Rebecca Lynn is a Co-founder and a General Partner at Canvas, where she focuses on early-stage venture investments. Lynn was born and raised in Missouri and began her career at Procter and Gamble. In a talk at Stanford she described part of the inspiring journey that took her to where she is today: “In this little town where I grew up, the highest-level math class was very rudimentary trigonometry. There just isn’t a way for a kid to come out of that background and possibly think about being an engineer. Because of that, we moved to a town with a much better educational system….”
- “I have said to a lot of people: ‘Why would you raise venture money? It’s just going to screw it all up.’ I’ve had a lot of people come in to our office that have interesting businesses. They’re profitable. But they think they want to raise venture. I look at the business and I say: ‘Wow. That’s going to throw off significant cash quickly. But it’s not going to be venture scalable. If you sign up for venture money, there’s a different expectation for you. There are other ways to [build and finance a business] than venture.” Venture is where you see there is an opportunity, but you need the capital to realize it and to scale fast enough to get there.”
A business must have certain attributes for an investment by a venture capitalist to be either possible or even beneficial. Bill Gurley points out that venture capital “is not even a home run business. It’s a grand slam business…. If your idea is not something that can generate $100 million in revenue, you may not want to take venture capital.” In other words, the venture capital business model relies on convexity (i.e., the financial downside is limited to what the venture capitalist invests, but the potential financial upside can be a 10,000 X return or more).
Venture capital punches way above its weight, but it is a small part of the capital markets overall. PitchBook figures tell the story for 2017:
The Series A landscape is changing: 1,689 Series A deals were completed in 2017 at $15.4 billion in total value. Compare that to 2012, when about the same number of Series A deals were completed (1,601) at less than half the value ($7.9 billion). PitchBook data shows a median Series A in 2012 as $2.8 million, with a 2017 median Series A sitting at $6 million. That’s also a 23% increase in median deal size from 2016.
Of course, definitions of a terms like “Series A” are important in trying to make apples-to-apples comparisons. For example, in October of 2014 Marc Andreessen said: “No competent VC is actually fooled when you show up after raising $6M in seed financing and say you’re now raising an A!” Some seed deals are actually Series A and vice versa. The definition of various rounds matter a lot when making comparisons. But if you squint the numbers tell a rough but important story about one type of business finance: venture-backed new businesses represent a relatively small portion of total US business starts over any time frame. You can also see that valuations have been climbing recently. To give you a sense of how small the number of venture backed startups is in a relative sense when compared to business formations more generally, in a very humorous post recently Collaborative Fund pointed out that in the US: “About 9,000 new businesses formed on Wednesday. Another 8,200 dissolved.”
Investing in a dental practice does not have convexity. A new business creating software for data centers may potentially have the necessary convexity. That a business is not a suitable candidate for venture capital is not a tragedy. There are many other ways to finance a business. Most successful businesses are financed by bank loans, sweat equity and money from friends and family. Loading up a business with venture capital can in many cases turn what would otherwise be an excellent opportunity into a needless failure. Roger Ehrenberg has a helpful side that describes circumstances that may favor bootstrapping a business:
- “Our approach overall as a firm is to be very thesis-driven. “Each investment followed a pretty intensive deep dive.”
Lynn’s approach to venture capital investing is to do a deep dive into an area with potential for an investment and only after that dive is completed look for the right investment opportunities. Fred Wilson has written about how people following this “thesis driven” approach differ from another style that sounds similar:
“Thematic investing involves identifying big themes and going after them. Examples from the world of web services would be ‘social networking’, ‘online video’, ‘ad networks’, ‘social media’, ‘real time’, ‘mobile’. I know many VCs who go about it this way. They identify the themes and then get busy filling out their portfolio with companies that fit those themes.
Thesis driven investing involves drawing a picture of where your particular area of focus is going. I like to take a five to ten-year view. And once you have mapped out that picture, it becomes your thesis. And you evaluate every investment you make in the context of that thesis.”
There are other approaches to venture capital that are more scattershot than thematic or thesis driven. The venture capitalist may invest based on the best opportunities that they encounter without reference to any specific theme.
- “I’m half intuitive and half analytical, and I’d say the same is true of venture.” ‘What I’ve learned over the course of my time in venture is: it’s only about 25% picking the right company and 75% building and fixing.” “For every VC their anti-portfolio is phenomenally better than their portfolio.”
Lynn uses an approach to her work as a venture capitalist that is a mix of art and science. Investing is in part an art because spotting patterns is not enough to determine success. The best venture capitalists also know when breaking a pattern or rule is valuable before others realize it is valuable and this is what you might call an analog process. Identifying exceptions well to patterns is something that humans excel at when compared to artificial intelligence. The gap between value and price produced by the breaking of a rule or patterns is what creates the mis-priced opportunity. Some people like Lynn love being actively involved in helping the business so much that being anything other than an early stage investor is unthinkable.
- “We have had a very concentrated portfolio.” “You just don’t have that much time to do a scattershot approach, serve on boards, and put a lot of money to work in those early rounds. We spend a lot of time with the companies to help make sure they’re successful.”
Charlie Munger has strong views on the importance of concentration in investing: “Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results…. The idea of excessive diversification is madness.” Jason Lempkin wrote a blog a post that addressed the investment concentration issue recently:
“There are 500+ new sub $200m funds raised since 2011, and my guess is 200+ in the past 2.5 years. This is great for founders:
- First time investors are generally less ownership sensitive. The longer you do it, the more you feel you need to own of each investment. You learn that owning just a little of most non-decacorns just doesn’t move the needle for fund economics — unfortunately. New investors are generally less sensitive to the % they own, and just want to get into as many good deals as they can….”
Making more investments at larger valuations is not necessarily better when it comes to being a venture capitalist. As Bill Gurley said in a tweet this past week: “Money in is likely a contra-indicator of future money out.”
So-called “spray and pray” systems are a particularly bad idea when it comes to venture capital investing. As an example of how spray and pray can go wrong, I know person who made the mistake of declining to participate in investing in Amazon in the seed round at a $4 million pre-money valuation. His regret over this error of omission in no small part drove him to write almost every seed stage check he possibly could during the Dot Com era. His batting average as an amateur in seed stage venture capital was terrible. His financial outcome was worse than throwing darts. He is a very nice person, intelligent, financially successful and very good at his job in his industry, but to say he is “not a good venture capital investor” as a result of his spray and pray approach is an understatement.
- “We focus on series A and B. What that means is you’re starting to get a product market fit. The dogs are eating the dog food. And now you need to scale. You need to grow a team. It’s probably a skeletal team at best at that point in time. You might have a couple of the marketing channels figured out just to prove the concept works, but you need things to scale. And you’re perhaps building your sales force. So that’s really where we come in, at series A and B, usually $5 to $10 million in that initial round. We always take a board seat.”
Investment risk has been significantly retired if the business is “starting to get product market fit” as Lynn notes. When this happens the value of the business rises, but the VC is less likely to forgo optionality by creating conflicts in a given area by making an early stage investment. Taking a board as Lynn desires seat gives her a ring side seat. A post on boards of directors will appear on this blog soon (perhaps next Saturday).
Mark Suster is writing a very informative series of blog posts on venture investing and startups that recently included this advice:
“If you’re talking with a typical Seed/A/B round firm they often have ownership targets in the company in which they invest. Since they have limited capital and limited time availability they often try to make concentrated investments across companies in which they have the highest conviction. If a firm typically invests $5 million in its first check and its target is to own 20% or more that means that most if its deals are in the $15–20 million pre-money range. If you’re raising at $40 million pre, then you might be out of their strike zone.”
- “We invest in a few deals a year, two, maybe three, deals a year per partner. And we get really involved.” “Because the angel environment has been so hot in recent years and you can now invest in so many Series A or B deals, the bar is pretty high, which is hard because there are so many interesting companies coming up, it’s difficult not to do more.” “The growth of angel investing [has] been funding a lot of companies that are now reaching the Series A funding level.” “A small fund has the opportunity to ‘return the fund’ much faster.”
A venture capital firm like Canvas must put a significant amount of money to work in each investment since small investments can have significant opportunity cost. Venture capital fund size in no small part determines the fund strategy. Investing at a Series A and B is typically optimal when you have the number of investing partners and fun size that Canvas does. In an interview Bill Gurley once said this about how Benchmark settled on the right fund size:
“We experimented with expansion coming out of ’99. We launched Benchmark Europe and Benchmark Israel and tried to replicate what we do, recognizing that entrepreneurism wasn’t a U.S.-centric thing. And it caused all kinds of distraction. We had done a billion dollar fund in ’99. So we told our limited partners in 2007, ‘We’re going to $400-million funds. We’re only going to do early stage. We’re not going to do international. We’re not going to do growth. We’re not going to do seed.’ I think it was very fortuitous timing because almost three or four years after we did that, all of our competition started scaling out in huge ways into different geographic sectors. They became stage agnostic. They raised huge, billion dollar funds. And, to me, that’s been the seminal event that led to our success — that we chose to focus. And being focused as an investor I think is the most important thing. It means giving up the notion that you’re going to scale up and take over the world. But I don’t believe that there are network effects to venture.”
It is common for people to not know how few venture capital firms and venture capitalists there are. Here are some stats from PitchBook: In the United States there are 2,661 VC’s and an average of 2.9 general partners per firm, which translates to 7,716 general partners. In other words, the number of investing general partners in ventre capital in the United States is ~ 6.6 X bigger than US Major League Baseball roster slots (about 1,200), but not by a lot. Many venture capitalists work in the business for decades, unlike professional baseball players who have an average major league career of about 6 seasons. If your dream is to be a venture capitalist, the number of slots you are competing for is very small.
- “If you look at my portfolio, I’m usually not [backing] the first company with an idea. I let that company break its pick and [zero in on] the second mover, the one that figures out the model when the market is ready for it.”
Craig McCaw likes to say that pioneers often get arrows in the back. The winner is much more likely to be the business that gets to product market fit first rather than the first business to start creating or selling a product. Sometimes a business that gets product market fit is overtaken. Or not. It depends. Lynn is saying that product market fit requires: (1) a business model and (2) a market ready for the product. Sometimes a startup is too early and will get an arrow in the back. This may seem obvious, but many people involved in a startup or new business are so wrapped up in their product and have so much invested financially and emotionally they gloss over these two factors since they are running out of runway. A mistake about product market fit can easily cause death from premature scaling. Spending on growing the business to early is often deadly.
- “I think the biggest difference I can make as an investor is to help [founders] recruit and help with business development and strategy.”
Some venture capitalists love to help with the tasks Lynn is talking about. Others like to talk about it, but don’t really do it when the time comes. Knowing the difference between these two types of investors is critical, which is why founders should do substantial amounts of due diligence before taking on an investment by calling people in the portfolio companies of the investor. The experience and nature of the investors will have a substantial impact on outcomes. For example, your friend Ralph may give you a higher valuation at the time of a financing, but you are probably screwing up you cap table and will not be getting the benefit of a professional venture investor who can help you retire risks and grow your business. Making a business into a success is in no small part about creating positive feedback loops. The more of these feedback loops a business can create the greater the probability of success. As just one example, when potential employees and investors see that a business has the best investors involved they are much more likely to get on board. The same feedback-based phenomenon applies to suppliers, distributors, the press, customer word of mouth, and many other factors that can drive business success.
- “Letting yourself be open and receptive to things that just happen to come your way- natural serendipity- is really important.” “Startups, life and everything doesn’t go necessarily according to Plan A really. Ever. What that taught me to do and to coach others to do is to say: ‘OK well, that didn’t work. Who cares? Put it aside. Let’s look for Plan B. And Plan B could even be better.’ And often it is better.”
Optionality is everywhere if you know how to find it. Sometimes a setback forces you to look for harder for optionality or in a different way. Living in a city, going to parties, taking classes, acquiring entrepreneurial skills, having cash in your bank account, avoiding debt are all examples of activities which increase optionality. Nassim Taleb wrote in his book The Back Swan:
[M]aximize the serendipity around you….Many people do not realize that they are getting a lucky break in life when they get it. If a big publisher (or a big art dealer or a movie executive or a hotshot banker or a big thinker) suggests an appointment, cancel anything you have planned: you may never see such a window open up again. I am sometimes shocked at how little people realize that these opportunities do not grow on trees. Collect as many free nonlottery tickets (those with open-ended payoffs) as you can, and, once they start paying off, do not discard them. Work hard, not in grunt work, but in chasing such opportunities and maximizing exposure to them. This makes living in big cities invaluable because you increase the odds of serendipitous encounters—you gain exposure to the envelope of serendipity.
10. “In terms of what type of people we look for, of course we look for somebody who’s smart and who’s focused. But we look for something else. We look for somebody who has something to prove. Somebody who has a chip on their shoulder, so to speak, that really– like, the company is a part of them. And this is what really separates the founder from the CEO. Somebody who’s a founder, that company is a part of them and they will do whatever it takes. When plan A doesn’t work, they’re going to work on plan B, C, and D. And those are the kind of people that are just incredibly driven and won’t stop. They will absolutely figure it out.”
There is an old joke about how some people are just more wired to look for opportunities.
“Worried that identical twin boys of five or six had developed extreme personalities – one was a total pessimist, the other a total optimist – their parents took them to a psychiatrist.”
“First the psychiatrist treated the pessimist. Trying to brighten his outlook, the psychiatrist took him to a room piled to the ceiling with brand-new toys. But instead of yelping with delight, the little boy burst into tears. ‘What’s the matter?’ the psychiatrist asked, baffled. ‘Don’t you want to play with any of the toys?’ ‘Yes,’ the little boy bawled, ‘but if I did I’d only break them.’”
“Next the psychiatrist treated the optimist. Trying to dampen his outlook, the psychiatrist took him to a room piled to the ceiling with horse manure. But instead of wrinkling his nose in disgust, the optimist emitted just the yelp of delight the psychiatrist had been hoping to hear from his brother, the pessimist. Then he clambered to the top of the pile, dropped to his knees, and began gleefully digging out scoop after scoop with his bare hands. ‘What do you think you’re doing?’ the psychiatrist asked, just as baffled by the optimist as he had been by the pessimist. ‘With all this manure,’ the little boy replied, beaming, ‘there must be a pony in here somewhere!’”
Grit isn’t just a willingness to soldier on no matter what. Sometimes there is “no there there.” it is time to fold up the tent and try something else. That some people are serial entrepreneurs is an outcome of this fact. Angela Duckworth’s web site uses this definition: “Grit is the tendency to sustain interest in and effort toward very long-term goals. Self-control is the voluntary regulation of behavioral, emotional, and attentional impulses in the presence of momentarily gratifying temptations or diversions.” Lynn seems to be including in her desired founder attributes having something to prove and being relentless about trying new approaches when encountering a problem in addition to grit.
- “Life just happens. Often things that may seem like the most tragic and dismal at that point in time are actually a catalyst for something even better. And what makes it a catastrophe or something a catalyst is really your attitude towards it and how you see the next day. Always be looking ahead and think about ‘Well maybe this just created an opportunity for me to do something different.’” “I never planned on getting into venture capital. It really was through a series of very lucky events, I would say, through some really amazing mentors that I had in my past, and through just keeping an open mind and taking advantage of opportunities as they came my way.”
Life is very hard to plan. Things happen. Stuff comes up. Sometimes I read obituaries when I run into one because they can often reveal a path in life that you would not believe if it was fiction. These stories illustrate how one thing often leads to another in an improbable way. Here is an example of a one thing leads to another story:
“At 10, her parents became part of what she describes as a cult-like fundamentalist Christian movement that equated intellectual pursuits with witchcraft. The family moved from central Ohio to Kentucky, where she was enrolled in a tiny private school. When she could, she read The Columbus (Ohio) Dispatch, then the Lexington (Kentucky) Herald-Leader, and ‘snuck in some NPR when they weren’t around.’ She sold tennis shoes in high school and picked up odd jobs to pay for college – at the loan desk at the campus library, making copies on the graveyard shift at Kinko’s. At the University of Kentucky, she volunteered for the student newspaper. After graduating in 1987, she met her future husband (then an architecture student at UK), got pregnant, and moved in with her husband’s family in Vermont. Galloway went to the local newspaper – The Hardwick Gazette – and, based on her student newspaper clips, was hired on the spot.”
What a story that is. Of course, some people’s lives are not very exciting. I have always loved a short story entitled Mayhew by Somerset Maugham on the topic of interesting people:
“The lives of most people are determined by their environment. They accept the circumstances amid which fate has thrown them not only with resignation but even with good will. They are like streetcars running contentedly on their rails and they despise the sprightly flivver that dashes in and out of the traffic and speeds so jauntily across the open country. I respect them…and of course somebody has to pay the taxes; but I do not find them exciting. I am fascinated by people, few enough in all conscience, who take life in their own hands and seem to mould it to their own liking. It may be that we have no such thing as free will, but at all events we have the illusion of it. At a cross-road it does seem to us that we might go either to the right or the left and, the choice once made, it is difficult to see that the whole course of the world’s history obliged us to take the turning we did.”
- “When you’re up you take some money off the table, and you play with your winnings. Take some money off the table. “
I have followed the approach to life Lynn describes above. Once you have achieved a certain level of financial success do you really want to go all the way back to where you started in your professional life? Life gets substantially better if you are playing with “house money.” The older you are and the more responsibilities you have, the more this statement becomes true. It is wise to risk not being able to take care of someone you love because you doubled down in order to get even richer? Should you instead find an opportunity that allows you to leave some of your money off the table? The engineering principle of margin of safety applies to this type of decision. Putting at risk: (1) what you have and need for (2) what you want and do not need, is bonkers. The famous related Charlie Munger quote is: “I had a considerable passion to get rich, not because I wanted Ferrari’s – I wanted the independence. I desperately wanted it.” Independence and having great choices are really wonderful things to have in your life. Lynn puts it this way: “Be happy. And then to continue to go forward. I think it’s a very good rule of life in general.”
Roger Ehrenberg: https://www.slideshare.net/RogerEhrenberg/from-bootstrapping-to-venture-rounds-a-startup-case-study
Fred Wilson: https://avc.com/2009/11/thematic-vs-thesis-driven-investing/
Mark Suster: https://bothsidesofthetable.com/how-to-talk-about-valuation-when-a-vc-asks-7376f5721226
Collaborative Fund: http://www.collaborativefund.com/blog/an-honest-business-news-update/
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