Venture Capital

New money into venture explains ups and downs in the market

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There’s been a lot of talk recently about what will happen to startup financing in 2016, including here on this blog. The consensus is definitely negative, but one thing that has buoyed my optimism about the prospects for our portfolio is the number of new funds raised in London recently. A lot of them are focused on Series A investing and favour the ecommerce and marketplace sectors that Forward Partners focuses on. Moreover, most of them are only a small way into their funds and under most scenarios will want to maintain a steady investment rate through 2016.

I just saw a great presentation from Mark Suster/Upfront Ventures on the State of the Venture Capital in 2016 which explains the discrepancy between the sentiment in the market and the observation that there are lots of funds out there which need to deploy capital.

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With this slide he’s explaining that in 2006-2007 investments into startups were equal to the funds raised by VCs, implying that only minimal amounts of non VC cash was invested in startups, but by 2014/2015 the situation had changed dramatically. In the last couple of years the ratio of money into startups to funds raised by VCs was 2.5 implying that an awful lot of non-VC money flowed into the ecosystem (the column headings in the charts are a little ambiguous, but the explanation I’ve given matches what Mark wrote here).

Mark also notes that startup valuations went up 3x from 2006-2015, and simple supply and demand logic suggests the non-VC cash in the market was important in driving prices up. He also surveyed 72 institutional investors in VC funds who said they think they will maintain their rate of commitments to new funds this year.

Pulling all this together it seems to me that any correction in the market we see this year won’t be because VC funds are investing less but because non-VC sources of capital are pulling back. That makes sense given that a lot of the froth was in big late stage deals where hedge funds and big fund managers like Fidelity were playing, and that is the sector of the market most closely affected by the downticks in public markets we have seen this year.

There will be a trickle effect down to earlier stages of investment, but most of our portfolio is still very young and the Series A market that’s most important to us in the short term is almost entirely comprised of VCs, and with a bit of luck will be less hit by any downturn than the later stages of investment. That fits with my observation about the number of funds in the London market and tallies with our experience in the first 5-6 weeks of this year, which is that our companies aren’t finding it noticeably harder to raise capital than they were last year.

Corporate innovation will harness the power of entrepreneurs

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Jon Bradford, founder of Techstars UK, once said to me that corporate innovation budgets dwarf venture capital. This tweet from Benedict Evans gives an insight into how much. The excess cash from Apple from 2006-2015 was greater than US VC funding in total.

That got me thinking, so I took a look at corporate R&D spend and it turns out that 2014 spend in the US was over $250bn and in Europe it was over $200bn. That compares with $86.7bn in global venture capital investment in the same year.

The interesting thing is that large companies are increasingly looking to the startup world to help achieve their innovation objectives. They, run accelerator programmes, and open ‘labs’ in startup hotspots and make acqui-hires.

These activities are interesting, but small scale. Over the next few years I expect we will see a lot more experiments as large companies work out how to harness the power of entrepreneurs. They have to. New markets are spinning up much faster than they can plan for and exploiting those opportunities requires a tolerance for failure and risk-reward balance that I don’t believe can exist inside large company structures.

I think truly innovative companies will get more sophisticated in the way they monitor the startup-ecosystem, get close to interesting companies, partner with them when appropriate, and know when they can acquire them effectively.

When they do that I predict a sizeable percentage of that R&D spend will flow into the startup ecosystem.

Big markets are spinning up and disappearing faster and faster

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The idea for this post came this morning when I saw these two tweets from Benedict Evans. One shows the newspaper industry growing steadily for fifty years and then declining for ten and the other shows the Japanese fixed lens digital camera market growing from nothing to 120m unit sales in ten years and then dropping by 80% in the seven years after that.

The market for the Japanese cameras spun up and disappeared more quickly than for newspapers. There’s a hypothesis that’s a phenomenon we are seeing over and over again. New markets, especially digital markets, grow big very fast, but don’t have legs. Other examples I can think of include

  • Word processing software – the market took off in the 1980s and is now in substantial decline due to Google Docs and Evernote. Evernote (arguably itself a new market) grew very fast but is now threatened by Quip.
  • Video cassette recorders took off in the 1980s, were replaced by DVD players in the 2000s, which are now being replaced by streaming services
  • Vinyl records were around for decades before being replaced by CDs in the 1980s, which were replaced by music downloads in the 2000s which are now being replaced by streaming services
  • Walkmans were replaced by MP3 Players which were then usurped by phones on a similar timetable
  • PDAs and satnavs were usurped by mobile phones in about 15 years
  • Blogging got going in about 2005 before Twitter and a collection of other sites took the wind out of it’s sales over the last three years or so

A few too many of these examples are linked to smartphones for my liking, but I do think there’s something in the idea that new markets have shorter and shorter durations. It fits with my worldview that the pace of change is accelerating. If the duration of markets is shortening it has implications for venture capital, because if companies take 7+ years to reach a big exit then increasingly their markets will have started to decline before they get big enough to sell or IPO and the model will break.

[Apologies for not posting the images from the two Benedict Evans tweets. WordPress won’t let me upload anything today…]

Venture investment was down in Q4 but may have further to go

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Screen Shot 2016-01-15 at 14.33.21

Yesterday I wrote that there are clouds on the horizon in the world of startup finance, but it was unclear whether valuations will continue to drop, level off, or even go back up. Today the new data from PWC shows that investment dropped sharply in Q4 but is still at historically high levels. As you can see from the chart above even though the $11.3bn invested in Q4 was 32% less than the $16.6bn invested in Q3 it was still higher than all bar five quarters since the 2000 bubble burst.

Moreover, the shape of the decline in venture investment after the NASDAQ peaked in Q1 2000 suggests that the current decline will go on for more than the 1-2 quarters we’ve seen so far. As I said yesterday, private markets react slowly.

However, on Mattermark this morning we had a post from Calacanis arguing that market deflation is almost complete and a post from Tunguz which concluded by saying he thought it likely that VCs will continue to pay high valuations for premium SaaS startups. For me the jury is still out on which way the markets will move next, although I do think that a further downwards move is likely at some point in the next year or so.

Clouds on the horizon

By | Venture Capital | One Comment

Through much of last year there was talk of a bubble in venture capital, particularly in late stage investments. Valuations were stretched, both on a fundamentals basis and compared with the public markets, and there were even whispers of a ‘new paradigm’ for valuing companies now that businesses can expand around the world so fast. It was inevitable that the heat was going to come out of the market at some point and my hope was that it would come out sooner rather than later, and that the down-rating would be more correction than crash and the collateral damage would be limited.

That process started quietly after the summer last year. Whilst valuations in the UK at the very early stages at which Forward Partners invests haven’t moved much (yet) friends here who invest at later stages are telling me stories of companies slashing their expectations by 40-50%. On the other side of the Atlantic the sentiment was even more negative, not helped by Fidelity (and others) writing down the value of their holdings in previously high-flying unicorns.

A bit of context is important. Information flows slowly in the venture world, at least compared with public markets, and changes like this take time to play out. That’s partly because investors look at returns over 5-10 years and are less concerned about their position at the end of the quarter, partly because transaction data is private and it takes time for people to find out what’s going on, and partly because deals are often put together over many months and people don’t like to radically change course. The last point is related to the first two.

The interesting question now of course is how far it goes and recent weakness in the public markets won’t help. NASDAQ is off about 10% since it’s Christmas peak and fears about rising interest rates, falling oil prices, weakness in China, and falling corporate earnings generally are contributing heavily to negative sentiment. Worse from a venture perspective is that GoPro and Fitbit have both seen huge falls in their share prices recently, adding concerns about exit potential in specific categories to fears about the market generally.

The good news is that innovation continues to happen faster and faster each year, so the fundamentals for startups are strong, and that this correction is happening now rather than after another couple of years of irrational exuberance. That said, we could bounce back to heady times quite quickly, particularly if central banks react to the current situation by deciding to keep interest rates low. The more likely, and to my mind healthier, scenario is that we see a few months of continued weakness in the venture markets and then things level off. I think it’s unlikely we will crash as hard as did in 2000 or 2008. Given the paucity of information and pace at which changes happen we will be left guessing which of these scenarios we are in for a good few weeks yet.

London VC investment up 130% YoY

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I read these stats in the Financial Times this morning and thought I’d record them for posterity. As you can see the UK and especially London had good years for VC investment last year. We’re still a long way behind the US though where $47bn was invested in 2014 (no 2015 stats yet, all data from CB Insights). If you adjust for a 5x difference in population the picture is better, but we are still only 45% of the US on a per capita basis.

It’s also interesting to note that London is accounted for a larger share of UK investment in 2015 than 2014 (64% vs 48%).

‘Must have’ products

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This weekend I was reading posts on A Founders Notebook post about Must have products and navigated to Clayton Christensen’s super interesting Job to be done framework for evaluating products.

As I’ve written many times before I believe that great product is the key to building a successful these days, but there were 30,000 consumer products launched in 2011 and the failure rate is c95%.

Investors have to find ways of identifying which products are going to be in the 5%.

The first place that many of us look is customer engagement. It’s a great sign if lots of people are using a product regularly. It’s better still if they are telling their friends. These are the reasons investors obsess over cohort data, engagement stats and NPS scores.

If you invest in pre-product companies, as we do at Forward Partners, then there’s no customer data and it gets more difficult. A common refrain is to look for products which offer a ’10x improvement’ – that works for some products, but there are many others which succeed where there’s no obvious 10x metric – gmail is a good example. We think a lot about use cases and many of the companies we work with use customer interviews and prototypes to find the features and benefits which will make their products ‘must have’.

The ‘job to be done’ framework takes the use case and places it in a real world context asking ‘what job is the customer hiring this product or service for?’. The language of ‘hiring a product’ is a little clunky, but as Christensen notes people only buy products and use services because they have a job that needs doing. This real world context is powerful because it forces you to make the analysis from the customer’s perspective and inherently factors in competing alternatives. The risk with thinking only about use cases is that they can sound cool but not work in practice because they miss an important facet of the customer’s context.

In the post I linked to above (and again here) Carmen Nobel describes research that Christensen did into why people buy milkshakes from fast food restaurants. It turns out that 40% of milkshake purchases are made by consumers on the way to work and drunk in the car.

From the customer’s perspective (and that’s what counts) they are buying the milkshake to make their commute more interesting and to stave off 10am hunger pangs. Thick milkshakes are great because they take longer to drink and do the ‘make the commute more interesting’ job for longer. Following the research the fast food chain made their milkshakes thicker.

Another major job that milkshakes are bought for is to treat children. In this case thicker milkshakes are unhelpful because parents have to wait longer for the kids to finish. Following the research the fast food chain made thinner milkshakes just for kids.

When I think through the successful companies in our portfolio it’s clear what job they are helping customers to do. With the less successful ones, not so much. That’s why I’m drawn to this framework. The most obvious application for us is in the analysis of individual investment opportunities, but I’m also thinking that it can be used to evaluate new market sectors that we might focus on, asking the question ‘what job will products in this new sector do for consumers?’

Any shift in power from founder to investor will be short lived

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I just read a re/code post which kicked off with the following sentence:

Investors are growing more conservative as valuations are cooling down, and the balance of power between entrepreneurs and VCs may be shifting back toward the money men.

This is a fair observation of what’s going on. When the heat comes out of the market some investors lose their nerve and valuations drop. I had lunch with a UK based Series B investor recently who told me that in the first half of this year his fund was refusing to invest at the high valuations asked by many companies, but that he is busy now because some of those same companies are back now asking for 40-50% less. In this environment the balance of power inevitably shifts a bit from founder to investor.

However, whilst the correction in price might be permanent, the shift in balance of power will only be temporary.

Almost by definition an investor’s strongest card is that they have capital. The bad news for investors is that card is getting weaker. The long term trends of increasing capital efficiency and commoditisation of capital are simultaneously reducing the amount of capital founders need and making it easier to get.

That’s why our strategy is to look beyond the money we invest to be as helpful as possible in every other way we can, and why we’ve invested in a very substantial team to execute that strategy.

The second problem with bubbles: overfunding

By | Venture Capital | 2 Comments

The first problem with bubbles is well known. Valuations crash, lots of companies aren’t able to raise money and go bust, and most of the good ones are only able to raise smaller amounts of money and have to layoff staff. Bubbles are brilliant for companies that exit before the burst, but for the rest they bring a lot of pain.

There’s a second problem though, and that is overfunding of whole industries. As Bill Gurley said in a recent interview, “Once your competitor raises $400 million, you don’t get to choose whether you’re in that game or not.” and the result is that whole industries get overfunded. They then spend all their money competing to grow and margins for everyone disappear. Strong companies are still built but exit valuations aren’t what they could have been because cashflows aren’t healthy and acquirers have choice.

There’s a good chance that’s happening in the home delivery market where large numbers of startups are well funded – Doordash, Postmates, Deliveroo and Instacart are the first ones that spring to mind, and then there are others which bundle product with delivery, usually food, e.g. HelloFresh, Munchery, and Blue Apron. Back in July CBInights reported that food delivery startups raised $1bn in 2014 and $750m in H1 2015.

My former partner at DFJ Andreas Stavropoulos describes this as ‘venture fratricide’.

On the Square and Match IPOs and hopes for a correction

By | Exits, Venture Capital | No Comments and Square both enjoyed strong first days after their IPOs yesterday. Match closed up 23% at a valuation of $3.5bn and Square was up 45% at a valuation of $4.2bn.

That’s good news for both companies, because first day declines can sour a stock for months to come. However in the run up to its IPO Square had indicated it would go out at between $11 and $13 per share, and then ended up at $9, and in October last year Square raised $150m at a $6bn valuation. So the share price has been trending down for some time before popping after the IPO.

The interesting question for me is what this means for startup valuations more generally. The obvious narrative is that investors thinking of investing in other late stage private companies are either going to walk away or insist on much lower valuations, which will then have a knock on effect on all company valuations, particularly as Box IPO’d at less than its previous valuation back in January, Fidelity recently wrote down the value of its holding in Snapchat, and there are lots of private companies sitting on valuations higher than similar companies with public listings.

A lot depends on what happens next in the public markets, particularly with the Fed preparing to raise interest rates, but I think there’s grounds for hoping that investors in late stage private companies will have a reaction, but won’t hit the panic button. I say that because investors in the $6bn round in Square have still made money on the deal. They had a ‘ratchet’ which repriced their investment in the event of a down round to give them a 20% return. If you compound the 20% with the 45% pop then when the markets closed yesterday they were showing a 74% profit on the Square deal. That’s a good return, but it came in a way that investors won’t want to repeat.

Hence I think investors will have a measured reaction and if we’re lucky some heat will come out of the market but we won’t have a crash.