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October 5, 2016

Recycling: The challenge and the opportunity for a Seed stage VC

My recent post gave rise to a host of questions around the issue of recycling. What does it mean? How do you do it? And what are the implications for venture investors? I attempted to respond in a Tweetstorm, but recycling is a complicated issue that warrants a more thorough discussion.

When Limited Partners (LPs) invest in a venture fund, they agree to pay an annual Management Fee on committed capital, usually on a declining scale over a 10 year period. In total, these fees amount to around 20% of an investors’ commitment, which implies that LPs only get to put 80% of their investment dollars to work because of management fees. This makes most LPs pretty unhappy - and it should. LPs generally expect to have 100% of their investment working for them, and best practice is to invest up to around 120% of committed capital when possible. Enter the concept of recycling.

Recycling can happen when a fund exits an investment, and rather than distributing the proceeds to LPs, reinvests all or part of the funds in portfolio companies. This sounds pretty easy, but in practice is quite hard, especially for Seed stage venture funds. By definition, Seed stage funds invest very early in a company’s life, meaning that time to exit can be 7-10 years, or more. Further, as a seed fund with higher cash-on-cash return expectations than later stage funds, IA Ventures doesn’t have much time for a company to exit before its other successful investments become too high-priced to warrant later stage capital. This is because a successful seed company often grows into an attractive Series A and perhaps Series B investment from the seed investor perspective, meaning a potential return on a new investment of 5-10x capital invested at each stage. We reserve for this likelihood, and this represents one of the bedrocks of our life-cycle approach to investing. But beyond the Series B, it is often challenging to get comfortable with 5-10x upside from that point, especially for “hot” companies that may be priced in the hundreds of millions of dollars by the Series C round.

So what generally supports recycling in seed stage funds are either companies that: (a) exit early because they get a great offer that is life-changing for founders but so-so for venture investors; or (b) exit early because it is apparent that the “big idea” won’t be realized and the founders and investors want to sell. And if these liquidity events happen early enough in a fund’s life, the proceeds can be deployed into fast-growth, highly attractive companies within the portfolio that still have 5-10x upside potential. These reinvested proceeds count towards recycling, and help to repay the management fees that were burdening the amount of capital available for investment. We had the good fortune of having two exits, ThinkNear’s sale to TeleNav and Simple’s sale to BBVA, early enough in Fund I’s life that we were able to effectively redeploy the proceeds into a set of attractive investments, including The Trade Desk Series B round. We ended up Fund I being around 116% invested, meaning that we invested $58M against $50M of committed capital. This is exactly where we wanted to be.

Hopefully this provides a flavor for how recycling fits into the seed stage venture firm’s portfolio construction and decision logic. A bunch of stuff has to go right in order to achieve a fund’s recycling goals (while remaining true to its return objectives), but we believe it is important to have this mind-set when embarking on a new fund. It is respectful and fair to one’s LPs, and, when used prudently, can amplify the gains available to LPs as well as the GP through carry.

September 28, 2016

The TTD Investment and the IA Ventures Model

A Little History

IA Ventures began life a little less than seven years ago, just as the world was coming out of the worst economic crisis since the Great Depression. The term “Micro VC” had yet to be coined. “Big Data” was still somewhat mysterious and edgy to those outside Wall Street, Government and Defense. Unicorns were mythical animals that pranced around meadows and were signs of good luck. And there certainly were no discussions of colonizing Mars (!). Upon reflection, 2009 seems almost a generation ago, but I guess that’s what happens when life, fueled by stunning advances in technology, seems to move at warp speed. But with all of these changes, a few basic principles still remain. The greatest venture funds - and firms - in history started small. They started investing very early in a company’s life, owned a lot and continued investing over time. In short, they identified great founders playing in large markets, took significant early risk, continued to lean in when risk/reward appeared attractive and ended up owning a lot for a *little*. This is exactly the model we have followed at IA Ventures since Day 1, and it was never more in evidence than in the seeding, bridging, growth investing and eventual IPO of one of our first investments. The story of this journey and IA’s approach to investing is plainly laid out below.

Jubilation - IA’s first IPO

Last week, we at IA enjoyed perhaps the greatest moment of our (relatively) young life, sharing the opportunity with one of our founders, and his team, to celebrate the occasion of going public. The successful IPO of The Trade Desk has had a salutary impact on perceptions of the best private companies in the adtech sector, as well as on technology IPOs writ large. But perhaps most meaningful to us at IA, it represents a company that we backed when it was a single founder and a PowerPoint (though an awesome co-founder had been identified), through myriad twists and turns, financing struggles and rejected M&A offers, continuing to provide timely financial support, all the way through to a 400+ person global company valued well in excess of $1BN. But rather than talking about what fueled our belief that Jeff Green’s vision, powered by the Company’s amazing colleagues and innovative clients, would ultimately yield a venture-scale outcome (Alex already does a great job with that here), I’d like to talk about how we as a firm put ourselves in the position to win. Because make no mistake, it is anything but easy, and stands in stark opposition to the strategies of many newer venture firms. But it is how we like to work with founders and, ultimately, believe it gives us the best chance to generate superior returns for our LPs.

Getting Started - The Seed Round

Brad and I started IA with a first close of $17M in January 2010. Our initial LPs were, shall we say, non-traditional venture investors, as many if not most were still smarting from the hangover of 2008/09. While we had a vision of closing our first fund at $25M ($25M was on the cover, while $40M was the hard cap), we had the good fortune of being able to close at $50M later in the year. This was nowhere on the radar screen, however, when we first met Jeff in October 2009 or invested in the Company in March 2010. Our initial investments in Fund I were scoped to be up to $750k for 12-15% ownership, with upwards of $2M going into our strongest companies over 2-3 rounds. We intended on doing some limited incubation (see: Vectra Networks, which we incubated as Trace Vector before getting the support of Khosla Ventures, Accel, DAG and other great investors), but were largely going to enter companies at the seed stage. The positioning to investors was “Old style VC,” starting very early (and always pre- product/market fit), building a concentrated portfolio and owning 10%+ of our best investments post-Series C. 20-25 portfolio constituents, of which 5-6 would represent our “best of fund” investments and capture more than half of the investment dollars. With this in mind, our first investment into The Trade Desk was $750k for ownership right in our target range. So far, so good.

Need Mo’ Money - The Bridge Round

Jeff and Dave Pickles (the CTO and co-founder, who joined around the time we and Founder Collective led the Seed round and Eric Paley and I joined the Board) had set a visionary and ambitious plan that involved a tech build that was nothing short of insane. Right in our power alley (!?!). As all great founders do, Jeff stayed close to customers and planted seeds well in advance of the Company’s ability to deliver, laying the foundation for great expectations (and rocking tech and product) and rapid adoption. The only thing that remained was shipping the product. Well, as is the case with pretty much every construction project and startup, stuff takes longer and costs more than expected, and The Trade Desk was no exception. So what did Jeff do? He did great work helping us understand the unfolding of the addressable market (his hypothesis that Programmatic would eat traditional ad buying was not yet clear to many), customer feedback and feature requirements (including query-per-second - QPS - throughput). He and Dave also provided us with revised estimates of release dates corresponding to key technical achievements that would put us in-market. At this point both Founder Collective and IA provided a bridge to this next set of milestones. Why? Because we believed in Jeff’s vision and hypotheses about the reshaping of ad buying, as well as his leadership, recruiting power and industry credibility, together with Dave and the tech team’s ability to ship.

Ugly Industry, Dearth of Believers, still - Bridge #2 + Non-VC Series A

Believe it or not, even after the Company’s successful release, adtech was still so hated and the programmatic opportunity so misunderstood that we had to bridge again, until we finally raised a Series A from non-traditional investors (in this case, successful entrepreneurs from in and around the domain who understood the opportunity first-hand and were happy to invest). At each step of the way IA continued to participate, such that by the time The Trade Desk was generating cash (on a total of $8M raised) we had invested a little over $2.2M across four funding events that resulted in us owning around 18% of the Company. But we had another big decision to make.

Gearing up for Global Expansion - The Series B

As the Company was rapidly expanding its global footprint, we as a Board decided it made sense to put more capital on the balance sheet to both support growth as well as secure a substantially larger credit line for financing receivables and a slice of term debt. Hermes Growth Partners, specifically the force-of-nature Juan Villalonga (ex-McKinsey, former Chairman and CEO of Telefonica) and the whiz-kid Alex Kayyal (now of Salesforce Ventures), stepped in to lead a $20M Series B. Given the Company’s growth and scale, it really had the character of a growth round, and was priced as such (the Series B being a misnomer given how cash efficient Jeff & Co. had been in getting to EBITDA positive).

Recycling Capital - Fueling IA’s Participation in the Series B

At this point in IA Ventures Fund I’s life, we were beyond the initial investment period, so we’d be making no new investments. We have a culture of wanting to recycle capital to between 110-120% of committed capital when possible, which means the intersection of: (a) portfolio liquidity events in a time frame where we can redeploy capital; and (b) later stage opportunities that have, in our opinion, 5-10x cash-on-cash return potential from that point onward. In the case of The Trade Desk, stars and planets aligned due to our earlier sale of Simple to BBVA, which generated significant liquidity, and our deep belief that notwithstanding the nine-figure price of investing in the Hermes-led Series B, it did, in fact, have the return profile referenced above. So IA ended up writing a $3M check into the Series B, bringing our total investment to $5.2M or just over 10% of our Fund I committed capital. On a fully-diluted basis, IA owned just under 17% post-Series B. This is exactly where we wanted to be. Was it seemingly out-of-step for a “Micro VC” to invest at such prices and to have so much of  a fund in a single company? Perhaps. But the way we secured our ownership was by being super early, being close to the arc of the Company’s development and culture, and ultimately having the conviction to lean in hard when opportunities presented themselves (or, in the early days, were necessitated by circumstance: step up or face a premature sale scenario).

The IA Ventures Model

The Trade Desk (Fund I). Vectra Networks (Fund I). Transferwise (Fund II). Digital Ocean (Fund II). Companies where IA was super early, leaned in hard, put ginormous dollars to work (as a % of fund size) and, as a result, owns 14-18% of four high-growth, post-Series C companies, three of which are approaching or beyond $100M revenue run rates and at or beyond EBITDA breakeven. We still believe others in these funds that could achieve these levels as well, but it’s still early, particularly for Fund II investments made in the latter part of its investment period. In each fund we have 24-28 investments, with 6-8 garnering the lion’s share of the capital over multiple rounds. Clearly we’re only seven years in with fewer than 60 data points, so it is too early to claim victory, but I do think that we’ve demonstrated that it is possible to be a successful life-cycle investor at MUCH smaller fund sizes than the traditional Series A and B firms. What it takes is deep conviction and perhaps irrational confidence to successfully invest in pre-product/market fit companies, write larger checks for greater ownership in the face of sparse data, and to amplify ownership and risk when you both want to and can do so. And this isn’t easy, particularly with follow on investors often being very ownership-sensitive and sometimes sharp-elbowed with earlier investors. But this is where the strength of founder relationships comes in, and this is something we at IA invest in very heavily. It is also an outgrowth of being so early and so supportive when there aren’t a ton of believers. As we’re now investing out of our third fund, we’ll have ever more data to validate or invalidate our hypotheses concerning our model. Sitting here today, I feel pretty confident that we’re onto something that fits our companies and our partnership just right.

The Real Heroes

All credit goes to the founders and their colleagues who give us the chance to do what we do. While the highs are often transitory and the lows can feel very, very low, getting to share last week’s IPO with Jeff, Dave, Brian, Rob, Paul and the rest of The Trade Desk team, those people who are helping to transform the advertising and media industries and employ more than 400 well-compensated, mission-driven people worldwide, made plying this particular trade feel very, very worthwhile.

March 12, 2015

Welcoming John to IA

Brad, Jesse and I are happy to announce that our friend and colleague, John Hadl, is joining IA Ventures as Venture Partner, effective immediately. We have personally gotten to know John over the past four years due to our shared investment in PlaceIQ: IA Ventures led the Seed round and John, on behalf of USVP, led the Series A. John impressed us from the outset with his deep domain experience, tireless work on behalf of the founders and insightful perspectives in Board discussions. Further, his open and transparent style strongly resonated with us as candor and collaboration are two qualities we value highly. From our relationship formed through PlaceIQ our interactions continued to expand. As John has spent time with us it became clear that our networks, experiences and styles, though different, are highly complementary.

In addition to being a strong cultural fit, John has an impressive track record both as an angel investor and as a VC. John was an angel investor in and an advisor to both AdMob (Google) and Quattro Wireless (Apple), as well as an angel in BlueKai (Oracle) and Whisper, among many others. John also served on the Board of JumpTap until its sale to Millennial Media. His investments while at USVP include GoPro (IPO), Quantifind, Swoop and ZEFR. John has a knack for identifying the right founders to execute against a particular mission, and actively supporting them in their quest. His track record and reputation as a true partner to entrepreneurs is tangible evidence of his skill and his value.

We are excited about John’s contributions to the team and all that we can learn from him. Hopefully he extracts the same value and goodness from us. We look forward to welcoming John into the IA Ventures family and are confident he will help us better serve our most important constituency - our founders.

November 23, 2014

Crowdfunding for start-ups: A durable trend or a bull market phenomenon?

Angel investing is red hot as is the concept of crowdfunding start up investment. Part of this phenomenon has been driven by the emergence of AngelList, the brainchild of Naval Ravikant. What started out as a way for a curated set of angels to invest in startups posting on the AngelList site has expanded to include the notion of Syndicates, investor groups headed by prominent angels who deploy capital pledged by themselves and others in a manner akin to a GP/LP construct. Syndicates have been thought by some to be directly competitive with venture capitalists, initially Micro VCs but then perhaps larger venture firms down the line. While Naval has consistently said that this isn’t his intention, it hasn’t stopped others from speculating about the end game for Syndicates.

A recent article in Fortune Magazine got me thinking about the compare/contrast between professionally-led angel syndicates (such as those on AngelList) and seed stage venture firms such as IA Ventures.

While we invest in partnership with angels in virtually every seed stage company we work with, we are generally the largest investor and lead the round. We also frequently lead seed-extension rounds to support angel and Friends-and-Family financed companies, which need extra runway to hit key operating metrics and business milestones that will enable them to raise strong Series A rounds. This is the bread-and-butter of how we generally initiate our relationship with founders and their companies. When we invest in a company, we reserve multiples of our initial invested capital for follow on investment. In our experience, these reserve multiples can end up being 3-10x of our initial investment over 3-4 rounds of financing, before the expected cash-on-cash return of the later rounds fail to meet our growth criteria (as we are constantly asking ourselves: “Is the probability-weighted return of this investment greater than or less than investing in a new seed stage company?”).

If there is one thing I’ve learned in my 10+ years as a seed stage investor, it’s that plans seldom unfold as expected. This is why: (a) we seek to finance companies adequately from the outset in order to give them a chance to prove or disprove their early hypotheses; and (b) reserve significant additional funds should they be executing well but need more time to hit key Series A metrics and milestones, or the macroeconomic environment becomes hostile and external fundraising is a poor or non-existent option. Having the resources available to support companies during hard times can be the difference between a good company hitting the wall or hunkering down, continuing to build, surviving the downdraft and emerging stronger than ever (and particularly stronger than their less well-financed - and now dead - competitors). It is this dynamic that makes me wonder about the current heat around crowdfunding, and if it can survive a cyclical downturn in venture investment.

If Syndicates exist to push more angel dollars into the early stage ecosystem, that is fine. But it should be done with a cautionary note: unless Syndicates develop the ability to support companies when there isn’t an institutional investor standing by if times get bad, they aren’t likely to endure. The composition of Syndicates - angels - are generally the first to tamp down risk tolerance because their main source of making money is imperiled and their angel portfolio isn’t likely to generate meaningful returns any time soon. So really the behavior of Syndicates aligns closely with the behavior of their constituents, angel investors. This is precisely why I believe Naval is right: Syndicates aren’t truly competitive to venture firms in that they lack the reserve mechanism and the ability to extend time horizon. But they do provide access to successful and experienced angel investors, and this is a good thing.

February 25, 2014

Financial interaction: the next generation

I have spent over 25 years creating, processing and analyzing financial transactions. I like studying them - a lot - whether an outgrowth of my time on Wall Street helping sophisticated entities manage risks, or through IA Ventures’ investments in Simple, TransferWise, and BillGuard. Transactions are fundamentally about people interacting with other people, and are initiated at the speed of real life. But at one time or another they have to touch our byzantine, outmoded, friction-filled financial architecture, and get completed at the speed of banks. Charting the path of a transaction through the bowels of the banks and other intermediaries in our current system would require tons of boxes and arrows and round-trips that would seem absurd to the Internet-savvy crowd. This is where we are today.

Simple was founded in 2010 with the mission to offer the first truly seamless user experience to retail customers, hiding that messy underbelly of the banking world. Transparent. Low-cost. Mobile-optimized. Goal-oriented. First-rate customer service. They did a ton of things right. But in order to get up and running (relatively) quickly and with a modest amount of capital, they had to work with partners and not actually become a bank. This involved a series of known trade-offs that Josh, Shamir and the Board made with an eye towards releasing a basic product, collecting feedback, iterating on the product and creating a delightful experience for Simple users. Obtaining a bank charter was always in the long-term vision, but involves a completely different magnitude of capital, legal and consulting work - and time. Rather than innovating in a vacuum, the Simple team wanted to get a product into the wild and let users help shape the roadmap. They never could have gotten it out so quickly (and without many times more capital invested) if they had pursued the charter route.

Much has been written of Simple’s recent sale to BBVA. Separate from the impact the sale has on my firm, I personally view the acquisition as a rare example of a “win-win.” By mid-2013, Simple had grown to the point where seeking a charter was a very real consideration, but one that would have required a massive capital raise and a fundamental re-shaping of the organization due to a raft of new operational, legal and regulatory requirements. In the process of thinking about a raise, Simple received a bunch of inbound M&A interest, the most exciting of which was from BBVA. Their executive leadership had met Josh and Shamir back in 2010 and they were early believers in the Simple team and mission. By late last year, they were ready to disrupt themselves by injecting Simple’s product-focused, tech-forward DNA into their $820 billion organization. BBVA has a scale US-based banking operation, Compass Bank, which can help support Simple’s infrastructure and capital requirements in the future. Terms were hammered out pretty quickly and a deal was done. I couldn’t be happier for the Simple team that they are joining a group that really gets them, will enable them to preserve their independent and entrepreneurial spirit while providing both capital and an enlarged customer base to change the face of retail banking. However, make no mistake: Simple is optimizing the banking experience. But that experience is necessarily tethered to all that comes with being a bank, for better and for worse.

Prior to the Simple announcement there has been a bunch of stirring around re-shaping the banking experience as we know it in a more fundamental way:

In the same Twitter thread Marc went on to say:

Zac Townsend of Standard Treasury weighed in as well, subsequently sharing a write-up describing a syndicate approach to raising the capital necessary to start a bank that doesn’t run afoul of Bank Holding Company regulations. But Marc and Zac’s ideas, along with concepts proposed by several founders we’ve recently met, all share a common thread: operating within the current banking strictures. A Bank’s involvement as the centerpiece of disrupting banking simply isn’t disruption, it’s derivative. 

I believe disruption will be found by identifying the atomic unit - the financial interaction - and designing a set of user experiences that make these interactions as easy yet robust as possible. This is not limited to retail banking but involves commercial banking and investment management. And with protocols like Bitcoin (see Marc’s post on Why Bitcoin Matters) and others to follow, why remain shackled to the notion of being a bank? As the incumbents become smarter and take more risks (e.g. BBVA) the opportunity within the traditional banking sphere would seem to be muted. There’s a very high price to even play the game (call it $25 million for the charter, legal work and start-up costs, plus another $100 million for regulatory capital) and an interminable period of time that is most assuredly NOT start-up time (two years, minimum, to get all the legalities hammered out and to get up and running. And, oh yes, you need a processor and a bunch of other stuff, too). If you believe that truly disruptive alternative financial protocols such as Bitcoin will be the foundation of our financial world in ten years, then trying to re-create a better bank by connecting with existing ones or building a brand new one seems like a costly and backward-looking play.

However, I can see a place for a small, tightly-knit skunk works team of product and UX people to rapidly iterate on optimizing the UX for a single use case they’re passionate about, be it retail or commercial. They can use an enabling platform such as BancBox (I’m not an investor) to rent the pipes so they can be 100% focused on user experience. They’ll find the ‘wedges’ into peoples’ financial lives that engender trust and make people want to drop their old-line banks. And then when the landscape becomes clearer for which non-bank protocols are winning, this team can simply lay their market-tested interface on top and be a ground-breaker in the next generation of financial interaction. Now this, to me, is disruptive. The bank of the future probably won’t be called a bank. By focusing solely on making the atomic unit - the transaction - fit within users’ lives, we can avoid the interim step of building a brand new bank and skip to the good part, requiring far less expense than buying a ticket to our highly dysfunctional banking show.

If you are such a team that’s excited to figure out what people really want from their financial interactions, and have a heavy emphasis on product design and user experience, then give me a shout. It would be fun, indeed.