stressful (e.g. you could read, work, play, etc in your car w/o needing to pay attention to the road), some people might choose to live further away from their work even if there weren’t good mass transit options available to them. The average American’s daily commute is just under an hour (round trip), so in aggregate that’s potentially a lot of incremental time when they might be doing email, web surfing, playing games, or communicating with friends. And commuting 2+hrs daily is less of a big deal if you can use that time for work or leisure.
Cars as a Utility – As someone who’s passionate about driving and cars, this is a potential trend that saddens me a little but seems inevitable nonetheless. The more connected our automobiles become and the more detached we are from the physical act of operating them, the more cars will become a utility for most people. People will still race cars (just as they still race horses), and a small number of people will dedicate time and resources to owning and caring for cars (just as they still do for horses).
But when internet connected computers control much of the operation and maintenance of vehicles, my hunch is that people in general and younger generations in particular will view cars as a utility rather than as a pursuit in and of themselves. The thrill engendered by aesthetics, performance, or luxury will probably be muted except for a hardcore passionate few. People will seek these in other consumer goods and cars may become less differentiated. In the 50′s and 60′s, a drivers license and car ownership were the central focus of most teenagers. Teenagers today, and certainly the ones coming of age in decades to come, probably won’t place similar emphasis.
Cars as a Media Platform – Again I think infotainment is only the tip of the spear but cars have been a media platform for many decades, since the advent of AM radios. Internet connectivity is turning them into a more individualized and more comprehensive kind of media platform. Radio as we know it won’t die, but audio services that are personalized and on-demand will proliferate in the near term (like Spotify now working with Ford Sync) which will mean targeting more like web/mobile ads. And longer term streaming video, games, and other media will become a bigger part of the auto platform both near term for traditional “passengers” and longer-term with autonomous cars. People will of course still whip out their smartphones and tablets in the car, but I anticipate manufacturers will find better ways to integrate connected media like cached storage via your work/home wifi connection or Slingbox type functionality with your home DVR.
The car is over a century old and how it’s propelled, who drives it, and other key aspects will change here in the 21st century. As a result younger generations’ attitudes about cars and personal identity are already changing. But autos will remain incredibly important in the internet age which is something you can only say about a handful of other transformative technologies from centuries past.
When we meet with entrepreneurs and ask about their competitive advantage or special sauce, one of the common responses is first mover advantage. “We’re the first company to do X in an rapidly growing market” or similar.
I’ve always felt being the first mover is a comparatively weak advantage and have been thinking about this more recently. While our portfolio at NextView is roughly equally weighted to consumer facing and B2B companies, it seems that for consumer companies in particular being first mover confers little benefit and the drawbacks probably outweigh whatever weak advantage might exist.
If you think back to the monster consumer software and internet companies that’ve been built in the last 2-3 decades, it’s actually far more likely they were fast and/or particularly innovative followers rather than first movers.
- Atari (home video game consoles)
- Twitter (microblogging)
- Amazon (e-commerce)
- Microsoft (OS – both text & GUI based, office productivity, game consoles)
- Apple (today’s Apple of smartphones & tablets… early Apple’s attempts at being first mover largely flopped like Lisa, Newton, etc)
- Facebook (social networking following in the footsteps of Friendster, MySpace, etc)
- Dropbox (cloud storage)
- Netflix (video streaming)
- Google (search… lots of predecessors)
- Square (card present payments on smartphones - predecessors like ROAM Data, et al)
The one segment of consumer companies where being first mover seems to have conferred real advantages has been “collaborative consumption” broadly. The final chapter has yet to be written for most of these companies but being a first mover does seem to have aided the likes of ZipCar, AirBnB, and Uber. I think this has less to do with network effects which are distinct from first mover (though the two are complementary) and more to do with locking up preferential access to supply.
So why might it be better to be a fast follower?
- Don’t Have to Evangelize - Perhaps the key downside of being first mover with a consumer product is having to evangelize a market and build it from a niche to broad adoption. This usually takes a lot of time, money, and energy. Evangelizing towards a mass market is arguably harder in consumer than B2B given individual consumers adopt based on a broader set of qualitative and quantifiable factors, where as businesses often attempt to quantify ROI more objectively. Google didn’t have to convince people that Internet search was needed… they just had to make it work better (via PageRank and subsequent innovations) and monetize it better (by copying GoTo/Overture with paid search advertising).
- Work Out Early Kinks - Dropbox wasn’t the first consumer cloud storage service. Companies like xDrive and others let you upload and retrieve files from the web nearly a decade earlier, and there were others like Carbonite that created hybrid local/cloud storage solutions. But Dropbox realized that one of the kinks of existing cloud storage services was that they were only well suited for alternate or backup storage, not primary storage. For the cloud to work seamlessly for primary storage Dropbox built client side products for an array of platforms, and worked very hard to make this client experience feel super native on every one. By finding a way to work out out this kink they’ve grown larger than all the other consumer cloud storage products out there.
- Wait For Complementary Technologies to Mature - Apple didn’t pioneer the smartphone but obviously the iPhone rightly deserves credit for defining the category and making it a global mass market. Of course Apple did some truly innovative things with the first gen iPhone launched in 2007 and also harmonized software and hardware better than anyone else. But part of their success was simply due to the vastly improved state of cellular data networks relative to when the first smartphones emerged. The Treo was a revolutionary device, but using one kinda sucked in the early days of digital cell networks. Similarly RIM had to build their own proprietary data network (after initially launching on Motorola’s ARDIS/DataTAC network) in order to get emails to Blackberries in a reliable and timely manner.
We sometimes think of being a fast follower in pejorative terms. Somehow first mover seems sexier, and to be fair some first mover startups have become category leaders or have successful acquisitions by larger companies. But the reality is that most fast followers are incredibly innovative companies, sometimes even more so than the early pioneers in their category. And at the end of the day most great entrepreneurs are focused on trying to build enduring, category defining companies. Being a fast, innovative follower might be the way to go…
It occurred to me that we usually refer to entrepreneurs associated with a startup as being “behind” the company or phenomenon. As in Mark Zuckerberg, the Harvard drop-out behind Facebook or so-and-so, the folks behind startup X. Upon further reflection it seems like this phraseology has things backwards… we ought to be talking about the teams in front of a new or important concept.
I mean this not simply as a paean for entrepreneurs. While the broader society’s esteem of entrepreneurs waxes and wanes, entrepreneurs have been getting plenty of love in recent years both from within and outside the startup ecosystem.
But the reality is new companies and new products don’t simply come into being themselves. As we all know too well a lot of time, energy, and creativity goes in first before any new innovation comes to market. All this work goes in before customers and the broader public ever sees anything. So to me thinking about founders and early employees being in front of a new product isn’t about stroking peoples’ egos, it simply makes more logical sense.
The other phrase we use is people X invented Y as in “Steve Jobs invented the smartphone”. But we usually reserve that terms for a select few, and in fact most entrepreneurs put their hard work not in coming up with an idea (most ideas are commodities) but in executing in the face of limited resources and a competitive marketplace. So most founders don’t really feel like “inventors”. And so we end up with so-and-so, the folks behind company X.
So I’ve resolved myself to think, speak, and write about teams in front of a product. Or at least “responsible for company X” rather than being “behind” it.
Yesterday was Apple’s shareholder meeting and as many of you know, there’s obviously been healthy debate about what they should do with the ~$137 billion in cash they’re sitting on. I had read somewhere that Apple’s cash pile was equivalent to Hungary’s GDP so I tweeted out the suggestion that perhaps an activist shareholder should push an acquisition of Hungary rather than thinking small (e.g. increasing dividends or issuing preferred stock).
Hungary probably wouldn’t sell their sovereignty and entire economy for 1x sales, but Apple has no debt so they could probably lever the deal and borrow money on top of $137 billion in equity. For some reason the notion of Apple hiking the taxes of Hungary to fund a dividend recap just amuses me…
But in all seriousness, what should Apple do with a massive and growing pile of cash? The three obvious buckets are of course to invest heavily in new products (the Apple TV or iWatch or whatever), return cash to shareholders (via dividends, buybacks, new class of preferred shares, etc), or acquire stuff. Besides Hungary, what M&A strategies actually make sense?
FWIW Apple isn’t Cisco or Oracle. Apple’s an incredible organization because of its long history of internal innovation rather than excellence in acquiring, integrating, and growing other businesses. Over the long arc of time (by tech standards) Apple has done very few acquisitions >$100M and has never done a billion+ dollar deal. Buying NeXT provided the foundation of what is now the desktop Mac OS plus brought Steve Jobs back to the Apple fold. More recently acquiring Quattro Wireless created the iAds mobile ad network and Siri was of course a technology acquired from SRI. Less auspiciously Apple bought a Swedish mapping technology company (C3) to form the basis of Apple Maps. Lastly Apple has bought several component companies (chip companies Intrinsity and P.A. Semi, flash memory company Anobit, and security hardware – Authentec) to be integrated in various iStuff.
Apple is fundamentally great at creating innovative new platforms that consumers love because they’re easy to use and rationalize digital fragmentation. They weren’t the first in PCs, MP3 players, smartphones, or even tablets yet Apple revolutionized each of those categories. Apple doesn’t really make money by selling software or even digital content, but they seamlessly integrate software and content to support a high margin hardware business.
But Apple’s DNA is about quantum leaps, not incremental ones. So if they were to become an acquisitive company, I’d argue they have to be as big & bold in buying as they are in product innovation. The three main vectors Apple might pursue are:
1) Buy Content – Content is strategically important to Apple’s platforms, but in the grand scheme of Apple it’s a pretty meaningless part of their business. If you add up all the content, software, and services (e.g. iCloud subscriptions) it’s about 6% of Apple’s revenue. To put that in perspective, all the chargers and other accessory stuff amounts to about 50% of the revenue Apple generates from content + software + services.
Some people think Apple should buy Netflix. On paper it makes sense… ~$10B market cap, deals with lots of content owners, a nascent library of Netflix developed content, and a happy/loyal consumer base. But it makes less sense to me… consumers love Netflix because they can get it on all kinds of hardware devices (TVs from many makers, game consoles, tablets, etc) and content owners deal with Netflix because they don’t want iTunes to dominate digital video as it has digital music. Apple could buy Disney instead (~$98B mkt cap) and own a vast library of content and the “infrastructure” to develop more (ABC/ESPN, movie studios, etc). They’d probably divest the theme park business but the rest of Disney would give Apple an incredible platform to rethink video @ home in an on demand world. It would also transform the company by making meaningful profits on content in addition to hardware. Time Warner (~$50B mkt cap) would be the other logical choice in this vector.
2) Buy Pipes - Many have thought that communications infrastructure would become “dumb pipes” and the content and/or hardware companies would win home “infotainment”. Pipes companies are still pretty valuable it turns out and on demand video hasn’t really eroded that… you still need cable or fiber to your home to watch Netflix, and it’s not like total revenue to the “cable” companies (Comcast, Time Warner Cable, Verizon Fios, AT&T Uverse) has really declined. Plus building out a telecom network to the home is pretty hard and costly… there’s a reason Google Fiber is available in precisely 1 of the top 100 US cities. The satellite TV guys (DirecTV, Dish Network) have good pay TV businesses and nationwide coverage but lack a true broadband internet offering so they wouldn’t be a fit.
Owning pipes and the content deals that go with them could strategically aid Apple in a couple ways. First the reason the iPhone was such a profitable success for Apple was because they got to double dip… consumers paid Apple and wireless carriers paid Apple (in the form of subsidies) for each device. No matter how awesome an Apple TV might be, it’s difficult to envision a similar scenario where cable companies subsidized the cost. By the time the iPhone came out there were 3-4 wireless carriers with national scale so it made sense for AT&T to do an exclusive with Apple, but cable still tends to be a local duopoly or even monopoly so less incentive to try to shift consumer share.
But if Apple owned one of the big cable companies they could essentially boost the profitability of TVs by internally subsidizing with monthly subscription revenue. They’d also instantly get access to a huge swath of TV and movie content out there. Plus if they bought Comcast ($106B mkt cap) it’s essentially a twofer of #1 (content production) and #2 (pipes) now that Comcast has fully acquired NBC Universal.
3) Vertically Integrate - Apple could also vertically integrate in more radical ways. I don’t mean buying Hon Hai (aka Foxconn) to control vast labor and production of Apple’s hardware. I mean component suppliers like Marvell ($5B mkt cap) or STMicroelectronics ($7B mkt cap) for chips, or Sharp ($3B mkt cap) or Toshiba for LCD displays, etc. Companies like Samsung and LG also supply Apple with displays, but since they compete in end-user devices trying to buy either of them probably wouldn’t make sense. The display components are super low margin so Apple is unlikely to do that, but the semi companies conceivably could be a better fit. But at the end of the day vertically integrating wouldn’t really transform Apple’s business in the way #1 or #2 would.
4) Buy A Social Platform - Really Facebook ($63B mkt cap) is the only one that makes sense to me from a strategic standpoint. Twitter doesn’t really give the same depth of strategic synergy and and Apple is a consumer company rather than business-centric so that rules out LinkedIn. But even though Apple could offer Facebook shareholders a 100% premium over the current stock price, obviously this one is never going to happen given Mark Zuckerberg’s voting control of the company.
My bet is that Apple does none of these things of course. Maybe Hungary is starting to look more plausible…