Category - From the Frontlines

1
The Future of Government (A Primer on Masternodes)
2
How J.Jill’s IPO Could Help Define E-Commerce Valuations
3
The First Time Founder Discount
4
How Slack and Facebook Are Making Access to Information Less Democratic
5
The Hidden Challenges of Starting a Company in Secondary Markets

The Future of Government (A Primer on Masternodes)

Happy new year everyone! As many readers know, I’ve been actively writing about and investing in the cryptocurrency sector since early 2013. And 2017 was obviously been a pretty extraordinary year for the space. Over the past few months, there’s been so much noise about bitcoin in the mainstream media, that I haven’t felt I’ve had much to add – if anything, I wanted to play a small role in reducing the hype.

Though, I’m gratified that in the past 9 months, the world has woken up to my first true loves in the crypto world – bitcoin and decentralized apps – I wanted to begin sharing a theme I feel is underreported and comparatively disruptive: decentralized governance and voting.

In early 2016, I was turned on to a protocol called Dash which had pioneered a new form of self-funding and self-governance through Masternodes. Masternodes are an incentive system available to large holders of a digital currency – in Feb 2016, that was defined as approximately $6,000 of DASH (which is worth $1.25M today) – that pay a daily dividend in exchange for “locking” up the coins, effectively telegraphing to the broader network that those coins are “stored,” and can be used by the protocol itself for network functionality for an extended period of time.

In exchange for the dividend, the network reaps the benefits of added layers of security, stability and speed. Specifically, the Masternodes only function if they are connected to the blockchain 24/7 via a unique IP address, and serve the network as basically outsourced computing power – keeping additional full copies of the decentralized ledger on more computers across the globe (24/7), and processing transactions more quickly.

Masternodes perform one additional service: they provide each holder with a single vote in how a protocol utilizes its financial resources. Masternode protocols have a built-in deflation rate (similar to bitcoin) that typically ranges from 5-100% to start. Some percentage of the annual inflation rate returns to the protocol itself to fund projects that would be accretive to the overall platform economy. Think of it is this way: if these crypto communities are basically tribal digital governments, then each token holder is a citizen, and each Masternode holder is a Mayor or Congressional Representative.

masternode1

As most of these protocols are still in relative infancy, the types of projects that are funded vary substantially. Projects regularly funded include things such as 3rd party developers looking for seed funding to build an application on top of a given platform, a community manager for a protocol looking for funding to attend a conference to espouse the benefits of a given technology, or even just a budget to pay a protocol’s monthly web hosting costs. Although there are dozens of emerging Masternode networks (listed here), I am currently invested in three: Monetary Unit, Crown and Bitsend*. As a practical example, here’s a current screenshot of Crown’s voting proposals:

masternode2

To help understand the above, there are currently 9 proposals that have formally passed by the required vote threshold. There are an additional 8 proposals at varying levels of popularity. The totality of approved proposals represents 25,150 Crown tokens, which at $3.10 each is $77,965 total funding. There is a new round of voting each month.

I can’t help but be fascinated by this emerging mode of digital governance and these miniature tribal governments that are springing up across the globe. In contradistinction to traditional capitalism where the wealthy’s interests are rarely aligned with poorer citizens, the wealthy in these networks (Masternode holders) are incentivized to vote for services that improve the economic benefit of literally every token holder (citizen). As more prospective citizens recognize the value inherent in a tribal government’s tokens, they are incentivized to purchase those tokens and accordingly reap the benefits.

Meaning that while today these budgets mostly revolve around community management, application development, etc, there’s no fundamental reason why they couldn’t expand to include health benefits, housing subsidies or other governmental aid in the future. The better the benefits, the more buyers (citizens), and the better the dividend to the voting class. This is circular – with the rich/poor capitalist alignment remaining irrespective of cycle.

Further, I believe this is a more sustainable model for new protocol funding than ICOs. ICOs enable a startup crypto protocol to raise a large amount of funding pre-launch or at launch with zero information available to the prospective investor about its future utility, usage or engagement. Masternodes enable protocols to provide dividends to large supporters but also force a higher level of inflation on the broader ecosystem. In order to survive, adoption of the protocol/token holders must increase quickly to offset the high level of inflation in this digital government (or else sellers will outweigh buyers and its value will go to zero). It’s akin to a startup that must hit multiple growth milestones year over year in order to reach its next level of funding (or else go to zero).

While I expect 2018 to be an extraordinarily volatile year for cyptocurrencies, one thing is clear: what started out looking like a toy, is now the next big thing.

*I am not a registered financial advisor. These protocols are stated for informational purposes only.

How J.Jill’s IPO Could Help Define E-Commerce Valuations

You’d be forgiven for missing a small cap retail IPO last week in the midst of the global Snapchat mania. Last Thursday, without much fanfare, J.Jill, a nearly sixty year old former mail order catalog company selling women’s apparel, quietly went public at a nearly $900M enterprise value. And surprisingly, for the complex world of digital commerce, J.Jill’s public market reception might actually be an indicator of what all these next gen direct-to-consumer commerce businesses are actually worth.

How a Small Cap IPO Could Help Define2

In past pieces for BreakingVC during 2016, I’ve discussed Amazon’s impact on both e-commerce and retail at length, as well as the three areas I’ve observed for opportunity to penetrate Amazon’s digital commerce force-field: (1+2) In Why Amazon Has Consumer Investors Bemused and Confused I wrote at length about both off-price retail (Marshalls and T.J. Maxx, for example) as well as mid to upper tier brand opportunities that Amazon fundamentally can’t capture and (3) in The Middleman Strikes Back, I described how Amazon’s anemic commerce margins prohibit it from a service heavy assisted/concierge-commerce provider.

But for everyone else – from Warby Parker to Harry’s to Bonobos to Everlane – what are these weird, sorta digital, sorta omni-channel, sorta personalization brands actually worth? And why is a sixty year old women’s apparel business that was previously spun out of a legacy retailer, Talbots, a leading indicator of value?

As usual, the Company’s S1 is a store of insight and surprises:

Personalization and Loyal Customers

If I were reading an untitled prospectus, I would’ve bet my money that the following block of text from the Company’s S1 “Overview” described a millennial-first next gen commerce brand, with a small but growing retail footprint:

We believe we have strong customer and transaction data capabilities, but it is our use of the data that distinguishes us from our competitors. We have developed industry-leading data capture capabilities that allow us to match approximately 97% of transactions to an identifiable customer, which we believe is significantly ahead of the industry standard. We maintain an extensive customer database that tracks customer details from personal identifiers and demographic overlay (e.g. name, address, age, household income) and transaction history (e.g. orders, returns, order value.) We continually leverage this database and apply our insights to operate our business as well as to acquire new customers and then create, build and maintain a relationship with each customer to drive optimum value.

Believe it or not, that is a sixty year old company talking.

The truth is that most retail businesses are really merchandising and logistics businesses more than personalization businesses. Most big box retailers – or at least the many that I speak with – admit that closing the loop between online-to-offline transactions is amongst their largest struggles.

This is a flaw that digital first businesses – even those with a retail footprint – claim they can solve. And all the moreso, a business such as Stitchfix, which is truly a data business at its core, led by Eric Colson, Chief Algorithms Officer. Case in point, a recent Stitchfix blog entitled “Ruminations on Data Driven Fashion Design,” which noted:

For example, can statistical modeling identify when a successful blouse has an attribute that is holding it back? If so, can we suggest a mutation that replaces the underperforming attribute? To illustrate, can we identify when a parent blouse is successful despite its leopard print, and then change it to the floral print that everyone loves this season? We are also examining how we can leverage less structured types of data. For example, can we extract features from images of blouses or the text feedback that clients provide in response to a blouse?

[To be blown away, visit the Stitchfix Algorithms Tour, built by Colson. It is a wow.]

Data is powerful. But it’s goal is to yield a more engaged customer; in J.Jill’s case existing active customers [within the past five years] represent 70% of annual revenues – an awfully consistent customer who sounds pretty darn comparable to all those subscription commerce businesses that have proliferated the market. And very similar to the vision today’s D2C brands are claiming: own a customer’s wardrobe/apparel/bathroom/etc with a non-commoditizing product and they will come back to you year after year.

J.Jill also looks a lot more like a direct to consumer business than your traditional retailer, with 42% of 2016 sales (growing to 50% in 2017) coming from direct channels.

How a Small Cap IPO Could Help Define E

What about its retail footprint? As discussed in the past, many of the next gen millennial brands are launching brick and mortar stores to prove a new customer acquisition channel against an overly saturated (and unprofitable) digital marketing environment. But with a footprint of only 275 retail stores, its brick and mortar presence is at least relatively comparable to the type of presence today’s next gen retailers are aiming for (as of today Warby has 44 B&M locations, Bonobos has 11, etc.) And these stores, like the millennial brands are conceptually customer acquisition drivers, as the S1 notes: While 64% of new to brand customers first engage with J.Jill through our retail stores, we have a strong track record of migrating customers from a single-channel customer to a more valuable, omni-channel customer.”

At the end of the day, J.Jill, this under the radar retailer looks surprisingly similar to today’s D2C commerce businesses:

  • Data-first approach (97% of transactions properly attributed to customer profile)
  • Heavy direct sales focus, with stores used merely as customer acqusion tool (42%, growing to 50%).
  • Not overbearing retail footprint
  • Brand quality margins (65.9% gross margins), as compared to 42% for Macy’s, 35% for Nordstrom or 40% for Gap – effectively double the margin basis as a traditional retailer.

What’s It Worth

I like J.Jill as a comp for many of today’s e-commerce companies for two reasons. First, as proven in the prior section, I think it looks much more similar than a casual observer might guess to those businesses. But secondly, at ~$500M in annual revenues, J.Jill is surprisingly small for a public retailer. Gap posted nearly $16B in revenue in 2015, Williams Sonoma is on the small side with $4B in revenues – even Lululemon has trailing revenues greater than $2B. This looks similar to emerging commerce brands which are typically much smaller than their relative press coverage would imply: Dollar Shave Club was on a $250M revenue run rate when acquired by Unilever, Warby Parker booked an estimated ~$200M revenue in 2016, and Trunk Club was on a reported $100M revenue run rate when acquired by Nordstrom. Most of today’s emerging brands, even at triple their current size, would look substantially similar to a small cap IPO.

The first piece of very good news for emerging brands is that there was a market appetite for a small cap offering of this nature whatsoever. Although the Company ultimately priced at $13/share, just below its suggested range of $14-16/share, the good news – again – is that market interest was strong enough not to justify pulling the offering entirely.

But that’s mostly where the good news stops. J.Jill’s IPO (even based on an estimated $15/share offering) would have it placed towards the bottom of a peer set on a valuation basis. The following graphs on valuation comps were initially published on Seeking Alpha:

How a Small Cap IPO Could Help Define 4 How a Small Cap IPO Could Help Define 3

Those are sobering multiples (and, the company actually priced 10% below these estimated multiples) for a company that stacks up extremely well on most operational metrics – for example, they boast higher product gross margin that brands such as Tiffany’s, Michael Kors, Ralph Lauren or even Abercrombie. They boast a higher direct to consumer sales percentage than most of their peers. They have an exceedingly loyal customer.

The biggest knock on the company is their growth rate: 10-15%/year – and one of their biggest divergences against today’s emerging brands who are mostly growing at 50-200% annually.

Given these multiples, e-commerce brands need to bank on the following two factors to earn a premium valuation in the market: maintain strong growth rates and maintain high visibility, momentum brands. J.Jill is a fundamentally strong company – and it has stolen much of the playbook from the online brands – but it lacks both velocity of growth nor excitement around its brand proposition.

The First Time Founder Discount

Venture is a cyclical business. But in spite of dire bubble warnings, recent unicorn implosions, and a February 2016 nosedive in public SaaS valuations, the NASDAQ has now been on fire for nearly the past decade. In layman’s term, we’ve been on a (only slightly variable) linear up and to the right curve since 2009.

That is contradistinction to the dot com boom of the late 90s which effectively lasted less than five years, from mid 1995 through NASDAQ’s peak in March 2000 – and, more importantly – was quickly followed by a deep recession which lasted for much of the early 2000s.

The effect of this extended period of abundance is a duration long enough for thousands of entrepreneurs to have raised venture money, struggled, solved, raised more money and exited materially (or failed, and, learned something).

As early stage investors, these founders (repeat founders, serial founders, successful founders, what have you) have become increasingly attractive to invest in because they frequently come with the ability to hire and scale up quickly as well as avoid many of the timely mistakes early in a company’s life that can eat up valuable seed stage dollars. Consider this the venture equivalent of a flight to safety, in an otherwise chaotic, early stage market.

The consequence of this flight to safety is that the early stage valuations of first institutional rounds for repeat founders have ballooned and round sizes have increased accordingly. I took a look at the past 24 months of investment data at Chicago Ventures to break out post-money valuation* and round size dependent on founder profile (n=30):

the-first-time-founder-discount

The highlights are that successful repeat entrepreneurs are raising rounds out of the gate nearly double the size of first time founders ($5.65M versus $2.85M, respectively). Anecdotally, the delta may actually be fundamentally wider as we’ve invested in repeat entrepreneurs far earlier in the go to market cycle (often, even pre-launch) than with first time founders (who typically have significant traction).

The effect of this is that first time founders need to thread often competitive markets on limited resources, and then, even with “traction,” will be blessed with only half the resources of more accomplished peers. This is why I tell entrepreneurs that in spite of press to the contrary, it remains a brutal fundraising market.

If there’s a silver lining, it’s that across both founder profiles, first institutional rounds represent approximately 25% of the fully diluted post-money valuation. Seed/A investors have clear ownership targets and that doesn’t seem to change much based on founder profile.

* For rounds raised on convertible notes I have used the cap on the notes as valuation. I recognize this is imperfect. If all notes converted at the cap, this would actually significantly underestimate the valuations of these rounds (as those caps are mostly pre-money caps) but I’m assuming some % of notes will either not convert (company fails) or convert at a discount.

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.

aohell

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.

slack-daily-active-users-021216-930x656

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.

01 cc northave beach aerial

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

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