Chris Dixon

Anyone who has pitched VCs knows they are obsessed with market size.  If you can’t make the case that you’re addressing a possible billion dollar market, you’ll have difficulty getting VCs to invest. (Smaller, venture-style investors like angels and seed funds also prioritize market size but are usually more flexible – they’ll often invest when the market is “only” ~$100M).  This is perfectly rational since VC returns tend to be driven by a few big hits in big markets.

For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this. Bad VCs don’t, and waste time on things like interviewing potential customers and building spreadsheets that estimate market size from the bottom-up.

The only way to understand and predict large new markets is through narratives. Some popular current narratives include: people are spending more and more time online and somehow brand advertisers will find a way to effectively influence them; social link sharing is becoming an increasingly significant source of website traffic and somehow will be monetized; mobile devices are becoming powerful enough to replace laptops for most tasks and will unleash a flood of new applications and business models.

As an entrepreneur, you shouldn’t raise VC unless you truly believe a narrative where your company is a billion dollar business. But deploying narratives is also an important tactic. VCs are financiers — quantitative analysis is their home turf. If you are arguing market size with a VC using a spreadsheet, you’ve already lost the debate.

From far away, things that are very different look alike. I grew up in a family of musicians and English professors. To them, the entire financial industry seemed corrupt. When I worked in finance – first on Wall Street and then in venture capital – I saw that the reality was much more nuanced. Some finance is productive and useful and some is corrupt and parasitic.

Most financial markets start out with a productive purpose. Derivatives like futures and options started out as a way for companies to reduce risk in non-core areas, for example for airlines to hedge their exposure to oil prices and transnationals to hedge their exposure to currency fluctuations. The sellers of these derivatives were aggregators who pooled risk, much like insurance companies do. The overall effect was a net reduction in risk to our economy without hampering growth and returns.

Then speculators entered the market, creating more complicated derivative products and betting with borrowed money.  This was defended as a way to increase liquidity and efficiency. But it came at the cost of making the system more complicated and susceptible to abuse. Worst of all, these so-called innovations increased the overall risk to the system, something we saw quite vividly during the recent financial crisis.

Venture capital is a shining example of capitalism just like Adam Smith pictured it, where private vice really does lead to public virtue.  Consider, for example, two of the largest areas of venture investment: biotech and cleantech.  Here we see the best and brightest – top science graduates from places like MIT and Stanford – devoting their lives to curing cancer and developing new energy sources.  These students may be motivated by good will, but need not be, since they will also get rich if they succeed.

A strong case can be made that the financial industry needs significantly more regulation, particularly around big banks and derivatives markets. But it would be a tragic mistake to create regulations that hinder angel investing and venture capital.  From the outside, VC and Wall Street might appear similar, but the closer you get, the more you understand how different they really are.

Suppose there is a pre-profitable company that is raising venture financing. Simple, classical economic models would predict that although there might be multiple VCs interested in investing, at the end of the financing process the valuation will rise to the clearing price where the demand for the company’s stock equals the supply (amount being issued).

Actual venture financings work nothing like this simple model would predict.  In practice, the equilibrium states for venture financings are: 1) significantly oversubscribed at too low a valuation, or 2) significantly undersubscribed at too high a valuation.

Why do venture markets function this way?  Pricing in any market is a function of the information available to investors. In the public stock markets, for example, the primary information inputs are “hard metrics” like company financials, industry dynamics, and general economic conditions. What makes venture pricing special is that there are so few hard metrics to rely on, hence one of the primary valuation inputs is what other investors think about the company.

This investor signaling has a huge effect on venture financing dynamics. If Sequoia wants to invest, so will every other investor.  If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.

Part of this is the so-called herd mentality for which VC’s often get ridiculed. But a lot of it is very rational. When you invest in early-stage companies you are forced to rely on very little information. Maybe you’ve used the product and spent a dozen hours with management, but that’s often about it. The signals from other investors who have access to information you don’t is an extremely valuable input.

Smart entrepreneurs manage the investor signaling effect by following rules like:

- Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides space and mentoring.  If a big VC has any involvement with your company at the seed stage, their posture toward the next round has such strong signaling power that they can kill you and/or control the pricing of the round.

- Don’t try to be clever and get an auction going (and don’t shop your term sheet). If you do, once the price gets to the point where only one investor remains, that investor will look left and right and see no one there and might get cold feet and leave you with no deal at all. Save the auction for when you get acquired or IPO.

- Don’t be perceived as being “on the market” too long.  Once you’ve pitched your first investor, the clock starts ticking. Word gets around quickly that you are out raising money. After a month or two, if you don’t have strong interest, you risk being perceived as damaged goods.

- If you get a great investor to lead a follow-on round, expect your existing investors to want to invest pro-rata or more, even if they previously indicated otherwise.  This often creates complicated situations because the new investor usually has minimum ownership thresholds (15-20%) and combining this with pro-rata for existing investors usually means raising far more money than the company needs.

Lastly, be very careful not to try to stimulate investor interest by overstating the interest of other investors. It’s a very small community and seed investors talk to each other all the time. If you are perceived to be overstating interest, you can lose credibility very quickly.

I’ve written a few times about what seems to be an exploding tech scene in NYC.  This is sometimes interpreted as arguing that NYC is a better place to start a company than the Valley. Most recently, Matt Mireles seems to be addressing people like me with his critique of the NYC startup scene (he makes some good points as does Caterina Fake in her response).

I’ve never meant my arguments to be about where it is better to start a company. California is a phenomenal place to start a tech company. NYC is a great place as well. (Note to Matt – it’s hard for first time founders everywhere). To me, the important question isn’t which place is better, but rather how we import the things that make the Valley great into NYC. As I said last year:

New York City has many of the same strengths as Silicon Valley – merit-driven capitalism, the embrace of newcomers and particularly immigrants, and a consistent willingness to reinvent itself.   Silicon Valley will always be the mecca of technology, but now that people here are getting back to, as Obama says, making things, New York City has a shot at becoming relevant again in the tech world.

I spent the past week in California and had the honor of meeting some legendary venture investors. I was deeply impressed: they are legends for a reason. Of course, they are incredibly smart and hard working and all of that, but most impressively, it was clear that they truly believe in making big bets on ambitious, seemingly wacky ideas to try to change the world. Every VC has this rhetoric on their website, but – at least in my experience – most just want to make incremental money on incremental technologies. (Side note: I noticed that the more powerful the VC, the more likely they were to pay close attention, show up on time, and not bring phones/computers into meetings.  I guess when you are changing the world, emails can wait an hour for a response).

California should be NYC’s role model and ally. The enemy should be people and institutions who make money but don’t actually create anything useful. In NYC, this mostly means Wall Street, along with the Wall Street mindset that sometimes infects East Coast VC’s (emphasis on financial engineering, needing to see metrics & “traction” vs betting on people and ideas, etc).

Matt should do what’s best for his company. God knows it’s hard enough doing a startup – you don’t need to carry the weight of reinvigorating a region on your back as well. That might mean moving to California. Meanwhile, forward-thinking investors and founders in NYC will continue trying to make things that change the world – in other words, trying to make NYC more like the Valley.

VC returns over the last decade have been poor. The cause is widely agreed to be an excess of venture capital dollars to worthy startups. Observers seem to universally assume that the solution is for the VC industry to downsize.

For example, Fred Wilson says about VC:

You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage…. I think “back to the future” is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits

Similarly, Bill Gurley writes:

There are many reasons to believe that a reduction in the size of the VC industry will be healthy for the industry overall and should lead to above average returns in the future.

All of these analyses start with the assumption that aggregate venture-backed exits (acquisition and IPOs) will remain roughly constant. I don’t see why we need to accept that assumption. The aggregate value of venture-backed startups, like all valuations, is a function of profits generated (or predicted to be generated). In technology, profits are driven by innovation. I don’t see any reason we should assume venture-backed innovation can’t be dramatically increased.

For example, innovation has varied widely across times and places – the most innovative region in the world for the last 50 years being Silicon Valley. What if, say, Steve Jobs hadn’t grown up in Silicon Valley? What if he had gone to work for another company? Does anyone really think Apple – and all the innovation and wealth it created – would exist if Jobs hadn’t happened to grow up in a culture that was so startup friendly? Jobs is obviously a remarkable person, but there are probably 100 Steve Jobs born every year. The vast majority just never have a chance or give a thought to starting a revolutionary new company.

Some people blame our education system, or assume that there is some fixed number of entrepreneurs born every year. I think the problem is cultural. As much as we like to think of our culture as being entrepreneurial, the reality is 99% of our top talent doesn’t seriously contemplate starting companies. Colleges crank out tons of extremely smart and well-educated kids every year. The vast majority go into “administrative” careers that don’t really produce anything – law, banking and consulting. Most of the rest join big companies. As I’ve argued many times before, big companies (with a few notable exceptions) aren’t nearly as successful as startups at creating new products.  The bigger the company, the more likely it suffers from agency issues, strategy taxes, and myopia. But most of all: nothing is more motivating and inspiring than the sense of ownership and self-direction only a startup can provide.

Whenever I see a brilliant kid decide to join Goldman Sachs, McKinsey, or Google, I think to myself: a startup just died, and as a result our world is a little less wealthy, innovative, and interesting.

Venture capital term sheets are not legally binding (except certain subclauses like confidentiality and no-shop provisions). That said, there is a well-established norm that VC’s don’t back out of signed term sheets unless they discover something really, really bad – fraud, criminal backgrounds of founders etc. The best VC in the world, Sequoia Capital, whose companies account for an astounding 10% of NASDAQ’s market cap, has (according to trustworthy sources) only backed out on one term sheet in the last 10 years.

Yesterday, one of the 40 or so startups I’ve invested in (either personally or through Founder Collective) had a well-known VC back out of a term sheet for no particular reason besides that they decided they no longer liked the business concept. It’s the first time I’ve seen this happen in my career.

In later stage private equity (leveraged buyouts and such) it is a common trick to “backload diligence” – you give the company a quick, high-valuation term sheet, which then locks the company in (the no-shop clause prohibits them from talking to other investors for 30 days or more). Then the firm does their diligence, finds things to complain about and negotiates the price down or walks away. If they walk away, the company is often considered “damaged goods” by other investors who wonder what the investor discovered in diligence. This gives the investor a ton of negotiating leverage. In later stage private equity, this nasty tactic can work repeatedly since the companies they are buying (e.g. a midwestern auto parts manufacturer) are generally not part of a tight knit community where investment firms depend heavily on their reputation.

I learned the basics of VC when I apprenticed under Jeremy Levine and Rob Stavis at Bessemer.  It was at Bessemer that I learned you never back out on a term sheet except in cases of fraud etc. I never saw them back out on one nor have I heard of them doing so. In fact, I remember one case where Rob signed a term sheet and while the final deal documents were being prepared (which usually takes about a month), the company underperformed expectations. The CEO asked Rob if he was going to try to renegotiate the valuation down. Rob said, “Well, if you performed better than expected I don’t think you would try to renegotiate the valuation up, so why should I renegotiate when you performed worse than expected.” That’s how high quality investors behave.

Besides simply acting ethically, firms like Sequoia and Bessemer are acting in their own interest: the early-stage tech community is very small and your reputation is everything. Word travels fast when firms trick entrepreneurs. What happened yesterday was not only evil but will also come back to haunt the firm that did it.

Howard Lindzon was nice enough to have me on his Stocktwits.tv show recently.  For those who don’t know Howard, he writes a fantastic blog. He writes in such an irreverent way it’s easy to overlook the wisdom behind what he says. My favorite recent Howard-ism was, talking about investing, “I like to look outside and see my [investments].” I take this to mean he likes to invest in things he understands, can touch, go visit, etc. This is probably the single best piece of advice in order to have survived the recent financial crisis. Fancy things like CDOs, Auction-Rate Securities, etc turned out to function much differently than advertised. Diversification across asset classes (CAPM etc) turned out to be useless: when things got bad, correlations went to 1. One reason I like investing in startups is you can go visit them – they are something tangible and understandable.

Howard is also the founder of Stocktwits. Stocktwits is potentially genuinely disruptive in that it dis-intermediates Wall Street. It is one of those things that some people think is a toy now but could end up being the next big thing.

Anyways, here’s the interview:

The pace of innovation in the New York area is very impressive right now. Some of the top entrepenuers in the country are building and scaling companies in the NY ecosystem - Ron Conway, yesterday in an email to me (published with his permission)

With the announcement of Roger Ehrenberg’s new fund – IA Venture Strategies – NYC now has another top-tier seed fund.  I’ve had the pleasure of investing with Roger a number of times. He’s not only a great investor but also a huge help to the companies he invests in. It’s great that he’s going to be even more active and I hope to work with him a lot more in the future.

The NYC tech scene is exploding. There are tons of interesting startups. I’m an investor in a bunch and started one (Hunch) so won’t even try to enumerate them as any list will be extremely biased (other people have tried). I will say that one interesting thing happening is the types of startups are diversifying beyond media (HuffPo, Gawker) to more “California-style” startups (Foursquare, Boxee, Hunch).

In terms of investors, NYC now has a number of seed investors / micro-VCs:  IA Capital Partners, Betaworks, and Founder Collective (FC – which I am part of – has made 7 seed investments in NYC since we started last year).  The god of seed investing, Ron Conway, who I quote up top, has recently decided to become extremely active in NYC. One of the nice things about having small funds is we don’t need to invest millions of dollar per round so we all frequently invest together.

NYC also has mid sized funds like Union Square (in my opinion and a lot of people in the industry they have surpassed Sequoia as the best VC in the country).  We also have First Round, who very smartly hired the excellent Charlie (“Chris”) O’Donnell as their NYC guy.

Then we have the big VCs who have also been increasing their activity in NYC.  Locally, we have Bessemer (Skype, LinkedIn, Yelp) and RRE.  Boston firms that are very active and positive influences here include: Polaris (Dog Patch Labs), Spark, Matrix, General Catalyst, and Flybridge. Finally, some excellent California firms like True Ventures have made NYC their second home.

The one thing we really need to complete the ecosystem is a couple of runaway succesesses. As California has seen with Paypal, Google, Facebook etc, the big successes spawn all sorts of interesting new startups when employees leave and start new companies. They also set an example for younger entrepreneurs who, say, start a social networking site at Harvard and then decide to move.

Over the last decade or two, the supply of venture capital dollars has increased dramatically at the same time as the cost of building tech startups has sharply decreased.  As a result, the balance of power between capital and startups has shifted dramatically.

Some VCs understand this. The ones that do try to stand out by, among other things, 1) going out and finding companies instead of expecting them to come to them, 2) working hard on behalf of existing investments to establish a good reputation, and 3) just being friendly, decent people.  Believe it or not, until recently, #3 was pretty rare.

As a seed investor in about 30 companies, I’ve been part of many discussions with entrepreneurs about which VC’s they want to pitch for their next financing round.  More and more, I’ve heard entrepreneurs say something like “I don’t want to talk to that firm because they are such jerks.” In almost all cases these are well-known, older firms who come from the era when capital was scarce.

Every experienced entrepreneur I know has a list of “toxic” VCs they won’t deal with. (Often because of horror stories like the “partner ambush“). There are so many VCs out there that you can do this and still have plenty of VCs to pitch to get a fair price for your company and only deal with decent, helpful investors. It sounds kind of crazy, but being a reasonably nice person has become a competitive advantage in venture capital.

Almost every startup has big companies (“incumbents”) that are at some point potential acquirers or competitors.  For internet startups that primarily means Google and Microsoft, and to a far lesser extent Yahoo and AOL.  (And likely more and more Apple, Facebook and even Twitter?).

The first thing to try to figure out is whether what you are building will eventually be on the incumbent’s product roadmap. The best way to do predict this is to figure out whether what you are doing is strategic for the company. (I try to outline what I think is strategic for Google here). Note that asking people who work at the incumbents isn’t very useful – even they don’t know what will be important to them in, say, two years.

If what you are doing is strategic for the incumbents, be prepared for them to enter the market at some point. This could be good for you if you build a great product, recruit a great team, and are happy with a “product sale” or “trade sale” – usually sub $50M. If you are going for this size outcome, you should plan your financing strategy appropriately. Trade sales are generally great for bootstrapped or seed-funded companies but bad if you have raised lots of VC money.

If your product is strategic for the incumbent and you’re shooting for a bigger outcome, you probably need to either 1) be far enough ahead of the curve that by the time the big guys get there you’re already entrenched, or 2) be doing something the big guys aren’t good at. Google has been good at a surprising number of things. One important area they haven’t been good at (yet) is software with a social component (Google Video vs YouTube, Orkut vs Facebook, Knol vs Wikipedia, etc).

The final question to ask is whether your product is disruptive or sustaining (in the Christensen sense).  If it’s disruptive, you most likely will go unnoticed by the incumbents for a long time (because it will look like a toy to them). If the your technology is sustaining and you get noticed early you probably want to try to sell (and if you can’t, pivot). My last company, SiteAdvisor, was very much a sustaining technology, and the big guys literally told us if we didn’t sell they’d build it. In that case, the gig is up and you gotta sell.