Musings of a VC in NYC

You Can Do Too Much Due Diligence

It's Monday, time for another lesson I've learned in the venture capital business. Today I will tell a story that I love telling. It has some of my favorite people in it.

Back in 2004, early in my blogging career, I heard about a service that had just launched called Feedburner. It provided a number of useful services for a blog's RSS feed. So I went and signed up and AVC became one of the first users of the service. I immediately liked the service and the idea. So I contacted the founder/CEO Dick Costolo, who has gone onto bigger and better things. I told Dick that I was interested in making an investment in Feedburner. My friend Brad Feld was also talking to Dick about the same thing so we decided to do the investment together.

As part of our investment process, we do a bunch of fact gathering/checking work that is called Due Diligence in the vernacular of the VC business. So my partner Brad Burnham and I put together a list of leading blogs and online publishers who had popular RSS feeds at the time. I think there were a dozen or so publications on that list. It included Weblogs (Engadget), Gawker (Gawker), NY Times, and a bunch more. We know most everyone who ran those operations so we called them.

What we heard was surprising. Not one of them was willing to hand over their RSS feed to a third party for analytics and monetization. We were very surprised to hear that and thought a bit about it. But, we decided, we could not invest in something that the big publishers would not support. So regrettably, I called Dick and told him we had to pass and why. Brad Feld went ahead with the investment and Feedburner closed their round without USV.

About six months later I ran into Dick at an industry conference. We decided to grab lunch together and during lunch he said to me "you know those dozen publishers you called?" I said "yes, what about them?" He said "every single one of them is on Feedburner now."

I was pissed. How could that be? So I said to Dick, "Would you consider letting us into that last round we walked away from." He said "No, but I will let you invest at a 50% increase in price". We did that and became an investor in Feedburner. And that worked out well when Feedburner was sold to Google a few years later.

So what did I learn from this lesson? First, trust your gut. I was using Feedburner and knew it was a very useful service. I felt that others would see that too. They did, but it took some time. Second, I learned that a service can get traction with the little guys and in time, the big guys will come along. I have seen that happen quite a bit since then. And finally, I learned that you can do too much due diligence. It's important to talk to the market and hear what it is saying. But you have to balance that with other things; the quality of the team, the product, the user experience, etc. You cannot rely alone on due diligence, particularly early on in the development of a company and a market.

Great Entrepreneurs Will Listen To You But Will Follow Their Own Instincts

I told this story in the comments to saturday's video post, but since not everyone reads the comments and I want this to make it into MBA Mondays, I figured I would turn it into a case study.

In the early days of Tumblr, I used to bug David Karp, the founder and CEO of the Company, about comments. Though I had hacked my tumblog with Disqus, I wanted to be able to comment on other tumblogs and the vast majority of them had no comments because Tumblr did not support them natively. I was fairly persistent in my argument.

But David held firm. He wanted Tumblr to be a positive place on the Internet. The entire design of the service was with that in mind. There were loves (upvotes) but no downvotes. If you wanted to talk about someone's post, you had to reblog it to your tumblog and then add whatever you wanted to say. David thought that would eliminate trolling.

Eventually, I gave up and moved on to pestering some other entrepreneur about something I thought they should do with their product. David kept building positivity into his product and today there are 106 million blogs with 50 billion posts on them collectively.

In hindsight, I think David was right and I was wrong. I wanted him to build something that felt more like Wordpress or Typepad (where I blog). He had something different in mind. And to David's credit, he had the courage of his convictions to follow his own instincts.

This is tricky territory for VCs and entrepreneurs. Because most of the time the entrepreneur will have a better feel for their product vision than the VC will. But there are times when what the entrepreneur is doing is not working and the VC will have to figure out how to get the entrepreneur to see that. I have learned to trust the entrepreneurs instincts until it is very clear I should not. Finding that line is art and not science and takes a lot of experience. And I still get it wrong from time to time.

Because It's Standard

Case studies are true stories that teach lessons. And one of the great lessons I got in my career was care of a lawyer named Morty. This is a reblog of a post I wrote in Feb 2007. I thought about it last week in an email discussion with a friend. And so I decided to share it with all of you as part of the MBA Mondays series.

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I woke up thinking about Morty this morning. I haven't seen or heard from him in over ten years. But Morty taught me one of the most important lessons about negotiating that I've ever learned.

Morty was Isaak's partner in Multex early on. They put up the initial money to get it started. Morty wasn't a venture guy. He was a real estate lawyer and sometime real estate investor. He was as conservative as you can get and never liked the startup/venture business. But he was Isaak's partner. And Isaak asked Morty to negotiate the term sheet for the seed round with me.

This was late 1992 and I'd been in the venture business for five years and was on my second or third deal on my own. I'd negotiated a bunch of term sheets by that point, but I'd never had a negotiation like the one I was in for with Morty. Actually I don't think I've ever had one as rough as that since.

Morty wasn't familiar with venture terms. They didn't make sense to him. So standing in an airport pay phone (before cell phones) I went line by line, term by term with Morty.

We got to redemption and he started in. "Why do you need this provision Fred?". I was getting tired of his non stop push back and blurted out "Because it's standard. We always get this provision. Always have, and always will".

That got Morty pissed. He shouted over the phone:

I don't give a f>>>k that you always get this provision. Doesn't mean shit to me. This deal will be the first time you don't get it if you don't explain why you need it.

That set me back on my heels and I weakly explained that if the deal goes sideways for years, we need some way to get out of the deal and redemption provides that path. I don't even remember if he bought that argument. But I do know that we had redemption in the Series A at Multex and pretty much every deal I had done at that time.

But the point Morty made rang true to me and I've lived by his rule ever since. I never ever say that a specific provision is "standard". Nothing is standard. You either need it or you don't. Explain why you need it and most of the time you'll get it or something like it as long as both sides really want to make a deal.

You Are Working Too Hard And Not Getting Anywhere

Continuing the case method on MBA Mondays, I am going to tell a story about a business model pivot that was not a full business pivot.

In the lull between Flatiron and Union Square Ventures, I made a few angel investments and the best one was in a company called TACODA that went on to become a Union Square Ventures portfolio company and in many ways directly led to the creation of Union Square Ventures. My partner Brad who I founded Union Square Ventures with had left the venture capital business temporarily and was involved in the creation of TACODA, having provided the initial seed capital to Dave Morgan, the founder of TACODA.

Dave had previously founded Real Media, one of the early ad server companies, and he had seen the need for better targeting of display ads on the Internet. His idea was to build a companion to an ad server that could collect behavioral data and target dispay ads to the people who actually wanted to see them. This became known as behavioral targeting. The intital business model was to sell the behavioral targeting engine to publishers who would then sell the behavioral segments to their agency customers.

The software cost between $10k a month and $20k a month and was sold as a SAAS service to publishers. TACODA closed a few big deals early on and got validation of the product and the market from that. But it got harder and harder to close these deals as publishers were wary of coming out of pocket big dollars on a new technology that they weren't sure would help them make more money.

After six or nine months of disappointing numbers, I recall a meeting with Dave where Brad pointed out that the team was "working too hard and not getting anywhere." Brad suggested that the company try a new business model in which it would operate the targeting engine in the cloud and sell the advertising in an ad network model and then share the revenue with the publishers. In effect, Brad proposed that we send the publishers checks instead of asking them to send us checks.

Dave saw the logic of Brad's arguments and slowly but surely pivoted the company into an ad network. And once the business model pivot was completed, revenue took off. In less than three years after the business model pivot, the company was doing north of $50mm in revenues and was bought by AOL for $275mm.

The moral of this story is sometimes you have the right product but the wrong business model. Fixing the business model can fix the company. It certainly did in the case of TACODA.

Tenacity And Persistence Pays Off

Continuing the theme of case studies for MBA Mondays, I want to use a milestone that was passed last night to make a bigger point about startups.

I have known Scott Heiferman since the late 90s. He was one of the early NYC web 1.0 entrepreneurs. We were quite friendly with Scott but we were not early investors in Meetup, the company Scott started right after 9/11. Scott and I were at an event together and when asked about something he replied that he viewed Meetup as "a twenty year project." He said that it would take at least twenty years for Meetup to achieve all that he wanted from it and possibly a lot longer. And that he was patient and committed to that timeline.

As we left the event, I turned to my partner Brad and said "we should invest in Meetup, Scott is the kind of entrepreneur that we like and respect." And eventually we did invest in Meetup and we have been investors in Meetup for almost six years now.

Meetup is in its second decade as a company and growing rapidly. Last night Meetup booked its hundred millionth RSVP. You can see the counter at the top of this page. That is one hundred million people who used the Internet to get off the Internet and go out and meet other people and talk about things they are passionate about. Now I realize that some of these hundred million people are the same people doing this again and again. But even so, a hundred million RSVPs is a big deal for a company that has been plugging away on this mission for more than a decade.

When you are at something for a decade or more, it can become a slog. It requires tenacity and persistence to keep pushing and innovating. In the past year Meetup has started growing faster than it has in quite a while. The chart below shows that:

Scott and his team are as passionate about the Meetup mission as they were when they started the company. They have a very long timeframe in their minds and they are executing against it. And they are winning with tenacity and persistence. Which is why we backed Meetup in the first place. Well done Meetup.

Don't Let A Good Crisis Go To Waste

My partner Albert shared this line on his blog almost five years ago now.  I find myself using it all the time. And it is an important lesson that I have learned in my career.

When something goes badly in your company, for many the initial instinct is to keep things under wraps as much as possible to avoid freaking everyone out. I would argue that it is better to acknowledge the crisis and use it to your advantage.

Change is hard to bring to an organization and a time of crisis is often a perfect time to make some changes that you have wanted to make for a while. It creates a perfect backdrop and context for doing that.

Maybe you are in the midst of a financial crisis brought on by a tough fundraising environment. Maybe you are experiencing some management turmoil. Maybe you've lost your largest customer. Maybe you are getting pummeled by bad press. It really doesn't matter what is the cause of the crisis, but all of the above will work well.

I have seen a portfolio company react to a financing crisis react by making important and overdue changes to its business model and organization. The financing crisis ended and the company emerged in a much stronger place.

I have seen an entrepreneur react to the loss of several important team members by shuffling up the organization, pivoting the product roadmap, and operating with a much leaner team. The company recovered from the loss of the key team members, launched a new product very successfully, and got onto a path to profitability.

There are a lot of these stories to tell. Because crisis is what brings clarity and focus. You get punched in the gut, you get back up, and you take care of business.

So if you are in the middle of a crisis in your company right now, think hard about using it as an opportunity to make some changes. There is never a better time.

Revenue Traction Doesn't Mean Product Market Fit

I recently had lunch with Mark Leslie, a successful entrepreneur and CEO, who now teaches at Stanford and works with startups, often as a board member. He told me about a paper he and a colleague published in Harvard Business Review called The Sales Learning Curve. I read the paper and it articulates something I have seen quite a few times myself.

The paper starts out with this observation:

When a company launches a new product, the temptation is to immediately ramp up sales force capacity to acquire customers as quickly as possible. Yet in our 25 years of experience with start-ups and new-product introductions, we’ve found that hiring a full sales force too fast just leads the company to burn through cash and fail to meet revenue expectations. Before it can sell the product efficiently, the entire organization needs to learn how customers will acquire and use it, a process we call the sales learning curve.

Not only does the organization need to learn how customers will acquire and use the product, it is also true that the product itself may not be exactly what the market wants. In other words, launching a product is not the same thing as acheiving product market fit. The organization may need another six months, a year, or even longer to get to prodcut market fit.

One of the things I have observed over the years is that a hard charging sales oriented founder/CEO can often hide the defects in a product. Because the founder is so capable of convincing the market to adopt/purchase the product, the company can get revenue traction with a product that is not really right. And that can hide all sorts of problems.

I am thinking of a company, which will remain nameless, that ended up selling itself in a fire sale. The company had strong revenue traction early on, and with that traction raised a big round of financing, which then led to a big increase in headcount, for both sales force and product/engineering, and then faced a lot of churn in its customer base. That led to a very difficult period where the company worked hard to iterate on the product while maintaining this high burn rate. In the end the burn rate killed the company and in my opinion it never really found product market fit.

Like Mark Leslie advises in The Sales Learning Curve, it is dangerous to ramp up headcount and burn until you are certain that you have the right product and the right people and processes in the organization to support the product. And early revenue traction, often driven by a passionate founder, can be a nasty head fake. Try not to fall for it.

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The Return Of MBA Mondays: I am going to try a new take on MBA Mondays, suggested by one of you in the comments last monday. I am no longer going to write posts on specific topics as I was doing. I am going to take a page out of the "case method" and tell stories that have a lesson, hopefully based on real situations that I have lived through. I don't know how well this will work, but I am going to give it a try.

Whither MBA Mondays?

I have been writing MBA Mondays every week since January 2010. There have been roughly 160 MBA Mondays posts to date. It is a substantial body of work. I have no clue how many words I have written on this topic, but it feels like a lot.

I am not sure where to go from here. I am spent and don't feel like I have any more MBA Mondays material. I used to look forward to writing these posts every Monday. Now I dread it.

So I am suspending this feature for now. Taking a sabbatical. I can't promise they will be back. But I am not sure they are over either. Time will tell.

MBA Mondays: Revenue Models - Gaming

Like last week's post on mobile revenue models, gaming isn't a revenue model itself, but it does offer a number of interesting revenue models and is worth discussing in a post in this series. This is the last post in the revenue model series, which is based on the peer produced revenue model hackpad we created at the start of the series.

Gaming is interesting because there are a number of revenue options that game developers can choose from when thinking about how to make money from their game. The hackpad lists the following:

View Gaming on Hackpad.

There is still a sizeable business in selling a version of the game to the game player. That's how the console game (xbox, etc) market works. It is also how downloadable games market works. And there is a vibrant market in mobile games that you have to pay for to play.

But the games market has been moving to newer models in recent years. In app upgrades is certainly one of the more important revenue models. Many of the most popular mobile games are free to play but offer in app upgrades to get more game elements or simply to eliminate the ads. This is an example of the freemium business model in action.

Advertising is another important revenue model. For many web based games, advertising is the dominant form of revenue. On mobile, advertising supports the free offer and the elimination of advertising is often the value proposition for the in app upgrade.

The revenue model that is mostly (but not totally) unique to gaming is virtual goods. Virtual goods (like a tractor in Farmville) allow the player to have more capability in the game and they can be earned over time but are often purchased to enhance game play. This revenue model was inititally created in the asian gaming market but has been adopted by game developers all over the world.

I have been waiting for non gaming web and mobile services to adopt the virtual goods model but have yet to see anything that feels like it is working really well. Virtual goods is another excellent implementation of the freemium approach to business model.

There are game developers who use all of these models at the same time. They might sell their game on certain platforms, they might offer a free ad supported version on mobile with in app upgrades and virtual goods. In many ways, I think the gaming market is the most sophisticated about revenue models of all the sectors in web and mobile. That may stem from the fact that most games have a finite life and so the developer has to extract real revenue quickly to get a return on the investment they have made in developing the game. I think there is a lot that the rest of the web and mobile services world can learn from the gaming market.

MBA Mondays: Revenue Models - Mobile

The last two categories in the revenue model hackpad (mobile and gaming) are not really revenue models, they are sectors that have interesting revenue models worth discussing in this series. Today we will discuss mobile and next week we will discuss gaming.

Here is what we filled out for mobile in the revenue model hackpad:

View Mobile on Hackpad.

Mobile offers revenue opportunities that the web does not for a few reasons. First, the downloadable app/app store model makes selling your software much easier on mobile than it is on the web. In 2012, almost $7bn of apps were sold in the iOS and Android app stores. Most of these purchases are being made as in app upgrades instead of initial purchases.

But as huge as app sales are, including in app purchases, I believe this will be the smallest of the big three mobile revenue models over time (app purchases, advertising, and transactions).

The mobile advertising market was estimated at around $3bn in 2012 but it is growing twice as fast as app purchases and is projected by Gartner to be over $20bn by 2015, a 90% annual compound growth rate (that compares to app purchases which are growing at about 30% per year).

I do not believe that we have yet cracked the code on mobile advertising. Mobile native approaches like Twitter's promoted tweets show the way. Interruption and "display" models aren't likely to work in mobile so we will need ad formats and solutions that are truly native in the mobile app and browser. The market is quickly innovating and I believe we will see a number of interesting models emerge this year which will cause the mobile ad market to grow quickly.

But as attractive as selling apps and running ads on them is, I believe the biggest and most attractive model in mobile is the transaction. Slowly but surely, our phone is becoming our wallet. And I don't mean wallet in the way that Google and PayPal think. I don't think we will necessarily have a mobile wallet. I think the apps on the phones will just have native transaction capability in them.

I have a friend who recently moved from NYC to SF and was back in NYC for a week of meetings. He told me he kept accidentally getting out of cabs without paying while he was in NYC. Using Uber in SF had trained him that once he had booked the ride on his phone, that was all he needed to do. Soon hopefully we will all be doing that with our Hailo app in NYC.

But that is just an example. Imagine if you could both checkin and checkout on your Foursquare app? Imagine if you could just walk into a movie or an airplane just using your phone (you can!). All of these things are possible without mobile wallets. The phone is our mobile wallet.

So I think transactions will be the biggest and most native form of monetization on mobile over time. That doesn't mean that you can't build a good business doing in app upgrades and mobile advertising. But it does mean that transactional networks on mobile is the biggest opportuntity in mobile that I see.

Next week, we will talk about gaming and then we will wrap this series on revenue models.