Multiple Compression In The “Winter” & Why It Matters
More Than Just a Podcast
Is It The End Of The World As We Know It?
The Game Theory of the Seed Stage = Pay Upp
My Two Year Old is Smarter Than You

Multiple Compression In The “Winter” & Why It Matters

To say that today was a rollercoaster would be an understatement. While I recognize I’m a relative novice to the financial markets, watching fast selloffs and panic selling is always mesmerizing – no matter how many times one has seen it.

I don’t know how Bill Gurley always seems to have impeccable timing, but last Thursday night (before Friday’s market pullback which started this whole mess) he ripped off an 8 piece tweetstorm where he warned that recent corrections in the public markets could have an adverse impact on the tech startup world. Re/code chronicled those thoughts in a piece entitled Winter is Coming, You Ready? Within the tweetstorm, Gurley made the following two points:

At the close of today’s markets, I decided to do a quick analysis to see how true that is. Especially with a few of the stocks I know very well: marketplaces such as Etsy, Grubhub, Shutterstock & Homeaway. As some of you may recall, I penned Unpacking Etsy’s S1 on TechCrunch a few days ahead of its IPO back in April. Here’s how those stocks stacked up back then on a GMV, Revenue & EBITDA basis –

Recall that on the day of its IPO, $ETSY actually spiked to an Enterprise Value of over $3 billion dollars so imagine an EV/GMV of close to 2x and an EV/Revenue of nearly 15x.

I re-ran the numbers at the close of today’s market and updated the company financials to reflect their trailing twelve months (2nd half of 2014 & 1st half of 2015) as opposed to just 2014. Here’s what they look like now:

As is evident, Gurley is 100% correct. Its not these companies aren’t growing (see below) its that their multiples have been cut by 50-65%. Only Homeaway seems to have avoided the carnage, most likely because it is the eldest, most profitable, with the strongest balance sheet. At the same time, to those of us in the tech world, it is the stock most likely to be entirely disrupted – by Airbnb – but no matter. The market is looking for stability, not growth. You can see for yourself: the market is applying nearly identical multiples to both Etsy & Homeaway – two companies at very different stages of growth and maturity.

Here’s why this matters: Most VCs (including Chicago Ventures) have typical rules of thumb we like to apply to companies when considering an investment that have (at least roughly) some correlation to public market comparable. For example for marketplace businesses, we’ve historically looked for a valuation to be anywhere from 1.5-3x annualized GMV. For an e-commerce business it might be similar. Its dependent on growth rates, and we expect to pay higher than public market multiples because our startups are growing 2-10x year/year, not 60%. But as public market multiples come in, we’re forced to reevaluate. For instance, if we’re considering a Shutterstock clone (bad example, but you get the point) and we’re forced to say – “Well, it really only has $800M market potential, not $2.5 billion potential” – then it drastically affects entry price.

How long current multiples will last is anyone’s guess – or whether they’ll have a snap correction. But one thing seems clear to me right now: my generation of younger VCs who were trained to assess top line GMV growth first will soon be forced to master other, more fundamental aspects of a business’ economics.

For those keeping score at home, here’s my assessment of those 4 public co’s trailing twelve month financials. I moved quickly to get this out the door before the market close & there could well be errors:


More Than Just a Podcast

I was honored when Harry Stebbings, founder of the 20 Minute VC asked me to be a guest on his show. He’s had a number of my close friends on the show as well as some industry heavyweights such as Brad Feld, Jason Calacanis, David Pakman and others.

The full audio of our interview can be found by clicking here.

But there’s a deeply important lesson behind Harry’s podcast – that you create your own destiny. Harry is 19. And he has the most popular podcast about venture capital in existence.

Between Kellogg and Chicago Booth, I would imagine I have between two and three dozen MBA students reaching out to me every year about how to break into VC. That number doesn’t include several dozen more from various professional positions in Chicago who are interested in VC, etc etc etc. All of them are looking for help – and that is fair – but they are looking at the world traditionally. Very few, if any, are brute forcing their own path.

With nothing more than a Skype account and a few cold e-mails, Harry has over the past year gained access to some of the top venture capitalists and entrepreneurs in the world.  Frankly, I’m jealous.

The podcast started simply enough when Harry recognized there was a massive amount of interest in VC, but no focused podcast less than a hour+ – effectively criminal in an age of more bite sized information. So he launched a product to solve it.

Harry’s story actually inspired me to reach out to some of the VCs I look up to for interviews on my blog (and those will be forthcoming in the next few weeks). This is a karma driven business and no one that I know of is succeeding who wasn’t mentored or given by assistance for no good reason other than pure altruism.

I have absolutely no idea if Harry is a good investor, or a good venture analyst (sorry, just the truth!). But a lot of investing can be taught – it’s access that is prohibitive. Harry is the latest proof point that there are plenty of openings to build a reputation, create relationships, and make a mark in this industry.

Is It The End Of The World As We Know It?

I don’t know. Maybe?

Over the past few weeks, we’ve begun to see a number of high profile startups failing to raise new rounds of funding such as Homejoy, GoodEggs and StumbleUpon:

While I’m by no means the first investor with this observation, I do believe it reflects an acceleration in the number of publicized growth stage companies failing to raise continuation capital (of course, given the sample size, timing could be entirely coincidental, but it doesn’t feel that way). In fact, it’s a timely development because it’s specifically the lack of companies failing that is concerning a great number of venture focused LPs. For example, an LP friend of mine recently noted the following to me –

The larger issue is that loss ratios in venture right now are way out of whack and not a lot of companies are failing. There are obvious outliers like Fab, Homejoy, Zirtual and Secret, but still a lot of unrealized markups. So it really comes down to how good the companies are that you’ve invested in and how durable they are.

What needs to be unpacked from that quote is that if “not a lot of companies are failing,” then it follows that someone must be supporting them. So it’s imperative to ask: who is supporting them and why? The who, in my mind, is reasonably well understood at this point: everyone from traditional growth firms, to corporate venture, to mutual funds, to wealthy foreign family offices. The why – at a high level – should always be: expected value, with “expected” certainly the operative verb.

But those expectations and estimations of future value may well be changing. A friend at a Top 10 growth firm noted to me the following this morning:

I think you’re right and, yes, seems like folks are pulling back.
One, public markets are the ultimate arbiter of truth and they’ve weighed in quite negatively on the mid-cap tech stocks : Yelp, Shutterstock, Marketo, etc etc
Two, the whole benefit of the mezz-pre IPO / late stage venture round : it’s a bridge to an outcome. Not a bridge to another bridge. If those late capital rounds are just helping you kick the can down the alley, then forget it. If you have a reasonable and purposeful plan in place to i.e. use the $ to tweak economics, or crispen the public story, or grow just a year or two more so you can have size and strength to show — then absolutely.
The consumer companies are struggling in particular. Haven’t quite nailed unit economics in most of these cases. People are just like – what do I get from this round?
There’s a lot of irrationality in the Seed/A/B rounds and a lot of rationality in the C/D/E rounds. Those two dynamics are coming to a head.

As a MicroVC with four years of investment experience under my belt, I won’t pretend to understand the nuances occurring at every stage of the ecosystem, but I will note a few of these “dynamics” I see coalescing:

Scale it Before You Nailed It

As a startup community, we are living in age of scale first. The reasons for that are below in the next section. And while there will be winners, scale first is both tremendously expensive and volatile. From the GoodEggs blog:

The single biggest mistake we made was growing too quickly, to multiple cities, before fully figuring out the challenges of building an entirely new food supply chain. We were motivated by enthusiasm for our mission and eagerness to bring Good Eggs to more people. But the best of intentions were not enough to overcome the complexity. Today we realize that in order to continue innovating in San Francisco, our original market, in order to continue figuring out all the complexity that is required to achieve our mission, we cannot productively maintain operations in other cities.

Similarly, from Ellen Huet’s Forbes article on Homejoy:

Homejoy faced pressures dreadfully familiar to many successful young startups: Raising a huge round (in this case, $38 million in 2013) comes with investor expectations of equally huge growth. To meet those expectations, Homejoy expanded quickly — too quickly, former employees said — into new and international markets, at one point opening in 30 cities in six months.

Cheung “was always telling the growth story … because we need to have this story to raise the next round of capital,” said the same former employee. “She really felt that if the company stopped growing really, really fast we’d be dead.”

As an investor, I am guilty of advising several of my investments to scale too quickly. What I’ve begun to realize is that in some ways it’s actually easier to scale than refine a business model.

For example, early on in my career playing poker professionally, I faced the following dilemma: I realized I was a big winner in $400 buyin games, but only a breakeven player in $1,000 buyin games (where the skill level was higher). I had two choices: I could study, grind, experiment and take a few months learning the ropes in order to beat $1,000 games. Or, I could simply play more tables of $400 games (thereby playing more hands per hour & winning more money). Initially, I chose the latter because it was the easier decision – I simply needed to play more (even if slightly more distracted) to win more money. I ultimately realized this was a mistake and spent months rebuilding my game.

Again the issue here is NOT that scaling is fundamentally incorrect. It’s that if your scale ambitions are so high, and you’ve gone so wide so fast, well then, you’re left with a “bridge to another bridge” – specifically what the market is beginning to reject.

Megarounds Causing a Loss of Fundamentals

The logic of today’s growth financing market operates as follows:

  1. The majority of markets operate as Winner Take All where outsized returns accrue to only a single dominant player, as outlined by Wealthfront co-founder Andy Rachleff in Demystifying Venture Capital Economics.
  2. Investors are therefore highly incentivized to create unicorns/decacorns/gorillas/whatever you want to call them.
  3. Cost of capital is at historically low rates, to the point of even negative interest rates in Europe – “flabbergasting” Berkshire Hathaway investor Charlie Munger. For reference negative interest rates actually “punish banks that hoard cash” in order to force lending.
  4. Therefore, focus is unilaterally on scale and growth ahead of fundamentals, with the theory being that once customers are locked in (either enterprise or consumer), the model can be refined.
  5. Because companies assume their competitors are optimizing for scale (i.e. trying to raise mega-rounds) they also raise mega-rounds.
  6. The convergence of multiple mega-rounds inflates cost structures/weakens economics for both companies forcing them to raise further funding.

From Bill Gurley’s Investors Beware:

The very act of dumping hundreds of millions of dollars into an immature private company can also have perverse effects on a company’s operating discipline. The only way to use the proceeds of such a large round is to take on massive operating losses. Historically, as a company neared an IPO level of revenues (say $50-$100mm), investors would expect convergence toward profitability. As these late-stage private companies digest these large fund raises, they are pushing profitability further and further into the future, as well as the proof that their business model actually works.

While the high level logic of the megarounds is sound: that unicorns should be prioritized for outsized returns – there appears to be an absolute uncertainty surrounding how far to scale and at what cost. Is 5 markets sufficient? 15? 50? 100? There will always be more potential ground to cover. Gurley’s point is that the recent spate of continual growth financings is akin to not knowing when to take some money off the table. The market may well give you a loan to double down – but should you?

Consumer Companies 

As noted above, the carnage (for the moment) appears directed at consumer companies. What’s disconcerting as a consumer investor is that it’s not simply social or media plays devoid of revenue at all, but even revenue generating transactional models such as Homejoy, Goodeggs, or Fab. I don’t have a good answer yet for why this is. If sales driven enterprise software companies are exempt from current market concerns, revenue generating consumer companies should also earn some credit. Maybe it’s about margins or delusions of Long Term Value? Unclear, but worth more consideration.

It’s also hard to know whether this is a coincidence of sample size, a temporary pause in the markets as investors get over-saturated with opportunities/deals (recall that the IPO markets entirely closed in the spring of 2014 for a month around the time was looking to go out – then boomed again), or a fundamental shift in investor perspective.

All that said, one thing is clear: from the people I’m talking to and the signs I’m seeing, it really feels different right now. Only time will tell.

The Game Theory of the Seed Stage = Pay Upp

Yesterday Hunter Walk published a post entitled: Seed Stage VCs Compete With Each Other But Not How You Imagine, which argued that in spite of the explosion of seed/MicroVC funds, the environment remains more collaborative than competitive. While, anecdotally, I agree with most of his thoughts, I do believe that from a game theory perspective the seed stage world should look far different.

In addition to Hunter,  Semil Shah recently reflected that he’s seeing increased downware pressure on seed valuations as investors (and LPs) tire of ballooned entry prices – especially with the lack of any material M&A.

If these trends are true, that top tier “branded” seed funds with institutional LPs will be increasingly subject to valuation discipline, it should (in a game theory optimal world) create an opening for a new generation of seed funds.

Here’s why –

Everyone Likes Storytime, Right?

In early 2015 I got extremely excited by a company involved with an exclusive group, that, well, rhymes with “I see.” I started speaking to this company about a week before their demo day via a referral from a founder in their class. As I recall they were trying to raise some money at a valuation cap of $5M.

It took me a few days to track down the people I wanted for diligence and we spoke the morning before demo day. They offered me an allocation at that moment but told me that after demo day, the entry valuation would double to $10M. I see this tactic a lot, and while I always find it a bit off-putting, I do respect their trying to incentivize closing some money early to build momentum.

For whatever reason, a few diligence points I was waiting on didn’t come in until later in the afternoon, but came back positive. I called the founders and told them I’d write them a check at the $10M valuation. They told me that they’d quickly filled their raise at $10M (and told me the rather seductive list of investors who’d joined at that price), but would be happy to have me at a $20M valuation. They wouldn’t budge.

Irrespective of whether this healthy or atrocious for the ecosystem, what would you do?

I passed citing “valuation discipline.” And in turn missed on one of the hottest companies I’ve seen this year. I later heard through the grapevine that the valuation ballooned as high as $30M for some investors. I sacrificed brand for valuation discipline.

Game Theory Optimal

Yesterday, Kauffman Fellow and all-star blogger/LP Samir Kaji responded to Hunter’s blog post asking if explosion in seed funds is lifting valuations?

@Samirkaji IMO multistage firms coming downstream causes more pricing pressure than lots of small investors. At least for our deals.

— Hunter Walk (@hunterwalk) August 4, 2015

What’s interesting to me about Hunter’s response is that it actually suggests that growth firms moving downstream understand the lifeblood of competing at the seed stage: Brand.

These growth firms want access to opportunities that founders aren’t traditionally considering them for. To become convincing they need to pay up. Upstart seed funds face the same dilemma.

Being branded affords certain advantages:

  • Theoretically it allows you to convince founders to take your money at lower valuations because you bring more value and more positive signaling.
  • It improves dealflow, thereby improving ultimate returns.
  • Your investments have more positive signaling associated with them, leading to less susceptibility towards the Series A crunch, and therefore improving returns.

If this is true, fund strategy should be largely centered around brand.

If I had to summarize what founders have told me they want in a Big VC Firm, it would be: 1. Brand name 2. Trust 3. Ability to follow-on

— Semil (@semil) July 23, 2015

In my mind, brand can be developed in a couple of ways: (a) A long track record of successful investments/exits (b) A more recent track record of well known investments alongside strong syndicates (c) Thought leadership/strong publicity/founder references. In my view, many entering seed funds – looking at A16z’s astronomical rise – believe that “services” are what matter most. Services are merely a means to building a brand – VC has always been a rolodex business, and services/help are pre-requisites to even compete in the game.

Here’s My Logic And the Cycle of Venture Disruption:

  1. Venture has proved to be a Winners Take Most business where the top few funds in each category produce the outsized returns. In order to become a top decile fund, it is vital to find yourself in this category.
  2. Becoming a top fund is a function of brand.
  3. Brand is a function of several variables, some of which are long-term – returns – and others which can be influenced near-term: syndicate partners, relationships, marketing, founder testimonials.
  4. Because quality of investments can be “influenced” by paying higher valuations for access, funds without brand equity should be willing to do so.
  5. Because of the increased number of seed funds, this logic should cause considerable upward pricing pressure – forcing prior “branded” funds (now more return/institutional LP sensitive) to pass and exercise discipline.
  6. After some duration of exercising discipline – and missing good opportunities – the first wave of funds will return to paying inflated prices to gain access but several from the second wave will have emerged.
  7. Over time, unbranded funds or funds that exercise extreme discipline will lose access to top opportunities, not perform well and will die out.
  8. Taking a very long term approach, as these funds die out, valuations will recede to lower levels as competition lessens and as branded funds are able to sell their “value” better than newer competitors.

It’s using this logic that leads me to believe that as long as seed funds continue to enter the market at record pace – those who are fortune to be backed by LPs with a long term view of the world – will continue placing upward pressure on startup valuations – but may also emerge victorious and as powerful players in the still maturing seed environment.

If you’re curious….

My logic assumes the following assumptions to be true (many of which are debatable). If you spot more, please let me know:

  1. Markets are game theory optimal and rational (obviously untrue)
  2. Venture stages operate similarly to WTA
  3. Founders remain largely valuation sensitive and will mostly optimize valuation while fundraising.
  4. Brand is a leading factor in access to top investment opportunities.
  5. Paying higher prices correlates to better deals


My Two Year Old is Smarter Than You

Because he is continually, persistently, (aggravatingly) asking “why.

And that is vital in a world mostly focused on the what.

One of the things I’ve noticed in many of the decks I see, entrepreneurs I speak to, even decisions I’ve personally been making is a disproportionate focus on the what of a business or market. How many customers does a company have? How much do they spend? How frequently are they purchasing? How much do they spend? How many times do they open an app? What is their workflow within the app? Which color drives conversions better? Those are all questions that answer the what. And they don’t tell you a darn thing about the why.

I don’t know how this defaulting to questions defined by what started. I joined my first startup in 2007 and it sure feels like we thought about why all the time. Part of me wonders if it has to do with the surge in A/B testing and “Growth hacking.” Both are important functions of a startup, and can answer a lot of questions about what is working better – which design, what affiliate channels, etc. But again, they mostly ignore the why.

Phin Barnes from First Round Capital has a very nice piece – Growth is Not a Hack – so can we please stop saying Growth Hacker – where he demands of a business to understand the why:

It’s tempting to just throw stuff at the wall and see what delivers the most users. Don’t fall into this trap. Hacks can lead to empty-calorie, engineered distribution that isn’t sustainable…At the First Round Community companies I work for, growth is a strategy based on observation of the market and understanding of the consumer. The most successful companies have frameworks and data to understand their users, engagement and acquisition. They can explain why growth is happening, see the business impact, and accelerate growth based on what they learn.

The truth is we’re all guilty of defaulting to the what: I’m guilty of this too. Last week I published a well read post on eSports that stated a lot of bullish facts about the eSports industry, its insane growth, engagement, etc. But I offered very few insights into the why. The why is the toughest question to answer, because in a world dominated by (or one where we ceaselessly laud) engineers and data analysts, it is often unquantifiable.

But the why is also often the most exciting question we ever ask: breakout writers Malcolm Gladwell, Steven Levitt, Jonah Berger and others have made a career out of taking the “what” we see around us in the world and explaining why it is so.

In a world where storytelling is becoming a determining factor of success, understanding why your market or customers are acting/reacting the way they are is crucial. As Bill Gurley recently noted, the importance of narrative is paramount. But it’s hard to build an exhilarating narrative on facts alone. I once asked one of my professors (and current Groupon CEO) Eric Lefkofsky how he knew he wanted to make an investment. He answered that if, while discussing a business with its founders, the case they were making was so compelling that he simply needed to jump out of his chair with excitement, that was the tipping point. Growth can pique interest, but only a exhaustive conceptual understanding of why can truly close the loop about a narrative.

Maybe it’s a bit didactic  of me, but I have been underwhelmed by the number of founders with a deep understanding – or even an infectious curiosity – for the why of their business. When I reflect back on the entrepreneurs I’ve been most excited to work with, it’s those special leaders who have a methodical understanding of why now, why this market, why this strategy, why this team, why we win, why this is working.

I can’t help but wonder if in a marketplace dominated by software intended to answer only questions of what (most BI dashboards, big data, etc) there is a massive opportunity for platforms that can begin to synthesize the why. On the enterprise side, it feels like we’ve gone from data aggregation towards predictive and actionable analytics. That shift has been accepted because those actions produce results – yet it leaves us dependent on variables we fundamentally don’t understand. I hope this changes. From what I’ve seen, Directors or VPs of Customer Insights typically don’t get hired until a startup exceeds 100+ people…I would challenge that habit and I wonder how much faster product/market fit could be discovered if the current growth versus understanding model were inverted.

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