Pace of VC investing by subsector

I couldn't sleep last night so I figured I'd see if I could confirm a nagging suspicion about the early-stage VCs I know. About six months ago it seemed like they were slowing down their pace of investing while the corporates and newer super-angels were doing a lot more deals. If this were true it would be an interesting warning sign.

So I downloaded d3.js, pulled out the list of VCs I put together for VCdelta and built a visualizer for Crunchbase data. It's fun to play with*.

Here's a graph of the deals the 150+ VCs have done since 2005, according to Crunchbase. If you go to the site and click "All" at the bottom, you get this, except it's live to add and subtract either VC firms or round types from and you can hover over the bars and see the names of the companies invested in that month**. You can also, if you click the subsets below, see who I included and who I didn't. And then add or subtract to your heart's content.

What looks like a small downturn in 2008 and 2009 in deals done is mainly due to VCs continuing to do later rounds--B and later. I assume many of these were into companies that were already portfolio companies.

Here are all the VCs, but just the rounds tagged Seed, Angel and A.

This makes it easier to see the dropoff in 2008 and 2009. But the low point in early stage investments came later than I thought, in 2009. It had seemed to me that early 2008 was dryer. Also, according to Crunchbase, more early stage deals are getting done now than in 2007.

New York City is on a roll, right? Right. Below are the NYC funds (not NYC deals) and how many early stage (Seed, Angel, A) deals they did.

Compare this to Sand Hill Road:

Sand Hill Road has remained relatively conservative into 2010 and 2011.

Some other VC subsets. I used the top 20 venture capitalists in Forbes' Midas List to create a 'smart money' subset of firms. Here are their early-stage deals. The pronounced uptick from the lows in 2008 and 2009 into 2010 and 2011 are heartening.

I also made a subset consisting of firms that have been around since before the 1980s, the 'old school.'  I assumed that if they've made it this long, they must be doing something right. Their increase in early stage investments, while less pronounced, is also heartening.

Last, the Super Angels. No surprise here.

The one thing these graphs don't do is support my original thesis, VCs are not slowing down their funding of early-stage companies. Interestingly, I found that even the VCs who have flat-out told me they are slowing down their investing are not really doing so: while there's fear in the market, VCs are also clearly seeing opportunities they can't turn down.

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* d3.js is awesome. The Yieldbot guys turned me on to it. I'm just learning it, so I know I'm manhandling it something awful, but it's a joy to work with.
** Let's do the usual caveats: Crunchbase data sucks for this kind of thing. It's incomplete, it's biased, it's not very clean or accurate, etc. This is all completely offset by the fact that it's free. If I had a better dataset, I'd use it, but I don't.

Valuation for investors

Twice in the past week I have had pre-product entrepreneurs tell me that they were raising seed rounds at an approximately $10mm pre-money. In both cases I had to pass, despite the merit of the management teams. Both companies told me that they have other early-stage investors ready to fill their rounds, and I'm glad. I am generally of the opinion that if an entrepreneur can get a better valuation while still getting value-add investors, then they should.

Plenty has been written recently by venture capitalists about venture capital to help entrepreneurs. Not much has been written to help newer venture capitalists. I think, in a way, this is because VCs don't care so much if those new to the industry succeed or not. If a new angel loses his shirt, well, one less competitor for me down the line.

I don't believe that, though. I think we need more investors. But smart ones, investors who make some money on their investments and so feel confident reinvesting it in a new round of entrepreneurs. Investors, like everyone else, get smarter and more helpful the more experience they have. Smarter investors is better for the ecosystem.

So, valuation.

Valuation in venture capital is tough. The amount of uncertainty between investment and exit is immense. But that doesn't mean that you shouldn't try to pay the right price. Valuing a startup correctly means estimating risk, not contemplating the unknowable. The idea that was briefly tossed around that valuation doesn't matter because a startup either goes big or dies is wrong. Ludicrous, in fact. There's a range of outcomes for every fund. The cliche that out of each ten investments, two are winners, three are failures and five go sideways shows this. The two winners determine whether the fund is an overall winner or loser, but how sideways the five go determines whether it's a good return or a great return. What happens to the second tier of investments matters.  And, for the math challenged, even if startup returns were binary, when you invest in many of them you get a binomial distribution, so expected value matters.

I look at valuation this way. For every company,

• I think about what the expected exit would be if the entrepreneurs were right: if they are right about the problem, about what their customers want, about their ability to execute, right about everything. 
• I figure out how much dilution I expect before the exit.
• I decide how likely it is they are right and multiply by the expected exit to get an expected value.
• I divide by three, because I'd like my investments as a whole to return 3x*. 

This is the post-money valuation.

An example. Company X is an amazing data-driven adtech company. It's going to disrupt some existing companies and if it does it should sell for $400mm in five years. I think, given the risks, that there's a one in ten chance they will succeed.

But I know they will need to raise a Series A to commercialize the product once it's ready, and a Series B to ramp sales once they have product-market fit, and a Series C to expand the product line. The Series A will be 33% of the company, the Series B will be 25%, and the Series C 20%. My stake will be diluted down to 40% of my original ownership.

So my post-money expected value of the company is $400mm * 10% * 40% = $16mm. I would be looking for a post-money of $5mm. If the company is raising $1mm in the seed round, the pre-money valuation would be $4mm.

You can see the difficulty in the $10mm pre-money. If the company is raising, say, $2mm at a $10mm pre, then the expected exit value would have to be $12mm/(10% * 40%) * 3 = $900mm.

Billion dollar exits are the sine qua non of the venture business. But they are rare. Rarer than you think.

I made a list off the top of my head of some 125 business-to-business advertising exits. I may be missing some obvious ones, but there were only a handful of $500mm plus exits in the last ten years, even fewer billion dollar ones (M&A exits, I didn't count IPOs, so I probably undercounted by one or two.) Here are the $500 million and up exits I have.

Company	Acquiror	Price ($mm)	Date
aQuantive	Microsoft	$5,900	May-07
Doubleclick	Google	$3,100	Apr-07
Omniture	Adobe	$1,800	Sep-09
Overture	Yahoo!	$1,630	Jul-03
Digitas	Publicis	$1,300	Dec-06
NetRatings	Nielsen	$817	Feb-07
AdMob	Google	$750	Nov-09
Right Media	Yahoo!	$680	Jul-07
Lending Tree	IAC	$675	Aug-03
24/7 Real Media	WPP	$650	May-07
Rosetta	Publicis	$575	May-11
Razorfish	Publicis	$530	Aug-09

Of the 125 exits, five were more than a billion, seven were between $500 million and a billion, 20 were between $200 million and $500 million, and 15 were between $100 million and $200 million. The rest were sub-$100 million. Remember, these were all exits--companies that didn't make it weren't counted. There's also a bias in the list because I am more aware of the large exits; I would be surprised if I missed too many billion dollar exits but I am sure I missed many $10mm exits. Also note that only a couple of the billion dollar exits here were as straightforward as my model: aQuantive was built through acquisition (and thus had substantially more dilution), Doubleclick had gone through several owners including the public markets, etc.

In fact, all else being equal (a priori, that is) billion dollar exits returned less overall than $500mm-$1bn exits, because there were fewer of them. Exits between $200mm and $500mm probably returned slightly more than $500mm-$1bn exits (also because there were more of them). The $100mm-$200mm range and less than $100mm range each return less than the $200mm-$500mm range**. Here's my estimate of what each of these ranges returned.

Exit Range	Companies	Total Est. Value
$1bn +	2	$3,000
$500mm - $1bn	7	$5,000
$200mm - $500mm	15	$6,000
$100mm - $200mm	25	$4,000
$50mm - $100mm	50	$3,750
< $50mm	100	$2,500

The sweet spot in adtech, the "average" expected exit value, seems to be around $400mm.

Every industry is different, you need to know yours. Make a list of exits over the last ten years, all exits not just the good ones. Then try and figure out how many companies were funded in your industry. This will inform your expected exit values in the success case as well as help you decide what percentage of funded firms get to an exit. Conditions change all the time, of course, but looking at the last ten years will probably keep you reasonably conservative.

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* I asked an engineer friend of mine how comfortable he is being in the buildings he helped design. "Pretty comfortable", he said. "You never worry?" I asked. "Look", he said, "There's a lot of math and experience behind choosing exactly how much steel and concrete the building needs to bear its load. I do the work carefully, run the calculations twice and make absolutely sure the answer I am getting is the right one. Then I multiply by three." [Edit: For those for whom anecdote is not analysis, I'll point out that a 25% IRR compounded annually for five years is 3x].

** The list I made is up here. Click on the headers to sort. I think all of the #N/As are sub $50mm exits except the two bolded ones, which I think are ~$200mm exits. [Edit: Wow, the sorting on the linked table was all screwy. Sorry. Fixed it.]

Neu VC

Put up a website. Took down the robots.txt today. Thought I'd tell you all first.

Now before you inform me--as Josh Reich did when I asked him to take an early look--that I should get a new designer, I'll let you know that I designed it myself. With help from my five year old.

Between being an investor and being an entrepreneur, the grass is always greener. I meet plenty of entrepreneurs who want to be VCs. I always ask them why. I love helping people start companies, but it's not the same as starting a company yourself.  That said, I think I add more value investing that I do founding, so investing is what I plan to do for the next fifty years of my professional life (or as long as anyone will let me, whichever comes first.)

While I have resisted describing myself as an 'it' rather than a person, it's definitely still true that people attribute more permanence to an entity than an individual. Thus Neu Venture Capital, where 'we' invest. We is just me (ever since Softbank hired my awesome intern away from me by offering him actual money to do the work rather than just scintillating conversation.) Consider it the royal We, without the royal part. The Neu came from a conversation with a friend in which she insisted that my children preface everything they like with a subtle 'neu.' I scoffed at this until one morning when my youngest informed me that the White House was where President Neubama lives. I will not require all future investments to prefix their company name with neu, but I won't promise it won't influence my decision either.

I looked at a lot of VC sites while figuring out how I wanted it to look, and the one thing that was an absolute requirement was something I learned from my Omnicom days: the operating companies are what it's all about. So the home page--in fact the only page--is the companies I've invested in. There is a box of information about me (with my real picture, not my avatar: bonus!) and an entirely uninformative box about what I am looking to invest in (I'll work on it) but it's primarily about the companies I've invested in. I'm good with that in lots of ways. But mainly because if you're known by the company you keep, I'm in great company.

Innovators can come from anywhere. VCs, not so much.

It ought to be remembered that there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success than to take the lead in the introduction of a new order of things. Because the innovator has for enemies all those who have done well under the old conditions.

- Machiavelli, The Prince

I put the kids to bed and started reading Forbes' Midas List, their list of the top 100 tech and life sciences VCs.  As I browsed, looking at where they went to college, I started to notice something:

Number of degrees by school, for the schools who issued more than one degree to a top investor.  Many of the investors got more than one degree, so the numbers sum to more than 100.

See the pattern? That's right, they all went to the same schools*.

I have to admit to being surprised. Not by the ordering of the schools, but by the sheer lack of diversity. The top four schools issued more than half of the degrees. The top ten more than 70% of them.  The top 15 schools include the ten bastions of the establishment: the Ivy League, Stanford and MIT.

It's striking that in a field where us gatekeepers are supposed to be spending our time finding and backing unusual people--those willing to take inordinate risk, come up with world-changing ideas, and generally just think different--we all went to the same few schools, the schools whose graduates would have done well under the old conditions, as Machiavelli had it. I wonder what VC would look like if its top practitioners were more different.

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* And, to avoid the appearance of hypocrisy, I should disclose that while I'm not on the list, I also went to one of these schools, Columbia.

Don't let the dumb money lead

When I don't invest in a company it's because (a) I didn't like the company, (b) I didn't know enough about the company's business to actually add any value, or (c) I didn't like the terms of the deal.  But I recently said no to a company where I liked all three of those things. What I didn't like was the lead investor.

Because of the way this company's process unfolded, they ended up with a wealthy financier as the lead investor. And even when a professional venture investor later offered to lead, they decided to stick with the original lead.   I think this is a big mistake for both the company and the investor.

Throughout my startup-related career I have repeatedly run into very successful hedge-fund operators, investment bankers, real estate magnates and big company executives who wanted to invest in startups.  I think supporting startups is an excellent use of money and I have always encouraged them... to follow experienced venture investors in deals.  None of them have ever taken my advice*.  They all thought that since they were so good at doing the exceedingly complicated deals they had made their mark with, doing a simple startup financing would be a snap.

Finance is a set of disciplines separated by a common language. What is complicated in your public market/LBO/distressed debt/M&A deal is not what is complicated in a startup deal (and vice-versa, I should think.) Just because you can navigate a DCF, a shareholders' agreement, and Delaware law doesn't mean you can do successful venture capital deals.

For several years an acquaintance who was one of the top people at one of the most successful private equity shops in... I don't know... the world, ever** would call me up about some startup or other he planned to back. He's sharp and invariably had very good reasons for backing the company. But these conversations always made me uneasy. He didn't know what competitors were doing or planning (or even who the competitors were, other than what the entrepreneur told him), he didn't know what valuations were and why, he had zero idea what customers wanted, and the terms he asked for were far more onerous than standard venture capital terms.

This last one is what bothered me the most, even though onerous terms may seem as if they are in the investor's favor***. The problem is that he had dictated these onerous terms because he intended to use them. And it wasn't even the terms themselves that bothered me, it was the attitude that ownership is a zero-sum game, that the pre-investment negotiating tension between investor and entrepreneur continued unabated after the investment. This dynamic should be very different in a startup than in, say, a LBO. In much non-startup finance, for instance, missing your annual plan means a renegotiation of control and ownership. In a startup a plan is just that, a plan. Things never go according to plan, and good entrepreneurs anticipate that and adjust. Your investors need to know this. And more than know it, be comfortable with it****. When investors and company executives start to fight, value is destroyed. Someone who sets up and expects this dynamic even before making the investment is poison.

Smart people who know nothing about the startup world besides what they've read in the Wall Street Journal should not be your lead investor or a control person on your board of directors: there's an excellent chance that they will not only not help your company but will actually harm it.

So who should lead your deal? Founders of venture backed startups know both startups and venture capital; they are great. People who have lead deals for many years and seen the cycle from startup to exit a few times are ideal, of course. People who have learned the trade by following professional VCs in many deals and being very involved from startup to exit can fit the bill. And, finally, non-venture backed entrepreneurs can be valuable, so long as their journey wasn't too easy: having empathy for the founder when things don't go according to plan is critical in remaining constructive.

Now I've been all of the first three at some point or another (and vicissitudes, I've had a few) so you could accuse me of self-promotion here. But the beautiful thing about being me is that I'm not a professional venture investor right now, so I have no particular reason to be self-serving; I invest because I want to see a particular startup succeed, not because anyone pays me to do it. So here's my advice: if you have no other choice, take the money; but if you have a choice between non-venture investor money and venture money, take the latter.

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* There is obviously a selection bias here.  If they were willing to take this advice, they probably would not have ended up talking to me in the first place.
** My not knowing the pecking order of PE shops or hedge funds is kind of part of the point. Your typical PE guy probably has no idea of the differences between, say, RRE and Venrock. And knowing these things is pretty important when you go to do your next round.
*** I don't believe this, but that's another post.
**** This isn't license to go missing your plan. If you miss your plan, you need to know why and what you're going to do about it. That's a big part of the point of a plan, after all.

The bubble this time

What is a bubble anyway? A positive feedback loop where the governor is on a time-delay. It's not necessarily a money thing. It's just that financial bubbles are easy to spot because price is easy to measure and a graph of the exponential positive feedback followed by the screeching halt (and ensuing positive feedback on the decline) of the governor kicking in is easy to read.

But I don't think we're in a financial bubble. Some prices seem pretty high, but nothing like the willing-suspension-of-disbelief levels I saw in 1999. The positive feedback loop is in the innovation industry.

Let me say, first, that I'm in favor of innovation. I believe long-run economic growth per capita is driven by innovation. I've dedicated my last fifteen years to trying to create or nurture innovative ideas, I'm part of this bubble.

But innovation is pretty constant. Look at this graph of US GDP per capita.

If the primary determinant of the slope is the level of innovation, then the level of innovation is remarkably constant over the time period shown*. This means that while those of us in the innovation industry are doing our jobs, grinding it out year after year, there's not much innovation in the innovation department. Also, it means that all the things we do to cheerlead innovation don't really have much of an effect. Innovation is a system we don't fully understand, one where we do not know how to change the level of output.

But over the past six months I have been inundated with talk of innovation. Incubators, summer programs, new venture funds, university initiatives, think-tank initiatives, government initiatives, innovation consultancies, etc. etc. The level of innovation stays the same, but the industry built around it is growing exponentially. As it will continue to, until reality kicks in; a classic bubble.

Again, don't get me wrong. I support this. In fact, despite the carnage that bubbles cause, I don't believe they're all bad. Here's a quote I've used before:

"Reckless, booming anarchy," in short, produced fundamental progress. It was not a stable system, racked as it was by bank failures and collapsed business ventures, outrageous speculation and defaulted loans. Yet it was also energetic and inventive, creating permanent economic growth that endured after the froth was blown away... Those who gambled on the future rise of the public lands in the West... were madmen only in the short-run business sense--only in thinking that future prospects could be realized all at once by means of an infinitely expansible credit system--and not in their basic sense of direction.

This is Greider describing the 1830's. Bubbles are the reckless booming anarchy that create permanent economic growth once the froth blows away. And, especially if you're an entrepreneur, more people trying to fund you, more people trying to give you below-market rent, more people trying to introduce you to more other people, more talented engineers willing to forgo big-company salaries for the chance to build something meaningful, it's all good.

But here's my worry. I've been investing in NYC tech startups for 15 years now. That means I've lived through 2002-2003 and 2007-2008. Those were hard times, times when a lot of people decided that starting tech companies was a bad idea, when people who had been gung-ho up and disappeared. Most of the people who started companies in the late 1990s stopped trying to start companies after the bubble burst: having learned a hard lesson, they decided not to put that valuable learning to use. The same positive feedback that creates exponential growth creates exponential decline.

I can't complain. My big breaks have come by being steadfast when others were fleeing. If I hadn't persisted in 2003, I wouldn't have the wherewithal to make investments today. In late 2007 and early 2008, I got the chance to invest in some amazing companies--even though I had no track record as an angel--because so few others were willing to write checks. But I'm just a born contrarian**. My worry is that when things smooth out, when people calm down a bit, this new build-up in the innovation industry suddenly disappears, leaving a whole new generation of entrepreneurs high and dry and with a distaste for the rhetoric of the venture capitalists and others who encouraged them to take a risk and do something meaningful.

There's no known way to recognize or gradually deflate a bubble. But this bubble, like all bubbles, is just froth around the constant innovation that occurs, bubble or not. It's possible to focus on the reality of the underlying innovation and not on the froth. Some VCs--USV, First Round Capital, Chris Dixon/Founder's Collective, Roger Ehrenberg/IA Ventures were the ones I ran into--continued investing in 2007-2008, when things looked grim. HackNY was running hackathons and NYC Seed was trying to support the NYC tech startup culture when others were backing away. There are many others who continued to build the ecosystem here then, and that gives me reason to believe they will continue to build it when the carpetbaggers have left.

I'm not saying that entrepreneurs should think about these things when raising money or that engineers should when looking for a job. But those of us who have the breathing room to make choices now, and who care about building a NYC tech ecosystem for the long run, should try to support the entities and people we think will be here whether it's rain or shine.

[Edit: I want to make sure this is clear: I'm not saying we should support people who were here, I'm saying we should support people who will be here. Having been here when it was hard is just a good indicator that they will be here when it's hard again, as it inevitably will be.]

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* For a longer run look at economic growth, which I think supports this thesis by showing that the level of innovation does change occasionally, read A Farewell to Alms.
** A loved one tells me that I am not a contrarian, I am just contrary.

Old Style vs. New Style VC

Wrote a comment over on David Lerner's blog on his "Are Super-Angels Extinct" post. He said

What I am saying is that some of these superangel funds may structurally resemble traditional VC funds, but they are something altogether different- and more akin to an angel group.

My comment was that structure matters.  If you set up the Red Cross just like a bank, with the same incentives, they would have caused the Panic of 2007.

Maybe it's just two different world-views.  I've thought about this and written about it for a long time.  My take is that if you want to create a better venture capital system, you need to change the system, not just the people.  Calling yourself a super-angel and saying you are different does not change the investing world.  Changing the processes and structures of the investing world will change the investing world.  There are firms (and super-angels) doing this.

In the spirit of changing the game, some "old-style" and "new-style" comparisons:

Old-Style	New Style
Money managers	Company builders
Organized like a law firm	Organized like a start-up
Generalists	'T-shaped'
Managing $1bn	Managing $25mm
Living on management fees	Living on expected future carry
Scaling by hiring more partners	Scaling by being more efficient
"Loose lips sink ships"	"You should read my blog"
Going to NVCA meetings	Going to the R Meetup
Joining Angel Investor groups	Writing $25k checks
Starting an owned seed fund/ incubator/ hackathon	Supporting a grass roots effort
Sports jackets	Kicks
Networkers	Community builders
Lawyers	Series Seed
Participating preferred	Straight preferred
51%	15%
LPs measure success by: IRR	LPs measure success by: IRR

Co-evolution and other housekeeping

A couple of weeks ago I wrote something for AdExchanger's 'Predictions for 2011' series. It needed to be brief, and I wanted to talk about what entrepreneurs will be beta testing two years from now.  I made a couple of observations that are pretty obviously true and then ventured this prediction:

Towards the end of [2011], the smartest entrepreneurs will start thinking about how to reinvent the core platforms to better support the needs of the best emerging applications. A dynamic similar to the software/hardware co-evolution of the '70s and '80s will begin, creating similar strategic opportunities.

I actually think this is a pretty tame thought, but once John published it people starting asking me what I meant and how it's actionable.

***** 

I should talk about what I'm thinking generally, though.  I've been pretty quiet since the Summer and where I used to be tightly focused on the data-driven web-based display-ad exchange ecosystem, I'm now a bit broader*.

1. In web-based display I've continued my 2010 push on the publisher side of things.  In addition to my investment in MetaMarkets--who are doing some pretty astounding things--and advising PubGears, I've got another pub side investment that should be announced anon.  I'm still looking for others doing something unique here, but to some extent I feel like these three companies are building 80% of what's undone in getting publishers back their negotiating leverage in a data-driven world.

2. The only other pieces of the web-based ROI feedback loop that I articulated in February that remain unaddressed are the piece at the marketers and the piece at the individuals.  I am still actively looking for companies in the former.  I've met a couple of really exciting ones and am working with them to get to launch-readiness, but want to meet more; this is a big area.  I'm trying to figure out what, if anything, could work at the latter.  I would have invested in Hunch, had I the opportunity back then, but I think there are other ways to address the consumer side of the people-product matching problem.

3.  Social may be one.  The social loop will share superficial characteristics with the display loop, but it's really completely different.  A softer, more subjective approach is needed. IMHO, the area with the most near-term leverage will be tools that help communicators understand the impact of how they are communicating and then help them make better decisions.  I've made an investment here that will probably also be announced anon.  I'm treading carefully in other areas of social because I've seen a lot of ideas imported from the display ad world rise and plateau: social is different and harder to scale.

4. Mobile.  In addition to my long-ago investment in Pinch Media (now Flurry) I've made an investment in a geo-data startup.  This one has not announced publicly, but it's a big idea.  Other than that, again I'm treading carefully.  Steve Jobs' reaction to Flurry earlier this year is an example of why: no matter where you invest in mobile, you're at the mercy of some pretty ruthless gatekeepers.  That said, it's exciting to think about how much value startups could add through the mobile platform.

5. Data is a big problem.  And, to be clear, it's been a big problem for a long time so it has some big and expensive solutions sold by big and slow corporations.  But the companies that are bringing data-munging solutions into the reach of smaller companies operating without teams of specialists are pretty interesting.  I've been trying to get a feel for the process, on a small scale, as my last couple of posts show.  But I've got a lot to learn before I even begin to feel competent.  (If you have something to teach me, I'll buy lunch.)  I want to find companies that can democratize data science.

6. Respect for the individual.  I think about this a lot.  I don't talk about it a lot.  It's a difficult area and using a rational thought process on something that's pre-rational in our makeup is tough.  I haven't been able to organize my thoughts, so I have no idea how I support the value-creation process.  But it's always there in the back of my mind.  I am open to suggestions.

So that's what I've been doing and thinking.  Points 2 through 5 will probably continue to be my focus through most of 2011.

*****

In terms of the AdExchanger bit, here's what I was getting at.

At IBM in 1988, in meetings to discuss moving an instruction's execution from the microcode engine to the hard-coded execution engine, I realized that our design team was at the tail-end of a long chain of product-market fit interactions. Because of the way end-users were using applications, applications had changed which parts of the operating system were critical paths, and the operating system designers had come back to us hardware folk asking that certain instructions be optimized for performance.

This was part of a long-standing and ongoing co-evolution between the hardware and the software.  Innovations on the hardware side changed what software was viable.  Innovations on the software side changed what was needed of the hardware.  Read Melinda Varian's intensely interesting VM and the VM Community, where she talks about the development of IBM's time sharing operating system, and think about it as a co-evolutionary process.  IBM in 1964 opened an office in Cambridge as a liaison to the MIT software engineers developing the first time-sharing operating systems.  Because of its proximity to the users, this office was instrumental in pushing IBM to change its mindset from building machines optimized for batch processing to building machines optimized for time-sharing.

During the next few years, both sides--the operating system writers and the hardware designers--pushed the other side to optimize around what they thought was needed or what they could deliver.  The software engineers pushed for address relocation capability and other features needed for time-sharing. The hardware engineers spec-ed a new processor to meet those requirements.  The hardware engineers floated the idea of virtual machines.  The software engineers built an operating system to take advantage of them**. 

Calling this co-evolutionary may be oversimplifying.  In fact, each layer of the stack co-evolved with the adjacent layers.  Sometimes the tension between different layers evolving differently led to entirely new organisms forking off, like Multics (which then evolved into Unix and its descendants.)  This process can happen in any multi-layer ecosystem that has different actors in different layers.

The data-driven display ecosystem is like that.  The tensions between co-evolving layers is evident (AppNexus/Google anyone?)  And forks are emerging.  I expect that within three years there will be a major fork away from the owned exchanges into a crossing platform that can better support the demands of the adjacent layers: the data exchanges, analytics, the DSPs and the SSPs.  Right now none of these are especially happy with what the exchanges are offering.  Not to say that they're unhappy, but they each have a laundry list of things they would improve or change.  The best of them are creating ways to avoid the exchanges, but only because there is no good alternative.  A platform would still be most efficient.

The exchanges, on the other hand, seem to be pretty content with the way things are.  Or, at least, they feel that they should be controlling the pace and direction of the evolution.  This opens the way for entrepreneurs to build something disruptive.  If you're an entrepreneur with the chops to build something here, you should start thinking about it soon.  2012 will be too late.

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* No Thanksgiving jokes, please.
** One great anecdote talks about how the early CP/CMS OS could only keep one virtual machine in memory at a time.  So when a user logged on, the OS would reserve space on the paging drum for the copy of their virtual machine while somebody else's was running.  When the paging drum was full, space would be reserved on disk.  Since the paging drum was so much faster than disk, people started showing up to work earlier and earlier so they could get a slot on the drum.  Finally the OS designers made the page slot allocation mechanisms dynamic.  They just weren't morning people.

More VC Coinvestment Visualizations

I've always believed that unless you try your hand at something, you can't really appreciate the people who do it well.  That was my motivation in creating the VC Coinvestment Network Map I posted two weeks ago.  And believe me, after munging that together I did appreciate the complexity of the process and the expertise of the people who can do it well.

As a side-benefit, I got to meet and talk to several people in the data visualization/network analysis community.  Drew Conway over at Zero Intelligence Agents was the first, and he put up a visualization of the data that teased out some of the structure that I couldn't find.

Now Linkfluence has put up a visualization that does something different.  It doesn't find the 'bones' of the data, as Drew did, but it allows you to find nodes and interact with them.  Below is a screen shot of my node and its neighbors (i.e. the companies and people I have coinvested with, per Crunchbase and AngelList data as of two or three weeks ago*.)  The screenshot doesn't show my cursor hovering over KP, but that's why their name shows up.  Also, we added links back to the Crunchbase database from each node (some of the people don't have CB entries, but that's a small minority of the nodes.)

It's pretty cool to play with.  Take a look.


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* The caveats and filtering I did to the data noted in my previous post still apply.

Venture Coinvestment Map

It was a grand plan. I was going to learn all sorts of new things: Pentaho, R, Processing. All sorts of new things. In the end, I got caught up in getting something done and learned none of those things. Again.

Using trusty old Python with the beautiful NetworkX module and the shockingly fast--if a bit rough around the edges--graph visualization tool Gephi, I pulled Crunchbase data to create a social network map of how venture investors coinvest. You can skip straight on down if you want, playing with it is more fun than reading about it (and more fun than learning Pentaho, it turns out.)

I can't believe Crunchbase didn't rate limit me* but most of the data is from their excellent database. I augmented it with info individuals have made available on AngelList. I didn't include any non-public info, even though I know of several excellent angels who didn't make the map because they've kept their activities under the radar.

I then had way too many nodes to make any visualization make any sense. So I did two things: any person mentioned as an investor who was also a venture firm employee was folded into the firm. I also made some fixes I knew of (merging my friend Roger Ehrenberg's IA Capital into IA Ventures, for instance.) I know some venture partners invest as angels outside their firms, but since this is a map of social connections, I think the step not only makes sense, but weights individuals more accurately. (Roger Ehrenberg, for instance, would not get the weight his activities deserve if his investing activity was split among three entities.)

Then, again to make it manageable, I took out any investors with fewer than five investments. Ran it through Fruchterman-Reingold. Colored venture firms red, people green and others (corporates, incubators) blue. Made node size proportional to number of investments.

The result is below, in Zoom.it. Some things that stand out:

- The network is incredibly connected. If you go into the "core", where the Sand Hill Road firms are, there are so many edges, they are indistinguishable. Generally, in this visualization, the drawn edges are more or less decorative, because there are too many to have them make sense.

- Because of the dense interconnectivity, there are not many noticeable subnetworks, from 50,000 feet. Here's a map key, such as it is, showing some areas that are distinguishable. The separation between biotech and the core is no more noticeable, to my eye, than that between web 2.0 and the core. I do find that the further I get from my own node, the less I know about the investors.

Map key:

I should note the usual caveats.  Crunchbase data is not a complete record of investment activity, in fact it tends to be severely self-selecting.  I assume both non-US and non-Internet-tech are underrepresented.  I know non-VC investment is underrepresented.  Also, my few fixes are not all-encompassing.  This was a project I had time for because of a couple of long train rides.  I do have the raw dataset (both gephi, graphml and pickled networkx graphs) for the entire network.  If you want them, let me know.

Drag and zoom.  Find your friends.



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* Or maybe because I was hitting their API while on the Acela, they figured it couldn't possibly be programmatic. In any case, to my fellow train passengers, I apologize for hogging the bandwidth.

OPM

I think Chris Dixon is one of the smartest investors around.  I co-invested in him when he was an angel and I've co-invested with his early stage fund, Founder's Collective.  But while I generally agree with his recent post on venture investing segmentation, I need to call bull on this:

What we are witnessing now is a the VC industry segmenting as it matures. Mentorship and angel funding are performed more effectively by specialized firms.

It's kind of surprising to me that someone who did such an excellent job as an angel would imply that he really wasn't the best investor for those companies in the first place but, hey, he's entitled to his opinion.  But saying you'd be a better angel if you were a firm is like saying that you'd be a better amateur athlete if you went pro*.  You can't be an angel if you have a fund.  And though this sounds like a semantic argument, it make a real-world difference to entrepreneurs.

What bothers me is the lumping of angel motivation and technique in with the "Super-Angel"/micro-VC motivations and techniques.  The otherwise excellent David Lerner makes this mistake when he says he intends to explicate the angel investing world and then lists, as half his angels, people with funds.  This is a fundamental analytical mistake: taking the average of a bimodal distribution tells you nothing very interesting at all.

There are reasons why angels existed in the first place.  While the lower cost of getting a startup from A to B has changed the dynamics of early stage rounds, it hasn't changed most of the fundamental advantages of having individuals investing their own money: a personal--rather than institutional--connection to entrepreneurs, the ability to make quick decisions, the ability to make decisions that may not seem fiduciarily responsible but are for the greater good, primary expertise in an industry and in company building rather than in money-management, etc.  Most importantly--despite what the Supreme Court may think--firms are not people and they don't, in the long run, act like people.  Angels do.

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* While this is the reasoning behind the modern Olympics and many college football programs, it flies in the face of the actual meaning of "amateur" and destroys what makes amateur athletics so appealing. 

It's not about the founders, it's not about the money. It's about what you're building.

I spent my Summer thinking about how I could continue to be useful as an angel investor.  Then this Angelgate thing happened and I can't seem to write the post I meant to write about it.  So I'm writing this instead, hoping to get some thoughts out of my head and move on.  I don't think I'm saying anything new here and this is just a distraction from real work, and I've allocated time as such, so forgive the disjointed style.

1. "Judean People's Front?  We're the People's Front of Judea.  Judean People's front, caw...  The only people we hate more than the Romans are the fucking Judean People's Front."  Every successful revolution is the same, cold comfort though it is, the most vehement feelings are directed towards people working towards the same goals in different ways*.   We're all on the same side and we all want the same thing: more and better startups.

2. Venture investment today is far preferable to every other system of financing innovation we've ever had.  It's not perfect, or even great, but it's far better than what was.  The financing of innovation has improved, in fits and starts, for the last five hundred years.  Think about how the early explorers were funded, think about how the Wright brothers were funded, think about how the second industrial revolution was funded.  For goodness sakes, think about how internet startups were funded fifteen years ago.  The new VC model is better.  The new angel model is better.  Should we make it better still?  Of course.  Should we talk about just chucking it all?  No.

3. It's better for entrepreneurs, but that's not the driving force here.  The entrepreneurs and investors are both bit players in a bigger show.  I tend to disagree with Jon that founders come first, although the why of my disagreement may seem a bit like theological hair-splitting.  Founders don't come first, the idea does.  If a founder thought it was all about them rather than what they were building, I wouldn't invest.  That said, no one works on building something as hard or as smart as the person whose idea it was.  I back ideas, but I believe in founders.  I believe in them because they believe in their idea.  But this semantic distinction leads to a fundamental difference: I'm not doing this to make founders rich, I'm doing it to see good ideas turn into great companies.  When this happens, the founders tend to make a lot of money, but that's a second order effect.

4. Likewise, investors make money.  But startup investors aren't in it for the money: the return on investment is also a second-order effect.  That said, investors need to make money; if they don't, they don't get to invest anymore.  That's true when you invest other people's money, but it's also true for angels.  I have a significant chunk of my money invested or earmarked for startups.  If I lose it, I won't be able to invest anymore.  If I make money, I get to reinvest it.  Not a week goes by when I don't wish I could invest in more companies or invest more in a company that no one else believes in yet.  But not a day goes by when I don't think about the gambler's ruin.

5. Seed-stage VCs are not in it for the money, not in itself.  Angels even less so.  No one on the Forbes 400 list made it there by dint of venture investing.  No one.  [Edit, 9/25/10: Should have checked first... John Doerr and Michael Moritz are both on the list, both by dint of their investment in Google.]  Venture investors aren't robber barons, they don't make the cut.  Think about the economics of a First Round Capital... a fund structured that way won't make the partners much more than minimum wage unless it's one of the top-performing funds in the world.  Any world-class investor would have made a multiple of what they made if they had been a world-class entrepreneur.  VCs have a lower beta, it's in the nature of what we do, but we're all on the same risk-reward curve.  The startup world is a choose your own beta kind of world.  Don't get pissed off when someone chooses a different one.

I'm not defending anyone and I'm not downplaying what happened (whatever did happen... I wasn't there.)  But if one of the guys in that restaurant likes you enough to gives you a valuation, I guarantee you that you can find a less well-known investor who will give you a higher one.  There is no collusion that could affect your outcome.  I doubt there is anyone who believes otherwise.  So I think the anger about this is really a pent up anger about the startup finance system altogether.  I've been an entrepreneur, I've raised money for a startup, and I realize how bad that process sucks, how random and uninformed it all feels.  We have to keep working at and looking for ways to improve it.  But let's not forget that we are all on the same side and we all want the same thing: for startups to have a better chance at success.

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* Of course, in this case there's been no anti-bolshevik league-like purges, no ice picks in the back of the head, no duels at dawn in Weehawken.  Well, not yet anyway.

Startup R&D has replaced corporate R&D

I have a problem with Yves Smith's and Rob Parenteau's op-ed in the Times:

Over the past decade and a half, corporations have been saving more and investing less in their own businesses... Since 2002, American corporations on average ran a net financial surplus of 1.7 percent of the gross domestic product—a drastic change from the previous 40 years, when they had maintained an average deficit of 1.2 percent of G.D.P. ... To show short-term profits, they avoid investing in future growth...

Smith and Parenteau evidently believe that since 1995 corporations have spent less on R&D, stifling innovation.   But, on the face of it, there has been plenty of innovation since 1995.  What gives?

Steven Kaplan and Josh Lerner say in their recent It Ain't Broke: The Past, Present and Future of Venture Capital:

Beginning in the early 1990s... American corporations began fundamentally rethinking [internal R&D facilities]... relying much more heavily on what has been termed "open innovation," i.e., alliances and acquisitions of smaller firms... venture-backed firms are approximately three times as efficient in generating innovations as corporate research.

Corporations are spending less on internal R&D.  But this is because internal R&D is far less efficient than buying venture-backed companies.  Smith and Parenteau forget that Savings = Investments.  When a corporation saves money, it invests it somewhere else.  Sometimes in something innovative.

Smith and Parenteau recommend

[Creating] incentives for corporations to reinvest their profits in business operations... impose an aggressive tax on retained earnings that are not reinvested within two years...  At the same time, the federal government must continue to encourage investment in the economy—ideally by creating incentives for investments in national priorities, like new energy technologies. 

This is exactly wrong.  Corporations should save money or distribute it to their shareholders to save.  That money should be turned into investment in innovative new firms that the corporations can later acquire.  And as to the government steering investments: if corporate-backed R&D is three times worse than venture-backed R&D, I can't even imagine how bad government-directed R&D is.

More investment does decrease consumption in the short-term*, and this is a problem during a downturn.  But because investment increases income growth, it increases the opportunity to consume longer-term.  It might well be that this is the wrong moment in time to encourage savings over consumption, but to create a policy that would discourage more productive investment for years to come makes absolutely no sense.

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* GDP = private consumption + gross investment + government spending + (exports − imports)

Why isn't Columbia part of the entrepreneurial community?

I was at a conference about a year ago and listened to the head of tech transfer of one of New York's major universities say "We're doing a great job. I don't think there's anything we could possibly be doing better." And he actually seemed to believe it.

I had a bit of culture shock. The last time I had heard that sort of complacency, it was when I worked at IBM in the late '80s (see how that turned out!) Since then I have worked at professional services companies and in start-ups. That sort of attitude at either would be quickly fatal.

Stowe Boyd notices that Columbia and NYU do not have the sort of relationship with the New York entrepreneurial environment that Stanford does with Silicon Valley or MIT does with Cambridge. I couldn't agree more.

Stanford (and Berkeley, I was reminded yesterday by an alum) has birthed companies all over Silicon Valley, from HP to Google. They are key drivers of the community there. And it's no accident that the global hub of biotech is in the few blocks surrounding MIT.

I have degrees from both Columbia and NYU, and have a soft spot for both. But when I approached Columbia back in 1998, backed by a seriously large corporation, hoping to create a funnel for potential entrepreneurs into Silicon Alley, I was stymied by disinterest. I probably could have made it work without the university's cooperation, but, really, I had better things to do with my time. I tried again in 2003/2004 with similar results. Maybe I was just talking to the wrong people. But, then, no one else seems to have made much progress either, at least as far as I can see.

Columbia* then and now, it seems, is more interested in the money coming from a patent than in providing an enhanced community for its alumni and a better economic environment for its host city. NYU is not nearly so bad, hiring people like Clay Shirky and backing places like NYCSeed. But even they are nowhere near as engaged with life outside the academy as Stanford or MIT. It's a frustrating thing, and I wish I knew what I could do about it.
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* The institution, that is, not necessarily the people in it. I hear tell of individual professors trying to steer bright students into entrepreneurial endeavours.

Taxing carried interest is nothing but a political circus

I should start by saying that because of the idiosyncratic nature of my thirteen years of venture investing, I've never been paid a carry. And, since I'm now a country gentleman, cutting the brush and tending the horses over here in bucolic Hoboken, I probably never will be. So maybe I'm uniquely qualified to give an opinion on the carried interest taxation issue, being neither fish nor fowl.

That is to say, I don't have an interest in how this turns out. But I do happen to dislike the political circus, the populist sop that our leaders trot out to convince us they are actually solving problems when all they're really doing is nothing.

Fred Wilson says, "someone has to pay the taxes to keep our troops equipped, our borders secured, our schools modernized, and our children healthy. It might as well be me and my wife."* So why do I think taxing carried interest as earned income instead of capital gains does precisely nothing?

The tax code has a certain mathematical beauty that rebels against the alchemy of turning capital gains into labor income just by decreeing it. So, while we could tax Fred on his carry at ordinary income tax rates, this would not, unless a whole lot else was changed, increase the revenue of the US Government by much, if at all.

Why? Because if Fred's firm paid him a salary instead of a cut of the gains, he would pay ordinary income tax rates on it sure, but (since VC firms are pass-through entities) it would be deductible to the firm's owners, the LPs**. To understand this you have to know how an LLC (or any "pass-through" entity) works. The LLC, when it has income or losses, reports them to its owners and the owners report their share as income or loss on their own tax returns. The LLC pays no tax, its owners pay all the tax. Also, the LLC does not just send a net profit number to its owners as the taxable amount, it sends a report of each item--ordinary income, capital gains, interest, ordinary expenses, etc.--and the owners slot each item into the appropriate spot on their own tax return.

So if a VC fund had a $100 gain, it reports now an $80 cap gain to its owners and a $20 cap gain to the people running it. The total tax take is $100 times the capital gains rate. If carried interest were considered ordinary income (i.e. salary), the fund would now report $100 in capital gains to its owners, a $20 salary to the people running it and, note this!, a $20 ordinary loss to its owners. Total tax take would be to first approximation capital gains rate times $100 plus ordinary income tax rate times $20 minus ordinary income tax rate times $20. For you ad folk who haven't done algebra since 11th grade, that equals exactly the amount being taken by the government now.

Of course, in this example, Fred pays more, but his LPs, big financial institutions and wealthy individuals in many cases, pay less. The VCs pay more and the the Money pays less.

If this is a question of fairness, as Paul Kedrosky implies, then let's talk about fairness***. Here's a scenario:

I start a company. I own all of it, since I started it. I raise $20 million in participating preferred with a ten-year redemption right at a $5 million pre. I now own 20% of the converted equity in the company. I use the $20 million to invest in other startups. Voila, I am a venture fund.

Simply by starting a company I have the same economic and tax characteristics as a venture fund, without any mention of a carried interest. In this sense VC funds are like any other startup. This illustrates that the same fairness argument being applied to VCs applies to entrepreneurs. Founders and VCs don't invest capital in their ventures but they both pay capital gains. No capital at risk, no capital gains treatment? If that's "fair" for VCs then it must be for founders, right? Be careful what you wish for.

To be clear, neither founders nor VCs "deserve" capital gains treatment. Neither founder's equity returns nor carried interest is a gain on capital, both are gains from labor****. Our society has tolerated treating these as capital gains because we want to encourage the activities. Personally, I think we should encourage both entrepreneurship and venture investing. Especially if it's merely a question of deciding how the same amount of taxes paid should be distributed between the VCs spending their not-especially remunerative lives***** trying to help people start companies and the Money that they're investing for.

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* As an aside, I think we could pay more for the two of these I support by cutting the two I don't. But that's neither here nor there in this argument.
** And noting that many LPs are tax-exempt does nothing for me. In this case, where talent and not money is the scarce resource, I believe the tax incidence will fall on the owners of the firm, not the people running it. This is probably the source of the juggle of who pays what in the first place.
*** Which is a fuzzy thing to talk about anyway. The only cogent philosophical arguments for levels of taxation I have ever heard are exemplified by Nozick and Marx. The one thought it should be zero and the other thought it should be one. I've never heard a moral argument for 15% or 35%. These are maximum efficiency arguments.
**** Why does capital get treated better than labor anyway? Not because, as Fred avers, it deserves it. Rather, it gets better treatment because it's more mobile. Higher rates here than in Bermuda? Money moves to Bermuda. Higher ordinary income rates here than in Russia? People don't move because of that (unless you're extremely wealthy.)
***** See point 6.

Who Invests in Quantitative Marketing Companies?

About a month ago Jay Yarow wrote about the financing of The Trade Desk. One of the commenters insisted that only Redpoint, Union Square, Highland, Sequoia or First Round Capital were expert enough to invest in online marketing firms. I think this is wrong-headed (and not just because I was one of the investors listed in Jay's article.) But, my opinion aside, what's the truth?

To find out, I made a list of some 150 display-ad companies by flipping through AdExchanger.com*, adding a few companies that exited early and then discarding agencies, ad networks, ad ops and rich media companies**. Of these, only those that had VC investors listed in the Crunchbase database are in the final results***. There were 90 of these.

I also split the list into five general categories: buy-side (19 companies), sell-side (20), marketplace (8), targeting (30), and measurement/verification (13). Each company was put into only one sector, unrealistic as that is.

So, what jumps out?

1. Number of Investors

There are a lot of different investors. I counted 200 institutional investors in the 90 companies.

2. Number of Investments

Most investors have one investment in the sector.

There are 154 investors with one investment, 27 with two, 12 with three and seven with more than three.

The top seven:

1. First Round Capital, with 11
2. Accel Partners, 9
3. Union Square Ventures, 6
4. IA Ventures, 5
5. DFJ, 5
6. SVB Financial/Silicon Valley Bank, 5
   
7. Redpoint, 5
   

The firms with three investments: IVP, Rose Tech, Mohr Davidow, Menlo Ventures, DAG Ventures, Founder Collective, Venrock, Shasta Ventures, Mayfield Fund, The Founder's Fund, Battery Ventures, Coriolis and Maples Investments.

3. Most Diversified

Many of these firms have invested in more than one of the five broad sectors.

Here's a table of the most diversified.

	Buy	Sell	Target	Market	Measure
Accel Partners	✔	✔	✔	✔	✔
First Round Capital	✔	✔	✔		✔
Union Square Ventures	✔	✔	✔		✔
Draper Fisher Jurvetson		✔		✔	✔
Redpoint Ventures	✔		✔	✔
DAG Ventures		✔	✔		✔
Institutional Venture Partners		✔	✔		✔
Mayfield Fund	✔	✔	✔
Menlo Ventures	✔	✔	✔
Mohr Davidow Ventures	✔		✔		✔
SVB Financial Group	✔	✔		✔
Coriolis	✔		✔		✔

4. The Truth?

What makes an investor a desirable investor in a sector? Time spent on the board of similar companies certainly counts, as does number of non-competing investments in the sector and adjacent sectors.

Under these criteria, USV, First Round, IA Ventures, DFJ, Redpoint, and Accel all stand out.

But another criterion is deal flow, the number of deals an investor looks at even if they don't invest. This sort of activity gives them a good view of the market, and a great network of potential partners. The deal flow criterion is harder to measure. My sense, from talking to entrepreneurs in New York, is that the investors who have talked to the most entrepreneurs in the sector are First Round, IA Ventures, Founder's Collective, NYC Seed, Genacast, WGI/Point, Coriolis, True Ventures, USV, Greycroft, and Spark.

I've worked with or co-invested with most of these investors. I respect their opinions and, if an entrepreneur tells me that one of them is interested, it influences me. But I don't always think they're right. Sometimes one of them likes a company I don't and sometimes I like a company they don't. None of them are always right and none of them make any investment a sure thing.

Given all the uncertainty about which companies will be successful and which won't, the predictive quality of who the investors are is too small to notice. Picking out five or six and dismissing all the others is silly. If you're an entrepreneur, talk to as many as you can and find the one that is best for you, no matter where they work.

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* I had a conversation with Greg Hills a few months ago where I asked the metaphysical question of who is quantitative marketing and who is not and he averred that the community is essentially self-defined by who are mentioned in, contribute to or comment on AdExchanger. I think this is as good a screen as any.
** Some of these should logically be included in 'quantitative marketing', but figuring which would take more time than I'd be willing to spend. If anyone wants to volunteer a list, feel free. Or, if anyone wants my hacked-together python scripts so they can do it themselves, let me know.
*** Crunchbase data is a bit funky. I amended it where I knew off the bat it was wrong, but didn't dig into every investment or investor. I am sure the data in this post is incomplete.

I know it's a good deal for you.

In the past few months I did not invest in a couple of companies whose businesses I really liked because they were raising seed financing through convertible debt.

Convertible debt is essentially a loan with an option to invest in the next equity round at a discount. So, for instance, a typical seed stage convertible note might give the lender the right to roll the principal and accrued interest into the Series A at a 20%-25% discount.

Chris Dixon posted about the reasons why convertible seed rounds are a bad idea. I agree with his reasons. But I have another, more investor-centric, one: seed stage convertible debt is usually a bad deal for the investor.

There's an old saying in the venture industry: lemons ripen before pearls are cultured. Startups that are going to fail usually fail quickly. Look at Scott Shane's numbers on startup failure rates, in the graph below. While these numbers are for all small businesses (not just venture-backed ones) and for companies started in 1992, they seem to jibe with what I have observed over my thirteen years of venture investing.

If you invest in companies at founding, 40% will survive to year six. If, on the other hand, you invest in the companies that survived their first year, 53% will survive to year six.

Let's say that, like Fred Wilson, 33% of your early stage investments fail, 33% go sideways (1.5x return) and 33% return 5x-10x*. (I assume that "early stage" means investing one year into the company's life.) Then, if 25% of businesses fail between year zero and year one, seed investors should expect 50% failure, 25% sideways and 25% success.

For a Series A investor (assuming the average successful exit is 7.5x and exits are five years after investment) the IRR of the fund under these assumptions before management fees and carry is 25%. Until the last decade, this was close to the average return for VC as a whole.

As a seed investor, I should expect higher returns (I am taking more risk): I want a 30% return, rather than 25%. I should also expect it takes six years to exit the investment rather than five. For sideways and successful investments, the return is the same dollar amount as the Series A investor (so, if I invest at a 50% discount to the Series A, I get 3x for sideways and 15x for successful exits.)

Running these numbers, I need to invest at a 50%-60% discount to the Series A to get my target return.

Even if my simplifying assumptions are too simplifying, the discount has to be at least 40% for a convertible note to be economically rational**. I doubt whether any Series A investor would let that stand because, in hindsight, the seed investors took very little risk***.

I've had a couple of entrepreneurs tell me that they wanted the round to be a convertible note because they wanted to limit dilution. What they are really saying is that they want me to invest at a higher price than I would if we actually agreed on a price. I understand that, and I sympathize, and I even recognize that many angels turn a blind eye to this because they want to pretend they are not getting a bad price. But let's be honest, they are getting a bad price.

As a matter of discipline, I have a handful of rules I won't break, no matter how much I like your company. One of them is that I won't invest in seed-stage convertible debt.

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* There is some evidence that venture backed firms are less likely to fail than startups as a whole, and there's a lot of evidence that Fred Wilson is a better than average investor, so his failure rates may not match Shane's. There is also some evidence that VCs keep companies afloat until about five years after their investment, then give up, so the failure rate curve for VC-funded firms may be distorted.

** Disregarding that some angel investors will take a worse return in the hopes that the Series A will be lead by a great VC, allowing them to take a carry-free ride on that investor's coattails.

*** To be fair, I think the VCs really just take the entirely sensible viewpoint of caring more about the ongoing management of the company than the people who put money in a year ago and haven't been involved since.

Tweet Congress: we want jobs and innovation

If a great company shows up on my doorstep, I try to invest in it. If two great companies show up on my doorstep, I try to invest in both of them.

I think it's pretty much agreed that at this point, the bottleneck in startup formation is not money, it's great entrepreneurs and great teams. We've also pretty much settled that startups are the engine of job growth and innovation. If we had a way to increase the number of startups in this country, the entire country would benefit.

The Startup Visa does this and it just took a big step forward, with legislation introduced in the Senate. That's great, but what it really means is that while the hard work may be over, the bruising work is yet to come. Now that this bill has a chance to become law, opponents will emerge to try and kill it. Nervous congresspeople will try to avoid taking a stand on something as controversial as "immigration" (no matter the uncontroversial merits of this particular bill.) We need to let them know we want this to pass.

Brad Feld and Paul Graham did the hard work, now it's our turn. Luckily, our work isn't so hard: go to the Startup Visa site, it has a tool to tweet your congresspeople about the bill.

I can't think of a single rational reason this bill is not a win for everyone. But unless we proactively push our elected representatives to pass it, chances are it will get lost in the twisty corridors of the Capitol, as so many good ideas do. So, go, now, and support it!