Venture Capital’s “Issue”

Earlier this week Fred Wilson, of Union Square Ventures, wrote a great post that lays out the Venture Capital industry’s overarching “issue,” titled The Venture Capital Math Problem (thanks to Ben Chiang for forwarding).  The article walks through the high level math of the venture capital industry, and explains why the pace of fundraising & investing in the industry has outgrown current market realities. The specifics of the math are debatable, as solid data is hard to come by for this industry, but there’s no doubt that the conclusion points to a significantly smaller industry (assuming you believe in free markets and efficient capital formation).

The question I have is whether Fred’s conclusion is correct…  Are we really heading toward smaller fund sizes, smaller partnerships, smaller deals and smaller exits?  The trend of the day seems to be a capital flight to established firms – those with proven track records are able to raise larger funds, while the younger, smaller firms are struggling to raise new capital.  But it will likely take another fund cycle before we have a definitive answer here…

Any thoughts?

Re-engaging & Interesting Podcast with Hal Varian

Wow, it’s been quite a while since I last posted here.  I’m going to try to re-engage and post more frequently going forward.

In the meantime, I recommend giving this podcast with Hal Varian a listen.  Hal Varian is the Chief Economist at Google and is basically the master of the Google ad auction.  He’s also a professor of Economics at UC Berkeley and author of a number of books.

Quick sidenote… I highly recommend his book Information Rules – a great account of how the businesses behind new technological innovations are ultimately governed by fundamental principles of economics.  Cool view on the tech industry through the lens of economics.

Prudent Advice for Startups as We Head Into a Downturn

It’s no secret that the global economy is in for some tough times, and no category of the economy feels the pains of a downturn more than startups.  With that in mind, I thought I would share some prudent advice that veteran investors are giving their portfolio companies as we head into this downturn.

Advice from renowned angel investor Ron Conway in an email to his portfolio companies (originally sent at the onset of our last downturn in 2000):

1. If you are in a funding cycle, you should raise your funding as soon as possible and raise as much as possible.
2. Many companies are ignoring certain VC leads we’ve provided in order to concentrate on the top tier only. While we have preached that in the past, this is no longer the case. Currently, top-tier VC bandwidth constraints, coupled with the market down draft, make it very important to take meetings with any VCs where you can get their attention. We have been working hard to open up this new bandwidth.
3. You must aggressively examine and pursue M&A opportunities (unless you have over 12 months of cash reserves!) to insure you have critical mass (including funding, customers, rolodex power, market share, cash, synergy, etc.).
4. Be realistic on valuations – they will fall so be ready and willing to co-operate.
5. Look for corporate partners to invest so you can raise more money. You should also consider a sale of your company to your corporate partners.
6. If you are entering a funding cycle start raising money sooner rather than later.
7. While it’s safe to say entrepreneurs have had negotiating leverage with the “down draft” in the market, the VC community will start exercising their leverage.

Conway’s email went on to stress the importance of companies’ Path to Profitability (PtoP), which I think is the most important take home message.  Cutting expenses, extending runway, and executing on (or at least showing) a clear path to profitability are of paramount importance for startups as we enter these difficult and uncertain times.  This stresses the importance of building a doomsday operating plan that outlines the knobs that can be turned if revenue slips and runway needs to be extended by judiciously managing expenses.

However, this does not mean that innovation should take a back seat to financial solvency.  Rather, companies must accept that the revenue opportunities that they have built into their operating plans will not be what they assumed – as consumers, enterprises and advertisers will all be dialing back their budgets.   But talented people pursuing innovative and sound business ideas should always be able to find funding – the catch is that business plans must make sense under assumptions that may have seemed almost draconian just a couple of months ago.

To end on a less pessimistic note, there is one thing that is important for technology startups to remember…  Unlike our last economic downturn, the technology industry is not in the eye of this storm.  This downturn is a Wall Street driven phenomenon, which must be kept in mind when drawing comparisons to the early 2000s.

Financial Crisis Therapy

With all of the media attention on the disastrous state of the financial markets and the relentless comparisons to the Great Depression, it is easy to think that the world as we know is coming to an end.  While I cannot pretend to say that we are not in the midst of a severe financial crisis that will take a long time (years, not months) to correct, I do think it is worth pointing out that there are some good reasons to keep an optimistic eye on the markets and the economy at large.   With that in mind, here are a few facts to help cheer you up:

• Corporate balance sheets are much healthier than in previous downturns.  The Fed reported that corporations held $14 trillion in cash & equivalents on their balance sheets at the end of Q2
• Inflation pressures are significantly decreasing – due to sharp declines in oil and commodity prices since their peak in early Q3
• Housing affordability is back to 1990/91 levels
• Exports remain relatively strong, unlike in previous economic downturns (but will this continue as our financial plague spreads to EU and Asian markets?)
• Forward P/E ratio for the S&P 500 is ~12x, while the 40-year average is 18x
• Rampant fear in the markets typically creates buying opportunities (see how active Warren Buffett has been recently?)
• Peaks in negative investor sentiment marked the market bottoms of 1987, 1998 and 2002
• High volatility also typically accompanies market bottoms.  The VIX Index (measures S&P 500 volatility) hit a reading of 58 yesterday – its highest ever.  The last four times the VIX went over 40, the market rebounded by an average of 15% during the following three months

While I am in no way proclaiming that we have reached the bottom or that the pain is over, I do think that it’s prudent to maintain a balanced view and be on the lookout for buying opportunities.  On that note – Google closed at its lowest price since March of 2006 today… just an FYI.

Links on the Mortgage Crisis & Financial Markets (Milken Institute, Pedrosky, Faber)

I’ve come across some insightful presentations and posts that help explain the current state of the mortgage industry and the global financial system / markets.  All great reads.

The Milken Institute’s presentation on the mortgage meltdown - a great (data intensive) overview of the lead up to the mortgage meltdown.  Makes you wonder how more people didn’t see this coming… (warning – quite long)

Highlights from Paul Kedrosky’s recent posts on subject:

• Credit Crisis, Companies, and the Economic Outlook
• Mark-to-Market Myths
• Get Your Banking Crises Correct:  1872/3 vs. 1929
• Warren Buffet on Charlie Rose

Marc Faber’s view on the global markets & predictions on what’s to come - Faber is a renowned contrarion, which is important to keep in mind.  But the points he makes are compelling nonetheless. (same warning – quite long)

IT Industry Competitiveness – Enablers & Rankings

I recently came across a report written by the Economist Intelligence Unit and sponsored by the Software Business Alliance (SBA) that benchmarks annual IT industry competitiveness in different countries.  The study compares the economic environments of 66 countries to assess the extent to which they enable IT industry competitiveness.  For me, the key take-away from the results is that while the US still leads in overall competitiveness, a number of other countries are quickly closing the gap.  This may not be particularly surprising given the increasing rise in global competitiveness over the past decade, but it is still a very concerning trend to say the least.  Technology acts as a huge multiplier of resources, and consequently a huge driver of productivity.  The US’s culture and institutional structures have long given our economy the competitive advantage of being able to foster innovation, particularly in the technology sector, at a rate unmatched in the rest of the world.  Today, more than ever, this is not an advantage that the US economy can afford to give up.

With that in mind, I think it is important to consider the factors that these economists use to assess an economy’s environment for competitiveness in the IT sector.  The six factors used in their framework are as follows:

1. Workforce – the supply of highly skilled workers
2. Infrastructure – the strength of technology infrastructure
3. Openness – the openness and competitiveness of an economy
4. Culture – the extent to which a culture embraces innovation
5. Legal Regime – the robustness of an economy’s legal protection of intellectual property
6. Government Leadership – the extent to which a gov’t balances supporting technology development and allowing market forces to work

While the US is still the overall leader in IT industry competitiveness, we are beginning to fall behind in the following key categories from above:  Workforce (shortages of talent); Infrastucture (low broadband penetration compared to Western Europe and East Asia); Openness (our inclination toward protectionism).  This trend has scary long term implications, and is something that we need to pay particular attention to in all aspects of our political and economic systems in the years to come.

India’s Next Phase of Growth

There was an interesting article in the Wall Street Journal yesterday on the slowing growth of India’s large IT outsourcing companies – namely Tata Consulting Services (TCS), Infosys and Wipro.  These companies have been some of the shining stars of India’s emergence in the global economy over the past 10-15 years.  But as the penetration rates for outsourced services have increased to the point where the low-hanging fruit is all but gone, these companies are also facing some macro headwinds as their own labor and recruitment costs rise and competition from other lower cost parts of the world (Philippines, Eastern Europe, etc) stiffens.  This is forcing India’s large technology companies to start exploring ways of moving up the value chain and into higher value services / consulting engagements and in some cases developing product, either for their clients or to sell on their own.

I think this is illustrative of a very interesting transition that the Indian economy is now going through.  As the opportunity to differentiate based on labor arbitrage alone diminishes, you will see more and more companies start to look “upstream” into more value-added functions.  The first phase of this seemed to be the emergence of the Knowledge Process Outsourcing (KPO) players who have successfully moved into higher value knowledge work.  Speaking in very broad terms, the next phase of this natural progression seems to be a move into product design and development work.  This has not historically been an area of strength for the Indian economy / workforce, which is why you see large corporations like Infosys working with the universities to create new educational programs that promote collaborative and discussion based classroom environments, as opposed to the more rote based systems that are more common in Indian universities.  There is no question that India has the economic foundation and the talent within its workforce to continue to evolve as its role in the global economy changes, but the challenges are very real and will only increase as this evolution continues.  It will be fascinating to see this unfold as India comes to represent an increasingly large share of world GDP.

Krugman Says Housing Slumps Last & This One Will Too

Paul Krugman, the well known author and Economics professor, wrote a short but sobering post explaining why the housing slump is far from over.  The chart below highlights his point – housing slumps last.

His post also lays out some facts that are tough to argue with:

1. Housing prices in real terms are still way above historical norms
2. Inventories of unsold houses are still very high
3. Previous bubbles, like the LA bubble of the 80s, took years to work off

Not exactly an encouraging fact pattern…

Max Levchin on Social Ad Revenues

Max Levchin recently wrote an interesting post titled “On social ad revenues“, which evaluates different approaches to social application development and the prospects for monetizing these applications. This post is essentially outlining the different approaches of Slide and RockYou, and explaining why he thinks (you guessed it) Slide’s approach is superior. He basically likens RockYou’s approach to that of a social ad network, and concludes that “the more your business looks like that of an ad network (augmented or not by the current sex appeal of being “social”), the less ultimately valuable it is.” He positions Slide on the other end of this spectrum, implicitly stating that their focus is on depth of engagement and creating what he calls an “inner-brand” (read: “e.g. ‘I go to Facebook when I want to SuperPoke people when I want to be clever,’ to toot my own horn”).

I won’t pretend to know the answer here, but in principal I have to agree with Max about the inherent challenges that the “proprietary apps augmented by partner apps” approach presents – you have no control of engagement on partners’ apps. Social app developers are in the business of creating social media programming, and leaving some of the creation of that programming to others is inherently a risky proposition. But to be fair, if companies like RockYou are discerning in their selection of who they let into their partner network and trust that these partners have and will continue to create engaging apps, in theory they can create a hybrid of proprietary and network apps that collectively have greater reach than could their own apps by themselves. The potential risk is that the “inner-brand” of your proprietary programming is undermined, but the potential reward is that your partners can create vertically focussed programming that is better for these verticals than the programming that you could create on your own – again increasing reach. With so few ad dollars being spent on this type of content today, the hybrid approach and the reach it brings does have its benefits, but what that will do to eCPMs as this industry matures is the (at least hopefully) billion dollar question… You can see where Slide and RockYou are putting their chips, and you have to love the competitive energy between these two.

California Sets New Education Standard – Algebra I Testing for 8th Graders

Last week the California State Board of Education voted to begin testing all 8th grade students in Algebra I within three years.  This comes in the wake of a finding by the National Mathematics Advisory Panel about the fundamental importance of algebra readiness.  This decision now sets California apart as having the highest 8th grade math testing standard in the Country.  Today, less than 50% of California’s students are taking Algebra I.

This is a big and bold step for both California’s and our Country’s education system.  We live in a world where college graduates with math and science degrees are in increasingly high demand by employers.  But yet in the U.S. the percentage of college graduates awarded math, science and engineering degrees is down significantly from 15+ years ago.  This is leaving America increasingly reliant on foreign workers to fill these vitally important technical jobs.  In 2001, a bipartisan commission on American National Security said that the second biggest threat to American national security was the threat of failing to provide sufficient math and science education in America (this was second only to terrorist attacks).

Needless to say, this is important stuff.  And it’s so great to see Calilfornia actually taking a leading role in improving the education system in America.

P.S. if you want to learn more about the state of the math & science education system in California, take a skim of EdSource’s Math and Science Report from January ‘08.