The Patriots are on their bye week after two huge wins vs. Tennessee and Tampa Bay. Cheers to my friend Dave who lost the online bet and posted this great photo on his Twitter account as payment.
The Patriots have played well against some weaker teams these past two weeks. Big challenges coming up over the next five weeks -- 2 games vs. the Dolphins, at the Colts, vs. the Jets, and at the Saints. They'll need to keep improving over the bye week to be up to the task.
I think that their defense is the surprising part of the team. They've played very well. The offense has done OK, but needs to be more efficient against the better defenses.
They seem to be in good position to win the division, but I think it will be challenging to get a first round bye in the playoffs. Denver and Indianapolis have two game leads vs. the Pats on that front, and Denver already beat the Pats head-to-head. The Pats will have to beat Indy to have a chance for a first-round bye. Otherwise, they'll be on the road for much of the playoffs.
I'm going to the game in Indianapolis in November. Should be a great time, and, coincidentally, I'm also going to the Celtics-Pacers game the night before. My team jerseys will get a good workout on the road!
I've written many times about the impending structural challenges in the venture industry. There is too much capital hoping for huge outcomes in an environment where a modest win should be considered a big win. It's critical that VCs be careful with the amount of capital they meter out to portfolio companies, and, for larger funds, this makes it tough for them to participate in these capital efficient deals.
The folks at Industry Little Hawk agree. They've written a white paper that describes why smaller venture funds (<$150M) offer the best returns. They have historical numbers to back it up.
The big question is what will happen to the big funds out there? They have too many people who make salaries that are too large and spend too much money on fancy offices. Limited partners in these funds are figuring out that these fixed comforts misalign interests between the General Partners in the venture funds and the Limited Partners who invest in these funds. Look for continuing pressure on these larger funds and a steady exodus of partners from these funds as they attempt to get closer to 'right-sizing'.
Although I hear LPs talk about this quite a bit, it will take years for this to ripple through the venture industry. For now, most venture funds will wait on raising a new fund, hoping for a better environment in a year or two. The industry won't really shrink until these funds give up on their existing model after failing to raise funds. 5-10 years from now, the venture business should look much different than it does today -- smaller firms with more nimble partners.
Another shoe to drop will be the fee model that is employed by venture firms. The more they can align their compensation with the LPs interest, the better. LPs will insist that VCs can't get rich off of high fees and will instead have to deliver significant returns in order to make some serious money. Look also for certain fund strategies to employ a very different fee structure when they can ensure that they only make money when the LPs do. I'll write more about that in the future.
There have been a few more posts recently describing structural problems in the venture capital business.
Fred Wilson called out VCs who claimed that they need to own at least xx% of a company to justify an investment. xx is usually 20% or more. Most VCs think this way because they have a large fund and want to have a manageable number of investments to worry about. Each deal may need to ultimately represent $10-15M over time. In order to justify that, you may need to own 25% of a company (or invest in much later stage companies).
Josh Kopelman explained why big funds will have trouble generating strong returns for the large bulk of money they have. Here's a great quote:
Take a $400M venture fund. In order to get a 20% return in 6 years, they need to triple the fund -- or return $1.2B. Add in fees/carry and you now have to return $1.5B. Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value. So assume that one VC invested in Skype, Myspace and Youtube in the same fund - they would be just halfway to their goal.
Both of these posts are worth reading in full. I'm going to cover some trends from the VC's investors on down that highlight structural problems in the industry.
Most VCs raise money from ranges of institutional investors (endowments, 'funds of funds' which manage large pools of capital for other investors, pension funds, wealthy individuals, etc.). Collectively, these are the Limited Partners in a venture fund, which is managed by the General Partners. There are several issues impacting LPs these days:
There has been a long term trend of lots of capital being available to invest, and therefore a desire to invest more into venture capital. As every LP increased their allocation to venture capital, they ended up increasing the amount they wanted to invest in a fund. Some LPs have minimums of $20M up to $50M (present economic difficulties excluded).
LPs often don't want to be more than 10% of a fund. So, their minimum investment levels imply fund sizes of $200-$500M, at a minimum.
However, LPs also don't like large fund sizes because they think that the VC General Partners make too much money from their fees (typically 2% of committed capital per year). So, here's the first conflict -- we have to invest $20M or it isn't worth our time, but we don't want you to have a large fund (or at least not a large fee income).
As Josh pointed out, it's hard to make money with a big fund as you need many big exits. This gets easier with a small fund as the sizes of wins required goes down proportionally. But, small funds aren't interesting to many LPs as they can't invest money in them to be worth their time.
And, in today's economic climate, there is a shortage of liquid assets available for LPs to use to meet their existing fund commitments let alone make new ones. That's one reason why new fund commitments are so low. Also, with VC returns being fairly low for the past decade, many LPs are moving out of venture capital or lowering their allocation, except for commitments to proven very top-tier funds.
There is also a structural problem with compensation. As you might know, VC General Partners get a salary from their management fee and then a piece of the upside on the aggregation of the deals in the fund. Typically, the partners would split 20% of the profits in the fund (not in each deal). The whole fund has to be above water for this to happen, and some top VCs have a 'carried interest' of 25% or even 30%. LPs are trying get everyone pushed back down to 20% if they possibly can.
Many LPs are compensated in the same way. They get a management fee from their investors and then get some level of 'carry' if their fund is profitable in the aggregate. If you think about this, it compensates everyone for achieving fund multiple, regardless of how long it takes to get there. You might think that an LP would be thrilled if they could send you all of their money and you could reliably return 1.25x their money in 12 months. Logic would assume that they would do that year after year. But, their compensation system keeps them from doing that. They'd only make 6.125% of the committed capital as a profit (you'd have to generate a 31.25% return, keeping 20% of it, 6.125%, and sending them the remaining 25%).
They'd rather let you hold the money for 5-8 years in hopes that you can return 2-3x their money, even if it means that you might lose half their money. That doesn't make much sense, but that's the basis of LP and GP compensation. If you generate a 2x eventually (to net 2x, the VC has to generate 2.25x and keep .25x for themselves as your carry), and raise a new fund that tries to do this every few years, you can eventually earn more money. But, chances are something that can generate a 2x return can also lose half its value. And, that's what's been happening in the venture space. LPs and GPs are trying to generate high returns and living with the losses. The glut of capital in the sector is one factor in driving down returns. For the VCs and LPs, their high management fees buffer this for them, but their ultimate investors are getting tired of it.
I expect there to be lots of changes. Foremost, capital will continue to drain out of the venture capital space. Second, there will be pressure on the venture fund terms, pushing down management fees so that the GPs only make significant money if the investors are also earning a profit. This will force the GPS to do the math that Josh Kopelman did and raise a smaller fund. That will force many funds ts close and many people to leave the business. Ultimately, it will be a healthier market, but it will take some time and a lot of gnashing of teeth before it gets sorted out.
Those are the facts. However, the production goes way beyond the facts. If you like your theater spoonfed to you one line at a time while you sit and watch, Sleep No More may not be for you. But, it may also be just what you need to wake up and explore.
This is a show that you go and find. You are dropped off on your own on one of four floors of the school. The environment has been changed to an incredibly detailed series of almost 50 rooms that you wander between. Every audience member is wearing a mask. You can examine and touch the sets. You can wander through any open door. You can walk right up to the actors. And, you are not allowed to talk. That's OK, because the actors barely talk, too. There's some murmuring between the characters, and some crying, laughing, yelling, etc. But, no lines of Shakespeare or any dialogue at all.
However, if you stay close to the actors, they'll whisper to you. I had several characters whisper things to me that indicated what they were thinking about. And, I had one 'private encounter' with one character who brought me into a small room and told me a story about their dreams. We didn't talk, but it was like being in a dream myself.
I identified some of the major characters, like Macbeth, Macduff, Lady Macbeth, and Duncan. But, I never figured out who some of the characters where. And, I figured out what many of the rooms were, but not all of them. I witnessed some of the major scenes in Macbeth, such as when Lady Macbeth tries to wash the blood off of her hands. But, I also never saw some of the others. And, I wasn't sure how some things I did see fit into the story.
However, despite my confusion, I didn't want it to end. I wanted to keep going and to try to put it together. Some scenes are put on more than once. I saw the major banquet scene twice. You could go to this show multiple times and still not see it all. I already have plans to return in a couple of days.
Despite the lack of dialogue, the show is anything but quiet. There is a constant soundtrack that varies by room. It's like the climactic music from a Hitchcock movie. The costumes and sets are out of the 1920s, as is the Manderley bar where you can take a break or hang out after the show. Some of the rooms where downright spooky, and the lighting and soundtrack created a haunting experience.
When my journey started, I wandered around trying to look at all the rooms. That was interesting, but next time I'll focus more on following the characters around right from the start. Of course, you don't know when you'll encounter a character or who they are. But, you quickly figure out who the major characters are. And, they develop entourages of audience members following them around. When they dart from one room to the next, you race down the hallway to keep up with them.
I'd strongly suggest brushing up on Macbeth before going. I read the synopsis on Wikipedia, but I'll try to find something even more detailed. I think it might help. But, the adventurer in me wants to keep going back to see it all and put all the pieces together. I can't imagine that it would be the same experience twice.
This was one of the most unique theater experiences I have ever had. Even when I was wandering around on my own, I was never bored. I can't wait to go back.
My friend and fellow Yankee fan, Angelo, was on me for not mentioning the Yankees on my blog in a while. And, he's right. The Yankees had a great regular season after a slow start. And, they were incredibly clutch in sweeping the Twins. I guess all these years living in Red Sox country have made me gun shy. But, with the Red Sox out of it (in a hurry!), I'll crow about the Yankees for a bit.
The key to the Yankees is their starting pitching. The more they can stick with three starters (Sabathia, Burnett, and Pettitte), the better chance they have. They've moved Joba Chamberlain to the bullpen, where he is very effective. Their fourth starter would be Chad Gaudin, not exactly imposing. I've heard that they are thinking of pitching Sabathia in Game 4 on three days rest. With a day off before a possible Game 5, they could go back to Burnett, Pettitte, and then Sabathia again for the possible games 5, 6, and 7. I like this strategy.
Of course, the Yankees bullpen has been excellent and is the best among the remaining teams, with Mariano Rivera as the one guy you'd always want on the mound at the end of the game, even as he approaches his 40th birthday.
The Yankees offense, other than A-Rod, Jeter, and Posada, was relatively quiet vs. the Twins. But, their offense is too deep to stay quiet. And, they don't need everyone to be hot in order to win. Jeter is the key. He's getting on base all the time and making heads-up plays in the field (as usual).
The Angels are the one team that gives the Yankees the most trouble. But, this year the Yankees split 10 games vs. the Angels and won 2 out of the last three in Anaheim. And, as the Red Sox learned, past results mean nothing.
As you might know, I've been doing a week-by-week bet on the Patriots. Each week, I've found a fan of the Patriots' opponent who was willing to bet with me on the game versus the point spread. The loser has to change their Facebook profile photo to one showing the winning team's cap. Ideally, it should be an actual photo of the loser wearing the cap. Here are the results so far:
vs. Buffalo Bills - Patriots win the game at the end but lose versus the point spread. My friend Bob takes small consolation in the 'win' and lets me just display a cap photo due to my business travel that week.
vs. New York Jets - Patriots lose the game as favorites, sealing my doom. Bruce gloats and gloats.
vs. Atlanta Falcons - Patriots play well and win. My friend Anil displays a Patriots hat for a week.
vs. Baltimore Ravens - Patriots play their best game to date. Another win. My new Facebook friend Kelly is a good sport.
vs. Denver Broncos - Patriots play poorly in second half and lose in overtime. I slink into Lids to take my picture with a Broncos cap, although the way this year is going, maybe I should invest in the company instead.
Overall, the Patriots offense has been the disappointment. The defense, when they aren't on the field too much, has played well enough. The offense has missed many opportunities. That certainly hurt against the Broncos. And, they were anemic vs. the Jets. Luckily, after all of their opponents so far have been undefeated, their next two oppontents are currently winless. A good blowout or two would be great for the Patriots.
Thanks to my new Facebook friend Ned for taking the bet on behalf of the disappointing Titans this week. Go Pats!
Some of this is cyclical. VCs usually only raise a new fund once every 3-5 years. So, one slow quarter or even a slow 3 quarters doesn't foretell the end of venture capital. But, it's clear that the VC business is shrinking in several ways:
LPs (limited partners or investors in venture capital funds) are commiting less money to the venture capital sector. This means that there will be fewer funds and those funds will be smaller than before.
LPs are getting tougher on the terms that they pay to VCs, particularly on larger funds. This is affecting the fixed management fees, which pay VC office rents and salaries, and the carried interest (share of the upside of the investments), which is how VCs used to make most of their income. LPs don't want VCs making big salaries off the management fee and want some level of return for themselves before sharing with the VC.
VCs are slowing down their investment to push out their fund raising into the future when, hopefully, things will be better. Also, some LPs are asking their venture capital funds to slow down their investment as the LPs are short of cash from liquid investments to use to make their capital commitments to the venture funds. Even multi-billion dollar endowments can have a cash crunch!
The old guard VCs are having an easier time raising money than upstarts. Much of the money being raised is by brand name funds or brand name investors. Innovative new funds are getting pushed aside due to the cash crunch at the LPs. And, poor performing funds will struggle to raise money.
Due to the slow exit environment, more companies are having to fund their growth internally or with their existing investors. As those investors old funds start to run dry, it will become difficult for even good companies to get access to the cash they need to grow. Some will sub-optimize their growth and others will be forced to sell before they would otherwise want to.
What does this mean to an entrepreneur?
You need to get your company to revenue faster and close to cash break-even faster. VCs are still going to be needed to get companies off of the ground, but it could be tougher to count on them for expansion stage capital. Of course, there are still other ways to get a company off the ground -- bootstrapping it, angel financing, etc.
Choose your syndicate carefully. VCs who are unable to raise a new fund will slowly whither away. The lack of sufficient new capital to invest and the associated management fees will cause partners to leave. Old investments in old funds get put into caretaker mode and will have trouble squeezing new capital out of the investors. Make sure your investors are healthy and have a long runway.
Look for other sources of capital as you get closer to break-even. If you have revenues and hard assets, you can consider debt to fund your business rather than equity. Don't over-leverage your business, but a modest amount of debt in a growing company is a good thing as it preserves the existing equity structure and is a source that can be tapped again as the debt is repaid. However, too much debt or debt in a non-growth company can be a killer. You need growth to repay the debt or the debt service will crowd out your operating expenses.
Don't count on your investors or board to solve this for you. They can be helpful, but the company's leadership needs to ensure that the company is financed, in partnership with the investor base.
Overall, I think that the start-up financing arena will be a place for innovation. There will still be plenty of venture capital for the best ideas and teams, but entrepreneurs will also be challenged to get their companies going without venture capital or plentiful late stage financing. One of the keys to success is keeping your company financed, and those who do so have a big advantage.
It's not secret that this has been a tough economic climate, particularly for raising money for an investment fund. Luckily, we're starting to see some positive signs. Some investors are still very tight for cash, but others are opportunisitcally making commitments. This has been coupled with an improving economic environment. We're not back to euphoria, but I think that most people think that we have at least bounced off the bottom.
At Sempre, we've been lucky to get great support from several partners who have helped us along while we are in a start-up phase. I'm overdue for publicly thanking and recommending them.
Foley Hoag and their Emerging Enterprise Center in Waltham, MA -- Foley Hoag is our law firm, but they are also gracious hosts for our offices. There are so many industry events at the Emerging Enterprise Center that you could probably meet most of the Boston-area high-tech industry just by hanging out here. And, the attorneys at Foley are very interested in working with entrepreneurs. They have an interesting blog as well, with interesting insights for entrepreneurs from the legal perspective. If you need a law firm for your company, Foley is a great place to go.
Delta Capital Partners and Mark Duffy have been great partners of ours in managing the back-office side of Sempre. They are very experienced and flexible. It's critical for start-ups to have part-time and experienced resources to round out their team. Mark has worked like he is part of our team, bringing his considerable experience to the internal side of Sempre.
Rebecca Fagan of Fagan Design has helped us maintain a professional look to our materials and web site. There's not much there yet, but you can check out her considerable body of work here. Rebecca is efficient and flexible. She's also sensitive to tight budgets, able to scale up her efforts if budgets allow and make practical trade-offs when they don't.
We're working with the Boston office of KPMG for our audit and tax filings. They won't be doing a lot until we're really up and running, but they've already provided great advice and some valuable introductions.
Most start-ups get some help and sponsorship from their vendors. Don't forget to thank them and, if possible, refer some additional business to them to reward them for betting on you.