Oculus

I’ve seen a handful of technology demos in my life that made me feel like I was glimpsing into the future. The best ones were: the Apple II, the Macintosh, Netscape, Google, the iPhone, and – most recently – the Oculus Rift.

Virtual reality has long been a staple of science fiction. In real life, however, attempts to create virtual reality have consistently disappointed. Oculus was founded on the contrarian belief that the right people at the right time could finally deliver on the science fiction promise. Hardware components had become sufficiently powerful and inexpensive, and the pioneering engineers who invented 3D gaming were eager to explore a new frontier.

Last year, my partner Gil Shafir and I spent time studying Oculus and virtual reality technology more generally. The more we learned, the more we became convinced that virtual reality would become central to the next great wave of computing. We were therefore thrilled when we got the chance to invest in Oculus later on.

Today, Facebook announced that they are acquiring Oculus. Facebook’s support will dramatically accelerate the development of the virtual reality ecosystem. While we are sad to no longer be working with Oculus, we are very happy to see virtual reality receive the support it deserves.

I can’t say enough about the Oculus team. Palmer, Brendan, John, Nate, and the rest of the team are true technology visionaries. They’ve assembled an incredible group of creative technologists from diverse fields. It was awesome tagging along for the ride, and I can’t wait to see what they do at Facebook.

Facebook’s embedded option

The best way to think of Facebook’s stock is as the sum of two businesses: the existing display ad businesses, and a probability-weighted option on a new line of business. This is how Wall Street views it. For example, here is a section of a recent Goldman Sachs analyst report on Facebook:

Optionality not in the model: further potential upside

While not in our model, as [Facebook] has not publicly expressed pursuit of these areas, we believe there are three obvious opportunities that the company could leverage its platform to capitalize on:

– Developing an external ad network

– Monetizing paid search

– Entering China

Of the three options, search is clearly the most interesting. An external ad network is inevitable. Google proved this model with Adsense. With an already huge base of advertisers bidding on CPCs, it is impossible for most other ad networks to compete on publisher payouts. But Facebook’s traffic is so great now that an external ad network might increase their revenues by 2x or so. The same goes for entering China. They might get another half a billion users who monetize at lower ad rates than US users. Neither move would put them in Google’s revenue range. They need a better business model for that. The only (known) models that deliver RPMs high enough to compete with Google are search, payments, and e-commerce.

At TechCrunch Disrupt last week, Mark Zuckerberg talked about possibly entering the search business. Investors had been concerned that maybe Zuckerberg really meant what he said in his IPO letter – that he just didn’t care that much about making money. By expressing an interest in search, Zuckerberg signaled that he understood Facebook’s immensely valuable embedded option and was thinking about ways to exercise it.

 

Ten million users is the new one million users

Entrepreneurs and investors have been enamored with consumer internet startups for the last few years. But there are signs this is ending.

Some observations:

– Thousands of early-stage consumer web/mobile companies were started and funded in last 24 months.

– There are only a few dozen VCs who actively write consumer Series A checks, and those VCs will only do a few deals a year.

– Facebook’s market cap is about half of what most tech investors expected before the IPO.

– A few breakout early-stage consumer hits (Instagram, Pinterest) have reached tens of millions of users in record time.

– Internet users have tens of thousands of services/apps to choose from but limited time and attention.

Some consequences:

– For consumer startups with non-transactional models (ad-based or unknown business models), you need something closer to 10 million users versus 1 million users to get Series A funded.

– For consumer startups with transactional models, e.g. e-commerce, the number of users required is often far lower because revenue is the more important metric. Hence, many early-stage consumer startups are switching to transactional models.

– It’s becoming increasingly common for early-stage consumer startups to do bridge financings (raising more money from past investors, usually on terms similar to the prior round) instead of Series As.

– VCs are increasingly focusing on B2B for early-stage investments.

– There will be a lot more consumer talent acquisitions.

Some advice:

– If you are thinking of starting a non-transactional consumer startup, be aware that you are entering what is perhaps the most competitive sector in tech in the last decade.

– If you can raise more money, do it. (Especially pre-launch: remember, there’s nothing like numbers to screw up a good story).

– Be prepared for lower valuations for non-transactional early-stage consumer startups (breakout later-stage companies, on the other hand, will likely continue to command high valuations).

Some thoughts on when to raise money, and the current financing environment

A key question for founders is when they should try to raise money. More specifically, they often wonder whether to raise money now or wait, say, 6 months when their startup has made more progress. Here are some thoughts on this question generally along with some thoughts on today’s venture financing market.

– In the private markets, macro tends to dominate micro. Venture valuations have swung by roughly a factor of 4 over the last decade. In finance speak, venture tends to be high beta, moving as a multiple of the public markets, which themselves tend to move more dramatically than economic fundamentals. Hence, it is easy to imagine scenarios where the same private company will command 1/2 the valuation in 6 months due to macro events, but it’s rare for a company to increase their valuation 2x through operations alone in 6 months.

– Therefore, when it seems to be the top of a venture cycle, it’s almost always better to raise money sooner rather than later, unless you have a plausible story about how waiting will dramatically improve your company’s fundamentals.

– Prior to the Facebook IPO, the consensus seemed to be that private valuations were near the top of the cycle. Today, FB is valued at up to 50% below what private investors expected. Moreover, the financial crisis in Europe seems to have worsened, and unemployment numbers in the US suggest the possibility of a double dip recession.

– It takes many months to understand how macroeconomic and public market shifts affect private company valuations since (with the exception of secondary markets) private transactions happen slowly. So we don’t know yet what these recent events mean for private markets. According to a basic rule of finance, however, it is safe to assume that companies “comparable” to Facebook are worth up to 50% less than private investors thought they were worth a few weeks ago.

– The question then is what companies are comparable to Facebook. Clearly, other social media companies with business models that rely on display or feed based advertising are comparables. Internet companies that have other business models (freemium, marketplaces, commerce, hardware, enterprise software, direct response advertising, etc) are probably not comparables. The public markets seems to agree with this. Defensible companies with non-display-ad business models have maintained healthy public market valuations.

– One counterargument to the “all social media companies are now worth less” argument is the discrepency between how the smart Wall Street money and smart internet money views Facebook and social media companies generally. The smart Wall Street money thinks like Mary Meeker’s charts. They draw lines through dots and extrapoloate. This method would have worked very poorly in the past for trying to value tech companies at key inflection points (and tech investors know that what matters are exactly those inflection points). In Facebook’s case, Wall Street types look at revenue and margin growth and the trend toward mobile where monetization is considerably worse (for now). Smart internet investors, by contrast, look at Facebook in terms of its power and capabilities. They see a company that is rivaled only by Google and Apple in terms of their control of where users go and what they do on the internet. Smart internet investors are far more bullish than smart Wall Street investors on Facebook. Thus if you believe the internet perspective over the Wall Street perspective, you’d likely believe that Facebook and social media in general is undervalued by the public markets.

 

Is it a tech bubble?

Every week a “we are in a tech bubble” article seems to come out in a major newspaper or blog. People who argue we aren’t in a bubble are casually dismissed as promoting their own interests. I’d argue the situation is far more nuanced and that people who engage in this debate should consider the following:

1) Public tech companies: Anyone with a basic understanding of finance would have trouble arguing many large public tech companies are trading at “bubble valuations” – e.g. Apple (14 P/E), Google (18 P/E), eBay (16 P/E), Yahoo (17 P/E). You could certainly debate other public tech stock valuations (there are a number of companies that recently IPOd that many reasonable people think are overvalued), but on a market-cap weighted average the tech sector is trading at a very reasonable 17 P/E.

2) Instagram seems to be the case study du jour for people arguing we are in a bubble. Reasonable people could disagree about Instagram’s exit price but in order to argue the price was too high you need to argue that either: 1) Facebook is overvalued at its expected IPO valuation of roughly $100B, 2) it was irrational for Facebook to spend 1% of its market cap to own what many people considered one of Facebook’s biggest threats (including Mark Zuckerberg – who I tend to think knows what is good for Facebook better than pundits).

3) Certain stages of venture valuations do seem on average over-valued, in particular seed-stage valuations and (less obviously) later-stage “momentum valuations.” The high seed-stage valuations are driven by an influx of angel/seed investors (successful entrepreneurs/tech company employees, VC’s with seed funds, non-tech people who are chasing trends). The momentum-stage valuations are driven by a variety of things, including VC’s who want to be associated with marquee startup names, the desire to catch the next Facebook before it gets too big, and the desire of mega-sized VC funds to “put more money to work”.

4) Certain stages – most notably the Series A – seem under valued. Many good companies are having trouble raising Series As and the valuations I’ve seen for the ones who do have been pretty reasonable. Unfortunately, since the financials and valuations of these companies aren’t disclosed, it is very difficult to have a public debate on this topic. But many investors I know are moving from seed to Series A precisely because they agree with this claim.

5) No one can predict macro trends. The bear case includes: something bad happens to the economy (Euro collapses, US enters double dip recession). The warning sign here will be a drop in profits by marquee tech companies.  The bull case includes: economy is ok or improves, and tech continues to eat into other industries (the “software is eating the world” argument). Anyone who claims to know what will happen over the next 3 years at the macro level is blowing hot air. That’s why smart investors continue investing at a regular pace through ups and downs.

6) The argument that sometimes startups get better valuations without revenue is somewhat true. As Josh Koppelman said “There’s nothing like numbers to screw up a good story.” This is driven by the psychology of venture investors who are sometimes able to justify a higher price to “buy the dream” than the same price to “buy the numbers.” This doesn’t mean the investors think they will invest and then get some greater fool to invest in the company again. For instance, at the seed stage, intelligent investors are quite aware that they are buying the dream but will need to have numbers to raise a Series A.

7) No good venture investors invest in companies with the primary strategy being to flip them. This isn’t because they are altruistic – it is because it is a bad strategy. You are much better off investing in companies that have a good chance to build a big business. This creates many more options including the option to sell the company. Acquisitions depend heavily on the whims of acquirers and no good venture investors bet on that.