The new adtech is disruptive, and that's a good thing

I was at Luma Partners' Digital Media Summit today. Great event, saw lots of familiar faces. I watched the adtech panel. Of the people I didn't get a chance to invest in, these are four of the smartest: Brian O'Kelley, Joe Apprendi, Michael Barrett, and Mike Leo.

Mike Leo said something that struck me as wrong. He said, roughly, "30% of the media spend is getting spent on the pipes"--by which I think he meant the other panelists' companies--"and that's eating into the creative and the content, where it should be spent."

This is exactly the wrong way to look at it.

The entire process between the maker of a product or service and the user of that product or service--what we call marketing--is friction. This includes the pipes, the ads themselves, and even the content created to wrap the ads. Friction, all of it.

I agree that we should reduce the friction, make things more efficient. But if we give credit to Wanamaker's 50% waste in advertising spend, then the 30% that's now being spent on the "pipes" is a 40% improvement. A 40% improvement over five years is pretty spectacular. But disruptive technologies do that.

Leo is looking at the wrong place--he's complaining about the one area of the marketing process that has actually shown efficiency gains, while giving a pass to creative and content, the areas that have fallen behind.

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.]

On failing

Don't confront me with my failures, I have not forgotten them.

- These Days, J. Browne

Six years ago. I was working on a startup with a bunch of friends, a big idea and one that got me out of bed every morning, excited to go to work. We had raised money from a Name and some amazing venture investors. We were going to be the next Google. My other gig, a venture fund, had just had the exit that put it over the top: one of the portfolio companies had gone public. Me and my two partners--one active and one silent--had made the fund back and then some. I was going to make more than living wage from the eight years of work that portfolio represented. At home, we had finished furnishing the house, our third child was on the way, and my roses were finally getting some traction.

I was out with a good friend recently. He told me an old college buddy of ours was having some trouble with his career, with his marriage. I'll call him, I said, I should talk to him. No, my friend said, he doesn't want to talk to you right now. He thinks you wouldn't understand. Everything's always worked for you.

Five years ago. Our Name investor had realized that if we stopped trying to grow the business, it would immediately begin making money. This was not what we wanted, we wanted to be the next Google, not a tiny mortgage lead generator. But he wasn't a venture guy, he wasn't an investor at all, he was a buyer of assets. He scared away the outside money, starved the business of cash, and forced us to accept a buyout. I had been pushed out of the company I had helped start. In the entrepreneurial community, there aren't many marks blacker than that.

Meanwhile, my active partner in the venture fund decided that the silent partner should not be paid their share of the fund, contrary to what our contract seemed to my non-lawyer eyes to say, and certainly contrary to what fairness dictated. When I refused to go along with that, he sued me. He also sued the silent partner. The silent partner fought back, and the whole kit-and-kaboodle got locked down. The vast majority of my assets were frozen, being held hostage to some ridiculous legal squabble for some indeterminate period of time.

Not entirely coincidentally, my marriage fell apart at that exact moment.

I had failed, utterly. I had no job, my net liquid assets were approximately zero, my reputation was in tatters, and the one thing in my life I thought was permanent was over. The struts that supported my sense of self all got knocked out pretty much simultaneously. Everything I had, everything I hoped for. Five years ago, today.

In what way are you the same person today that you were twenty years ago? There is no atom of matter in you that was there twenty years ago, there is no piece of you that is the same as it was. The pieces of you, the functioning of you, the pattern of you are all different. Why are you you? What is you? What is it that continues? When the Buddha told us to meditate on death this is the question he wanted us to ask ourselves: what where you before you were born, what are you after you die? In what way are you still you even twenty minutes from now?

I'll tell you an answer, although me telling you no more gives you wisdom than reading a cookbook gives you nourishment: we are a span of links in a chain of causality. My existence now causes my existence a minute from now, and that a minute from then. There is no me except my self causing my next self every tick of the clock. In consequence, I am subject to the Markov property: how I arrived at the current me is irrelevant, every option available to me is embodied in who I am now, not in how I got here.

I'm no saint and failure did a number on me. Someone told me what intense stress would do to my psyche, the stages of irrationality I would go through. Frustratingly, the knowledge of them did not allow me to avoid them. But failure taught me some humility, and being humble forced me to abandon the personas I had built and my arrogance of idealism. And I finally learned that except in how it hobbled me, my failure made no difference--all that mattered was what I did next.

Five years after everything fell apart I have the best portfolio of startup investments in one of the hottest spaces in tech. People I respect and admire recommend me to entrepreneurs. I am allowed to be productive. And I spent Memorial Day with my loved ones and was happy and relaxed and even looking forward to getting back to work after a long weekend. I appreciate it, all of it, every time. I haven't forgotten I had nothing. I take nothing for granted. But I don't now and never did believe that the past determines the future. The future is determined only by the choices you have now--the ones you can find a way to allow yourself--and what you do with them.

I don't think saying that everything's always worked for me is wholly accurate. But it may be that it is entirely true.

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.

The client does not care if you are intellectually stimulated, Kendall, they just want the goddamned sales curve to start moving up

Every revolution has its reactionaries. I was going to respond to Kendall Allen's article The Math State, but didn't, for a few reasons: it wasn't convincing enough to need a response, I've stated my answer to the objection elsewhere, and Joe Zawadzki is a better writer than I am.

I want to note, though, that when I accepted an offer to work at Omnicom, some 15 years ago, I was handed a copy of Peppers and Rogers.  This was the future, I was told, One to One Marketing. Some six years later the Economist wrote that "the marketing department is the last part of the modern corporation to resist automation." It's interesting that after so many years of wishing for it, the industry starts to object as soon as it becomes plausible.

This new math state is not new. It is a stage in a journey that some of us have been taking for more than a decade and one that will take another decade to reach its apotheosis. For those who don't like it, I'll trundle out the old Rosser Reeves quote that everyone in the agency world says they believe but that few really do:

What do you want out of me? Fine writing? Do you want masterpieces? Do you want glowing things that can be framed by copywriters? Or do you want to see the goddamned sales curve stop moving down and start moving up? 

- Reality in Advertising, R. Reeves, 1961.

Almost a license to print money

Advertising, in time, proved almost a license to print money, and the effects on broadcasting of the revenue model it introduced can scarcely be overstated. It gave AT&T, and later the rest of the industry, an irresistible incentive not just to broadcast more but to control and centralize the medium. To see why, compare the older model: When revenues came from the sale of radio sets, it was desirable to have as many people broadcasting as possible--nonprofits, churches, and other noncommercial entities. The more broadcasters, the more inducement for the consumer to buy a radio, and the more income for the industry. But once advertisements were introduced, radio became a zero-sum game for the attention of its listeners. Each station wanted the largest possible audience listening to its programming and its advertisements. In this way advertising made rivals of onetime friends, commercial and nonprofit radio.

This is Tim Wu in The Master Switch*, describing the beginnings of commercial radio broadcasting.  When AT&T (who was competing with RCA to dominate radio broadcasting) started using its 'long lines' to carry programs to transmitters across the country, they discovered that advertising to a mass audience was far more profitable--and could support professionally produced, higher quality content--than any other business model available to them. This, in turn, lead the industry to successfully lobby the government to allow only a few, high-power 'clear channel' broadcasters (instead of allowing many lower-power ones.)

It's interesting to see how advertising, because it pays for attention, a resource too easily divisible, caused media to agglomerate. The media industry, in protecting itself from competition, has to limit the number and variety of voices that are heard.  Mass media is, by its nature, homogeneous media.

Two things:

1. Mass media, as it is today, is not the only way things can, or should, be. There was a vibrant radio culture before it became a mass medium, with a more democratic voice.

2. Our adtech allows advertisers to reach small audiences. The advertiser no longer needs mass media. Mass media will, however, fight to maintain their current market position. In almost all of the other media this book chronicles, the government was eventually enlisted to regulate out weaker players. The fight over net neutrality was one of these efforts, but certainly not the last.

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* Required reading. This is the first book in twenty years that, as soon as I finished it, I started reading again. A history of the rise, consolidation and disruption of the telephone, radio, motion picture, and television industries, it elucidates the history that can inform scenarios of the possible future of our industry better than any other analysis. It's a good read, too, with wonderful descriptions of the people behind the inventions and companies and how the culture of their times influenced them.

Advertising, the Fallacy of Perfectibility, and the Best Minds of My Generation

Between men and brutes, there is another very specific quality which distinguishes them, and which will admit of no dispute. This is the faculty of self-improvement... perfectibility... It would be melancholy, were we forced to admit that this distinctive and almost unlimited faculty is the source of all human misfortunes; that it is this which, in time, draws man out of his original state, in which he would have spent his days insensibly in peace and innocence; that it is this faculty, which, successively producing in different ages his discoveries and his errors, his vices and his virtues, makes him at length a tyrant both over himself and over nature. 

- The Social Contract and Discourses, Jean-Jacques Rousseau

An entrepreneur I'm working with on an adtech company asked me recently "does any of this make any difference?" It's a good question.

Here's something you probably didn't know about me: when I ran venture capital for the world's largest advertising agency holding company back in the '90s, I refused to invest in internet advertising companies*. I did not think banner advertising was useful. I have not come so very far from that view.

* * * * *

There is a sometimes infuriating disdain of advertising among those who wear Northface and Converse, drink Starbucks and Horizon Organic milk, and find out about the farmers' market from drop cards in the local organic grocery store. But that they can hate advertising while being avid consumers of it isn't irrational, because advertising has two faces.

Before World War I in America, a belief in perfectibility was widespread.  Not just human perfectibility, but technological. Businessmen created and grew businesses based on a belief in perfectibility. All success required was creating the best product at a fair price, driving competitors out of business and cementing a permanent monopoly, all for the betterment of society. Competition, to people like Henry Ford and Theodore Vail, was a waste of resources. Creative destruction would have seemed like madness.

In this no-nonsense model, advertising was product news, an attitude typified by the Bates agency in New York in 1904, who viewed anything more as "bad copy--too literary and too general, lacking prices and good information." John E. Kennedy, the head copywriter for Lord & Thomas in those years thought that "instead of general claims, pretty pictures, or jingles... an ad should offer a concrete reason why the product is worth buying."  One of the students of this method said this method of copywriting "aimed at an appeal to reason and intelligence rather than the time-honored assumption that the public was a mass of dumb, driven sheep, who could be swayed with mere picture-and-catch words."**

This approach, though it was itself a reaction to an earlier character-and-jingles driven approach (Aunt Jemima, the Uneeda slicker boy and the Arrow Shirt man were all products of this earlier approach) finds its intellectual rationalization in the Chicago School. George Stigler described it: advertising provides information to buyers, allowing them to make better choices.  Because the Chicago school believed that economic actors were rational, and that economic activity must have some underlying sense, this was the only coherent explanation... even if the facts on the ground at the time did not bear it out (Stigler published his seminal Economics of Information [pdf] in 1961.)

By that time, advertising had changed. Many times. The War to End All Wars itself may have been the catalyst. At the beginning of the conflict, fact-based ads played well to a righteous population. But later, when war-weariness had taken hold, patriotic advertising showed that appealing to the emotions may be even more powerful, especially when the facts aren't all that pretty. Advertising can persuade. Posters of Uncle Sam pointing his finger and saying "I Want YOU for U.S. Army" worked.

But the creator of that image, James Montgomery Flagg, had misgivings: "A number of us who were too old or too scared to fight prostituted our talents by making posters inciting a large mob of young men who had never done anything to us, to hop over and get shot at... We sold the war to youth."***  These are the poles advertising swings between: providing information so people can make better decisions about which products to buy, and persuading people to do things they might otherwise not have done. This is why people can hate advertising while listening to it closely, both of these approaches are at work, sometimes in the same ad.

The carnage of WWI had another effect: the idea of perfectibility itself fell out of favor. There was no one after that war that could still believe that those in power were infallible or even that doing the right things leads to the right outcomes. A belief in the universal power of reason now had a powerful enemy in American culture: pluralism. I'd argue that the battle between openness and control that we see happening to the internet now (cf. Google v. Apple) is a battle between perfectibility and pluralism, between one person knowing what is best and the belief that progress proceeds from chaos.

* * * * *

Productivity growth has made our lives enormously better. And it is one of the keys to making the lives of our offspring better than ours. If there is one guiding principle in my work, it is trying to help nurture innovations that create productivity growth.

Productivity is not just doing more with ourselves, it's also preventing waste, and guiding resources to their best use. This last is what Hayek called "the economic problem." Hayek said that the solution was the price system, the "invisible hand" that put resources where they are needed. This is an astonishing insight, but it falls short. Hayek, I have to assume, never bought a car.

The price system may be the best way to make sense of decentralized knowledge when the resource being apportioned is tin, as in Hayek's example. But when we go to buy a car, we have many choices at any given price point. The cars, although similar in most regards, are different, and we can't choose on price alone. Choosing the car that is best for us requires more information. Some of this information (mpg, how it looks) we can find out ourselves, if we know to look. But in many cases putting the onus on the potential consumer to discover all possible choices is inefficient. When looking for a place to buy produce, I will not know to look for the farmers' market that I do not know exists. Advertising is key here.

I believe that after an efficient price system, an efficient matching of people with the provider of a product or service that is most appropriate to them is the economic problem.  When Jeff Hammerbacher laments that "The best minds of my generation are thinking about how to make people click ads," I think he's falling for a technocratic idea long discredited, one that only engineers still believe: perfectibility.  Jeff is young, and very smart. He may believe that there is a single best product or service in each category that can be found using the appropriate Google search. And perhaps he believes that he himself should be the person who can decide what people really want, as Theodore Vail did, or Henry Ford tried to do, or Steve Jobs tries to do. Because if he didn't believe in his own omniscience, and if he personally would prefer not to have some other person making his choices for him, then he would have to agree that each person needs information to make the right choices for themselves. In that case, if I put an ad in front of someone, and that person decides to click it, then I must be solving a very difficult problem indeed.

Getting a click means that you have shown the clicker something valuable to them. If you don't believe in perfectibility--in making peoples' choices for them--then the click is a win.

* * * * *

I make a sharp distinction in my ad-tech investing between better matching and persuasion.  I only invest in the former (although sharp lines can not always be drawn.) The data-driven media buying and ad placement companies that are a large part of my portfolio are all clearly aimed at putting the appropriate information in front of the right person****.  I see companies that I think will be successful persuaders, but I don't invest in these; they make me uneasy. I suppose you could say that I'm not very businesslike in that regard, that I don't appreciate the art of selling, that I don't appreciate the art of advertising, that I don't appreciate the cultural value of advertising, that I don't have a sense of humor. I guess that's all true.  But, in my opinion, the companies that make the biggest difference to their customers are the ones that make their lives better.  While I recognize that the customer of the ad-tech company is the advertiser, not the potential consumer, and that the advertiser's life is certainly better if it sells more product, I'm not buying it. While being once-removed from treating the consumer like a mark may ameliorate the ethical considerations, it does not make it good business, not in the long-term.

[Edit, five hours later: I will revise something I wrote forever. So, on the blog, I try to finish and then hit publish. This time, as soon as I did, I realized I had not closed the loop on the argument.

Here's my point: if you believe in perfectibility, that your product is the best one for everybody, you probably also believe that all you need to do is buy mass media ads telling everybody about the existence of your better mousetrap. If you have lost the belief in the perfect, then you will feel the need to compete for the attention of people on other than the facts, because the facts don't differentiate you. Competing on facts is better for society, and for the regular person who sees ads.

The people who are thinking about how to get people to click on ads are of two types: those who just want you to click on the ad, and those who want to put an ad in front of you that would be valuable for you to click on. Saying that the latter is somehow of ephemeral benefit is misunderstanding what is economically worthwhile. By matching the right ad to the right person, we can provide information even while allowing everyone to have their own individual tastes.]

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* OK, that deserves some caveats.  I did invest in an ad network... two weeks before their IPO. I sold in the IPO. There was free money like that in 1999. I also heavily invested in the interactive agencies but, and this is my point, none of them would stand for being characterized as purveyors of advertising or, in many cases, any sort of marketing at all. Jeff Dachis' infamous difficulty in describing what Razorfish did on 60 Minutes being a case in point. It wasn't until Agency.com acquired iTraffic that any of the companies I worked with became involved with display advertising in any meaningful way.
** The Mirror Makers: A History of American Advertising and Its Creators, pp. 49-51.
*** Ibid, p.76.
**** While these technologies can also be used to put a persuasive ad in front of the person most liable to be persuaded, I don't think this use provides as much lift, and I hope it will be squeezed out.