Enough With the Gloom & Doom on Groupon

In 2000-2001, I remember reading negative article after negative article on Amazon. It was burning money quickly, e-tailers were going under left and right and brick & mortar stores were re-asserting themselves. People kept a diligent death watch for it after the demise of Webvans ($1b) and others. In reality, what was going on was a rationalization of the e-commerce space, a pruning of the weak. As scale effects kicked in and they offered new services, suddenly the company swung to profitability and the rest is history. Using Google, I can't even find articles from those days. 

I have a similar feeling about Groupon. I have been amazed by the manic swings in public opinion on Groupon that we have seen over the past year. Lately, it has all been gloom and doom. The company goes public at $20/share ($2 above targeted range and trades up 30-50%. First headline I see: "Groupon gets a pop–but not the 1999 kind". Come on guys…enough with the dramatic trash talking.

I'll be the first to admit that I have no crystal ball about the future of Groupon nor an in-depth knowledge of its solvency. However, $700m will certain give them a nice runway to work things out. There are several high level factors that people seem to be ignoring about the company.

1) like all e-commerce spaces, when they rationalize, everyone suffers and, in the end, it is usually the top 2-3 companies that come out dominant. The number of daily deal sites has already dropped from 300 to 180 and continues to fall rapidly. There is scale advantage to being large in everything from online acquisition costs to logistics to call center efficiencies to branding.  These grow with time.

2) everyone wrote off Amazon around 2000 and 2001. Eventually, the company fully leveraged its economies of scale, tightened its cost structure, got to break even and then rolled out new products/services. You now have everything from Amazon stores to Amazon private labeling online service & fulfillment for other large retailers to all of its cloud infrastructure (AWS). Groupon will follow a similar path. It will grow, it will get to breakeven and it will innovate. We have not even seen the services yet that will eventually drive profitable growth for the business in the future.

3) why has no one been commenting on the incredible talent in the firm. First, if you give Eric, Brad and Andrew opportunity to iterate, they will figure out solutions. They are quintessential entrepreneurs. $700m buys a good amount of runway for them. Second, they have hired folks like senior data experts from Netflix to figure out preferential targeting and a former Amazon finance exec as CFO. There is a lot of top talent there.

4) does the world expect 10-15 of the largest, most connected venture firms in the world (as well as the two top investment banks) to allow anything to happen to this company? I think it is safe to say that Groupon is well buffered.

So, enough Groupon bashing and enough Groupon hyperbole on the other side. Let this team innovate, grow and take full advantage of the $700m they just raised. I can't guarantee that things won't end in tears here but I can say that they have a lot more going for them than the press/analysts have been willing to admit. 

Buckle Up for the Next Chapter

I don't want to pile onto or repeat some of the great posts of the current market conditions. Fred Wilson's post, Storm Clouds, was one of the better initial snippets on what is going on. One of the advantages of being in Chicago is that we are the first to lose liquidity and the last to get it. So, we track the number of term sheets from the Valley hitting Chicago as an indication of froth. When it goes up, we know that the Valley has so messed up its ecosystem that they are willing to fly in Winter to Chicago. The planes have been flying in with significant frequency, some driven by the Groupon halo and some driven by a hunger for deals at 50% the price of the Valley. I made the call in June 2008 that the cycle had ended and to buckle up:  Rough Ride Ahead.  I am not prognosticator but rather a risk handicapper. I still believe the next 5 years will produce some amazing wins but we will have a rough interim period here in the next year or so.

Having survived three VC cycles, the pattern is usually the same.

In Stage One, fear sets into the market when the public markets pull back and VC's grow concerned that they won't get exits. They stop feeding the funnel. Valuations fall in the Valley and they pull back their activities to their "two hour radius".  The markets eventually stabilize and VC's come out with a more cautious approach, often looking hard at core fundamentals, take extended periods of time on diligence and price deals somewhat conservatively. Recruiting of talent is rational and effective.

Stage two, the market starts to heat up, companies start to ramp, revenue grows and VC's start to pick up their activity. They have moved from fear to semi-greed.

Eventually, in stage three, a couple of deals pop in a big way (Groupon, Facebook, Playdom, Zynga, etc). Suddenly the VC's begin to get greed and fearful that they are going to miss the next big win. They start pricing deals not at core fundamentals today but at expect or hoped for revenue in the future. If the deals inflect they look like heros and if not, they have a portfolio of destroyed cap tables.

Indicators of Stage Three are:

— frequent "pre-emptive" rounds at 50-100% the expected valuation to "take the deal off the market"

— high valuations in excess of historical norms ($5m revenue, $50m pre-$, $20m revenue-$200m pre-$)

— general sense of anxiety and envy in the Valley with fear of missing the next Facebook dominates partner discussions on Monday's

— talent wars with pricing on salary, tenure shrinks

Well, guess what, we have a lot of term sheets hitting Chicago, talent wars are resulting in Google engineers getting paid $3m+ not to leave, valuations are insane and momentum investing in vogue (term sheets after 2-3 days). My suggestion to VC's is to wait for you pitch and it may be a bit of time before things come back around. My belief is the leading indicator will be an increasing rate of IPO efforts and perhaps a market pull back. Be smart and be ware…  That said the revolution is still alive and strong!

VC’s Mathematical Challenge

There is no doubt that the venture industry is going through a major house cleaning right now. Much of the pruning that should have been done post Bubble is finally going on now as LP's start to wake up and pull back a bit from the asset class. One of the main challenges has been the mismatch between LP demand in the category and the declining liquidity of it. The main question people as is what is the right amount of capital that should flow into the business annually to keep it healthy. Let's look at the mathematics from the exit perspective:

Average annual number of acquisitions:250
Average sales price:$80 million
Average annual number of IPO's:100
Average value of IPO:$150 million
Total annual value of venture backed exits:$35 billion
(IPO's have been down below 10 recently and above 200 in healthy times but below 60 for the past 8 years)
(sale & IPO values have fluctuated but these are swags)

Assumed VC ownership at exit:70%
Exit Value going to VC's:$24.5 billion
Target Fund multiple:2.5-3x
Capital Deployed to hit:$8-10 billion

This means that for the industry to continue (a la 1990's) generating IRR's north of 20% net in this exit environment, no more than $10 billion should be flowing into it during any given year. If the IPO market wakes up, this number goes up. If it stays asleep, it goes even lower. In a strong year (250 IPO's & 300 acquisitions at $200 million & $120 million avg values respectively), total annual exit value jumps to nearly $90 billion. Filter this through and the industry could handle roughly $25 billion in new capital.

Well, until just the first quarter of this year, industry fundraising has been north of $30 billion for several years and the exit markets have been significantly below even the initial levels above. Our industry stays healthy if no more than $10-15 billion per year is raised. So, we've been at 2x that rate. The LP's have hopefully figured this out and we'll see smaller brand funds and fewer total funds.

How many funds can survive in this kind of market? Let's do the math again:
Couple of mega-mega funds like NEA, Oak, TCV & Menlo: say 5 x $2 billion each = $10 billion
Number of brand funds:say 25 x $500 million each = $13 billion
Number of next tier funds:  say 40 x $200 million each = $8 billion
Fundraising cycle: every 3 years
So, just these initial 70 funds results in $10 billion+ per year raised.

Assuming that there will be around 300 funds around in total, this leaves about $5 billion/yr for the remaining 230 groups. Using the 3 year cycle, this results in each of these funds being under $65 million in size. If the exit environment remains moribund, then all of these number have to discounted even more to get to $10 billion in total industry dollars annually.

So, the industry has to drop from 500-600 groups to 300 groups and the LP's need to pair everyone back. No more $4 billion Mega-mega funds, no more $700-800 million brand funds, no more $300-400 million next tier funds and no more $100-150 million remaining funds. If the LP's don't do this, we end up north of $25 billion per year again and terrible returns.

Can LP's contain themselves? We'll see once conditions start to improve in the economy. In the interim, it will be ugly times for VC fundraising…

Enough Wall Street, Enough

"Even as I write I am watching the eunuchs now posing as Wall Street CEOs bend over backward before some congressional committee…We at Morgan Stanley are pleased by your investment. Now, if you ever want to see a dime of it back, go away. We’ll call you if we need you." — Michael Lewis

It boggles my mind how many articles I am reading that defend the short-sighted land grabs at our banks & insurance companies. Does Wall Street get it?  If you lose so much money from stupid & greedy activities that your firm is insolvent, you don't get to stick your hand in the piggy bank for bonuses. Show contrition, not indignation. The way that the rest of the world operates is you get to the end of the year, you look at your profits and your cash balances. If you have the cash to pay the bonuses, you pay them. If you don't have the cash, you don't. So, Wall Street, if your performance has been so strong that it deserves bonuses, pay them out of your cash. Oh, wait, you don't have the cash…

Some of the Wall Street crowd claim that their divisions were highly profitable and, therefore, their groups deserve bonuses. Sounds good to me. You just need to have the groups that hemorrhaged all the losses pay back that capital to the firm. If you can't get this money back, guess what…no bonuses. If you feel that this isn't fair, join the crowd. You are part of a single firm. You rise and fall together as a single firm. You can't keep the positives and ignore the negatives. With hedge funds, buyout funds, real estate funds, venture capital funds and commodity funds, if one partner's deal is a huge hit but another partner's deal tanks and wipes out the profit, no one gets a bonus (carry). This is because the fund's management team rises and falls together. Is it a bummer for the partner who delivered the big win? Yes. Does this mean he/she is owed a bonus? No.

If you don't have the money to pay the bonuses, why not just borrow the money? Isn't this the fundamentally sound way to run a business? Bankrupt your firm and borrow money to pay your bonuses.  Also, make certain that you go to the bank and tell them to give you the money but leave you alone to do whatever you want. Why do they insist on silly things like covenants, coverage ratios and sound business practices? Sorry to burst your balloon but lenders (including the government) have a voice.

If you've dug yourself so deep into a hole that no private sector firm will (or can) lend you money, sounds to me like you need to really tighten your belt, get real or go under. If the government is the only one who will give you money, even more so. Actually, this usually means that your firm is toast and existing contracts are voidable. I don't believe that the term "bonus" ever makes it into the dialog.

I agree that it took an entire nation to get us into this mess. I also agree that we should not make Wall Street the scapegoat for everything. However, Wall Street seems to be one of the few insistent that they should get rewarded. The other culprits are enjoying having their homes repossessed or investment portfolios cut in half. So, Wall Street, grow a pair (to quote Mr. Lewis) and do the right thing. Don't extort excessive compensation from a vulnerable country because you think you have leverage. And to everyone else, please stop the parade of articles and op ed's trying to take the offensive on this issue. It will only get worse over time.

Some very rational people, people that I respect, seem to be jumping on the band wagon to justify all of this behavior. They are indignant that a populist witch hunt is descending upon Wall Street. Unfortunately, unless Wall Street wakes up and smells the coffee, this will get worse and worse. Actions have equal and opposite reactions. When J&J had its issues with the Tylenol scare, it didn't tell people to stop complaining and go back to buying Tylenol. It took the financial hit and aggressively addressed the issue. In fact, it went beyond what most people expected.

Somehow, finding ways to sneak additional cash out of the system while continuing to ask for more loans does not strike me as an effective show of contrition. Furthermore, being vocal and indignant in your response does not seem to advance the cause much either. Worse, it really angers an already volatile population. Put gas on this fire and I will guarantee you that you will get the Populist Revolution that you fear. And, everyone earning more than minimum wage is going to get dragged into your Class Warfare if you keep this up. 

One last, tangental thing. Unless we rebalance things here in the US, we are in a lot of trouble. When we reward financiers significantly above entrepreneurs (not to mention doctors or teacher or…the usual list), we will end up with a nation of arbitragers versus engineers, manufacturers or founders. Our best and brightest will go where the money/bonuses are. Not so good in the long run…

Josh Lerner on Serial Entrepreneurs

"A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be."
        — Wayne Gretzky

peHUB had a recent post by Connie Lolzos on Josh Lerner's recent research about serial entrepreneurs. There are two general camps. One states that success begets success and serial entrepreneurs are likely to repeat. Lightning does strike twice (or three, four, etc times). Another position is that success is driven predominantly by serendipity which greatly reduces the chance of serial success. Furthermore, once a founder has hit it big, is he/she as hungry the second time when their bank account overflows.

Josh Lerner looked at a cut of data around success rates of serial and first time entrepreneurs (Paper link: Download 09-028
). As Connie mentions:

According to its authors, including renowned HBS professor Josh Lerner,
successful entrepreneurs have a 34 percent chance of succeeding in the
next venture-backed firm, compared with 23 percent who failed
previously, and 22 percent chance for new venture-backed entrepreneurs.
(Honestly, I had no idea new entrepreneurs, or even second-time
entrepreneurs with one failed company, had a one in five chance of
succeeding. If I were a new venture-backed entrepreneur, I’d be pretty
heartened by that data. Those are way better odds than you’ll find in,
say, the restaurant business.)

This would support the serial entrepreneur camp's claims obviously. Furthermore, it also quantifies the chance of success for those first time entrepreneurs…around one-in-four. I would imagine that this number goes up significantly during downturns like today when competition is reduced and a likely liquidity event occuring during a market recover (in 3-4 years).  Timing of launch has a strong impact on venture success.  Lerner comments that great entrepreneurs are more likely to launch during these times and have the vision to see what could be versus what is.

Connie also pointed another interesting fact about how many venture backed deals involve serial entrepreneurs. It looks like only 13-16% of the time do VC's back serial entrepreneurs. So, 6 out of 7 times, a new entrepreneurial team (often coming from other start-ups though) gets the VC money. Another positive for emerging entrepreneurs.

…Or Assuredly We Shall All Hang Separately

"We must all hang together, or assuredly we shall all hang separately." — Benjamin Franklin at the signing of the Declaration of Independence

Dan Primack set off an interesting dialog around his article Radically Reinventing Venture Capital. There is a growing wave of articles about new or revised models and debate around what went wrong.  He described a suggestion by one Boston VC who proposes that LP’s think about funding individual VC’s as single partner entities. These are all interesting and thoughtful discussions, but I believe that they are over thinking things. I offer that the heart of our issues rest in our industry’s compensation incentives mixed with a fine market melt down.

Venture capital used to be a business about creating revolutionary businesses to change the world for the better. Wealth was driven by carry, the GP’s share of profitable investments. Investor, entrepreneur and VC were aligned, all focused on profitable investing. This has broken down.

The LP community has moved aggressively into alternative assets to kick start unfunded obligations. Furthermore, consultants, advisors and staff have concentrated this capital on a shrinking list of investment firms.

At the same time, market disruptions have basically shut down the IPO world and the VC’s main escape hatch. With public options diminished, acquisition multiples have declined, which has reduced the frequency and size of investment exits. For example, while investments normally take 3-6 years for exit, in this environment, only 20% of deals have exited since 2003. This had backed up VC’s portfolios.

The toxic result is that VC’s look increasingly to management fees instead of carry for compensation. This breaks the alignment between LP & GP. This incents & focuses VC’s on raising larger funds, more often and deploying it quickly.  If a group raises $800m every two years, it adds management fee in $20m per year chunks. Three funds, eight partners leads to $6-8m/yr per partner in just fees. Carry is a nice to have versus need to have.

As long as LP’s go along with this, things won’t change. Unless the money drives this, behavior & incentives won’t change. They need to regain the alignment between their interests and the VC’s.  One heretical idea would be to move current compensation from being based on assets under management to salary based with escalators. By relatively fixing the current compensation regardless of assets (increase it for new hires), VC’s will have less incentive to raise capital for the sake of driving current fee. Rather, they will be focused more on the carry. Granted, carry grows with fund size assuming returns are the same, but we all know that returns suffer when funds are too big and are deployed too quickly. So, there is some governing factor to imprudent asset accumulation.

I also liked the structure of Warren Buffett’s first funds. He established a base rate (say a 6% return) upon which no carry was charged. So, the first 6% of IRR is free which makes sense, as venture’s goal is to drive alpha above more conservative asset classes. Unlike with hurdle rates, he did not have a “catch-up” after 6%. Rather, he charged 25% of the profit above the 6%. So, a VC is worse off (from a traditional 20% carry) until IRR’s in the low teens and then better off above the low teens. This gave no bonus for poor results and superior compensation for strong results.

I don’t know if the LP community has the appetite for this kind of approach regarding fees. They are fighting to get allocation into a narrowing list of venture firms so are unlikely to rock the boat for fear of exclusion. They are, unfortunately, in for a rude awakening if they can’t find another way to align their interest with those they entrust their capital.

Fifteen Year Cycle

As the bad news keeps pouring in, a lot of people are wondering what we can expect in the coming years. Additionally, everyone is trying to figure out what hope exists. Well, I’ll give two thoughts on this (briefly).

First, the world of technology is driven by two factors: the laws of exponentials and the Black Swan. Progress does not occur linearly but exponentially. We can expect to see changes the magnitude of the past 100 years in just the next 20 years. This means a lot of people are going to a) be really busy and b) be dramatically better off. These changes will come from places you can’t predict (Black Swans). Market crashes and negative developments are not the only unexpected six sigma events.

Second, markets run in roughly 7 years cycles and technology in 15 year waves. Vacuum tubes to main frames to mini-computers (DEC) to PC’s (Apple/Microsoft) to the Internet. The next wave, then, should start in 2010-11 and hit full force in 2015-16. Many in the business (us, Kleiner, etc) feel this will be in Cleantech. The energy market is 10-20x the IT market. We are not talking about billion dollar markets but trillion dollar ones. There will be a lot of casualties but some enormous wins.

So, there us no doubt that life is really brutal today. But, prepare and get ready for enormous, explosive market opportunities. It’s going to be mindblowing.

So, I stick my neck out again typing on my small iPhone. I declared the old venture cycle dead last June. I am declaring the the next cycle, even bigger than the former, will kick in during 2010 with foundations forming by the end of next year. I also believe we will see 30-40% of remaining venture firms will not survive to see this through (food for another post)…

Hate to Say I Told You So…

Back in June of this year, I did a post called Rough Ride Ahead: Buckle Up & Get Your Money Now (if you can). My words of advice were:

"If you are close on terms with an
investor, do what you need to get it closed now. If you have access to
capital, draw it down and don't touch it as it may need to last a
while. If you have a high burn rate, you had best start aggressively
cutting it now. If you are going into this cycle burning $1m/mo, you
will have no ownership left by the time the cycle turns up and if you
are burning more than $500k/mo, your cap structure is going to take a
hit if things turn out as badly as I fear. In these kinds of times,
breakeven is great (wait out the competition) and $100-200k/mo burn is
manageable."

Well, things have hit full force and all of the VC's are panicked over the dire situations facing their portfolio companies. Above is a proxy for what most are saying now four months later. Why the sudden sense of urgency? Hasn't this venture market been basically dead for the past couple of months? I can only assume that the market crash has dimmed whatever hope that an upturn was around the corner.

To understand better why the Valley is sweating bullets right now, you have to understand the context of their portfolios. For the past two years, the Valley has felt very confident. They have been investing in an array of companies at crazy high valuations that, in many cases, had not figured out their revenue models. As LP's pushed and shoved into these funds, groups have been able to raise funds roughly every two years. In addition, because they have twice the size of older normal funds, they have added partners and now put twice as many deals into each fund (40+ vs 20+). Lastly, these funds, since 2003, have only had 10-20% realizations.

So, the average branded Valley firm has probably 3 recent funds (and several legacy ones) say in 2003, 2005 and 2007. Each one has 40+ deals and only 8+ exits. So, they have nearly 100 existing portfolio companies plus whatever legacy deals are around going into this down cycle. Follow-on financings have become very difficult and other VC's are getting very predatory in their negotiations. With probably north of 120 children to take care of each, you can see why the Valley is not very happy right now.

This is going to get 2001 ugly for those firms unable to cut burn, grow revenue and get to breakeven. VC's are going to be in triage mode and more likely to let the truly wounded investments go. You entrepreneurs will need to take control of your own destinies or Darwin will do it for you.

In case you are curious what the Valley is advising firms to do, below are the links to several of the more popular VC communications to entrepreneurs about this down draft. Enjoy…

Sequoia's R.I.P to Good Times Presentation
Ron Conway's Email on the Meltdown
Benchmark's Gurley Email to Portfolio Companies

What Are Some of the Hedge Guys Doing Now?

After the downdrafts, you would assume that people would be jumping into market to bottom feed. However, a number of the smartest guys have massive cash positions. Clearly, they are waiting for the other shoe to drop. From a recent Whitney Tilson piece:
"These are smart guys, but I
think they're wrong here — and think that this is extremely
bullish:

Some hedge-fund titans have yanked most of their money out of the stock
market, a bearish sign amid Monday's euphoria and an indication of how the
hedge-fund business is changing amid chaos.

In recent days, Steven Cohen, the hedge-fund manager who runs the $14
billion SAC Capital Advisors, moved about half his funds, or about $7 billion,
into money-market and other short-term securities, eliminating much of his
fund's exposure to the stock market, says a person close to the fund. Mr.
Cohen plans on sitting on the sidelines for the rest of the year — trading a
small portfolio himself but keeping shuttered most of the stock portfolios of
his other managers.

Israel Englander, who runs the $14 billion Millennium Partners fund, has
shifted about $6 billion from the stock market into cash, a person close to
the fund says.

Meanwhile, John Paulson, manager of $35 billion Paulson & Co. — who
made a spectacularly successful bet against the housing market last year —
has much of his fund in cash equivalents.

The retrenchment by Wall Street's "smart money" crowd is part of a larger
effort by hedge funds that have put a total of as much as $400 billion into
cash equivalents recently, according to David Kostin, an analyst at Goldman
Sachs Group Inc.

Of course, much of the smart money has been wrong in the credit crisis.
Many hedge funds have lost big money in the past year. That said, Messrs.
Paulson, Cohen and Englander have fared better than most: Mr. Paulson's main
fund is up about 20% this year; Mr. Englander's main fund is down 0.5%; and
Mr. Cohen's main fund is down more than 9% through September. This compares
with a 29% loss in the Dow Jones Industrial Average, year to
date."

…Like An Oversexed Guy in a Brothel (Buffett)

"Wall Street," reads the sinister old gag, "is a street with a river
at one end and a graveyard at the other." This is striking, but
incomplete. It omits the kindergarten in the middle.

Frederick Schwed, Jr., Where Are the Customer's Yachts?

Some of you may fear that I have jumped feet first into the Prozac laden, Doom & Gloom crowd. I am actually just the opposite right now. We have spent much of the past two years getting liquidity in our portfolio so, unlike 1999, we are going into this down draft with a light number of existing investments to navigate through these troubled waters. I am actually looking forward to finding our next generation of successful investments.

There are a couple of areas that do well in these  kinds of markets.  The most obvious are those solutions that eliminate distinct & meaningful chunks of expenses from companies's income statements. "Productivity" savings with secondary benefits don't count. This means that there was an expense before (credit card fee or brokerage fee or inventory cost) and now its gone. You will find very willing buyers if it is clear cut and does not require lengthy or expensive implementations or retraining.

Performance based revenue models also excel in these times. Customers have little spare capital to spend so they don't want to use it with the "hope" that they will get something back. If your proposition is that you get paid when they get paid, companies will view this as significantly less risky and much more acceptable. Also, if you are in the customer acquisition world, these can be gravy days as acquisition costs (advertising, search, etc) grow cheaper by the day.

There are an array of other models but these are two clear, classic ones for these times. Our company, Performics, doubled business every year throughout the tech bubble and crash. It was one of the leading performance based marketing firms in the US and now owned by Google.

So, while everyone is either dispondent (last week) or manic (this week), you should focus on business models that work in times of low budgets and exceptionally skeptical buyers. Nod your head to all of these horror stories and build up your business quietly in the background. It is the best of times and the worst of times.

Just remember: "If you're gonna panic, do it early." –Peter Lynch
Click here for other funny & interesting Wall Street quotes collected by Michael Ross