Musings of a VC in NYC

The Targetspot Value Proposition

Doug Perlson, CEO of our portfolio company Targetspot, has penned an opinion piece in Forbes about monetizing online audio that does a great job of explaining what Targetspot is and why it matters.

I particularly like this paragraph:

Yet, ironically, this is exactly the type of high-quality online inventory that advertisers are asking for--it is associated with major media companies with respected brands in their own right. Furthermore, with all the ad clutter on a given Web site (display, video and text--sometimes all on the same page), Internet radio advertising offers a unique ability to cut through the noise and deliver a message that is both literally and figuratively heard. It's a high-impact medium that has only recently opened up to the advertising masses through advanced technology solutions.

Organic Synergies

I don't believe in the keiretsu model of VC investing that was briefly fashionable in the late 90s. I don't think you can or should force your portfolio companies to work together. It has to happen organically, if at all. But when it does, it makes my heart warm.

I saw this post on the Etsy blog (called The Storque) yesterday. Apparently a number of sellers in the Etsy community are starting to use Twitter to get the word out on new stuff they have up on Etsy for sale.

Strangelittlebird says:

My sales have increased since I started twittering.  I think as sellers we're all looking for ways to get our great items just a few more seconds of publicity, an Twitter certainly offers that opportunity.

That's most excellent!

You can also follow The Storque on Twitter. I did just that yesterday.

Our Run In With Auction Rates And What It Taught Me About Markets

Over the past month, my wife and I had a run in with the auction rate security market. We emerged unscathed but there were a few uncomfortable moments and they taught us a few things about markets that we had sort of understood but not at a gut level. There's nothing quite like a few sleepless nights to teach you lessons you'll keep for the rest of your life.

It all started almost a year ago, when we parked a significant amount of cash in tax free municipal bonds. The cash is intended to be used to fund a purchase we plan to make later this year. We wanted the money to be totally safe, very liquid, and produce income that we didn't need to deal with the hassle of calculating and paying estimated taxes on. So with the advice of some experts on tax free bonds, we purchased three auction rate tax free municipal bonds.

For those who don't know what an auction rate security is, here's a short explanation. If you want a longer one, click on the link in that last sentence and wikipedia will do its magic for you. Auction rates are generally long term bonds (corporate or muni) that have their interest rate reset every week via an auction. This does two things. First, it allows the borrower (the corporation or municipal government) to pay short term rates on a long term security. And that can be very beneficial to the borrower. It also allows the purchaser of the bond to have much higher liquidity because the auction rate security is re-auctioned every week. So every week, you have the opportunity to say that you want out and you get out. At least in theory.

We've owned auction rate munis on and off for almost 10 years so it's not like we were new to this market. But the amount we parked in auction rates last spring was significantly more than we'd had in auction rates in the past. I understood how they worked, but honestly never paid much attention to the specifics.

One specific provision of auction rates that is really important, but I honestly knew very little about until the past couple months, is the penalty rate (or maximum rate). If a bond auction does not generate enough demand at any time in the life of the bond, it's reverts to a long term bond and pays a maximum rate of interest.

Until the recent problems in the fixed income market, brought on by the subprime mess, the auctions of these securities didn't generally fail. There were a ton of buyers in the market and there was plenty of liquidity. But several things happened that have changed the auction rate market, at least temporarily.

First, and most importantly, the issuers of auction rate securities generally get the bonds insured against default in order to improve the credit quality and rating of the bonds. These bond insurers have gotten into trouble in the subprime mess and they are in various stages of financial distress. Without the security blanket of the bond insurer, many of these auction rate municipal bonds look a bit riskier and so the demand for them has gone down.

In addition, there is a general de-risking going on across all of the capital markets with investors opting in favor of really safe investments right now. So that further dampened the demand for the weekly auctions.

Starting late last year, auctions starting failing. And they have continued to fail for most of the first two months of this year. Investors who were sold a "safe and liquid" bond are waking up to find out that they now have a "pretty safe and illiquid" bond. They are also finding that the interest rates they are now getting have gone up.

So when I got a call from the person who manages our bond portfolio about a month ago telling me that "your bonds have not yet failed an auction but you should know that the risk of it happening has gone up", I started paying attention. I did my homework and got a list of the three bonds we owned and drilled down into the details of what they were. I focused on the borrower, the borrower's credit, the rating, the insurer, and most importantly the penalty rate. All of our three bonds were issued by government managed utilities in NYC (like water and sewer). All were AA rated borrowers and AAA rated by virtue of bond insurance. All were insured by insurers who were in the news. But most importantly, all had penalty rates above 12%, with one at 15%.

We thought long and hard about what to do. We went for a week or two where we watched to see if the bonds would pass the auctions. In every case they did. As we noodled it over, we came to realize that the auction rates we held were really solid securities because of the penalty rate. Even though we needed the money to be liquid later this year, there were investors who would love to own the securities at a maximum/penalty rate of 12-15%. So there were investors coming into this market almost hoping for an auction to fail. That provided the necessary liquidity to the auctions of these specific bonds.

But even though the bonds were solid, the rates they were paying had gone from 3% in the fall of 2007 to over 7% in February. That's how messed up the auction rate muni market had gotten. We were getting paid over 7% tax free for bonds that were solid. And the borrower, in our case the local government utilities, just saw their interest expenses go way up.

Ultimately, we decided to bail out of the market and now our cash is sitting in a money market fund paying a fraction of what we were getting in the auction rate market. But we decided that we should not be taking advantage of a messed up market with cash that we have committed to spend later this year. And so, along with a lot of other "safety first" money, we left the auction rate muni market last week.

The most interesting class I took at Wharton where I got my MBA was called "speculative markets" and in that class I learned that markets include different classes of investors. There is the safe money, the hedgers, and the speculators. For example, when a company (like YHOO) get a takeover bid and the stock soars, the safe money generally leaves the stock, takes its gain, and the stock trades into the hands of speculators who are now taking the risk that the deal will in fact go through. They are a different kind of investor who is getting paid to take those kinds of risks.

The same thing has happened to the auction rate security market, at least temporarily. The safe money, at least our safe money and I am sure many others' safe money, is gone from that market. And in its place are speculators who are willing to take the risk of illiquidity and even default (which is very low in the muni market) in return for getting tax free interest rates of 7% to 15% (which are the equivalent of 10-20% taxable).

What was my big takeaway from this whole affair? When risk is appropriately priced, there is a market for something. And in the case of auction rates, the risk is illiquidity and so you must focus on the penalty rates. When they are priced appropriately, the market works. When they are not, the market doesn't work. Thankfully the people who helped us construct our auction rate portfolio understood this. Now we do.

Well Done Facebook

Back in January, Sam Gustin of Portfolio Magazine asked me the following question in an interview:

Do you think that Facebook C.E.O. Mark Zuckerberg has what it takes to take a potentially $15 billion company public? Or do you think Facebook should follow in Google's footsteps and bring in an experienced technology C.E.O. like Eric Schmidt before they go public?

I replied:

I think [Zuckerberg] can do it, but he's going to need some help. Bill Gates found [early Microsoft President and C.O.O.] Jon Shirley. Larry Ellison had a number of people over the years that have helped him run his company. It doesn't mean that Zuckerberg has to give up control of the company. Larry and Sergey have never given up control of Google. Everyone knows that. They just delegated certain responsibilities to Eric, and they've given Eric the ability to weigh in on every issue that matters to the company, and they've created a structure that works. I'm sure there are some frustrations at times, but it works, and it's made all of them fabulously wealthy. So I think absolutely Mark needs to do that. And I think if he's willing to listen to the people around him, including his board, his confidants, and his management team, he will do that.

Well Mark Zuckerberg did just that this winter and it resulted in the hiring of Sheryl Sandberg as COO. I don't know Sheryl, but her resume is impressive and she seems like the perfect alter ego for Mark. I hope and expect that this will work out well for Mark, Sheryl, and most importantly Facebook. Well done.

Marc Andreessen on Obama

Marc starts out his blog post on Obama with the following statement:

I've tried very hard to keep politics out of this blog -- despite nearly overpowering impulses to the contrary -- for two reasons: one, there's no reason to alienate people who don't share my political views, as wrong-headed as those people may clearly be; two, there's no reason to expect my opinion on political issues should be any more valid than any other reader

And then he goes on to write a fantastic post on Obama, based largely on a 90 minute private meeting that he and his wife had with Barack 18 months ago.

You all know where I stand on the role of politics on a personal blog - bring it on, it's an important topic that we should all be discussing. Thankfully Marc ignored his better instincts and shared a bunch of great stuff with all of us. That's courageous because he'll take some hits for this. But not from me. I applaud you Marc.

I will add that the Gotham Gal and I had an opportunity to meet with Barack in a room of about 10-15 people in the fall of last year and we were able to get a few minutes of one on one conversation. He was conversant in topics as wide ranging as venture capital, web technology, and the challenges of raising teenagers in NYC. I totally agree with Marc's first point, Obama is a normal guy. I liked him that day and I like him more and more every day.

Incenting The User To Put Up A Profile Picture

I have not seen this technique before, but it sure worked with me.

I logged into a brand new web service today and this was my default profile picture.

Changing it was the first thing I did.

Very clever.

The Second Order Network Effect

The web is all about building networks on top of networks. The Internet is the base network, a global connection to 825 million people (that’s comscore’s Jan ’08 number and it doesn’t include mobile devices).

We’ve been building networks on top of the Internet network since we first got the Internet, but the creation of social nets in this decade has been transformative. We now have “social” networks like myspace and Facebook which each reach over 100 million people a month. These networks have rich social graph databases that know who we care about most among the >1bn people hanging out on the Internet around the world.

So that’s why Facebook platform was such a big deal. They allowed developers to build apps that can tap into the Facebook social graph. The top three Facebook app developers, Slide, Rock You, and Zynga have built networks of Facebook apps that respectively touch 4mm, 2.2mm, and 1.3mm people each day. And they’ve done that in less than one year. That’s not yet the kind of numbers an event like the Oscars can produce, but these numbers rival many cable networks daily viewers.

What’s happening now is that these app networks are becoming networks themselves. They are allowing app developers to join their networks and tap into the people hanging out in them. Because these app networks were built on top of social graphs (first Facebook, then Bebo, soon myspace), these networks are able to leverage the social graph to provide social network utility to app developers.

I call this a second order network effect. Building networks on top of social networks produces even more utility to app developers.

I am an investor in Zynga and saw some data on their new social game network that I found very interesting. With their permission, I am going to show you how and why this is happening.

But first, a short explanation of what a social game network is. Zynga makes social games. Examples are the word game Scramble, the hugely popular Texas Hold’em, and the war game Triumph. They all are connected via the game bar at the top of the app which shows your friends (from the social graph data they have access to) and what game they are currently playing. The game bar is the “game lobby” of the social game network.

Last week Zynga launched their social game network via the Zynga API.  To date fourteen game apps have joined with another ten on deck to launch this week. This about triples the number of games in the Zynga Game Network.

Here’s a screen shot of one of the games that joined in the first week, called The Dot Game. It’s a fun social game where you connect dots in a race against a friend to cover the board.

You’ll see at the top of the screen shot, right below the Facebook toolbar and above the game itself is a section of screen real estate that shows my friends on Facebook who are playing games in the Zynga network and what games they are playing. If anyone is currently active in a Zynga network game, it will show that and what game they are playing.

In the first week of the Zynga Game Network, almost 75,000 clicks were sent to third party apps that have joined the network. And those third party apps sent back about 32,000 clicks to the Zynga Game Network. It’s important to note that the Zynga Game Network is currently sending more clicks out to its partners than it gets back. More on that in a minute.

Here’s a screen shot of the Zynga Game Network dashboard for game developers. It shows for each third party app in the network how many clicks they are getting and how many clicks they are giving.

You’ll see that on the first day the network generated a lot more clicks to The Dot Game, about 3,000. The next two days as the network attempted to balance out the clicks a bit, the network got back more than it gave. On Friday, the network started giving more again and has been doing that ever since.

Zynga is initially giving more clicks to its partner game developers than they get back to help jump start other games. Having more successful apps in the network means more clicks for everyone. That’s the second order network effect in action.

How valuable is a click? Well Zynga’s experience has shown that early in the launch of a new game, most clicks result in an install and a game play session. Of course not every game play session turns into a repeat player. That’s where game design and evolution comes into play.

Here’s some data on two of Zynga’s own games, Triumph a Zynga developed war game, and Scramble, a Zynga developed word game.

These charts show the daily active users for both games.  Zynga has had to take different tacks with each of these games. Triumph is a real time game that they continue to evolve and improve resulting in more repeat usage and growth. Scramble is primarily a “turn based” game like Scrabulous. The secret in a game like that is viral tuning to increase the number of people that you play the game with.

So if you have a social game that you’ve built, getting clicks is not the only secret to success. But it is a big part of it, particularly early on in the life of a game. Joining a game network like Zynga a free way to get clicks. The Facebook directory has over 17,000 apps in it. It’s very hard to get noticed there. You can buy installs and many apps do that. And with Facebook cracking down on invites and notifications, it's even harder to build an audience for your app. So if you are a game developer you should also join a game network and though I am clearly biased, I think Zynga is by far the best choice.

Wikipedia defines “network effect” as:

a network effect is a characteristic that causes a good or service to have a value to a potential customer which depends on the number of other customers who own the good or are users of the service. In other words, the number of prior adopters is a term in the value available to the next adopter.

That last part is key. The “number of prior adopters” is the value to “the next adopter”. So if you are picking a game network to join, go to the one that has the most game players in it. You’ll get the most clicks that way.

By interconnecting many of the Facebook game apps, Zynga and other open app netwworks are creating an open channel for everyone to participate in, so that companies don't have to compete to own and control separate networks. Like the Facebook itself, all networks have more value with more nodes.

The biggest winner in all of this is the user. When you play social games that are in an open social game network, you will see and can play with more of your friends. And playing games with your friends is what social gaming is all about.

For Emma, Forever Ago

If you follow my tumblog, you'll know that I've been obsessed by this record since discovering it on Daryn's tumblog on thursday.

For Emma, Forever Ago is by Bon Iver, but that's just a name chosen by Justin Vernon who is the amazing artist behind this record. Bon Iver is sort of french for "good winter' and reflects the fact that Justin recorded this record in "a remote cabin in the woods of Northwestern Wisconsin" over the course of last winter.

This record has the sound of a warm fire burning in the house with the snow and wind swirling outside. The vocals are wonderful. And at times, it has an intensity that is shocking.

The first song to get me was Flume which I linked to above on Daryn's tumblog. You can hear the "single" called Skinny Love on my tumblog as well as the ending track called Re: Stacks.

For those who aren't into clicking around, here's one more track called Blindsided.

Blindsided - Bon Iver - For Emma, Forever Ago

Comments or Discussions?

We had a dinner party the other night and seated to my left was a person who had been involved in writing one of the most popular blogs on the web for several years. That blog did not have comments initially and then launched a 'velvet rope' approach to comments where you had to get approved to leave a comment. The idea was sort of like TED. You supposedly increase the quality of the discussion if you keep the riff raff out. Guess what? It didn't really work. It never does. The "riff raff" is always the source of the best discussions.

The next day I was talking to the founder of a popular blogging service about comments. He pointed out that many comment threads are filled with garbage like LOL, 'you are an idiot', or worse.

He pointed to the comments here at avc and noted how good they were.  He called them 'discussions'.

First, I agree with him. The comments here at avc are the best thing about this blog. You all make this blog what it is and I totally appreciate it.

Back to the dinner party. On my right was our long time friend Helene. She's totally into the presidential race this year and noted that she finds the political discussions on this blog quite good. She's not much for the geek stuff that goes on here but she's really enjoying our political debates

I pointed out to both of my dinner partners that I try to weigh in on the discussion as much as I can and they thought that had a lot to do with the overall quality of discussions.

I am not sure about that. First, until I moved to disqus and got the ability to reply to comments via blackberry, I wasn't much of a presence in the comments here and they were certainly just as good for the first four years as they have been recently.

But I do think the blogger needs to be active in the comments. Arrington is. Winer is Scoble is. Jarvis is. And the comments at all of those blogs are pretty good.

I think that blog comments (or call them discussions) are fantastic and are often lost behind the main page. On many of the best blogs, the responses to the posts are where the action at, including this one.