Puny Little Human

HotelTonight is changing the way I spend nights in New York and think about the long tail of local commerce

Usually when I am in New York City, I head out to Long Island and crash at my fiancé’s parents’ house in Roslyn and take the train or drive into the city the next morning. But there have been a few occasions when I just want to stay in the City and be spared the 1 to 1.5 hours commute into town.

I’ve used HotelTonight a handful of times and it has proven to be an incredibly powerful app to find cool new places to stay at affordable prices. The density of New York City and the wide availability of cool boutique hotels makes the app super useful. Each time I’ve used the app, I show up in the city without a reservation and am reasonably confident that I will be able to find something that is:

• Close to $100 a night.
• Near a subway station.
• Be an interesting experience - I would say that this has been the coolest part of HT.

Discovery is often talked about as a need around digital media: to be able to dive into the long tail.

However, there is also a critical problem for local merchants that exist in the long tail of physical locations. I would argue that this is actually the richest area of opportunity around mobile Internet and with multiple angles of attack. There are merchants in the long tail that offer amazing value or experience for money, but may underspend on promotion and location.

I never realized just how many boutique hotels there were out there in Manhattan. And staying at one can be a refreshing change of pace from the cookie cutter chains. I just stayed at Gild Hall Hotel in Downtown. There was leather and wood everywhere. Everywhere. They had this quirky and cool leather rhinoceros statue.

Yelp and Foursquare have been apps that facilitate local discovery. Ness is also tackling this problem. They are all powerful. I think the group buying model is the one that has the greatest opportunity for success if user acquisition costs can be controlled and load balancing for merchants can be solved.

HT is one that I have both used for discovery purposes, but also adds the benefit that I think are incredibly powerful:

• The hotels listed tended to be more boutiques and long tail.
• The proximity component is really strong, and not for the reason you would think. Because you can only book for a room in the evening at 12PM, you have to book for somewhere that you can get to within 1 day. I think constraining the map boundaries greatly enhances the apps intensity of discovery, particularly in a city like New York.
• They are going after a merchant where reservation and transacting are strongly tied to the discovery process. The beautiful “h” signing at the end of the process is a wonderful finishing touch.

I think there will be really amazing apps that look a lot like HT for other types of local points of interest. I think those will be where the thick revenue driven outcomes for startups will come.

The mechanics of venture financing (Part 2)

This will conclude the things I talked about in my previous post about venture financing. 

So when we left off with Fitfoods yesterday, they had just closed a Series A financing for $1 million. Which is great, but it’s also bad. We have cash, but we also have investors. And it is really important to understand:

“Investors dollars do not equal customer dollars. Not even close.”

What that money gets you is runway. 1 year of runway to be exact, if everything goes according to plan.

But even if they do, you will likely still need to raise more money. Let’s say that some time passes and your team is really gelling and moving things along with Fitfoods. The prototypes are coming together and you have the early distribution relationships coming together. It took a lot of work, but it looks like there is a market out there and they will be ready for your product.

Unless you have had revenue coming in already, you will need to raise another round of financing. This round may be the same or more than what you raised for your Series A, but if things have been going your way, you will likely be raising a “growth round.” In the case of Fitfoods, now that your early prototypes are going well, you will need to start scaling your manufacturing output to meet demands from your customers and partners. You will also need to hire more sales and marketing folks to build that big market you know is out there. That will cost more money. Let’s say you believe you will need $5 million to do all of those things for the next year.

You don’t want to wait until the end of Year 1 to go out to raise that money. Just like before, it will take you several months to raise this new round of financing. So let’s say you go out at month 9 and meet with new investors. You work with that funnel all over again and you were able to sell yourself to a new investor with your vision and potential. You raised $5 million.

So what happened? Well let’s expand our financial analysis out another year. We can assume that you will do some revenues. In this case: $2 million. But that won’t be enough to offset the $5 million in expenses you will generate. So the $5 million we raised in the Series B will help us offset that cash burn.

And this time around, you were able to convince the new venture capitalists to increase your pre-money valuation. You have made progress and your company is more valuable than what it was before. Now it has a pre-money valuation of $10 million. Not bad!

But again, you will be diluted. Remember, you are basically selling shares in your company for cash. Fitfoods issues new shares of the company to your Series B investor for $5 million dollars. How many new shares? Enough for them to own 1/3 of the company.

One thing about the above slide that is probably wrong. Right now, it assumes that both you and your Series A investor are both diluted during this round. Oftentimes, your Series A investor will also want to maintain their level of ownership from previous rounds. This is known as maintaining their “pro-rata.” This will almost always be spelled out in the term sheet that they gave you during your Series A. If that happens, then your Series B investor will own 33%, your Series A investor will still own 25%, and you will actually be diluted down to 43%. But, the pro-rata right for your investor is a right, and your investors can choose to exercise it or not in subsequent rounds. Usually this is taken as a good sign of confidence and, keep in mind, those investors will have to inject more capital into your company at the current round per share price in order to maintain that pro-rata. 

But, this ultimately spells more dilution for you. You already own 50% or less after only 2 rounds of financing.

So what comes next? Well, at least for the world of financing, that’s pretty much it. Fitfoods will continue to grow and you will continue to need to provide financing to the company until it hits cash flow break-even, when your cash flows from running the business exceed your cash burn. Then you will no longer need investors to provide you with financing, you will be able to finance your business yourself.

Of course, along the way, you may have been significantly diluted down.

But ultimately, for venture backed businesses, the day you most look forward to is…

So, in the example of Fitfoods I delivered to the Cornell class, I said that Kraft made an offer to buy us out. The CEO of Kraft is a Cornell alumna, and I thought that would be a nice touch. Let’s say that they find your business to be very strategically valuable. And so she offers you $50 million for your business.

This is where the economics of equity becomes important. Based on what your most recent ownership positions are, that will be how you split the proceeds from the sale of your company. Remember, you each hold different shares of control in the business, and that is essentially what Kraft is buying from you. So, as we can see, you get $25 million, your first VC gets $8.3 million, and your newest VC gets $16.7MM. Your first VC put in $1 million and made 8x his money. Your Series B VC made just a little over 3x his investment. This makes intuitive sense. The first investor came in when your company was younger and took on greater risk and he has been compensated for that. Your second investor came along when your company had made more progress and was more seasoned. He took on less risk.

But also notice who made more absolute dollars? VC A made $7.3 million in profit and VC B made $11.67.

And this is where things get a little ugly. All of the things which I illustrated above is for a company that has led a charmed life. The honest reality is that the chances that you might raise venture capital is low and the chance that you may be able to take that company to exit are low as well. Not as dismally low as some would have you believe, but they are not a cause for optimism. The small minority of companies who hit it out of the park are charmed and generate the lion’s share of the attention, but they are not the majority.

I hope that this was a useful bit of information for you! I had a lot of fun giving this presentation. It was to a group of material science students who are working on ideas radically different from the social/mobile/Internet stuff that I have focused on and are wildly popular today. But at the same time, there is something about what they are working on that just seems so very substantial and possibly world altering. I hope they succeed. I hope the things I talked about will help them.

The mechanics of venture financing (Part 1)

A few days ago, I was asked to give a presentation on venture financing for Marty Murtagh’s MSE 4070 class at the Materials Science department at the Engineering School. I tried to condense down some of the things that I have been learning and working on over the last year into a keynote presentation.

I thought I would share them with you.

So let’s say you decide to start a company. You have been working in your lab and come up with an scientific breakthrough. It’s food that is delicious, but also allows you to lose weight when you eat it. Let’s assume no side effects.

Huge market! Right? There are some things which are automatically $100 billion market opportunities. This is one of them, along with commercial teleportation, the cure for male baldness, and immortality.

You have successfully spun this technology out from your university, have successfully incorporated and are ready to go. You did some simple math and realized it would take about 1 year to get your prototype to be ready commercially and during that year, you will need about $1 million to cover your expenses for the year: paying yourself, your cofounders, your early employees, office space, continuing R&D, early sales and marketing expenses, etc.

You may have taken financial accounting and learned about the accrual method, but since this is a startup and you have very little financing options, we’ll stick with purely cash.

As you can see, you have no cash from revenues (operations) or financing to offset the cash burn you will have for expenses. You need someone to give you cash.

Who is going to give you cash?

You have no cash. You’re a university student who just graduated with a boatload of debt. Your parents will not give you cash. They just spent 20 years of savings to put you through college. Your local bank is not going to give you cash. They make loans to SMEs and home buyers, not risky technology based businesses. You can cover some of your expenses on credit cards, but you probably don’t have a very high credit limit on your card.

The truth is, venture capitalists probably aren’t going to give you cash either. Chances are, Mark Zuckerberg, you are not. But that’s ok. This is all hypothetical. Let’s assume you actually are one of the rare few college dropouts/recent grads who can raise money from VCs.

Oh. One nice thing. You and your cofounders do own 100% of your company. That will not last for long…

It’s a automatic $100 billion market opportunity that you’re trying to tackle, so you have that locked down. And the science behind it is patented and hard to replicate, unlike web startups. And let’s assume you have a badass team of science and business folks.

I won’t go too much into the science and art of raising venture capital. There is an incredible corpus of knowledge written out there about that. I’ll stick with the mechanics of the financing.

Suffice it to say, you want to raise capital from people that you know understand the problem that you are tackling. You don’t want to raise from a firm that specializes in Internet companies, if you are focused on a consumer packaged good.

While venture firms that specializes in food related investments are rare, there are some out there. Highland Capital, out of Boston, for example, has a practice specializing in consumer retail, and were one of the investors in Pinkberry. Cayuga Venture Fund, located locally to Ithaca were one of the early investors in Cheribundi. You want to target the firms and, more importantly, the partners who specialize in those investments.

One of the best lines I ever heard from a hedgie who briefly was in the venture capital world, and why he did not like it, was that, “Venture capitalists are in the entrepreneur’s shorts!” The relationship that you, the entrepreneur will have with your VC will be… intimate. So make sure he (and it is almost always a he) will be able to add value to you.

So you go through the fund raising process and get turned down by lots of people. After 3 grueling months, you finally get a term sheet from a lead investor and fill out the rest of your syndicate. You get $1 million wired to your bank account and suddenly you are in business!

So if we take a look back at the financial snapshot from earlier. You see that you now balance out your cash outflows with a cash inflow of $1 million from financing. In this case, an equity financing and not debt. You are going to be ok for the year. You just closed your Series A. But if money never comes free, what did you have to give up?

You gave up control.

If you look on the right, you see that now, you (and your cofounders) own 75% of the company while your investor owns 25%. Very quickly, you will own less than 50%. How did that happen?

There are many, many important terms in the term sheet that you get from your investor. The one term that gets the most attention is the valuation. I don’t think it is always the most important term. I have seen enough cases to know that it is not always, but typically it is.

Your investors will give you a pre-money valuation of your company. If you were a mature company with lots of available financial data, then they would do a big financial valuation and discount to the present all of the future cash flows they would receive as equity holders and come up with a net present value for the share of the company they are getting. But since FitFoods is a startup that will be doing who knows what in even 3 years, it’s often just a negotiated process. Sometimes, you will use very messy comparable transactions from other venture financings, but those are far, far from perfect. Let’s just say, from a negotiated process, you arrive at $3 million pre-money.

$3 million pre-money with $1 million invested will give you a post-money valuation of $4 million. That will also tell you how much of the company you gave up: 25%. Not only are you giving up 25% of control, as exercised through per share voting rights, but you are also giving up 25% of the economics when your company sells. In the vocabulary of venture, those are known as “liquidity events.”

The mechanics of how that would work is that you would issue new shares to the Series A investor until they owned 25% of the company and founders were diluted down to 75%. In this case, there are no shares being sold between entities. It’s actually a pretty important distinction with tax implications, but I won’t go into that.

So if you were to incorporate your company with 1,000,000 shares, split among you and your cofounders, you would issue your VC 333,333 shares for $1 million during the Series A. Your total shares outstanding would be 1,333,333 at this point. Your 1,000,000 would give you 75% ownership and their 333,333 would give them 25%. Remember: no shares were sold between you and the VC. It was all new shares issued by the company.

This also implies that your per share value is $0.75. 1,000,000 divided across 1,33,333 shares equals $0.75. This will be important for the future as well.

There are also other very important terms that will impact your exit economics and control. Terms like liquidation preference can have a huge material impact on how much money you make when you sell. It’s why you can sell your company for a gain and not see a single cent. Also important is being able to control the board of directors, which decides on firing and hiring the CEO. The board can also make decisions such as issuing new shares that can dilute you down to nothing. Understanding those terms of control are not necessarily quantitative, but incredibly important.

That was actually a longer post than I had anticipated. I will continue in Part 2 with the mechanics of follow-on financing and exit.

Startups are like Jeremy Lin.

Startups are like Jeremy Lin. If you weren’t there for him before he was famous, it’s going to be really tough for you to be there for him now. 

The world of venture backed startups is full of stories quite similar to the story of Jeremy Lin. Everybody doubts that the entrepreneur can succeed. No one ever expects it. And when they suddenly explode, everyone suddenly wants to be their friend. Investors suddenly take an interest and want to get into their next financing round. But who are you?

There are a number of churches in New York right now that have reached out to Jeremy Lin, hoping that he will attend their Sunday service. I don’t know which one he will pick, but I am sure it would be the one that showed him the most hospitality while he wasn’t a somebody. 

I think that’s when venture capitalists get the most sheepish. “I never thought you were going to be huge, but here you are, changing things. Can I talk to you about your next financing event?”

Its almost like a fairy tale. 

One of the things that I have learned in this last (almost) one year in venture capital is that you have to be there for people when they are not at their best. Not because you think they will be big, though you should have that conviction, but because it is the right thing to do. 

Lean Back

Image by Getty Images via @daylife

The first month that I got Netflix, it was amazing. You could blaze thru your favorite movies and shows for days at a time.

The second month of Netflix, I ended up spending 10 to 15 minutes browsing through some serious dreck before finally finding something worth watching. Maybe 5% of Netflix is truly amazing stuff, the rest if seriously dreck, and good films are not being released to Netflix at nearly a satisfactory rate. Admittedly, I’m probably an edge case in terms of taste and rate of media consumption, but I know that this is not just a problem that I have.

Which is why I think that new modes of lean back media consumption that are building out recommendation engines are going to have their day. It’s going to be a narrow window of opportunity for winners to emerge in the next 2 years. That’s why I’m so excited about the NYC video hack day the fellas at Shelby (including my boy Chris Kurdziel) are planning for early September.

Video is only starting to take off. Long form premium content creators and publishers will have to figure out a good way to address it. Premium inventory against amazing shows such as the West Wing the Wire will grow and a highly correlated long tail inventory will emerge for cult shows like The League or The Guild. The ability to both serve those videos and monetize thru extremely valuable ad units will be something to be coveted in the near future.

I’m really excited.

The 9 out of 10 startups fail statistic needs to be discredited NOW

While I am by no means a Silicon Valley veteran, 3 weeks is more than enough time for me to hear the “9 out of 10 startups fail” statistic more times than I could care to count.

It is a false and misleading data point that has lodged itself into the community consciousness and drives home a cynicism that should not be tolerated.

There’s a fantastic Quora post on the topic here: http://www.quora.com/What-is-the-truth-behind-9-out-of-10-startups-fail

I highly recommend taking a moment and reading the responses. I excerpted some key lines:

From Chuck Eesley (emphases are by me)

Phillips and Kirchhoff (1989) find, using the 1976-1986 United States Establishment Longitudinal Microdata (USELM) files of the U.S. Small Business Administration, new establishments show an average survival rate of 39.8% after 6 years.

Audretsch (1991) similarly uses a nationally representative sample of businesses from the U.S. and shows that survival rates vary with certain industry characteristics. As one might expect, in industries where small firms do more innovation, survival rates are higher and in industries with scale economies and with high capital intensity, failure rates are higher.

Survival rates also are likely to be higher for technology-based businesses, for VC-backed firms, and for more highly educated entrepreneurs. Ed Roberts in his 1991 book, Entrepreneurs in High Technology, finds that out of a sample of spin-outs from MIT Lincoln labs, only 15 percent had gone out of business at the end of five years. He also finds that those with a Master’s degree had the best performance.

Only 15% of venture backed startups go out of business after 5 years.

There are some excellent answers, especially by the always-wise Brandom Smietana. 

But the spirit that I want to get to is this: I have too often heard entrepreneurs or investors say something along the lines of the following:

“9 out of 10 startups fail, therefore…

• You should not even try.”
• VCs will be incredibly risk averse to back you. Beware.”
• You have to protect your secrets.”

Cynicism. Antagonism. Paranoia. The cavalier attitude by which so many Silicon Valley denizens throw around this statistic feeds these negative attitudes.

To be sure, while the vast majority of venture backed startups survive, not all of them return the 10x type returns that investors crave. But even that meme is hyperbole at best.

If an investor is looking for a 25% IRR with an average holding time of 5 years on the invest, he needs a 3x return. A 50% IRR on 5 years is 7.5x.

High, certainly, but not untenable. A $20 million post-money valuation would need a $140 million exit value. This is, of course, assuming no dilution and liquidation preference shenanigans. Even so, looking at the exit environment that exists today, those are not absurd outcomes!

Bottom line: is there great and tremendous risk involved with starting a company? Absolutely. But when faced with such starkly pessimistic accepted wisdom, behavior becomes influenced and not in an agreeable fashion.

Let’s ditch the 9 out 10 statistic as a wildly inaccurate harbinger of a dark future that we want no part of.

Related articles

• Growth startup v/s lifestyle startup: why should there be a difference at all? (paraschopra.com)
• 500 Startups Adds 21 New Companies (blogs.forbes.com)
• A Look At The Three Startups That Wowed The Judges At Plug And Play’s Summer EXPO (techcrunch.com)

Idea vs. Execution

Image by id-iom via Flickr

Over at Quora, an interesting response to the question: What could the Winklevoss brotheres have done to protect their idea?

The writer uses the story of the Walt Disney’a two creations: Oswald the Rabbit and Mickey Mouse as an example. As some people may know, Micky wasn’t the first anthropomorphic cartoon character that Disney created. It was Oswald. But, besides the recent references to him in Epic Mickey, most people would just think he was a early sketch of Mickey Mouse.

Oswald the Lucky Rabbit was a big success. Unfortunately, Disney was pushed out by his partner at the time. But, Walt picked himself up, slightly altered the design to create Mickey Mouse and the rest of history. Many of you likely wouldn’t have ever heard of Oswald if not for Epic Mickey.

Basically, the point is that: ideas are important. But the right ideas in the wrong hands are not worth anything. Ask a dozen people and one or two will say: “Man, I had the idea for Amazon way before Jeff Bezos.” But Jeff Bezos had something that few of us have. Hustle.

In 1994, Amazon did not exist. 3 years later, the company went public with revenues north of $100MM a year. In 2000, the company reported net losses of $1,411MM. Today, it is one of the most celebrated Internet e-commerce companies and is disrupting the heck out of a thousand year old industry.

And that is the gut wrenching image of guy hustling and executing, turning pie in the sky into burgers in his hands.

MBA psychology continued: the self-directed search for a startup job starts now

A few weeks ago, I talked about “Advancing the cause of early stage careers at business school”. It may be a good time to revisit that topic. Why? Well, two reasons really:

1. My investment banking classmates have started raking in their offers en masse. The next wave will be the consultants. It’s a great thing for the overall mood of the school, especially since this year looks like it will turn out to be a good year to be in business school.
2. If you are looking to work with an early stage startup, the company you are hoping to work with is likely getting funded right now. Depending on how early stage you can stomach it, they may not even raise a round until April or March.

There’s no real way for you to time your entry into a startup. Depending on what they are working on and what they need, an MBA may not be the best fit, especially if you are looking for something in the summer. If you happen to go to a business school in the Bay Area, Boston, or New York, then you’ll be in great shape to join any of the various number of startups coming out of those regions. If you happen to be in a more remote location (such as Cornell), the summer may be your best bet. But, don’t overlook the possibility of doing a remote project.

That having been said, my thoughts on how to pitch a startup on you interning with them for the summer are below. Keep in mind, my model has not been validated by any results, but I think they are fairly sound:

Come up with a concrete project that you hope to be able to do for the companies with a solid idea of timeline, resources needed, and what your end deliverable will be. Some feedback that I have gotten on this: if you can quantify a ballpark amount of cash revenue that you can bring for the startup if you complete this project, even better! Remember: “Cash flow is more important than your mother.”

Related articles

• How to find the perfect startup job: Start with ‘when’ (finance.fortune.cnn.com)
• MBA psychology: Advancing the cause of early stage jobs at business school (www.zdanielshi.com
• Why we need to teach MBA’s about modern entrepreneurship (and what Harvard Business School is doing about it) (startuplessonslearned.com)