New Year Letter – 2019 was the Year of Accountability

December 2018 was my first time writing a New Year Letter. I meant to write one going into 2020 before the tick tock of the clock, but vacation got in the way. Now better late than never.

My 2018 letter was spurred by a realization that holiday cards of yore – often with a folded up long-form letter inside – had devolved to simple family images, most without context for what’s behind the smiles and loving embraces. This year, I noticed a new trend. There is a correlation between card stock thickness and net worth! None of this is to say I don’t like receiving Shutterstock cards – keep them coming. 

This year, I will look behind and ahead as I did last, through three lenses – Family, Profession and Context (the broader world we live and work in). For most, the interesting part will be “Context”. Feel free to jump there.

Family – reading fuels curiosity, and a year of sweat

Ashley and my two kids Skye (7) and Winter (6), while not quite Irish twins, have reached a whole new level of twinsiness. Especially after a long vacation, Ashley and I find them inseparable and increasingly self-sufficient when together. I certainly never played Monopoly with my sister for three hours – bless their young hearts! They are not without the occasional fight but usually treat each other with care and respect (for their ages). The big change for Skye and Winter in 2019 is a shared acceleration and passion for reading, which serves as both a call and answer in their voracious cycles of curiosity. Skye is now into chapter books, and Winter is into long comics. 

Ashley too had a big year. She beat her personal best at the Chicago Marathon, shaving 4 minutes to hit 3:10. Dang. She also went on strike with the Chicago Teachers’ Union – an experiential history lesson in the roots, consequences and realities of collective bargaining for our whole family. I am proud of the impact she has on her students and in awe of her patience with them and everyone she touches – including me. Ashley and I continue to have a lot of fun with each other. Though we’ve been married for nearly 14 years, I still find myself surprised she picked me and am thrilled with the flow of our partnership. We had our first true weekend away together since the kids were born, leaving them with my amazing MIL in VT and driving to Montreal for two days. Mon dieu!

In 2019, I self-indulged in much personal reflection. I turned 39 – close enough to being over the hill that I am realizing the fleetingness of life, while also feeling lucky to register this when there is yet much ahead of me. Oddly, this is not unlike a venture fund where the weight of every marginal decision becomes heavier the further you are through deploying the capital. Not that it should… it’s just that we are only human. 

So what do I want to spend my time on personally and professionally? What should I do now that will be harder or impossible later? Ideas continue to swirl, but in 2019 I channeled these questions into endurance athletics. I have never been athletic – more of a drama club, choir guy. But I have a talent that has gone under-appreciated until now… I can eat almost anything any time. It turns out this is pretty helpful for endurance events. So I bought a wetsuit, a road bike and signed up for a full 140.6 mile Ironman in Louisville. The Louisville swim got cancelled, so it became more of a training day, and I become an Ironman* (emphasis on the asterisk). To eschew the asterisk, I signed up for another Ironman three weeks later in Panama City, FL and got it done… with the swim. We’ll see what happens this year.

Profession – a new fund at HPVP

I and the whole Hyde Park Venture Partners team were thrilled to raise our third fund in 2019, totaling $100M. We did this through the hard-earned successes of entrepreneurs we invest in and with the confidence of a tremendous group of investors, many returning and some new. I liken our new fund to a “Series B”. Just like a Series B stage company, we’re doing many of the right things and have hit some nice milestones, but there is yet much to prove. 

Our first $25M fund took us about 30 months to raise, our second $65M fund 18 months, and this one 12. This shortening trend is going in the right direction, though I’m reminded each time we do it that raising capital informs our own empathy for entrepreneurs’ fundraising travails. It is also a pleasure to reconnect with existing investors and meeting new ones. We are lucky to have many accomplished entrepreneurs, professional investors and executives among our investor base, and we learn something new from each in every meeting. The more I speak with these people, the more I realize how much I don’t know or haven’t experienced (back to the opportunity cost of life). Would that I had a month to shadow each like an intern!

HPVP also expanded its team by three people in 2019. That’s not a large absolute number, but still the 50% increase brings fresh thought and energy to everything we do. Our expanding team challenges us to break out of the ruts we’re used to driving, though damn we can be stubborn! 

Above all, we’ve continued to partner with many top entrepreneurs, investing more with existing partners and backing new teams in 2019. It’s been a particular pleasure for me in 2019 to spend much of my time with several highly experienced founders/executives, whom I mostly try to stay out of the way of, learn from and help when I can!

Context – signs of accountability

In my Dec 2018 letter, though loathe to do so, I crossed the business/politics divide and spoke about Trump’s extreme shortcomings as a leader and the political and business risks that result. I will cross that divide again this year. Unfortunately, the administration’s heliotropic tendencies make Trump such a dominant factor in considering the context of our economic and societal state. 

Interestingly, Trump’s special brand of economic protectionism and antagonism is not quite (yet) the undoing of our economy that escalating tariff wars had many, including me, predicting a year ago. Unemployment remains low, and output is still healthy though slowing a bit. Certainly in the venture/startup world hiring remains tight and there is access to capital, though the “flight to quality”  that we saw begin in 2017 continues. More capital continues going to larger rounds for the most proven companies.

Perhaps this is indicative of the larger reality of our economy – a stark juxtaposition in position and opportunities between haves and have nots. For example, while the tariffs have not yet dragged the overall economy down, they have caused extreme pain for farmers, commodity producers and the communities that surround them. This is sadly ironic given ag state voting patterns in 2016 and upsetting to see a constituency fleeced by political con jobs and storytelling. More on that below. 

As a city dweller, it’s easy to look around and think everything is going well for everyone. Most major cities are late in extended periods of growth in population, housing and wages. As a Midwest investor, however, I spend a lot of time driving through small towns, ones not even large enough for a Walmart. These are multi-generational home-town cultures now being re-cast around Dollar General. With ag down and other opportunities so limited in these places, it’s no wonder why their voters rolled the dice on Trump in 2016. We shouldn’t forget that, especially as we look ahead to 2020.

The point here is that even three years in, it’s easy to be shocked and upset about Trump in lieu of understanding the why behind his rise. Adolescents in the US are primarily taught about the righteousness of our elected democracy, its role in leading other countries to the same and its success in vanquishing the horrors of monarchy, fascism and communism. In this, we often overlook the imperfections of our own founding, but moreover we are misled to believe that representative democracy rooted in a literate citizenry is the human equilibrium. In fact, the equilibrium is probably the reverse: power, money and education in the hands of a very few as lords over the rest – whether this be monarchy, fascism or today’s kleptocratic version of communism in Russian and China. Some version of this was the standard for most of human history.

In Nicholas Wade’s Before the Dawn and Yuval Harari’s Sapiens the correlation between organized society and the development of speech are explored deeply. One causal hypothesis for the correlation is that speech was premise for humans to organize beyond family clans because storytelling was the necessary skill for a leader to unite followers that weren’t kin. In other words, aspiring leaders have to talk their way to the top in one way or another. The word “story” is an innocuous and harmless noun here, but the distance from truth to history to myth to lie is a short one, traveled for millennia by human leaders. Trump simply re-paved the faster lanes of this road, journeying along the dividing lines between haves and have nots. We see this in the business world too. Adam Neumann did something similar at WeWork, taking everyone for a ride.

Fortunately, while we can’t take democracy for granted, there is some robustness. As I said in 2018, “our nation is beginning to reject Trump like the body’s protective sack around a splinter, pushed back through the skin.” This is culminating – almost in a literal sense – with the impeachment process. While Trump is not likely to actually be removed (even I can buy arguments why at this point we should leave it to the election), impeachment proves that there is indeed some accountability for leaders who lie or otherwise pursue their own interests. This is important, not just for our politics but for our society. If for most of human history we were in the pre-truth storytelling era, will the “post-truth era” reign after a short few centuries of more enlightened human experience? I don’t think so. Trump’s impeachment is proof that we can still be grounded, and this political leadership accountability trickles down to broader society.

In fact, there is a good argument that 2019 was ubiquitously the Year of Accountability. In the broader economy, 2019 was a record breaker for public company CEOs stepping down, more leaving than in the financial crisis. While some of these departures were generational cash-outs after a long bull run, many resulted from boards enforcing business or moral accountability, as at Boeing and McDonalds respectively.  In the startup world we saw several spectacular events of accountability with the cratering of WeWork and fraud charges at Outcome Health. It’s the sign of a healthy system when specific problems can be rooted out without the tide having to go out completely to bare the naked swimmers at the expense of the modest, as happened in 2008.

There is hope. Have a terrific 2020!

I’m not saying the bull run is over, but just in case…

Like everyone else who watches the news, we too have heard about the yield curve inverting, raising the question, “Is this finally the end of a ten year expansion?” Also like everyone, we don’t know. What we do know is that there is a greater level of risk to the economy than there was 6 months, 12 months or 18 months ago.

What has changed? Ignoring politics (really), tariffs and tighter immigration threaten to stifle two major engines of continued growth domestically – namely consumption and talent availability. Meanwhile, the global economy is slowing due to normal late cycle dynamics, the arrival of emerging economies to a highly “developed” state, as well as greater systemic drag from the budding of protectionist policies and rogue nations. In the tech economy, some (not entirely unexpected) cracks are appearing with WeWork struggling to IPO and Uber and Lyft on long stock price declines following their IPOs. Changing investor expectations resulting from these events befalling tech’s favorite children will no doubt trickle down into mid-stage and early-stage investing.

We’ve thought much about what this could mean for our portfolio companies and how we help prepare them to weather any dip. Our approach is to look at increasing macro risk through three lenses: Customers, Capital and Acquirers.

Customers: Our companies are not immune to belt tightening among their own (mostly B2B) customers, domestically or globally. Many of our portfolio companies serve large global enterprises, so even slowdowns in non-U.S. regions can have an impact on their metrics such as a higher cost of customer acquisition (CAC) – fewer customers in the market with budget to buy, so it’s harder and costlier to find them; and lower lifetime value (LTV) – customers are more likely to cut or reduce spending. Of course, this “LTV to CAC ratio” is a key software-as-a-service indicator. Under circumstances where there is pressure on the top and inflation on the bottom, we advise our companies to focus heavily on customer success and retention and to be less aggressive on sales team hiring and burn to maintain efficient growth.

Capital: The common retort to a potential economic downturn’s effect on startup fundraising is, “Hey, VC funds have so much money. They have to invest it.” While it’s true that venture capital funds raised more than $130B in 2018, surpassing the 2000 dot-com peak, that same comparison reminds us not to take levels of “dry powder” for granted. As we saw in the dot-com collapse, in a downward market, dry powder can stay on the sidelines or focus inward on existing portfolios, reducing the number and levels of new company financings. We certainly expect our best companies to maintain access to capital, but the bar will go up for those in the middle. Given this, we are advising our companies to raise capital (within reason) while the getting is good. Indeed, our best companies all have very strong balance sheets that could last several years or more if needed.

Acquirers: Just like investor capital can stay on the sidelines, corporate and PE acquirer money can too, despite the abundance of both. In a downward environment, exit horizons are likely to extend – all the more reason to encourage companies to bolster their balance sheets and prepare for hyper-efficient growth if needed.

Especially in a changing environment, startups serve themselves well by understanding the investors from whom they are trying to raise capital. How an venture investors look at a possible downturn will depend on their own fundraising cycle. Investors at the tail end of an investing period will pull back quickly, reserving more capital for existing investments and worrying about their own fundraising plans. Investors with fresh powder will have a heightened preference for efficient growth and will likely take their time in deployment to time-average the possible effects of falling entry prices and because their own fundraising cycles will extend as well. Things will simply go slower.

We are neither sounding the alarm nor plugging our ears, just staying attuned to our markets and prepared to adjust if necessary.

Inside the inside round

I’ve had two conversations about inside rounds in as many days – one with a portfolio company and another with a company outside of our portfolio. Both are entrepreneurs that I admire, have known for years and with whom I can be honest. These conversations made me realize that entrepreneurs have little window into the psyche of investors when it comes to inside rounds. So here is how we VCs (or at least this one) looks at it:

There are good inside rounds, and there are bad inside rounds. (more on the use of “bad” below)

Good inside rounds are when things are going so well that existing investors want to increase their ownership by maximizing their check size and not maximizing price.

These rounds can happen at any stage, from post-seed through D. Sequoia has been known to do this often, other “multi-stage” funds are developing similar histories.

It’s obvious why an investor would want to do this, but why would an entrepreneur be willing to accept an inside term sheet – perhaps at a lower price then in a market process – when things are going well? After all, if things are going so well, wouldn’t other funds be willing to bid up the price, likely diluting the entrepreneur less?

Most of the time, yes. But fundraising the right way takes time, especially if you have not consistently built relationships over time that can quickly be called in for term sheets. So the hungry inside VC says to the entrepreneur “Hey, there’s so much going on in the business, let’s just set a fair price and get this done quickly, so we don’t get distracted.” I have said those words before. It’s not an unreasonable position, but it should always be for the entrepreneur to decide. I have also said those words. 

Good inside rounds are becoming more popular as multi-stage venture funds grow larger and enjoy a decade of strong track records in their rear view. These trends mean funds want to get more money to work when they see something going well and have less need for external valuation markups to prove things are working to their limited partners.

Hunter walk sums this trend up nicely in a sardonic tweet:

Bad inside rounds are when a company doesn’t have the story to raise money from a new external lead.

“Bad” is a strong word, used here for simple juxtaposition and effect. Such rounds don’t always mean the company is doing “badly”, just that progress is either difficult to judge from the outside or the post-money of the last round needs time and progress to be “grown into”, either due to a miss on plan or a shift in market pricing. Occasionally inside rounds occur only for lack of planning – a company ran out of money much more quickly than expected, before having time to go to the market to raise. There are also marginal cases, where perhaps a company has a good story, but not a great one. It can probably raise, but not from an attractive investing partner or without spending many months being distracted from growing the business.

Here’s the frustrating thing about inside rounds for entrepreneurs: In the good state, you can’t beat your insiders off with a stick. In a bad state, they may not return your calls. How annoying. What’s up with that?

In simple terms, investors want a return. If the market is telling them the company can’t attract capital from outside investors, they are thinking one or all of several things: (1) this company isn’t a great place to put money, (2) even if I think the company is good, if we fund it further and then still can’t raise new money later, that doesn’t help, (3) what do other investors see that I’m not seeing?

That said, most investors are willing to fund a company with a moderately sized inside round (call it 30-50%+ of the prior round) if the following conditions are met:

  • The company has made tangible progress, and…
  • The management team gets along with each other and the board, or…
  • There is a(n) acquirer(s) lurking around

But here’s the catch. You usually receive only one “get out of jail free” card before the discussion shifts to a sale or shutdown instead of a second inside round. And, there’s a catch to the catch: an inside round is, of course, not “free”. Inside rounds are usually flat in valuation at best and therefore very dilutive to founders. So let’s call your one inside round a last resort, a Wild Card.

Given the above, here are general rules for how to think about inside rounds as an entrepreneur. 

In the good case:

Be true to yourself on whether you want to spend the time checking external options. Good inside investors will respect that.

If you decide to take a “good” inside round, remember that if things don’t go well, there may be revisionist history on how the “good” inside round is viewed by your investors, reducing the likelihood of another inside round later. Fresh blood has its benefits.

In the bad case:

If you are on the margin between being able to raise externally and needing to do an inside round, raise externally if you can. Save your Wild Card.

If you’re going to raise an inside round, make sure it provides a full 18 months of runway. There won’t be another, so leave yourself time to make real progress on metrics… and time for an escape ramp for exit if needed.

Good luck!

Okay, so what’s the number?

I often have conversations with founders that go as follows:

Me: That sounds like terrific progress with customers and revenue, how does churn look?

Founder CEO: A number of our customers are upselling very quickly and they all love the product.

Me: Excellent, and how does that net out in churn?

Founder CEO: We also think our product works a bit differently than most SaaS products. 

Me: Okay, I’m sorry to be pedantic [I use that word] but what is the churn number?

Yeah, VCs are like toddlers. If you don’t give us what we want, we will keep asking for it. 

So what’s wrong with this conversation? Before you conclude that I was “asking too soon” and that the founder is simply demurring politely from being probed for numbers too early in our relationship, let’s assume that we have already been sharing data and the founder is comfortable with telling me details about her/his business. Assuming that, the problem with this conversation is that in my mind I’m thinking that s/he either (1) doesn’t know the number, (2) doesn’t know the number is important or (3) thinks the number looks bad and (4) is therefore worried about telling me.

None of these four possibilities bodes well for the entrepreneur raising money. Let’s parse it out:

  1. Doesn’t know the number: At an early stage, a CEO should know every key metric for their business as well as understand how and why each is changing.
  2. Doesn’t know the number is important: Every CEO should know what KPIs apply to their business. Of course, these are different by business model: SaaS, e-commerce, marketplace, etc… More on this below.
  3. Thinks the number looks bad: If it’s not bad, then telling me will prove that. If it is bad, sometimes that’s just the reality, and we will both learn a lot from discussing why. Remember, early stage investors are accustomed to imperfect businesses.
  4. Is therefore worried about telling me: *Most* investors like to work with entrepreneurs that are transparent – with good news and bad alike. While perhaps it’s understandable to be putting on the best face you can for potential investors, remember that all of these investor pitches are simply dress rehearsals (in both directions) for your first post-financing board meeting together. You are certainly going to want to be transparent at that point.

You’ll note that the founder in the dialogue above says something we hear on occasion to explain away metrics: “our [pick one: SaaS, ecommerce, marketplace] startup works differently than most.” There are rare cases where that is true and so a standard metric or threshold for “best in class” doesn’t apply, but most of the time there’s nothing different or special about the economic model… except that it’s not working, at least yet. And that’s okay. We are early stage investors; we get our hands dirty; we pick the entrails off the floor and help make sausage. 

Indeed, for these reasons and others, I cherish that building relationships with entrepreneurs is not  just about getting to the number – that’s not my point. I want to hear the context, how it fits your big picture and ultimately your vision… for sure! But investors do need to know the number, know that you know it’s important and believe you are transparent.

Seed, speed, and we’re still here: my first decade in venture

December will mark a decade for me in venture. I didn’t start full-time, but it was nearly ten years ago that I landed an internship with a small fund in Chicago and “screened” my first startup story. I was a first-year business school student with a flip phone. A year later when I graduated, only one of my classmates went into venture full-time. It wasn’t I. After being an angel for several years further with my partner, Ira, we parlayed investing from a profession to an occupation in 2012.

On a personal basis, this run is unique for me against my prior three decades where people, places and engagements came and went in vignettes of 2-4 years. Now I have the pleasure of having known and worked with many of the same people – both entrepreneurs and investors – for ten years. Viewing the arc from original financial crisis to current 3.5% unemployment and from the launch of A16Z to the IPO fireworks of 2019, here are the changes that most impress upon me:

  • Seed: Ten years ago, seed investing was the uncouth cousin of venture capital, led by a group of pioneering angels and incubators, like Jeff Clavier and YC, who seeded for passion and intrigue, not management fees and prestige. That worked out nicely. Today, funds less than $100M represent about half of the partnerships being formed, and the data show that Seed may be the last refuge in venture for outsized returns. Later stages are unambiguously competitive with capital.

 

  • Speed: As summer approaches, entrepreneurs joke about us VCs taking the next two months off. In my earliest days as an investor, I saw some of that. No more. Entrepreneurs don’t slow down, and neither do (or can) we. There is more capital now, and there is no excuse for lazy money! On the startup side a decade ago, it wasn’t uncommon to see a struggling startup plod along for 3 or 4 years, still trying to raise that first round past angels. The forces of creative destruction are far swifter now. Companies form and then grow or bust much faster. Here in the mid-continent that is a measure of two positively increasing factors – the willingness to take risk (and accept failure) and a growing opportunity cost for founders and employees. Both good things.

 

  • FAANG: While Facebook, Amazon, Apple, Netflix and Google were all around ten years ago, they neither collectively represented >10% of public market caps nor greater than 3% of US GDP as they do now. Neither were they the menacing overlord of the tech ecosystems where our startups play. Since then, entrepreneurs and investors alike have repeatedly bet on innovating in their ecosystems, only to be (repeatedly) burned. This is a looming risk to future innovation that we worried less about “back then”, and it shouldn’t be lost on us that today Facebook may just have done the same again in crypto.

 

  • #metoo and beyond: As have most industries, venture has received its pro rata comeuppance for the under-representation and inequitable treatment of women, minorities and other constituents. Some progress has been made, but there is plenty more work for all of us to do.

 

  • It’s not just the valley now: 10 years ago, few believed you could build big companies outside of Silicon Valley. Now there are many examples – Grubhub, Shopify, Duo, Fieldglass, etc – and valley investors want in. Whether here in the Midwest, Texas, the Southeast, or Mountain West all the big venture funds are paying attention, hopping airplanes and writing checks. The valley’s cup truly runneth over, and that is game changing for entrepreneurs and us seed investors.

 

…yet some things don’t change. Despite two rounds of sirens foretelling the end of venture, we are still here! First the JOBS Act’s crowdfunding and then crypto ICOs were going to put us out of business. It turns out there’s more to what investors do and what entrepreneurs want than quick cash from strangers. Thank goodness.

So what’s ahead? As we dawn on the 2020s, our team has been thinking more about this. Next post.