How I Invest

As part of my year-end reflection and 2010 road map, I have been thinking deeply about how exactly I invest. How do I pick the companies and sectors on which to focus? I quickly realized that the principles I applied in the math of derivatives are the same ones I use as a venture investor. In short, I look at everything as a limit: "What does this (company/sector) look like at infinity?" I see most progress as being asymptotic, e.g., there is a period of accelerated development and rapid growth, beyond which gains are much harder and more costly to achieve. The goal is to find businesses at the early part of the rapid growth phase, but where they are close enough to rapid growth that they don't require decades of funding to get there. For instance, if you had invested in machine learning in the 1960s (or natural language processing in the 1980s) back when it held so much promise, you'd have gone bust many times over waiting for commercial success. Does it mean that machine learning and NLP are unattractive fields? No. But if you were 20-40 years early then I'm sure it seemed that way. My goal as an investor is to avoid such delayed gratification.

While other investors invariably have their own language to describe this exercise, I find calculus to be a helpful tool for testing one's assumptions around a particular investment and for providing valuable discipline to avoid "style drift." Though I make the occasional investment to learn about an interesting business or to work with a particular group of investors, my investing is largely characterized by the discipline noted above.

From a process perspective, this generally means that I have a vision of the future "at infinity" and work backwards to identify potential investment candidates. The key for me is once a candidate is identified, are they close enough to the rapid growth phase and is the market sufficiently ready for this growth to take place? How many times have you heard an entrepreneur say "We were just too early." The road is littered with great ideas whose time had not yet come from a commercial perspective. It is this timing issue where I spend a tremendous amount of time on due diligence, reaching out to industry contacts and testing their receptivity (and willingness to buy) the product/technology in question. Does this approach mean I'll miss some huge ideas that were simply on nobody's radar screen? Sure. But is it a more risk controlled way of reaching for big gains? I think so.

So given this approach, what are some of my "visions for the future?"

1. Machine-driven trading will continue to proliferate, and represent a sustained source of alpha.

If my thesis is right, the most attractive opportunities will exist in the following areas:

• Alternative data. The key question is whether it is more valuable as a distributed vendor product or as a closely-held proprietary product that is traded.

• Modeling platforms. Most platforms today have the ability to ingest structured, quantitative data. Future platforms will be able to consume and model both structured and unstructured data, and to mash up disparate data sources with a limitless number of systematic trading models. They will also provide for straight-through processing, generating trading instructions and executing trades directly from the modeling platform.

• Database architecture. The relational database of today will be inadequate to process the massive amounts of unstructured data - in real time - that tomorrow's (and, in fact, some of today's) trading models require. This also encompasses distributed and high-performance computing.

• Predictive analytics. Extracting insight from large bodies of textual data will challenge current analytical frameworks. New methodologies will arise to meet this challenge. This also includes event notification and anomaly detection, which has relevance for anti-terrorism and anti-fraud applications as well.

2. Tomorrow's ad exchanges will resemble the stock and options markets for equities.

This has implications for liquidity, price discovery and hedging:

• Aggregated buy- and sell-side ad demand. Fragmented exchanges will be be stitched together, leading to a consolidated view of sell-side inventory and buy-side interest. Price efficiency will skyrocket. Buyers will be able to hedge and speculators will be able to take a view on the direction and volatility of context-specific impressions.

• Consolidated buy-side optimization platforms. Agencies and brands will have access to platforms that integrate disparate forms of data and metadata, exchange prices and enable ad campaigns to be optimized and ROIs to be calculated. They will control the structuring, buying and monitoring of online ad programs.

3. Social media will simply be called "media," and viewed as a fully-integrated part of the overall media buy.

Distribution, monetization and ROI measurement will be key drivers of success:

• Apps that aggregate fragmented audiences across Twitter, Facebook and other social media outlets.

• Platforms that facilitate monetization of these fragmented audiences, and deliver a powerful suite of tools for agencies, brands and content owners to use for advertising, promotion and ROI measurement.

• Tools that enable agencies, brands and content owners to carefully control which ads and promotions are displayed to which audiences, placing reputation protection and control in the hands of those with the brand and relationship equity.

These are but three of the themes I am actively pursuing today. Success is by no means assured: I am banking on a vision of the future which may or may not come to pass. But if the focus is on true seed stage investing, then not to take a bold forward-looking approach is dooming one to derivative and "me too" ideas. This is simply not the way I choose to invest. It isn't fun, and in my opinion won't ultimately yield the greatest profits, either.

2009: A Year of Opportunity

2009 entered like a lamb. A tired, wounded lamb. The financial markets were in shambles. Consumer confidence had plummeted. Fear permeated almost every walk of life. Holiday parties a year ago were filled with gallows humor: "Boy, this has been a crappy year. How can things get much worse?" From a public markets standpoint, they did get worse until an abrupt V-turn in April caused both equity and credit markets to soar. Confidence began to creep back into the picture, though the average consumer - as well as the largest venture capitalists - were still feeling a chill from the economic downturn. 2009 is closing on a big up note, with continued strength in the equity markets coupled with some apparent improvement in the labor markets. With rising interest rates in the offing, however, there is still plenty of uncertainty going into 2010 - notwithstanding the historic Wall Street payouts.

From a personal standpoint, I couldn't have imagined how fertile the environment would be for early-stage investment. I personally invested in 12 companies during 2009 across my three areas of focus: financial technology, advertising technology and digital media (only 10 are listed on my IA Capital Partners deal page as two of the companies are in stealth mode). Even more importantly, both my legacy portfolio and my 2009 vintage companies performed well from an operating perspective, notwithstanding the challenging economic environment. Being a small, non-institutional investor with liquidity gave me opportunities to deploy capital at attractive valuations with terrific entrepreneurs without butting heads with larger venture funds. 2009 also saw the rise of the small and nimble venture fund ($15-$40MM), with the ability to write $250-$750K checks and roll up the sleeves to help nascent entrepreneurs succeed. Founder Collective (Domdex, AdSafe Media), Contour Ventures (Ticketfly) and Metamorphic Ventures (OrcaOne) are but three of the VCs in this size range who have been great partners to work with. And while Betaworks isn't technically a fund, I put them into this same camp of hands-on, value-added partner (Bit.ly, TweetDeck, Stocktwits).  I also have had the pleasure to work with some larger venture funds who are willing to invest early in a company's evolution and act like smaller VCs, but with the resources to finance continued growth as circumstances warrant. True Ventures and Foundry Group fall into this category. They have shown me that being larger doesn't mean being impersonal and risk-averse.

While social media might seem over-heated, in many ways it feels as if it is just now coming of age. Buddy Media saw astonishing growth in 2009, fueled by brands' recognition of the importance of social media and the power of ROI-based online campaigns. Ticketfly, which brings state-of-the-art integration of social media and e-commerce to concert venues hit the ground running and is already generating substantial revenues in only its first year. TweetDeck and Bit.ly also witnessed rapid user adoption as Twitter and Facebook continued their inexorable growth, bringing one's real-time presences together in one place and generating valuable data about online trends. TLists has already indexed hundreds of thousands of Twitter Lists, and rendered them easily discoverable through its powerful semantic search technology. It has also brought a suite of powerful List management tools to publishers, including partners such as the Wall Street Journal, The Atlantic and Huffington Post. And Stocktwits has continued in its mission to bring smart, experienced, action-oriented content to its users and partners such as NASDAQ and Bloomberg.

Like social media, advertising technology has seemed like a field with too many ideas chasing too few scale opportunities, but portfolio companies Invite Media and Domdex have carved out important and valuable niches in the spheres of ad optimization and search re-targeting. My positioning in financial technology has been heavily focused on the systematic/quantitative trading community, having backed Selerity (ultra low latency event notification), Alphacet (high-end quantitative modeling with automated order routing) and my home-grown company Kinetic Trading. Each firm is generating revenues and has momentum going into 2010. I believe that start-ups in predictive analytics, high performance computing, database architecture and event detection will be important areas for investment in 2010.

Thanks to all who helped make 2009 a year to remember. I couldn't have dreamed of working with such a great group of entrepreneurs and co-investors at the beginning of what was shaping up to be a dismal year. Notwithstanding the inevitable macroeconomic challenges of 2010, I am confident and early-stage investment will continue to provide attractive opportunities for those with the vision - and the guts - to take advantage.

Thoughts on Taking Venture Money

My (highly intelligent and experienced) friend Chris Dixon just posted on the importance of VC brands. He makes many good points and you should read his perspective. But the issue Chris raises begs a more fundamental question: whether or not to take venture money, and if so, from whom?

There are many variables that come into play. Are you a seasoned and successful entrepreneur? Do you have a functioning product with demonstrable traction? Does your team include a strong founder-technologist with a strong reputation? Taking venture money early is simply not an option for many, if not most, start-ups. If you are a guy like Chris who has already made top institutional investors money (Bessemer, General Catalyst) from a prior start-up (SiteAdvisor, sold to McAfee after 14 months), getting venture backing for your next company (Hunch) is not much of a struggle. But this is the exception and not the rule. And while raising money as a seasoned and successful serial entrepreneur from legacy backers isn't difficult, it is generally a wasteful time-suck pursuing venture money early in the game. This is not the same as "Don't talk to VCs." Absolutely not! VCs are invaluable sources of input, contacts, and pitching experience for the new entrepreneur. These are opportunities not to be missed. But to spend enormous amounts of time trying to raise first-round money from venture investors is almost always a mistake.

So where to go? Strategic angels. Small venture firms and "super angels." Entities, be they firms or individuals, whose charter is to take pre-revenue risk at a fair price and help these nascent companies succeed. At the seed stage it is critical, absolutely critical, to build the right investment syndicate. Getting money from mom, dad and friends is ok, but is not going to deliver the value-added of a strong seed-stage syndicate of professionals who may be tough on valuation, but bring a discipline and culture of support to the venture. Angels and small firms, just like brand-name VCs, can be due diligenced fairly easily. There are a finite number of these people and firms, and they can be tracked down through either VCs, online research or smart networking quite easily. But as is the same with venture firms, warm introductions are critical to getting the right meetings and being taken seriously. Fair or not, reality is that the best of these investors get bombarded with deals, and need to impose filters to effectively manage inbound traffic. And the most powerful filter is receiving a deal from a trusted source. So if you are a start-up seeking seed funding, I'd create my target list of angels and small firms/super angels and work my rolodex like hell to get the right introductions. Otherwise, you are fighting an uphill battle.

Let's say that you've gotten that seed funding, something in the $250K-$1.5MM range, that has helped you prove out the business model, win early customers and generate some revenue traction. And let's say that you are in a capital-efficient business, where you don't need $20MM to ramp growth, but something in the $2-$5MM range. While it may make sense to take more money down the line, this amount is likely sufficient to build a very valuable business at scale (but perhaps not the $100MM+ business that we all dream of). Where should you get this Series A money? The "big brand" firms with huge pools of capital? Medium-sized firms? Small firms? Not an easy question, with virtually countless permutations. That said, t I do think there are three factors all entrepreneurs should keep in mind when making this decision.

1. Size of fund
2. Deal partner
3. Domain expertise

Size of fund: In general, the larger the fund, the larger the required exit in order for an investment to be worthwhile. A fund with assets north of $500MM is going to be hard-pressed to invest $3-$5MM in a company and be ok with an exit less than $100MM, assuming they own 20% of the company. The payoff simply doesn't move the meter. They want to "lean hard" (e.g., put more money into and shoot for a mega-exit) on winners, because nominal dollar returns to pay back the fund are critical. This is where alignment of motives breaks down. ROI is not the measure, it's dollars returned. This creates a problem for entrepreneurs who may want to accept the $60-$70MM exit (which, incidentally, is many times more likely to occur than the multi-hundred million dollar exit), but where the VCs have a blocking position and can force such a deal to be turned down. So it's important to understand that taking money from large, "brand name" firms (and the two generally go hand-in-hand) often means that you are "going for it" - no sub-$100MM exit for you. It will either be a home run or you'll be stuck for a long, long time. As long as you go in eyes wide open, then ok. But this is a material barrier to those running capital efficient businesses who want to preserve the optionality of exiting across an array of scenarios.

Deal partner: As mentioned above, having the right deal partner is critical, regardless of whether you are talking about the seed round, the A round, B round or beyond. A strong deal partner can help materially de-risk a business through sound mentoring, prudent board leadership and valuable connections. The brand of the deal partner is far more important than the brand of the firm. While having a brand name firm might help in future fund-raisings (unless they choose not to invest - then you're screwed), it pales in importance to a great deal partner. Deal partners become great because of what they do, not who they work for, so raising the next round with a great partner, even if they're not at one of the "elite" firms, does not in my experience represent a barrier to fund raising. And if the deal partner has good chemistry and a positive attitude towards working with the first-money in seed investors, so much the better. Then everyone can be pulling in the same direction. It is a powerful combination.

Domain expertise: An extension of the deal partner concept. Certain firms have experience at certain things. Those firms most active in your space and close to the end-users you want to sell to should be the highest on your hit list. They have the benefit of "pattern recognition," having lots of data about firms like yours, how they might stumble and ways in which the growth plan can be better executed. They are also likely to have great contacts on the recruiting front, absolutely essential to building a Series A company in rapid growth mode. And while your deal partner is the one you work with most closely, having others in their firm able to help out with introductions, occasionally sit in on strategic Board sessions and to identify key recruits will prove invaluable over time.

While there are always exceptions, these are the factors I've found most important in helping entrepreneurs achieve their business and strategic goals. Good luck, and be careful out there.