Evolving our investment strategy

By | Announcement, Entrepreneurs, London, Startup general interest, Strategy, Venture Capital | No Comments

This is a long post (1,900 words). For those of you who are time poor here’s the tltr:

  • Forward Partners operates a focused investment strategy because it helps us make better investment decisions and provide better support to our companies
  • A good focus area for us is one that can generate 50+ deals and where we can build some generalised expertise that helps with our decision making and value add
  • Until now we have focused on marketplaces and next generation ecommerce
  • Recently we evaluated lots of options and did a deep dive on Applied AI before selecting it as our next area of focus

For the three and a half years that we’ve been going, Forward Partners has operated a focused investment strategy. We observed that small transactions of all types are increasingly moving online and backed the companies that were helping to accelerate that trend. That meant lots of consumer and small business focused marketplaces and next generation ecommerce companies. Lost My Name, Appear Here and Thread are three of the better known examples, but overall there are 37 companies in that portfolio.

We chose to be focused for three reasons. First, and perhaps most important, being focused enabled us to build up expertise that resulted in better investment decisions. Specifically, we feel we have strong capabilities in working out whether customers will value products highly and whether it will be possible to market them cost-effectively online. Secondly, we have seen so many similar companies now that we have a good sense of what they should be achieving by when. We are better able to see problems coming and advise on strategies to work around them. Being expert in an area makes us better board members and hence better able to win deals with the best entrepreneurs. Finally, focusing allows us to add more value operationally so our companies can execute faster and with higher quality. The companies we back often share the same challenges as each other and because we focus our team has solved those problems many times over.

However, venture capital is a dynamic business and good focus areas don’t last forever. We are still seeing lots of marketplace and next generation ecommerce opportunities, but as we move into our second fund we decided to add another focus area to make sure we will continue to have enough high quality opportunities to invest in over the next four years.

Our first step was to define the what we mean by a “good focus area”. For us the following characteristics are important:

  • Will generate 50+ deals
  • We can build knowledge that’s broadly applicable across the focus area and gives us an advantage versus other investors
  • We can articulate a few underlying investment theses
  • We can articulate use cases
  • Suitable for early stage investment
  • The UK has some kind of advantage

Then we had a high level discussion about what areas we might focus on next. A couple of interesting things came out of that. Firstly we like to invest in sectors that are rising from the low point of the Gartner Hype Cycle. Investing at this point leverages our key capabilities of assessing whether customers will love products and whether companies will be able to market them cost-effectively. If we get the timing right then mass adoption should be achievable. Investing with this strategy means we don’t chase the very rapid value appreciation that sometimes occurs at the beginning of the Hype Cycle, but we think the benefits of focus outweigh the cost of the lost opportunity.

The other interesting point to come out is that investing in deep tech at the very earliest stages is difficult. One of the key drivers of success for us as a fund is backing companies that make rapid progress and are able to raise up rounds a year or so after we invest. To do that they must pass valuation milestones. With ecommerce and marketplace companies those milestones relate to sales and unit economics and are easily demonstrable. Progress at deep tech companies, on the other hand, is based on internal development milestones and it’s difficult to predict how next round investors will respond. Until a product is released and is in the hands of customers, which can take years, the only evidence of success is internally reported improvements in algorithms and the production of code. I’m sure there’s a way to solve this for deep tech investments, but we haven’t figured it out yet.

The next stage for us was to brainstorm potential areas of focus. Each member of the investment team went away and over a couple of weeks contributed ideas to a shared Google Doc. Then we reconvened with the objective of choosing a single area on which to focus. Via a process of discussion, voting and then amalgamation of ideas we decided to look seriously at making “Applied AI” our next focus area. That would mean investing in companies that were using well understood artificial intelligence techniques to build new and superior products.

We felt that Applied AI is attractive because:

  • It’s a broad enough area to generate 50+ deals
  • Is one where we already have knowledge and could could go on to develop a deep expertise in the different techniques and their application
  • Is at the right point in the Hype Cycle and plays to our strengths in evaluating demand

The major concern we had is that AI more generally has been a popular investment theme with other investors for some time and we wanted to make sure that Applied AI is sufficiently differentiated to be a viable investment focus for Forward Partners.

We decided to go away and do some work to improve our understanding of the area with the aim of answering the differentiation question and convincing ourselves more generally that Applied AI has the potential to yield a flow of high quality investment opportunities over the next 3-5 years.

To that end we sought to answer the following questions:

  • What are the AI techniques that can be applied cheaply and predictably by startups?
  • What capabilities do those techniques enable? (e.g. natural language processing enables conversational interfaces)
  • What use cases can these techniques be put to? (e.g. conversational interfaces to FAQ databases can improve customer service)
  • Are there enough use cases where the addition of ‘intelligence’ makes the product meaningfully better?
  • How can Applied AI startups meaningfully show progress in their first year of operations?
  • How much AI talent is required at pre-seed and seed stage Applied AI startups and can we find enough companies with that talent?
  • How can we add value to Applied AI companies?
  • What are some hypothetical strategies for Applied AI startups to obtain the data they need to train their algorithms? (Addressing the “cold start” problem.)

The first three of these questions relate to the size of the opportunity set. To choose Applied AI as a focus area we had to believe there is the potential for 50+ deals that would make sense for us. To get an answer we mapped an extensive list of Applied AI techniques against the Gartner Hype Cycle, and put them into a spreadsheet linking them to the capabilities they enable, then linked those use cases to capabilities, and finally the use cases to ideas for companies. After that we scored the company concepts based on their attractiveness as Forward Partners investments and looked to see how many high scoring opportunities there were. Fortunately there were many.

Screen Shot 2017-07-26 at 20.10.30.png

Once we had comfort on the size of the opportunity we turned to the final three questions which relate to whether the opportunities will work as early stage investments. Our approach this time was to hold workshops and meetings with people who had experience of building applied AI businesses. Thank you in particular to Matt Scheybeler, Steve Crossan, and Martin Goodson for helping us with this part of the journey.

One important learning at this point was that in the early stages of Applied AI startups the artificial intelligence component isn’t that complicated. We heard multiple times that you can get 80% of the way there with statistics, that almost any AI technique will get you the next 10% and that it’s only when you get to the last 10% that you need to get clever. That was great to hear for two reasons:

Most startups with true potential don’t get to the last 10% in their first couple of years so hard to find AI talent isn’t a prerequisite to get started.

Our existing strengths in building products that resonate with customers and driving growth aren’t eclipsed by a requirement for deep tech knowledge – i.e. we can help.

The other important point we learned is that Applied AI startups can get product to market quickly and drive predictable value appreciation in the timeframe of a pre-seed or seed investment. We talked through numerous real and hypothetical examples and got confident that when we make Applied AI investments they will be able to raise their next rounds at a good step up in valuation. That’s one of the most important questions any VC has to answer and we were pleased to find that because they can get started with simple algorithms, Applied AI startups aren’t different from other software startups in this regard.

The final piece of our investigation was to think about the “Cold start” problem. We talked about three different data strategies for Applied AI startups and what that would mean for us:

  • Founders have access to some proprietary data
  • Founders have an innovative idea for using publicly available data
  • Founders will generate data from their business and develop algorithms later

In the first two of these cases Forward Partners needs to evaluate whether there is value in the data pre-investment and to help the founder extract value from the data post investment. In the third case we need to be able to evaluate whether the business will be able to generate data, and then if they can the evaluation is the same as in the first two cases. All of this points to us enhancing our data science capability at Forward Partners.

Our conclusion therefore, is that Applied AI is an attractive focus area for Forward Partners. It looks promising that there will be the required volume of dealflow, we can see how an early stage investment strategy will work, and we can leverage our existing strengths to help businesses in this new area. The only new requirement is that we enhance our data science capability.

Hence for the last couple of months we have been targeting Applied AI deals alongside our traditional focus area of marketplaces and next gen ecommerce. Wherever possible we like to take an experimental approach so we have decided that we will run with it until the end of the year and then evaluate. In parallel we are investigating what sort of data science capability we need. That will in large part be determined by the sort of opportunities we see and end up investing in, so for now we are relying on relationships with people who help us on an ad hoc basis with a plan to bring the capability in house when the picture gets clearer.

And I’m pleased to report that we have already made our first two Applied AI investments. Neither is announced yet, but watch this space 🙂

Rich vs King – entrepreneurs should choose between wealth and control

By | Entrepreneurs, Startup general interest, Venture Capital | 7 Comments

I’ve just finished reading Founders Dilemmas by Noam Wasserman the central point of which is that for entrepreneurs there is a trade off between wealth and control. In my experience, few founders see it this way.

“But wait!” I hear you say, “I can have both wealth and control, like Larry Ellison or Mark Zuckerberg”.

Theoretically it’s possible, but Wasserman conducted a study of 10,000 startups over ten years and concluded that:

Although the desires for wealth and control seem complementary, as entrepreneurial motivations they turn out to exist in perpetual tension with one another … Even a seemingly reasonable strategy for achieving high levels of both wealth and power, rather maximising one or the other, is actually more likely to put them both out of reach.

460 of the startups in the study were particularly closely analysed and within this group Wasserman found that the equity stakes of founders who remained CEO and kept control of their board were only 52% as valuable as those of founders who had given up the CEO position and control of the board.

The reason is that many of the decisions which maximise wealth nibble away at a founder’s control. The most obvious of these is raising venture capital which typically involves giving up a substantial chunk of equity, granting certain shareholders extra control rights, bringing outsiders onto the board (who may one day seek to bring in a new CEO), and making a difficult to reverse commitment to a high growth strategy and eventual exit. Hiring great people, either as co-founders or execs will also maximise wealth creation but come at the expense of control as such people demand a say in how the business is run and generous share or option packages.

If you are an entrepreneur beware the cognitive bias that makes you think you are Superman, that you can be an outlier like Zuck or Ellison. It’s great to have that self belief, it’s what enables you to move mountains, but it is irrational and you want to make sure you use it in the right way and don’t let it lead you down the wrong path.

Founders Dilemmas is well worth a reading if you are part of the startup ecosystem. It’s a dry read, but it systematically explores the decisions that founders make and their impact on wealth, control, and other success criteria, helping you to better understand the situation you are in and the things you should think through.

Institutionalising the fear of failure

By | Entrepreneurs, Innovation, Startup general interest | 9 Comments

I was shocked when I saw this table in the Economist on Friday. In general I think that a little fear failure is healthy, without that entrepreneurs wouldn’t think through their chances of success properly, but that too many people use it as an excuse for not starting businesses, or as a cheap explanation for why our startup ecosystem lags the US (I wrote about this in more detail in 2007, and my views haven’t changed much).

Failure is a multi-headed beast, and bankruptcy is one of many things that would-be entrepreneurs have to worry about, but it sets the tone for how a nation thinks about business failure is easy for governments to change.

What leaps out from this chart is the difference between France and Germany on the one hand and the UK on the other. The sad truth is that bankruptcy laws give entrepreneurs in two of Europe’s largest economies good reason to fear failure. Nine years is much too long a time to be stuck with debts if you go bankrupt. There is, of course, a balance to be struck between encouraging people to start companies and protecting creditors, but I think we have that about right in the UK. I hear occasional stories about unscrupulous entrepreneurs here who get credit from other startups, don’t pay, and then use the bankruptcy laws as a shield as they go about their business seemingly unencumbered by the fact that they owe somebody else money, but they aren’t too frequent and I don’t believe that the prospect of bankruptcy inhibits many people in the UK from starting companies.

I doubt the same is true in Germany and France.

It is tough founding a business

By | Entrepreneurs, Startup general interest | 14 Comments

The Wall Street Journal today has a great article designed to help potential entrepreneurs figure out whether they are cut out to found their own businesses.  If that is you then the whole piece is well worth a read.  Being an entrepreneur can be a fantastically rewarding occupation both financially and at a personal level, but it is manifestly the case that not everyone is cut out for it.  Moreover, unlike most jobs, once you have founded a business and employed a few people leaving the company can be prohibitively difficult.

The article is structured around 10 questions that entrepreneurs should ask themselves and then after each one there is a brief discussion of the issues.

In the remainder of this post I’m going to bring out the single best question and the subsequent discussion and the list the remaining questions without the discussion (you can go back to the WSJ for that).

Single best question: 

Are you a self-starter?

Entrepreneurs face lots of discouragement. Potential buyers don’t return calls, business sours or you face repeated rejection. It takes willpower and an almost unwavering optimism to overcome these constant obstacles.

John Gartner, an assistant clinical-psychiatry professor at Johns Hopkins University and author of the book “The Hypomaniac Edge,” theorizes that many well-known entrepreneurs have a temperament called hypomania. They’re highly creative, energetic, impatient and very persistent — traits that help them persevere even when others lose faith.

“One of the things about having this kind of confidence is they’re kind of risk-blind because they don’t think they could fail,” Prof. Gartner says. And, he adds, “if they fail, they’re not down for that long, and after a while they’re energized by a whole new idea.”

The other questions:

  • Are you willing and able to bear great financial risk? [there is a reason many entrepreneurs are already wealthy]
  • Are you willing to sacrifice your lifestyle for potentially many years?
  • Is your significant other on board?
  • Do you like all aspects of running a business?
  • Are you comfortable making decisions with no playbook?
  • What is your track record of executing ideas?
  • How persuasive and well-spoken are you?
  • Do you have a concept your passionate about?
  • Do you have a business partner?

I have seen many entrepreneurs struggle with different questions on this list and their companies have hit bumpy patches as a result.  Conversely just about every successful company I can think of has been able to cover off all of them.  Not necessarily via a single individual though – and founding teams need positive answers for these questions between them not for each person separately.

Many of these questions apply also to ‘professional CEOs’ who come into startups when they through the inital founding stage, but are still small.

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New study showing that for entreprenneurs past success is the best indicator of future success

By | Entrepreneurs, Startup general interest, Venture Capital | 10 Comments

In May last year I blogged about some research in the FT which seemed to show that experienced entrepreneurs with a new venture were no more likely to succeed or fail than first timers.

That ran counter to my intuition at the time, and to most of yours (although we need to be careful of success bias), and indeed a couple of you pointed to research which showed the opposite – i.e that previously successful entrepreneurs are approximately 1.5 times as likely to be successful with a new venture than first timers.  Interestingly, entrepreneurs who have been previously unsuccessful are only slightly more likely to be successful the next time round as complete novices are with their first venture.

New research today from the highly regarded HBS professor Josh Lerner backs up these later results.  According to his paper, as reported on PE Hub:

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

As PE Hub points out these are pretty high percentages in the first place, which is good for everyone.

The other interesting piece of this research is the assessment of VC value-add.  In a nutshell according to Josh’s research we don’t make much of an impact on the chances of previously successful entrepreneurs, but we are a big help with first timers and people who failed the first time round.

Putting these two stats together and it is easy to see why previously successful entrepreneurs are sometimes successful at achieving very high valuations when they raise venture capital into their companies.  The VCs know they are 50% more likely to be successful, and the entrepreneur knows it doesn’t really matter which VC she chooses….. As a caveat to this I’m going to say it is also important to remember that we are talking about statistics here and they mask a lot of variation between companies.

The final interesting stat in the PE Hub report is the percentage of VC deals that are backing serial entrepreneurs – it is surprisingly low at around 15% (and not all of these will have been successful the first time round).

To finish I’m going to offer a quick recap of the discussion that happened last May.

This questionof what predicts success is a very complex one which encompasses many variables and where much of the research is suspect.  In addition to experience the following are also important:

  • the impact of experience on risk appetite – knowing what he is getting into an experienced entrepreneur may choose not to start a new venture or to opt for a smaller success with a higher probability of getting there
  • whether you are in a novel space or not (Clay Shirky) – experience counts for less in genuinely new areas
  • Whether the previous success was due to market timing (repeatable) or good execution (less repeatable)
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Some challenges facing the venture industry

By | Entrepreneurs, Startup general interest, Venture Capital | 9 Comments

Anyone who has read my recent posts on the future of venture capital will know I am optimistic about where we are headed.  This post is about some of the challenges that we will face along the way.  And they are not trivial.

Over the last couple of days Umair Haque has set out a lot of the problems facing the venture industry in two posts – Five Problems Venture Capitalists Should Have Solved (But Didn’t) and Asleep at the Wheel of Creative Destruction.  His central point is that as VCs we have collectively failed to generate the innovation that might have helped avoid some of the current problems the world is now trying to find solutions for.

The reasons for that, according to Umair is that VCs have been:

  • too risk averse
  • focused on maximising near term returns
  • confusing immitation with innovation

There is a lot of truth in this.  As is often the case Umair describes the situation as more extreme than I would.  In my view the world is not in as bad a place as he would have it and there is more good in the venture industry than he gives it credit for.  But he is directionally correct.

Which means things need to change.

I think that change will come because:

  • Since the late 1990s the venture industry has been mesmerised by the
    prospect of massive short term returns – initially via the public
    markets and latterly via trade sale of fast growing web assets to
    highly rated public companies.  These short term exit opportunities simply won’t be there, forcing startups and investors to focus on longer term growth.
  • This in turn will shift much of the focus back to fundamentals and away from trying to anticipate where the exit hype will be in 2-3 years time.
  • Significant capacity will come out of the US market, reducing the money for immitators (which largely came from tier two funds anyway).

On their own these are pretty significant changes for the venture industry, but to complicate matters further the areas that are ripe for innovation may stretch the existing venture model both in terms of investment mindset and holding periods.

In his Five Areas post Umair repeatedly seeks new ways of conceiving value – and this creates challenges for investment committees looking to deliver what they have promised to their limited partners – i.e. near certainty of returning 10-30%+ net IRRs.

Two examples:

  • Umair states, and I agree that communications needs reinventing, and that advertising in its current form is not the answer.  The challenge comes when you combine that with the trend towards ‘free’.  Then it can be difficult to see how to exit a business at the sort of levels we need to target in the 3-5 years we have at our disposal.
  • Similarly reconceiving capital markets is tough because they are an integral part of the venture capital model.  The exit is crucial to everything we do and finding a new way to do that could be compared with trying to change the wheels on your car whilst you are driving.

None of this is to say, of course, that these challenges are insurmountable, just that they will be tough.

I think Umair is correct in saying transparency will help which is in part why I am writing this post.  In the final analysis the venture capital industry is a channel for money from limited partners into startups and we have to live within the constraints of that model.  It is easy to say that VCs should be more risk averse and invest over the longer term, and I think we should, but to do so we first need to convince our limited partners (who are our customers) that they should change the terms on which they make funds available to us.

Apologies for a slightly rambling post, but I think the final point I am heading to is that it seems to me VCs on their own aren’t going to be able to change enough to unleash the innovation that Umair describes.  It will also take help from entrepreneurs to find ways to bring their startups close to the 3-5 year exit model and from LPs to stretch out fund terms.

Traction or revenue

By | Business models, Entrepreneurs, Startup general interest, Venture Capital | 11 Comments

Last night at a Techrunch event in London someone who was at a talk I gave in Manchester earlier this year asked a VC panel if they still shared the view I expressed at the time that for many consumer internet startups the right strategy in the initial stages is to prioritise growing traffic over building revenues.

The point being that now we are in a credit crunch a more conservative strategy might be appropriate.

Unfortunately I wasn’t in the room to defend myself having irritatingly arrived too late (my fault), but if I had been there I would have stood by that comment – with the two caveats that you still need a strategy for monetisation even if you prioritise traffic in the early days and that I was talking about VC scale businesses.

I think those arguments apply equally in good times and bad.  My logic then, as now is:

  • For mass market (primarily) free to use sites unless you have got a lot of traffic then garnering meaningful ad revenues will be impossible.  Minimum critical mass to get advertisers to really engage comes in at around 1m uniques in the UK and maybe 5m in the US.
  • Generally speaking, for a business with VC scale funding and ambitions the revenue available with traffic under these levels is secondary in terms of value creation to reaching minimum critical mass in your user base.
  • Therefore growing traffic is more important early on than growing revenues

This strategy worked for Google and Facebook across cycles and is working for Twitter now.

Note though, that these are all very successful businesses and if there is any doubt that VC funding is available then finding revenue to ensure survival makes a lot more sense.  That can be either for pre VC companies or businesses that have had a Series A.  And VCs are getting a lot more conservative at the moment.

The other caveat is that the display advertising market is getting soft and there are new and legitimate doubts about whether straight forward banners on social media sites will ever generate much revenue.  Simply having hundreds of millions of page views (or the potential for them) is therefore less attractive.  That monetisation strategy is getting trickier.

The other point I want to make is possibly more important: focusing on what VCs want is not necessarily a good idea. 

Venture capital is only appropriate for a small percentage of businesses – i.e. those which have potential to exit at significant valuations (for us around $200m+) and which need at least $5-10m to get them there.  For businesses that fall outside of those parameters then raising venture capital can be value destructive – and often is.

So for me the right thing for any business is to focus on what is best for it’s existing shareholders and then only if there is a natural fit with what a VC wants to do you go ahead and raise some money.  That is very different to bending the strategy out of shape just to get a VC on board.

Making the case for cash out deals

By | Entrepreneurs, Venture Capital | 5 Comments

Don Dodge has a write up from a Microsoft conference last week where he chaired a panel of VCs.  His main message is that VCs are still investing (true, but at a much slower pace…).  The piece I want to bring out though is the discussion of how to motivate founders.

Don reports that John Giannuzzi of Sherbrooke argued that stock options don’t motivate founders, and that they don’t align the interests of founders and VCs, largely because there is no downside risk.  Instead he prefers to ask founders to invest in the business, so they are directly aligned.  I can see the logic of this argument, but my suspicion is that in practice for founders who are not independently wealthy (which is most of them) this approach will tend to push you towards smaller outcomes.

At DFJ Esprit we have done a number of deals where we have let founders partically cash out, including, and this echoes the approach of Founders Fund (early investors in Facebook, Slide and a number of other hot web startups), as described by Don:

Founders Fund approachFounders Fund
has a completely different approach, allowing founders to cash in some of their stock in the first funding round. Founders Fund, as the name implies, is a VC firm started by founders of startup companies. Peter Thiel and two other PayPal principals, along with Sean Parker (Napster, Plaxo, Facebook) are the partners at Founders Fund, and each has been through all the phases of starting a company. They feel that investor’s interests are more aligned if the founders have some money on the side so they aren’t compelled to accept the first exit opportunity that comes along. They feel the startup founders will be more willing to hang in there for a longer period of time and hold out for a bigger exit.

Too true.  For many founders a little bit of early liquidity takes away the short term requirement for relatively small amounts of cash (school fees, slightly bigger house etc.) and allows them to focus on aiming high.

You do, of course, have to be sure that everyone will still be motivated to turn up to work.  At the end of the day that is mostly a judgement call, although making sure that the founders still have much more wealth tied up inside the business than they have outside it is also to be recommended.

Planning for growth

By | Entrepreneurs, Innovation, Venture Capital | 2 Comments

For the past week or two I have been enjoying reading Judy Estrin‘s Closing the Innovation Gap, in which she describes how key elements of the innovation ecosystem in the US are failing and suggests some actions to rectify the situation.  As part of this endeavour she seeks to understand what it is that really drives innovation and how that is different from development and as such sets out the following framework for understanding the application of R&D resources:

  1. Current generation.  Maintaining continual incremental improvement through product or process change required to meet existing customer needs.  [NB This is the bare minumum to stay alive.]
  2. Next generation.  Making advances in science and technology or business processes as required to maintain market leadership or to leapfrog competitors.  These innovations might be incremental, orthogonal, or breakthrough.  [NB This is the minimum steady state requirement for most high growth venture backed businesses.]
  3. Future growth.  Even the most successful companies need to look beyond their current customers and markets to investigate potential areas of growth for the future.  They also need to be prepared to take advantage of radical disruptions in their current markets.  [NB This is where the opportunity to generate outsize returns lies, but there will be minimal short term return on investment.]

I like this framework for the way it sheds light on the detail of the returns from different areas of resource allocation within R&D budgets.  Judy’s main point is that as a society we need to spending more on 3. Future growth which I agree with wholeheartedly, but the framework also has application in resource planning for individual companies, particularly when times are tough.

Depending on their profitability, cash resources and prospects for raising further money many small companies are having to ration resources.  Analysing R&D spend using Judy’s approach will help if there are difficult decisions to be made – eating into 1. Current generation carries clear short term risks, sacrificing 2. Next generation might be sustainable for a short period of time but no longer if valuation progression (or even maintenance) remains a target, and any exciting long term plan probably needs to include 3. Future growth.