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1
How Slack and Facebook Are Making Access to Information Less Democratic
2
The Hidden Challenges of Starting a Company in Secondary Markets
3
Why Amazon Has Consumer Investors Bemused and Confused
4
The Increasing Cost of Consumer Startups
5
How to Not Fail When Predicting the Future

How Slack and Facebook Are Making Access to Information Less Democratic

Earlier this month Jonathan Libov, an Analyst at Union Square Ventures penned a widely circulated piece on the importance of paying attention to “fringe” technology and interests in the corners of the internet. He noted:

Fringiness, if you will, is in many ways vital to the business of venture capital. Sure, there is a large segment of investments that are wholly mainstream from the start and can be found by some combination of being in the right place at the right time and good execution (e.g., Uber). But there is a large segment that capitalizes on the arbitrage of thought, culture and research. Inasmuch as a venture capitalist has developed ideas and conviction about how the world will develop, hanging around the fringe is an opportunity to participate in big opportunities that are priced well because the majority of other investors haven’t caught on yet.”

I agree with Jonathan. But there’s one problem: the fringe, which used to be accessible to anyone with a mouse and keyboard, has, over the past several years become increasingly opaque and inaccessible. So what changed?

First, some history: My earliest memory of the internet’s fringe was in America Online WaReZ chat rooms a subculture where people swapped files, tried to gain administrative accounts. (It was during this period that I taught myself how to code in Visual Basic simply so that I could write hot-key functions to sit on top of AOL). In those days, conversations within the walls of AOL’s interest groups and chat rooms were undeniably private – neither indexed nor aggregated – and nowadays, probably flushed and lost forever.

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But that would quickly change post-AOL, transitioning into a longstanding period of heavy archival. Online communities and interest groups enjoyed a largely public discourse for much of the past 15 years. Usenet newsgroups (and all the amazing content of the alt. and rec. topics) were initially indexed by DejaNews and later made fully searchable by Google. As Usenet was fading, massively searchable online forums powered by UBB.threads and later by the vBulletin platform were wholly indexed by Google and remain archived and accessible to this day.

And the trend continued with Reddit’s rise to popularity. As the world of micro communities and interest groups began to transition away from individual web forums and centralize within Reddit’s walls, they adhered to the ethos of content accessibility. Although their pages have historically ranked poorly on Google, they do, in fact, rank, fully meta-searchable and transparent.

But Reddit’s advantage – massive amounts of centralized content and interests – was also its curse, yielding an often aesthetically messy, abuse ridden experience. Alex Shye, an entrepreneur in the Bay Area, likened Reddit’s architecture and experience to Craigslist – which had been successfully unbundled into vertical specific marketplaces such as Uber, Airbnb, Thumbtack and others – and predicted that Reddit would be similarly unbundled into vertical specific content platforms and communities.

He was right. Sort of. Reddit is being unbundled. But not by vertical specific sites. That honor has been assumed by massively horizontal platforms: Slack and Facebook.

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Slack, the $3.7 Billion communication platform has expanded from its root as a team based communication tool and now boasts tens of thousands (at least – the number is not publicized) of individual teams/communities. Many of these communities have thriving discussions, but are not fully public – often demanding an application process for entry – nor are they explicitly archived or searchable. How many of the more than 3M Daily Active Users are in interest-based communities is anyone’s guess. But anecdotally, it’s high.

Concurrently, Facebook Groups have been consistently growing in absolute number and engagement for years, now boasting over 1 billion Monthly Active Users. Teddy Citrin at Greycroft Partners recently noted that the launch of Groups’ Discover Flow has for the first time offered transparency into the scope and depth of Groups’ unique memberships. But even so, these Groups are also membership gated and their content remains unindexed by Google and downright unsearchable – unless one is a member.

And there may be one additional macro-trend at play: as messengers, led by WhatsApp, FB Messenger, Line, and Kik continue to incentivize native brand engagement and content/product conversation, that may yield large volumes of incremental content, reviews, comments, and awareness that leave the broader searchable ecosystem.

Admittedly, there has always been discourse existing beyond the internet’s open walls, whether it was cased in e-mail or IRC channels. But excepting e-mail, the conversations have still generally occurred in open mainstream channels. But recently, I have watched my own dependency on Slack and FB Groups increase materially to maintain relevancy of certain interests. [I have also watched more private conversations get revealed on Pastebin – but that is a separate discussion.]

The fringe exists as the “fringe” for a reason – it is by intention intended to sidestep mainstream conversation. But nevertheless, from my vantage point, it’s becoming increasingly opaque. If you are also thinking about this shift in community and information, feel free to shoot me a note, would love to chat.

The Hidden Challenges of Starting a Company in Secondary Markets

Fred Wilson’s much debated post, Second and Third Tier Markets and Beyond, sparked an important discussion about operating and investing in businesses outside of the Valley. Case in point: within 48 hours, the piece generated a heated Twitter exchange (including input from the one and only Bill Gurley), a Pitchbook analysis of the best M&A outcomes by region, and even a capitulation of sorts from Fred.

Wilson identified a couple of important challenges of building in these markets, namely lack of conviction, lack of money, lack of infrastructure, and shallower talent pools:

But there is a dynamic that goes on in these third tier markets where the local investors look to investors in the first and second tier markets to come down and “validate” their investments. And the investors in the first and second tier markets won’t come down and do that without a strong local lead. This game of “chicken” happens ways too often in these markets and is incredibly frustrating to entrepreneurs in these markets. These third tier markets need a few strong Series A focused VC firms who have large enough fund sizes to be aggressive lead investors and also have the conviction and stomach to play that game. That is what USV, and Flatiron before it, did in NYC. That is what Foundry did in Boulder. That is the game Upfront is playing in LA. Every third tier market needs a few VC firms like that. And being that investor is a terrific way to make a lot of money.

The truth is you can build a startup in almost any city in the US today. But it is harder. Harder to build the team. Harder to get customers. Harder to get attention. And harder to raise capital. Which is a huge opportunity for VCs who are willing to get on planes or cars and get to these places.

And his insights are a good start. But as someone who’s lived the Chicago startup scene since moving here in 2007 to help build CardRunners Gaming, I’d like to suggest three other non-obvious challenges of building companies in secondary or tertiary markets. This is a tough love blog intended to provide guidance within secondary markets and enable founders to actualize their potential. If you can get through it and internalize it, it’ll make you stronger.

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The Press Challenge

Although the press outside of SF & NY may not be bulge bracket publications, they are nevertheless not constrained either by distribution (digital solves that), nor by space. But they are constrained by a dearth of quality stories. Meaning that Chicago, for example, has a finite number of private unicorns or venture backed IPOs – so, if you want a quote from the CEO of a Chicago unicorn company for example, you’ve got finite people to call.

The effects are that it can force a cycle of manufactured, often unwarranted positivity, feature stories, even local awards on companies that are downright unproven or even floundering. Moreover, it enables certain founders, especially those with a natural PR inclination, to run from magazine shoot to newspaper interview to conference to panel and back, all the while ignoring the actual company they’re supposedly running. It’s akin to Mark Suster’s admonition to Be Careful Not to Become a Conference Ho: “If you’re a startup CEO — don’t kid yourself. Get back to work. There’s a team in the office in need of your guidance.” But that warning is amplified in secondary markets where founders – sometimes entirely unproven, even occasionally on the brink of shutdown – are paraded around by the press, conference organizers and awards shows as local heroes.

PR is a wonderful tool and an extraordinary opportunity for the right situations (building a story for hiring, consumer marketing, etc). But it is a challenge to ignore the phone when the press circuit is continually calling. Local founders must learn to say no at the formative stages of their business.

The Self Delusion Problem

If an entrepreneur goes to raise money in the Valley and is unsuccessful they are forced to concede one of the following points: either (a) I am not a good fundraiser or storyteller, (b) This should not be a venture backed business*, (c) I have not proven sufficient traction, or (d) This is not a good idea period. [There may be other nuances or derivatives of these four, but you get the idea.]

This is because the Valley funds over a thousand new companies annually, plays host to hundreds of seed stage funds, and has the deepest network of angel investors anywhere in the country. Lots of companies get funded and you didn’t.

But in Chicago, an entrepreneur can ignore all of those failings and instead simply blame Chicago: It is Chicago with its low risk tolerance, or its culture of demanding revenue, or its disposition towards boring enterprise businesses, or excuse Z that are the reason my company didn’t get funded.

Unfortunately, some businesses with outsized potential certainly do fall through the cracks in smaller markets (Fred alludes to this as well). But that simply serves to reinforce the potential for self delusion: wherein founders, should they so choose, never need to admit that their startups do not meet the threshold for investment. This can enable a cycle where local founders become resentful and/or spend years fundraising for a business that will simply not get funded.*

The Cap Table Problem

A big pitfall of secondary markets is poor cap table planning and management from the earliest stages that materially affects long-term growth potential. It typically falls into one of two buckets:

(1) We have met multiple companies that were otherwise intriguing except for the fact that a single investor (often an angel) owned more than 50% of the company. This matters because with an option pool, and 25% dilution of the impending financing, it leaves even a solo founder (let alone a 3-person founding team) improperly aligned for future growth needs.

(2) A company that initially raised money from angels at too high of a valuation, that later took on a bridge or even a fresh round of capital from that same group of angels (again, at a higher valuation). SO, by the time the company had proven product/market fit, it’s prior valuation was dislocated from the market values traditionally ascribed by venture institutions.

#2 is a far more egregious problem, often generating a vicious cycle of dependency on amateur investors. Now, to be fair, every market suffers from questionable practices of non-professional investors. But those practices are exaggerated in secondary markets that lack pre-seed infrastructure or successful entrepreneurs to properly seed the next era of startups.

In almost all markets, even ones without much institutional venture, there are copious numbers of high net worth individuals, successful real estate operators, or financial services pros who are looking to enter startup investing – either because they can’t generate alpha in their core jobs or because startups are sexy.

The problem is this: once the vicious cycle of dependency has been initiated (and because no one has an interest in marking down their investments) it is extremely difficult to disassociate from it. Which isn’t to say that great companies won’t be built with such a founding structure. Many have. But it does make it difficult to attract experienced local entrepreneurs or traditional institutions to the cap table.

Summary

Secondary and tertiary markets provide a lot of benefits for startups looking to build great businesses. Lower costs of living enable a lesser burn rate. Less competition for great talent and easier accessibility to successful advisor networks are also a big positive. That I am very bullish on Chicago should be obvious: despite being an East Coaster (DC & NYC) – and with opportunities in numerous cities – I’ve made it my new home.

But pitfalls and challenges abound. The better informed entrepreneurs are, the better non-SF markets are likely to perform.

* My intention is not to be crass or insensitive. There are many great businesses, digital and offline, that are simply not a fit for institutional venture funding. My first startup, CardRunners Gaming, is one such company – profitable from day one and profitable now, even a decade later, although it’s total market potential was at most $10M. Had the company raised institutional money, it would have imploded upon itself trying to stimulate growth in a market that simply could not accommodate it.

Thankfully, other investors such as Bryce Roberts at Indie.vc are building innovative funding models, intended to accommodate non-venture digital businesses. Here’s a great article on their efforts: Venture Capital and Its Discontents

Why Amazon Has Consumer Investors Bemused and Confused

Amazon’s recent entries into home servicesfood deliveryprivate label clothes & shoes, as well as a wide range of private label home items represent its most brazen efforts ever to attack the entire retail stack as well as penetrate seemingly defensible network effect businesses.

Over the past couple of years, Chicago Ventures has made a number of investments in service-enabled (concierge) commerce businesses believing that their service layer provides a real defensibility against Amazon’s low (no) margin approach. Writing in TechCrunch this past December in “The Middleman Strikes Back,” I noted then:

“If you sell practically any physical good online, Amazon, the Internet’s most powerful retailer, is a perpetual threat. With their distribution, leverage and logistics expertise, they have the wherewithal to undercut on price, and process and deliver products faster than practically any startup — not to mention, they can operate at a loss if necessary.

So where is Amazon exposed? On a services level.

Amazon’s operating margins — already tight at 1.3 percent — don’t allow for much room to train and mobilize a large human concierge force. Which means that building a human-focused, relationship-driven personalization platform actually provides for a tangible differentiator against Amazon — one of the few ways to effectively compete against the giant (and, perhaps more importantly, one of the few ways to build defensibility in a commerce segment traditionally dependent on “brand” as its only de facto moat).

One further point: Amazon is predominantly a destination for directed search – either on a specific product or specific category basis. But as purchasing increasingly shifts to mobile, it turns out that it continues to be difficult to search, discover and catalogue individual items. Concierges – especially when leveraged via a mobile interaction point – reduce that friction and enable a new purchasing behavior.”

But outside of these concierge commerce businesses – which by the very nature of their human capital costs will inherently be lower margin businesses[1] – are there still opportunities to build consumer businesses in a world increasingly dominated (or potentially undercut) by Amazon?

At an event today in Chicago, Amazon employees from nearby fulfillment centers packed 2,000 care packages to send to soldiers abroad who are not able to come home for the holidays Friday, December 4, 2015. Since 2010, Amazon has shipped more than 12 million packages to APO and FPO addresses. The Amazon care packages for the troops included holiday chocolates and snacks alongside an Amazon Fire tablet. The care packages for soldiers headed off in an Amazon branded trailer—one of thousands that Amazon has started to roll-out to increase capacity in the supply chain. Amazon’s Vice President of North America Operations Mike Roth said, “I couldn’t be more pleased that our very first Amazon trailer headed out on the road carrying such special packages—thousands of boxes filled with beloved holiday items and Amazon Fire devices to support troops abroad this holiday season.  (Photo by Peter Wynn Thompson/AP Images for Amazon)

Although many investors and operators I’ve asked privately have expressed mostly bemusement or skepticism about Amazon’s recent efforts, I’ll admit that Amazon has me perpetually on edge.

On Brand Authenticity

On a recent swing through the West Coast I asked several experienced e-commerce entrepreneurs (generated hundreds of millions in annual revenue, raised hundreds of millions of dollars from bulge bracket VC firms) the Amazon question.

The responses were similar: that it is fundamentally unlikely for Amazon to win a branding war in many product categories. For example, one founder noted, Proctor & Gamble or Johnson & Johnson, both of whom are seeing many of their product categories be unbundled by startups, lack the credibility to build authentic new brands in today’s social and content based environments.

How can a corporation claim to represent certain values as underpinning its products when its entire history of operations has been largely antithetical to those same values? Consumers, he argued, are simply too well informed now to be tricked by that ruse.

That strikes me as true – in certain categories. Here’s my view on how many product categories break down from a consumer’s perspective on importance. For context, I believe that purchasing decisions primarily hinge on four variables: Recall Impact is the speed at which a name brand is immediately recognized by a consumer, Authenticity Impact is the natural fit between company (or founders) and its product and messaging, while Review Impact refers to the import of 3rd party or peer-to-peer product reviews.

AmazonConfused4

The takeaway is that authenticity matters – but not always. Bargain shoppers are focused less on company values and story and a lot more on trusted brands who will provide a consistent quality of product at a low price point. Whereas mid-tier buyers care a lot less about traditional household brand names and base far more of their purchasing on crowd sourced information and reviews. This trend is more eloquently described by Itamar Simonson, a Professor at Stanford GSB who argues that we’ve reached “the decline of consumer irrationality,” that is, a large segment of consumers are less malleable to high level branding than in the past.

Amazon’s platform allows it to potentially excel within reviews, recall and price. Reviews, because it has habituated its customers to checking peer reviews before purchasing (and if its products warrant positive reviews, consumers will take note), and Recall, because the Amazon name is effectively ubiquitous with quality and convenience.

What this means is that Amazon has a very credible case to steal market share from bargain brands and mid-tier brands, but will face resistance as it moves into categories where authenticity matters a lot or if its product is subpar, irrespective of price. This is likely why its AmazonBasics line has fared well (low cost, commodity products, mostly electronics), whereas its initial line of diapers was pulled from the market. I am personally suspect that its forthcoming “Mama Bear” line of baby products and organics will be successful

On Irrationality and Execution

As an investor, my job is to pick and help businesses that I believe can execute on models that are defensible and sustainable. But Amazon has shown an unwillingness to accept any network effect as impenetrable and a preference for building, rather than acquiring.

That said, the questions I wanted to unpack are: (a) Is Amazon likely to out-execute a focused, fast growing startup and (b) Are they rational?

Let’s start with (b) – are they rational? I asked a respected consultant to the Fortune500 on strategy and corporate development with deep experience in retail. His thoughts:

“Amazon has always had a very unusual way to do strategy, breaking many of our rules.  But along the way, they have also proved that it is a very bad idea to do that.  How do I know that?  Look at the profit margin per sales dollar, the profit margin per employee, and simply the lack of net profit over the many years.  They are masters at “trading dollars” rather than making money.  Until very recently, profits have been essentially zero.  Never before in history has a major retailer grown without making buckets of money all along the way.

Along the way, to provide the appearance of dynamic growth, they have aggressively been crashing into markets and selling things at or below their real cost (including all true costs of operations).  How do I know that?  They make no money in the end, and that shows me their true costs, which they work very hard to hide in the individual business sectors.

Amazon does appear to act irrationally, and it is only the superior irrationality of the stock market that allows them to have the capital to do that.  Can the profit from AWS actually support the entire enterprise?  I have no idea.  But I would not want to compete with Amazon in any product space.”

Irrespective of whether one is an Amazon bull or bear (and I think it’s important to learn Chamath Palihapitiya’s take on the bull case) it does appear that their actions in any given business unit are highly experimental, to the point of appearing irrational (though employees will tell you Amazon is extraordinarily data driven). As an operating business, they are either fools or geniuses – both of which are reasonable perspectives – but many of their business launches do appear irrational. For example, Handmade, a direct Etsy competitor announced more than a year ago, has yet to launch and seems an odd market to attack given that Etsy’s market cap at $1.1B, or 33bps of Amazon’s, is downright immaterial.

The second question worth exploring is whether Amazon is likely to out-execute a more nimble startup. Amazon’s past is riddled with failures such as the Fire phone, Amazon Local (its investment in Living Social was also unsuccessful), and others. Whereas its successes, led by Amazon Web Services, Prime, and Echo are undeniably game changing. The reality, like most of life is likely grey – that Amazon’s outliers are outnumbered by its hundreds of somewhat successful experiments

Insights From Public Markets

To date, Amazon’s aggressive low cost pricing and capex-intensive logistic arsenal has most visibly punished traditional brick & mortar retailers. Sears, Macy’s, Nordstrom, Williams-Sonoma, Kohl’s and others have all lagged the S&P 500, often precipitously, for more than five years. In the following two graphs, the S&P 500 is the blue line.

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AmazonConfused5

But there’s one glaring exception (in the second graph). Off-price retailers, led by TJ Maxx & Ross Stores have surged, doubling the return of the S&P500 over the same period, and trading at multiples double to triple those of traditional retailers:

AmazonConfused7

In fact, the three brick & mortar retailers with the highest multiples: TJ Maxx, Ross Stores and Michael’s share one unique characteristic: they have effectively zero e-commerce. In fact, the retailer with the next highest multiple is Costco – who do not rank in SEO and whose e-commerce gated and exclusive to annual members.

So what’s the logic? Has Wall Street simply lost its mind & just hates online shoppers?

No. Each of the retailers in the high multiple bucket shares a commonality: a perception of being Amazon-proof. Off-price retailers have a particularly complex business model: frequently changing merchandise, material inventory differences on a store-by-store and geographic basis [3], and opaque relationships with the brands themselves. Those are complexities that are difficult to productize online because of the fast changing nature of the inventory – and for the time being the street assigns a premium to that non-commoditized revenue. [4]

The same is true of both Costco and Michaels. Costco, historically, has enjoyed a structural moat against other retailers because of its membership club and unique approach to high volume/bulk items. That, of course, may be changing – sales were flat for the first time in six years in the last quarter – and it’s possible that slowdown is related to Amazon’s Subscribe & Save. Michael’s stores, the behemoth craft superstore also trades at a material premium to most retailers, presumably because of a combination of (a) its custom framing business, a major revenue driver, has been reluctant to transition online and (b) over 50% of the store’s product revenue comes from private label brands, insulating itself from selling purely commoditized supplies.

High level – these are the insights investors and entrepreneurs should be focusing on when innovating in direct to consumer businesses. With an effectively infinite war-chest and a fearless leader, Amazon’s willingness to compete, even with mid-cap companies such as Etsy and Grubhub is unprecedented and its potential impact, significant. Those insights suggest a focus on building deeply authentic products, innovating in product mixes that are not naturally leveraged by Amazon’s existing logistics, and/or focusing on defensible transactional network effects businesses[5] – while avoiding mid-tier, commoditized product tiers or businesses that compete on logistics.

[1] There may be exceptions. There’s a reason Stitchfix has been investing heavily in data science, reportedly employing 60 FT data scientists. Data, even if only partially automated, is they key to reducing these concierge related overhead costs.[2]

[2] The paradoxical element of it all is that if a concierge commerce business (such as Stitchfix) becomes a purely data/AI personalized retailer, then they have unknowingly just played into some of Amazon’s greatest strengths: data leveraged personalization. It would seem there is a balance to be struck in this cycle.

[3] As an aside, one of the amusing nuances of the off-price retailers is that because of their changing inventory, and store-to-store inventory differences, each visit provides a sense of surprise and often delight – that same “surprise” many of the e-commerce based curators have tried to recreate online with mixed success. Turns out you could’ve just walked into an off-price store all this time!

[4] This is also why I am personally intrigued by the online consignment players. TheRealReal for example has enormous operational complexity because of the one off nature of its inventory – and forced to streamline processing costs (photography, content, authenticity verification, tagging) to the point of being profitable even on $100 items. Our investment in Luxury Garage Sale takes this complexity even further: moving thousands of truly unique SKUs across the country to its different retail stores, and even further re-leveraging the consigned items by putting them in try on at home and return boxes, called Luxbox

[5] Grubhub’s network effects, though strong from a technical perspective, are arguably weaker as consumer behavior shifts towards expecting a holistic delivery experience. This is because the company at present does not fully control that experience. Amazon, by virtue of its logistical prowess, can begin to recast the network in its favor, especially if it is willing to undercut on price and subsidize the costs of speed. Whether that is cost effective for them is irrelevant – Amazon is not concerned with short term profits.

 

The Increasing Cost of Consumer Startups

If you have the dubious distinction of spending as much time around consumer facing seed VCs as I do, you likely start or end every conversation with some variant of “what’s exciting you these days?” And for the first time in my nearly 5 years in venture, the answer for the past six months has inevitably echoed some variant of “it’s been slow.”

So what is going on?

The narrative for the past several years has been that the proliferation of cloud services, AWS in particular, has vastly reduced the cost of getting a startup off the ground. But I believe the low cost days have rather abruptly come to a halt – at exactly the wrong time. Not because AWS is suddenly expensive, but because the types of consumer behavioral shifts now being targeted are fundamentally more expensive.

Although I’ve been socializing this for a few months internally and amongst peers, I finally mustered the courage to write this piece after reading Sam Lessin’s Era of Lean Startups Comes To An End and Michael Eisenberg’s The Big Disruption.* Recode’s The App Boom is Over also plays a supporting role. Here’s the punchline: the low tech, low cost, low hanging fruit of the digital (and subsequently, mobile) era – digitizing or mobilizing offline to online processes – are coming to an end**. And until the next great platform or behavioral shift, the costs of innovation will be material higher. As we used to say in my card playing days, “the price of poker just went up.”

Here’s how Sam Lessin, writing at The Information puts it (pretty graph and all):

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For the past 10 years or so, startups have had two defining characteristics. First, they cost almost nothing to start. The intersection of good open-source software, infrastructure as a service, inexpensive distribution, and some plug-and-play monetization options like Google’s Adwords or an app store put all the power in the hands of small technical teams.

Second, when something worked—as rare as that was—the ability to scale and create extreme value very quickly was unprecedented…

But things are changing once again. Open-source software and infrastructure as a service will remain cheap forever. But the low-hanging fruit of highly scalable software startups has mostly been eaten. The winners in areas like media, messaging, advertising, and games have been established.

The next big opportunities seem to be shaping up around things like self-driving cars, on-demand services, VR, bots, bio, drones. But such opportunities lack turnkey generic infrastructure which enables development costs to drop close to zero. They are all expensive games in which to participate.

And Michael Eisenberg, founder of Israel-based Aleph takes it one step further:

Much of the next level of innovation will play out in the physical world, the financial markets and the world of experiences. Those innovative companies will take more money up front and they will become ever larger parts of VC portfolios.

I actually think Eisenberg gets even closer to nailing the emerging reality than does Lessin. For example, on demand services are expensive to scale, but cheap to launch. Bots are inexpensive to code. A lot of drone infrastructure is commoditized and modular at this point. Etc. But there are certain assets that are immutably capital intensive: real estate, logistics, banking, just to name three.

Let’s take the future of transportation for example (old timers might call this “logistics”). Boom is building the next generation of supersonic jets in a hanger outside of Denver. An actual real life jetplane. That is inherently capital intensive. The TSA/airport disrupters, as related in the WSJ’s All You Can Fly Experience, either purchase planes outright, lease planes, or pre-book large amounts of latent inventory – all demanding large upfront capital commitments. Turns out, putting a physical plane into the air is pretty darn expensive. Other next gen transport cos such as the Hyperloop raised $11M out of the gate to prove a prototype and another $80M soon after with a working test run. Good luck as a MicroVC.

Or, let’s take the reimagination of living. Whether its co-living operators such as WeLive and Common or subscription based flexible living models such as Roam, these companies also demand large upfront leasing obligations and build out costs. The paradox for seed investors is that a traditional seed round of a couple million dollars really only provides for a single (or at most, a couple) leases – all of which remain below full utilization for many months, constraining growth and economics. Want to bet on tiny homes or e-commerce driven pre-fab modular homes? That comes at a price too: Bluhomes raised $11M to launch its prototypes, and tiny home networks such as Kasita and Montainer also demand heavy prototyping and manufacturing costs to scale up their networks. ***

Even the millennial-first ecommerce brands (Bonobos, Trunk Club, Warby Parker, Baublebar) have, over the past several years, shown an increasing disposition towards brick and mortar exposure to combat clogged online acquisition channels. Not to mention a significant push from investors into private label inventory in order to boost otherwise anemic contribution margins across the sector. Stores. Inventory. All material overhead costs. And early in a company’s lifecycle too.

If, as Eisenberg suggests the “next level of innovation will play out in the physical world,” there is likely to be a bifurcation of the seed stage funding stack. Strategic angels still have a place as founders may need $500k-1M to show an MVP, prove one element of the technology, and surround themselves with credible advisors. But the emerging world of capital intensive or asset heavy companies puts a material strain on the $25-50M MicroVC funds who are most comfortable writing $250-750k checks into $1-2M funding rounds.

Sure, these rounds may still occur, but they won’t be as a frequent. Future funding requirements for those businesses – often in breakneck succession – might well crush the model. And, at a minimum, only the MicroVCs with the absolute strongest upstream brands will survive. These VCs will have two options: ship checks into far larger rounds ($7-15M) with a similar risk profile or target more incremental, derivative companies with lesser upside and more balanced financing needs. The shift is occurring “at exactly the wrong time” – right when hundreds of seed funds have recently been raised.

Of course, of course there are still amazing, cash efficient, asset-light opportunities across consumer sectors. But, anecdotally, they are harder to discern and appear less frequent. Irrespective, these more physical/experiential companies represent bold bets on the future – and investors had better come to terms with it. For better or worse, the price of startups has just gone up.

* Tomasz Tonguz at Redpoint released “The Decline of New SaaS Company Formation” this morning with data suggesting that new SaaS companies are being started with reduced frequency in 2015 & 2016. It’s likely the same “low hanging fruit” argument could be applied to traditional SaaS (non AI/ML, chatbots, etc) as well, as Tomasz notes: “The key systems of record in SaaS are already in place. Salesforce, Netsuite, Marketo/Eloqua/Pardot/Hubspot, Zendesk. Subverting those incumbents is going to require a meaningfully better product or substantially more effective customer acquisition channel.”  

** Grubhub and Opentable are two quintessential examples of this transition. Whereas in an offline world, one might pick up a phone and call a restaurant to book a reservation or order food delivery, Opentable enabled that process to be fulfilled via frictionless point and click. Many of these digitization transitions, including our investment in Spothero, have the additional benefit (and value creation) of opening up highly opaque inventory, thereby increasing frequency. 

*** One could make the case that startups can offset these overhead costs via pre-order/pre-sale/Kickstarter revenue.

How to Not Fail When Predicting the Future

“In the strict formulation of the causal law – if we know the present, we can calculate the future – it not the conclusion that is wrong, but the premise.” – An overview of the “Heisenberg Uncertainty Principle” from Uncertainty: The Life and Science of Werner Heisenberg

It’s common parlance to suggest that venture capitalists are in the business of “predicting the future.” Investments are referred to “bets,” and there’s a material uncertainty about the future. Case in point – a VC primer from The New Yorker’s 2015 profile of Marc Andresseen, “Tomorrow’s Advance Man”:

In venture, it’s not batting average that matters; it’s slugging average. Boldness is all. When Google Glass appeared, a16z joined a collective to seek out investments, and Andreessen declared that, without the face shield, “people are going to find they feel, basically, naked and lonely.” Google withdrew the product in January. But, he would argue, so what? His thesis is that such a16z failures as Fab and Rockmelt and Digg and Kno are not merely a tolerable by-product of the risk algorithm but a vital indicator of it. It’s fine to have a lousy record of predicting the future, most of the time, as long as when you’re right you’re really right. Between 2004 and 2013, a mere 0.4 per cent of all venture investments returned at least 50x. The real mistakes aren’t the errors of commission, the companies that crash—all you can lose is your investment—but those of omission. There were good reasons that a16z passed on buying twelve per cent of Uber in 2011, including a deadline of just hours to make a decision. But the firm missed a profit, on paper, of more than three billion dollars.

At Chicago Ventures, we are often discussing and brainstorming which factors or precedents we can identify that are predictive of future success. But over the years I’ve come to believe that venture investing isn’t the act of betting on the future; on the contrary, investments are a test of how well we truly understand the present.

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Over the weekend I was re-reading William Duggan’s Strategic Intuition, a book I first read in business school, and which goes to lengths to demystify the unplanned creative sparks that underpin legendary strategic insights. Early on, Duggan takes a deep dive into understanding the scientific method, using Thomas Kuhn’s The Structure of Scientific Revolutions as a guide; and while I expected to mostly skim that section, it set off lightbulbs for me as regards our challenge as investors:

Kuhn goes on to explain that a breakthrough is part of both the past it came from and the future it starts, in the same way that a bend in the road serves as the end of one direction and the beginning of another…The common idea of how a lap of progress happens is a leap of imagination. Kuhn gives us an alternative to imagination that we can apply to realms of achievement other than science. He shows us in detail how the bend in the road happens: a selective combination of elements from the past makes something new. The elements themselves are not new.

This sequence for paradigm shift – achievement, than theory – is exactly backward from common ideas on how progress happens. In the typical notion of the scientific method, first you posit a theory, and then you conduct an experiment to test it. If your experiment works, you have an achievement. But this is the experimental method, not the scientific method. The experimental method is part of the scientific method, but it’s not the first step.

Scientific advance does not come about by a leap of thought to a new theory, but rather from combining specific achievements that lead to a theory, which explains them. It’s an act of combination, not imagination. Specifically, it’s the selective recombination of previous elements into a new whole. Pieces of the past come together to make a new future.

I think as entrepreneurs and investors consider the future, they should be singularly focused on the question: what has actually been achieved?

For example, Webvan – one of the public failures of the dot com era – was predicated on the assumption that the web (html/desktop) was a sufficient enough technological achievement to enable on-demand last mile delivery. It turned out that while the internet did facilitate real-time transfer of information, the opex of managing trucks and warehouses was prohibitively expensive (communication was not yet ubiquitous enough to enable crowdsourcing). The working assumption for this decade’s last mile players (Deliv, Postmates, Doordash) is that the GPS-empowered smartphone is a strong enough achievement to enable cost-effective crowdsourced delivery.

This take on experimentation versus achievement touches on broader themes I’ve been struggling with such as bitcoin and virtual reality. Is Facebook’s acquisition of Oculus an achievement for VR or merely an incremental step in its experimentation period? I am of the belief that VR is still deeply experimental and that technological progress, especially for consumer facing technologies, are rarely “achievements” until their presence has become ubiquitous through a native or modular platform layer (web, and more recently mobile are the two ultimate examples of this).

Bitcoin, on the other hand, may actually be somewhat silently transitioning into its achievement phase. Were historical increases (or recent surges) in bitcoin’s market price “achievements?” No, of course not – bitcoin is a commodity – the price is utterly irrelevant. But I’ve begun encountering increasing number of companies that have integrated the blockchain for accounting, certification, escrow, location or identification, often without advertising themselves as “blockchain companies,” but simply because blockchain tech enables them to optimize a process they couldn’t without it. While price is largely irrelevant, broad adoption of platform is not.

As entrepreneurs and investors, it’s a heck of a lot of fun to imagine the future. But bets on the future need to be predicated on a discerned analysis of the present. This approach was a new, nuanced insight for me into the question of “why now?” and I hope its helpful to readers as well.

 

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