August 2010 Archives

I just love the Stocktwits Macro Weekly. Gregor Macdonald of Abnormal Returns writes it and this week sums up some pretty important points.

This last week the Federal Reserve finally gave in and admitted that the economy wasn't where it was supposed to be: high unemployment, US budget out of control, stimulus that wasn't stimulated without the US Government pumping more money into our economy, creating pretty much an unsustainable loop. That took interest rates on US Treasuries to record lows and the stock market didn't like that either. Too bad you optimist stocktraders - it still amazes me that anyone can think that recovery can happen with so many people out of work. Who is going to spend money if they aren't making any money? Duh!

We're in for a long haul here. Double dip, single dip, whatever. The economy sucks and now the general population is pulling back its spending after realizing that things weren't getting better even as the Fed was blowing sweet smoke our way. If people keep spending less, then how can businesses make money? So they are pulling back also and not investing as much. And the cycle continues.

But what this means for startups is...it's harder than ever to make money. Back in my post, Mark Fletcher at Startup2Startup and the Evolution of Startup Business Strategy, I noted how Mark smartly adjusted his funding and operating plan based on the environment at the time. He noted three stages that he had raised money and built startups in; now I believe we're entering into yet another stage. This is because we're in an economic downturn AND I believe there is a serious bubble forming in internet only startups.

What's a startup to do?

Raising money doesn't seem to be a problem. If you have a star team and a decent idea, you can woo one of the many super angels or micro VCs. They are all operating on the strategy of investing in what I call "exploration" which is to give you enough money to leave your job and then work for a year or less and see if you can get anywhere. Regular angels can also be part of this effort, although I'm sitting on the sidelines (see my bubble post).

However, if you want this to NOT be a 6-12 month sabbatical into the world of entrepreneurship, at the end of which probability says you're gonna be left without a job because you couldn't get your idea developed into a business, you're going to have to do things a little bit differently.

Item 1: The general population is pulling back in spending.

This means either whatever product or service you're making has to be EXPONENTIALLY better than the competition or else you'll never get enough users on board to pay for your service. INCREMENTALLY better might have worked when there was no bubble in internet only startups or in an economically better climate. But now you'll have next to zero chance.

Corollary: Go for revenue from the get-go.

Going for revenue has been talked about extensively, but I still meet entrepreneurs with no notion of monetization. Now that the available pool of consumer cash is shrinking, the fight for their cash is going to be even more fierce.

Item 1a: Businesses sense the consumer pullback and they are pulling back too.

The pullback trickles through businesses to your B2B startup. Internal budgets are tightening up as companies conserve cash as they don't know where the economy is going to go. So building something EXPONENTIALLY better for them is critical too, rather than incremental improvements on what's out there.

Item 2: Competition is ridiculous.

Corollary: Instead, tackle a business that NOBODY ELSE is tackling.

This is a serious problem of the bubble. Competition pops up everywhere. To me, the unsexy is in, as these are the last bastion of untapped areas where the internet can go and disrupt. But still people want to make photo sharing and social networking just a little bit better. Too many people tackle the sexy problems and not enough of the unsexy problems.

The other areas besides unsexy are completely untapped business opportunities. Yes, it's tough to find these. But still, I meet entrepreneurs who have found them. If they can find them, why can't you? No more social networking photo sharing apps please! Nobody said entrepreneurship was easy; it's damn hard to find business opportunities that are completely untapped.

Item 3: Users are bombarded by too many services AND now they have less money to spend. Likewise, for businesses, their budgets are being cut.

Corollary: One year is not enough, two is barely enough, maybe need more time. Startup austerity is IN now more than ever.

Still people are raising for one year. I can't see how anyone in this climate can get to any kind of breakeven in one year. Of course there are always outliers, but most of the ideas I meet won't get there in a year. I have been telling people to plan for two years (remembering there are two levers here, what you raise and what you burn) but with the economy the way it is, I am wondering if even two years is enough. It seems that our super smart folks in the US Government aren't doing the right thing to truly stimulate the economy, and I say that knowing the trying to drive the economy is not an easy thing (and especially cleaning up the mess created by all our nice lobbyists, politicians, and Wall Street greed). It's going to take years for us to get back on track, now that the inertia of consumer confidence is moving downward.

No matter what, austerity in spending whatever you raise is going to be even more important. You need to survive as long as possible, giving yourself the maximum amount of time to try things and to pivot several times if necessary, and along the way praying that the economy is going to come back.

But it's obvious to me that many entrepreneurs are unwilling to go into starvation mode for that long. All I have to say is, good luck to you and let's talk at the end of a year after your raise.

Item 4: More entrepreneurs keep piling into the internet space.

Corollary: Radical idea: Try creating a startup in another space besides the ultra crowded space of internet only startups.

You have strong entrepreneurial desires? Then why try to build a business in an industry where everybody who wants to be an entrepreneur is piling in en masse? I am getting connected to startups in other industries and there are some really interesting things going on out there in the world beyond the internet. In my bubble post, I posted about an emerging space that is hardware plus software plus internet - what other spaces could use your entrepreneurial energy to go and disrupt? Are there any industries that are adjacent to what you learned in school, or where your interests are, or where your previous experiences lie? How about another location where there is growth like another country?

Someone once said to me that in times of economic distress, there were tons of opportunities and investing in these times could yield some amazing results as long as you reserved some capital to do so. These are definitely some interesting times as an angel investor. Like Mark Fletcher, I am doing the smart thing by watching the economy closely and adjusting my investing strategy based on the conditions of the environment at the time. More entrepreneurs could do better by applying this tactic as well.

DISCLOSURE: I am not a direct investor in Stocktwits but rather an indirect one through my investment in betaworks. I love what they do, so go and sign up for Stocktwits newsletters and read everything they send you.

"There's something f%$@#! up about every early stage startup..."

- Andy Weissman, @aweissman, betaworks

About 2 years ago, Andy Weissman over at betaworks made that statement. I thought it was funny at the time, but 2 years later, I have found that statement to be one of the most profound I've heard.

Since then, I've met a constant stream of early stage startups. Every one has something wrong with it; the idea, the founders, the competition, the funding plan, whatever. Sometimes there are multiple things wrong with them. I don't think anybody has come with an idea and team and plan that was perfect. In fact, I think it's impossible.

At early stage there are too many variables. That is why the risk of failure at early stage is so great. You don't have enough of...everything...or anything...to properly pursue a business idea. And then there are the things that are totally out of your control, such as economic or competitive forces. These things will swing every which way and there is nothing you can do about it...and tanking your startups along the way as you look on with frustration and helplessness.

If you fixate on what is wrong with early stage startups, you'll never invest. It's way too easy to find something wrong with one.

Some of those I take as a given. For example, in the internet space there are tons of young founders who have never been at another job in their lives. But the idea is great, and we love their energy and creativity so we bet on them knowing at some point they may need to step down as leader of their businesses...or we'll get into a painful argument with them about why they need to step down and they don't want to. Sometimes we bet on these people simply because they are smart and theoretically smart people will adapt/pivot their way to success better than not-so-smart people, even though they lack real world business experience.

Some of those I know we will have to fix later. Whether we are willing to put in the effort to fix them later is another question; many investors hope that there is someone who gets involved who has the time and desire to watch over things. The need for a new, more seasoned CEO is one of those; perhaps the strategy needs to change, or somebody isn't pulling their weight in their functional area, or can't grow into a more expanded role.

Still, the number of f%$@#! up things any early stage startup has can be a scary thing. It took me a while to understand this and then just live with the fact that there are going to be things really wrong with every startup I meet and then fund. For me, it's become a game of which f%$@#! up things are you willing to put up with, how many are OK with you, and why.

Accepting the fact there are going to be f%$@#! up things about early stage startups is critical; if you can't live with that fact, you probably shouldn't be investing in early stage. It may drive you nuts.

Time Diversification: Strategy for Investors

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Last week, I had the pleasure of meeting Jim Robinson IV of RRE Ventures (twitter: @jdrive). In our conversation, he mentioned something I thought was super important, which was that successful investors also diversify across time, in addition to diversifying their investments.

I thought that this statement was extremely important and something that is commonly not done at all, and dangerous to ignore.

What is Time Diversification?

Time diversification is:

Adjusting your strategy based on what is going on in the economy at the time.
Learning from what worked and what didn't in previous economic cycles, and applying those principles to where we are today.

Investing the right way for where you are today in an economic cycle and doing it across multiple economic cycles. The second part of this statement is hard for those investors who have not been doing this long enough to experience multiple cycles.

Why Time Diversification?

The main danger of not time diversifying is if you go out the gate strongly and put a sizeable percentage of your funds in a short amount of time, you may end up getting caught by the negative aspects of a given part of an economic cycle.

Anyone knows that predicting what will happen in the economy is near impossible. Famous economists' track records on predictions are pretty dismal. So the only thing you can do is to spread out your investments across time and try to ride whatever upside is going on today while mitigating risks of the downsides that appear along the way.

But if you put out all your money in a short amount of time, you could end up investing at a time when there is a downturn right around the corner which could crater your current investments and leave you with little cash to recover. Think about all those investors who raised funds in 1999 or 2000 and put money into companies who had stratospheric valuations, only to see them disappear as the dotcom bust wiped out all that value in late 2000.

Or you may miss an upturn by investing in yesterday's downturn driven investment strategy.

So ideally, your strategy will be affected by time diversification. For example, prior to the 2008 economic downturn, we were investing in startups who were building for users primarily and on the assumption that if you get users, you'll eventually find a way to monetize. This strategy began to kill startups as we entered the downturn because:

1. Startups needed a longer time to generate revenue, and needed to survive a longer time to do so.

2. Startups' burn rate was too high and they ran through money before they could get revenue or raise the next round. Many entrepreneurs were unwilling to give up their lifestyle and lower burn and thus died accordingly.

3. Prior to the downturn, startups could go raise their next round on little revenue but decent traction and great, quality product. As we entered into the downturn, investors became instantly conservative and if you didn't have traction AND revenue after the seed round, your chances of getting funding dropped to zero.

Thus many of us changed our strategy and started looking for startups who could survive and gain early revenue to survive long enough to create a sustainable business model. This ended the popularity of consumer internet startups focused on interesting user activity and caused a rise investing in B2B startups, and those consumer internet startups who could build an early business model based on making money off users.

As economic conditions change, we should examine where the economy is at that time and what the conditions tell us about how we invest, and what we should invest in. Timing it is near impossible, so we hope that adjusting our strategy over time, taking our lumps if we don't act fast enough, riding the upturns when they come can help us keep our returns in the positive.

Why Do People Ignore or Don't Time Diversify?

Some reasons why people ignore time diversification, or don't do it:

1. Naviete - Simple lack of knowledge that this is important can mean that someone didn't think about time diversification. Or they may have learned about it in school but wasn't aware of its importance, and thus forgot about it. Or didn't know how to integrate it into their strategy.

2. Lack of real world experience - Humans learn best through experiencing things first hand. Many people simply haven't been through enough economic cycles to know what to do depending on where they are in one. That's why talking to guys like Jim Robinson IV is so valuable because they've been in it since before the dotcom boom.

3. Irrational exuberance - Especially in periods of upturns, it can seem that you can do no wrong. Think about between 1995-2000; investors in the early part of that period made tons of money and, as Jim puts it, we all looked like geniuses no matter what we did. Or it could be a period of investment flurry, like what I believe is happening now where lots of internet startups are being funded left and right; you feel like you have to get in or else miss out. So during periods like these you may experience irrational exuberance and thus invest fast to try to get at as many deals as possible because you don't want to miss out. The problem is that you ignore the fact that your funds are also dwindling fast.

4. Conversatism kills - Venture investing in particular is a risk taker's game; you really have to be out there investing constantly in upturns and downturns (which is partly the reason for this post). If you're a conservative risk taker (yes I think such a person exists!) and you wait until you're "sure" that you're in an upturn, OR you get in a downturn and pullback after the downturn begins, you're always going to be investing at the peaks and pulling out in the valleys.

5. Economic cycles can be very long - In fact, long enough that an entire generation may no nothing but incredible growth and prosperity. This was experienced in the period between 1982 and 2000 where the S&P 500 rose from about 100 to an intraday high of 1552.87 in 2000. Those growing up in a period knowing only growth have not experienced downturns and thus we can get fooled that value of our investments will always rise.

What to Do?

Some thoughts on what to do:

1. Pace your investments. Don't get caught up in having to invest in every deal that comes along. It may seem that every deal is super hot and can't lose, but experience tells me that everything looks hot but the probability of success is very low.

2. Be disciplined in the amount of money you invest in each company. Do not get over-exuberant and start making bigger bets in the beginning. Look at the total amount of money you have and make it stretch across many years. Pick an investment size that allows you to do this. I made this mistake in the first years of my investing. Originally I thought that I should do $50K investments. That drifted upwards quickly as I got caught up in the excitement of being involved in deals to $100K. But now, I am down to $25K chunks in an attempt to still be involved but not run out of funds. Just think back to the number of investments I could have made if I had stuck with $50K, or even $25K, if I had not done $100K chunks. For each $100K startup, I could have invested more broadly into two $50K or four $25K investments. Another danger of going out with too high investment sizes is that you may pick a lot of losers, or get caught in an economic downturn. Then recouping your investment gets harder.

3. Be a student of economic history and do not ignore it. The first big downturn I lived through was when the first Bush invaded Iraq. It was a tough time but it didn't hit me too hard as I had a job. The second period was the dotcom boom-bust. That was much more severe; having been at Yahoo, I saw our stock climb to amazing heights in 2000, only to watch them drop to amazing lows by the end of the year. There was a time when we all thought naively that the run up in internet stocks would never end. We even snickered at those who left Yahoo in 1999 or 2000 and cashed out at "such a low stock price" of 150. Now who had the last laugh? There is nothing better than first hand experience of such events and looking at the dumbass thinking we had back then. Lacking that, all I can say is that you should read a lot, talk to a lot of people, and take lessons from those who have lived through these times. I would also caution you to really watch out for books which were written for a given period. I remember reading about real estate investing and how buying houses was a great, no-loss wealth building strategy. Well, now look at where we are with that. Examples abound everywhere; be careful what you read and add it to your knowledge base.

4. Invest when times seem bleak - It is scary to be putting money out in times of economic downturns. However, these are times when bargains can be found. You also don't want to miss the next run-up in the markets by waiting too long.

5. Resist the temptation to be over-exuberant - It is tempting to try to chase all the hot deals going on at any time. However, in the last 4 years of investing, I have never seen a time where there WEREN'T hot deals around. I doubt that will change anytime in the future, so be disciplined and keep to your strategy.

6. Track valuations from the marketplace. - Keep track of them and watch out when the valuations start climbing. It is a signal that something is going on. It is not necessarily a bubble forming, but it could be. Most likely the competition for the deals has become fiercer as more money has become available in the marketplace for investment into startups. I would develop a limit to the valuation you are willing to stomach, no matter what the deal is and stick to it. Be flexible to violate the rule if you find something that you really like because you may want to get involved for reasons other than the valuation being too high.

What am I doing? Tracking the economy closely. Seeing what the government is doing, or not doing, or doing a crap job of. Keeping my ear out on what's happening with valuations. Talking to venture investors and angels who are out there investing actively. I meet regularly with my financial planner and listen to what he is seeing out in the marketplace. I also talk to the entrepreneurs and see who is geting funded and why, as well as those that didn't get funded. And then who got bought, or just went IPO, and how/why. It's an immense amount of information but all of it is interrelated and affects what I am doing now, how I do it, and what I will do in the future.


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This page is an archive of entries from August 2010 listed from newest to oldest.

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