Peter Thiel’s CS183 @ Stanford: Startup—Venture Capital and You

I.  Venture Capital and You

Many people who start businesses never deal with venture capitalists. Founders who do interact with VCs don’t necessarily do that early on. First you get your founders together and get working. Then maybe you get friends, family, or angels to invest. If you do end up needing to raise a larger amount of capital, you need to know how VC works. Understanding how VCs think about money—or, in some cases, how they don’t think about it and thus lose it—is important.

VC started in late 1940s. Before that, wealthy individuals and families were investing in new ventures quite frequently. But the idea of pooling funds that professionals would invest in early stage companies was a product of the ‘40s. The Sand Hill road, Silicon Valley version came in the late 1960s, with Sequoia, Kleiner Perkins, and Mayfield leading the field.

Venture basically works like this:  you pool a bunch of money that you get from people called limited partners. Then you take money from that pool and invest it in portfolio companies that you think are promising. Hopefully those companies become more valuable over time and everybody makes money. So VCs have the dual role of encouraging LPs to give them money and then finding (hopefully) successful companies to back.

Most of the profits go back to LPs as returns on their investment. VCs, of course, take a cut. The typical model is called 2-and-20, which means that the VC firm charges an annual management fee of 2% of the fund and then gets 20% of the gains beyond the original investment. The 2% management fee is theoretically just enough to allow the VC firm to continue to operate. In practice, it can end up being a lot more than that; a $200m fund would earn $4m in management fees under a 2-and-20 structure. But it’s certainly true that the real payout that VCs look for come with the 20% cut of the gains, which is called the carry.

VC funds last for several years, because it usually takes years for the companies you invest in to grow in value. Many of the investments in a given fund either don’t make money or go to zero. But the idea is that the companies that do well get you all your money back and then some; you end up with more money in the fund at the end than LPs put in to begin with.

There are many dimensions to being a good VC. You have to be skilled at coming up with reasonable valuations, identifying great entrepreneurs, etc. But there’s one dimension that is particularly important, yet surprisingly poorly understood. It is far and away the most important structural element of venture capital: exponential power. This may seem odd because it’s just basic math. But just as 3rdgrade arithmetic—knowing not just how many shares you get, but dividing that by the shares outstanding—was crucial to understand equity, 7th grade math—understanding exponents—is necessary to understand VC.

The standard Einstein line on this is that the most powerful force in universe is compound interest. We see the power of compounding when companies grow virally. Successful businesses tend to have an exponential arc to them. Maybe they grow at 50% a year and it compounds for a number of years. It could be more or less dramatic than that. But that model—some substantial period of exponential growth—is the core of any successful tech company. And during that exponential period, valuations tend to go up exponentially.

So consider a prototypical successful venture fund. A number of investments go to zero over a period of time. Those tend to happen earlier rather than later. The investments that succeed do so on some sort of exponential curve. Sum it over the life of a portfolio and you get a J curve. Early investments fail. You have to pay management fees. But then the exponential growth takes place, at least in theory. Since you start out underwater, the big question is when you make it above the water line. A lot of funds never get there.

To answer that big question you have to ask another: what does the distribution of returns in venture fund look like? The naïve response is just to rank companies from best to worst according to their return in multiple of dollars invested. People tend to group investments into three buckets. The bad companies go to zero. The mediocre ones do maybe 1x, so you don’t lose much or gain much. And then the great companies do maybe 3-10x.

But that model misses the key insight that actual returns are incredibly skewed. The more a VC understands this skew pattern, the better the VC. Bad VCs tend to think the dashed line is flat, i.e. that all companies are created equal, and some just fail, spin wheels, or grow. In reality you get a power law distribution.

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An example will help clarify. If you look at Founders Fund’s 2005 fund, the best investment ended up being worth about as much as all the rest combined. And the investment in the second best company was about as valuable as number three through the rest. This same dynamic generally held true throughout the fund. This is the power law distribution in practice. To a first approximation, a VC portfolio will only make money if your best company investment ends up being worth more than your whole fund. In practice, it’s quite hard to be profitable as a VC if you don’t get to those numbers.

PayPal sold to eBay for $1.5bn. PayPal’s early stage investors had a large enough stake such that their investment was ultimately worth about the size of their fund. The rest of the fund’s portfolio didn’t do so well, so they more or less broke even riding on PayPal. But PayPal’s series B investors, despite doing quite well with the PayPal investment, didn’t break even on their fund. Like many other VC funds in the early 2000’s, theirs lost money.

That investment returns take a power law distribution leads to a few important conclusions. First, you need to remember that, management fees aside, you only get paid if you return all the money invested plus more. You have to at least hit the 100% of fund size mark. So given power law distribution, you have to ask the question: “Is there a reasonable scenario where our stake in this company will be worth more than the whole fund?”

Second is that, given a big power law distribution, you want to be fairly concentrated. If you invest in 100 companies to try and cover your bases through volume, there’s probably sloppy thinking somewhere. There just aren’t that many businesses that you can have the requisite high degree of conviction about. A better model is to invest in maybe 7 or 8 promising companies from which you think you can get a 10x return. It’s true that in theory, the math works out the same if try investing in 100 different companies that you think will bring 100x returns. But in practice that starts looking less like investing and more like buying lottery tickets.

Despite being rooted in middle school math, exponential thinking is hard. We live in a world where we normally don’t experience anything exponentially. Our general life experience is pretty linear. We vastly underestimate exponential things. If you backtest Founders Fund’s portfolios, one heuristic that’s worked shockingly well is that you should always exercise your pro rata participation rights whenever a smart VC was leading a portfolio company’s up round. Conversely, the test showed that you should never increase your investment on a flat or down round.

Why might there be such a pricing inefficiency? One intuition is that people do not believe in a power law distribution. They intuitively don’t believe that returns could be that uneven. So when you have an up round with a big increase in valuation, many or even most VCs tend to believe that the step up is too big and they will thus underprice it. The practical analogue would be to picture yourself working in a startup. You have an office. You haven’t hit the exponential growth phase yet. Then the exponential growth comes. But you might discount that change and underestimate the massive shift that has occurred simply because you’re still in the same office, and many things look the same.

Flat rounds, by contrast, should be avoided because they mean that the VCs involved believe things can’t have gotten that much worse. Flat rounds are driven by people who think they might get, say, a 2x return from an investment. But in reality, often something has gone very badly wrong—hence the flat round’s not being an up round. One shouldn’t be mechanical about this heuristic, or treat it as some immutable investment strategy. But it actually checks out pretty well, so at the very least it compels you to think about power law distribution.

Understanding exponents and power law distributions isn’t just about understanding VC. There are important personal applications too. Many things, such as key life decisions or starting businesses, also result in similar distributions. We tend to think about these things too moderately. There is a perception that some things are sort of better than other things, sometimes. But the reality is probably more extreme than that.

Not always, of course. Sometimes the straighter, perceived curve actually reflects reality quite closely. If you were to think about going to work for the Postal Service, for example, the perceived curve is probably right. What you see is what you get. And there are plenty of things like that. But it’s also true that we are, for some reason or other, basically trained to think like that. So we tend to miscalculate in places where the perceived curve does not, in fact, accurately reflect reality. The tech startup context is one of those places. The skew of distributions for tech startups is really vast.

This means that when you focus on the percentage of equity you get in a company, you need to need to add a modifier: given something like a power law distribution, where your company is on that curve can matter just as much or more than your individual equity stake.

All else equal, having 1% of a company is better than having 0.5%. But the 100themployee at Google did much better than the average venture-backed CEO did in the last decade.  The distribution is worth thinking hard about. You could spin this into argument against joining startups. But it needn’t go that far. The power law distribution simply means you have to think hard about a given company is going to fall on the curve.

The pushback to this is that the standard perception is reasonable—or at least is not unreasonable—because the actual distribution curve turns out to be random. The thesis is that you are just a lottery ticket. That is wrong. We will talk about why that is wrong later. For now, it’s enough to point out that the actual curve is a power law distribution. You don’t have to understand every detail and implication of what that means. But it’s important to get some handle on it. Even a tiny bit of understanding of this dimension is incredibly valuable.

 Peter Thiel’s CS183: Startup—Notes Essay—Follow the Money

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Fenwick & West Results: Silicon Valley Venture Capital Survey – Third Quarter 2012

The terms of venture financing for 117 companies headquartered in Silicon Valley that reported raising money in the third quarter of 2012

Overview of Fenwick & West Results

Venture financings in 3Q12 continued to show solid price increases from their prior round, but 3Q12 was not as strong as 2Q12.

  • Up rounds exceeded down rounds in 3Q12, 61% to 17%, with 22% of rounds flat. This was another strong quarter, but not as strong as 2Q12 when 74% of rounds were up, 11% down and 15% flat. This was the 13th quarter in a row in which up rounds exceeded down rounds.

Series B rounds were especially strong, with 92% of Series B rounds up, and Series E (and later) rounds were relatively weak, with only 44% up. However 64% of the Series B rounds were software and internet/digital media companies, while only 39% of the Series E rounds were from those industries, and as described below, software and internet/digital media were the strongest industries.

  • The Fenwick & West Venture Capital Barometer™ showed an average price increase of 78% in 3Q12 – again a solid result but a decrease from 99% in 2Q12. There were three financings in 3Q12 that were up over 750% (two in internet/digital media and one in hardware), and if these three were excluded the Barometer would have been up 50% rather than 78%.
  • The median price increase of financings in 3Q12 was 23%, down from 30% in 2Q12, and the lowest median price increase in the past two years.
  • The results by industry are set forth below. In general the software and internet/digital media industries continued to be the strongest, cleantech showed good results on very low volume, hardware lagged a bit and the life science industry trailed significantly.

Overview of Other Industry Data

The third quarter of 2012 was generally not a strong one for the venture industry, with the upcoming election, the looming “fiscal cliff” and global economic uncertainty perhaps weighing on investors’ minds.

  • Venture investing in the U.S. was down slightly in 3Q12 compared to 2Q12, and 2012 is on track to be below 2011.
  • M&A was down slightly in 3Q12 compared to 2Q12, and was also down slightly in the first nine months of 2Q12 compared to the first nine months of 2011.
  • The number of IPOs was down slightly both in 3Q12, compared to 2Q12, and in the first nine months of 2012 compared to the first nine months of 2011.
  • Venture fundraising in 3Q12 lagged 2Q12, but year to date fundraising in 2012 was above 2011 levels. Funding continues to be concentrated in a limited number of large funds, although less so in 3Q12 than 2Q12.
  • Venture Capital Investment.Dow Jones VentureSource (“VentureSouce”) reported that U.S. companies raised $6.92 billion in 820 venture financings in 3Q12, a 14.6% decrease in dollars and a 5% decrease in transactions from the $8.1 billion raised in 863 financings in 2Q12 (as reported in July 2012). Similarly, venture investment was down 15%, and the number of financings was down 3%, for the first nine months of 2012 compared to the first nine months of 2011.Venture capital investment in Silicon Valley was down 22% from the first nine months of 2012 ($8.2 billion) compared to the first nine months of 2011 ($10.5 billion), although the number of deals was only down 6.5%. That said, Silicon Valley received 39% of all U.S. venture investment in 3Q12.

The median amount raised in a 3Q12 financing round was $3.7 million, the lowest quarterly median amount since 1997. This result was driven in part by first round financings, whose median amount raised is on track to be $2.5 million for 2012, which would be the lowest annual amount since 1992.

The lead venture investors in 3Q12 were Google Ventures with 21 deals, Kleiner Perkins with 17, and 500 Startups and NEA with 16 each. Google Ventures recently announced that it was increasing its annual fund size from $200 million to $300 million, which will allow it to make more late stage investments (Sarah McBride, Reuters, 11/8/12).

Similar to VentureSource, the PwC/NVCA MoneyTree™ Report based on data from Thomson Reuters (the “MoneyTree Report”) reported that $6.5 billion was invested in 890 deals in 3Q12, a 7.1% decrease in dollars and a 1% decrease in transactions from the $7.0 billion raised in 898 deals in 2Q12 (as reported in July 2012). The MoneyTree Report also indicated that venture investing in 2012 is on track to be below 2011 amounts in both dollars and deal volume, and that seed stage venture investing was especially weak.

The MoneyTree Report also reported that software and internet/digital media investing remained strong in 3Q12 at $2.1 billion, but both industries declined in dollar terms from 2Q12 amounts. Life science investing, led by follow-on biotech financings, increased in dollar terms from 2Q12, but is down 19% year-to-date compared to the first nine months of 2011. Cleantech investing declined 20% in dollars compared to 2Q12, but saw an increase in the number of deals as investing in this sector appears to be shifting to smaller, less capital intensive deals.

  • Merger and Acquisitions Activity. Dow Jones reported 99 acquisitions (including buyouts) of venture-backed U.S. companies for $13 billion in 3Q12, a 10% decrease in transactions, and a 5% decrease in dollars from the 110 transactions for $13.7 billion reported in 2Q12 (as reported in July 2012). Nearly half of the companies acquired this quarter were based in California. For the first nine months of 2012, there were 314 acquisitions of venture backed companies for a total of $39.5 billion, a decrease from the 404 acquisitions for $40.6 billion in the first nine months of 2011.

Similarly, Thomson Reuters and the NVCA (“Thomson/NVCA”) reported 96 venture-backed acquisitions in 3Q12, a 6% decrease from the 102 reported in 2Q12 (as reported in July 2012). IT companies dominated the acquisition environment in 3Q12, with 70 of the 96 transactions.

  • IPO Activity.VentureSource reported 10 IPOs of U.S. venture-backed companies raising $807 million in 3Q12. This was a slight decrease from the 11 IPOs raising $7.7 billion ($6.8 billion was Facebook) in 2Q12 (as reported in July 2012).Similarly, Thomson/NVCA reported 10 IPOs raising $1.1 billion in 3Q12, compared to 11 IPOs raising $1.3 billion in 2Q12. (It appears that Thomson/NVCA includes sales by shareholders in their calculation of the amount raised). Six of the IPOs were in the IT industry, six were from companies based in California and all were from companies in the U.S. For the first nine months of 2012, there were 40 IPOs compared to 41 IPOs in the first nine months of 2011.
  • Venture Capital Fundraising. Thomson/NVCA reported that 53 U.S. venture funds raised $5.0 billion in 3Q12, a 15% decrease in dollars but a 40% increase in funds from the $5.9 billion raised by 38 funds in 2Q12 (as reported in July 2012). Fundraising for the first nine months of 2012 was $16.2 billion raised by 148 funds, a 31% increase in dollars from the $12.4 billion raised in the first nine months of 2011, but a 13% decrease in funds. The concentration of fundraising by a few large funds decreased a bit in 3Q12, where the top five funds accounted for 55% of fundraising, as compared to 2Q12 when they accounted for 80% of fundraising, but was still significant.Thomson/NVCA also reported that the number of mid-sized venture funds ($250-800 million in size) raising funds has declined significantly over the past five years, with 41 and 45 raising money in 2006 and 2007 respectively, while only 16 raised money in 2011 and only 10 raised money in the first half of 2012 (Private Markets, Mark Boslet, 10/2/12).Dow Jones reported generally similar fundraising results, finding that $4.73 billion was raised in 3Q12 (but by only 37 funds) and that fundraising for 2012 to date was $17.5 billion versus $12.7 billion in the first nine months of 2011. However Dow Jones found that 9% more funds raised money in 2012 to date compared to the same period in 2011.Venture fundraising again lagged venture investment in 3Q12 by a significant amount.
  • Developments in Non-IT Fundraising. With traditional fundraising by non-IT venture funds (e.g. life science, cleantech and hardware funds) especially challenging, some alternative funding mechanisms are appearing. This funding is often by entities, such as large corporations and governments, that have motives for investing in addition to financial return (e.g. filling product pipelines, diversifying a nation’s economy), or that have a longer time horizon.For example Thomson/NVCA has reported that corporate venture capitalists participated in 17.5% of life science financings in 2011 through the first half of 2012, up from 15.3% in the 2010/2011 time frame. Large pharmaceutical companies are also expanding their investments in, and forming closer ties with, traditional venture capitalists (Timothy Hay, VentureWire, 10/9/12). Johnson & Johnson is even creating early stage “innovation centers” in life science hubs such as San Francisco, Cambridge, London and China to improve access to early stage life science companies. (Brian Gormley, VentureWire, 9/18/12).Similarly, in the cleantech area, Broadscale Investment Network has been formed to connect large energy corporations with energy start-ups for investing and partnership purposes, and well known companies like GE and Duke Energy have paid to participate in this venture. (Yuliya Chernova, Venture Wire, 9/24/12).In sovereign investing, the Russian government backed fund of funds, RVC-USA, has committed up to $400 million to U.S. start-ups focused in medical devices, IT infrastructure, energy efficiency technologies and telecommunications. Similarly, another Russian fund, Rusnano has invested hundreds of millions in U.S. venture funds, especially those focused in the life sciences (Jonathan Shieber, LBO Wire, 9/11/12).
  • Kauffman Report on Immigrant Entrepreneurs.A recent Kauffman Report by Vivek Wadhwa concludes that the U.S. is becoming less attractive to foreign entrepreneurs. The report found that the percentage of Silicon Valley-based companies with a foreign born founder decreased from 52% over the period 1995-2005 to 43% over the period 2005-2012. Visa/immigration problems was listed as a major problem. The improvement in the entrepreneurial environment in countries outside the U.S. was also a likely factor. The report found that by far the largest number of entrepreneurial immigrants to the U.S. came from India (33%), followed by China (8.1%), the U.K. (6.3%), Canada (4.2%), Germany (3.9%), Israel (3.5%) and Russia (2.4%).
  • Accelerators and Angels.As noted above, early stage venture investing has declined recently, but the growth of early stage non- venture funding is continuing and may be offsetting this trend.For example, the number of accelerators and incubators continues to grow, with worldwide estimates ranging from 200-700. There is concern, however, about the value of some of these accelerators. A recent study by Kauffman Fellow Aziz Gilani of venture firm DFJ Mercury analyzing 29 accelerators found that 45% failed to produce even one graduate that obtained venture funding. David Cohen of Techstars has encouraged accelerators to publish their track records, so that entrepreneurs can be better informed in their selection process. A possible trend in the accelerator environment is increased specialization, with accelerators focusing on assisting entrepreneurs in a specific industry. (Tom Stein, Private Markets, 9/512; Mark Boslet, Private Markets, 10/2/12).Angel investing also continues to grow, increasing 3.1% in the first half of 2012 over the first half of 2011, with 40% of such funding going to seed and early stage companies. Jeffrey Sohl, “The Angel Investor Market in Q1/Q2 2012: A Market in Steady Recovery”, Center for Venture Research, October 10, 2012.
  • Venture Capital Return.Cambridge Associates reported that the value of its venture capital index increased by 0.61% in 2Q12 (3Q12 information has not been publicly released) compared to -5.06% for Nasdaq. The venture capital index was also slightly higher Nasdaq for the 12 month period ended June 30, 2012, 6% vs. 5.82%, but still lagged for the ten year period ending June 30, 2012, 5.28% to 7.21% per year. The Cambridge Associates venture index is net of fees, expenses and carried interest.
  • Venture Capital Sentiment.The Silicon Valley Venture Capitalist Confidence Index™ produced by Professor Mark Cannice at the University of San Francisco reported that the confidence level of Silicon Valley venture capitalists was 3.53 on a 5-point scale in 3Q12, a small increase from the 3.47 reported in 2Q12. Venture capitalists expressed concern about high valuations, macro economic uncertainty and life science funding, but felt positive about the depth and breadth of innovation in Silicon Valley, especially in the mobile, cloud and payment industries, and the availability of strategic acquirors with substantial cash holdings.
  • Nasdaq.Nasdaq increased 6.1% in 3Q12, and is flat in 4Q12 through November 8, 2012.

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Venture Capital IPO Report For Technology Companies Based In The United States – 2012,1st Half

During the first half of calendar year 2012, 30 venture capital-backed U.S. technology companies went public, raising a total of $18.6 billion in gross offering proceeds. This compares quite positively to the $2.19 billion raised during the second half of 2011. $16 billion of the difference was attributable to one oversized deal, the Facebook IPO. Stripping out that large transaction from the aggregate dollar amount, the IPO market showed a sequential increase of 18%.

Eight Digital Media and Internet venture-backed companies had IPOs garnering $16.7 billion total consideration. 11 Software, Financial Services, IT and Mobile companies secured $1.1 billion during the period. 5 life science companies went public, raising $331 million in gross proceeds. 6 companies in the remaining industries of Electronics, Alternative Energy, Manufacturing and Networking raised $468 million.

With respect to pricing, of the 30 total IPOs, 15 priced above their expected range. 3 priced within the expected original or revised range and the remaining 12 companies priced below the original range sought. There was a much higher percentage of companies pricing their offerings either above or below their range and relatively few within their original expectations, suggesting significant pricing volatility. Also, as of 7.31.2012, 22 of 30 (73%) IPO share prices were higher than their initial flotation price, little improved when compared to 69% of positive IPOs in the second half of 2011.

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The Pitch Book 4Q 2012 Venture Capital Rundown

VC Overview

VC investors completed 685 investments in U.S.-based companies totaling $6.1 billion in 3Q 2012, dramatic drops from the levels achieved in 2Q 2012. The drop-off in dealmaking was not confined to a particular stage of the
investment cycle, as angel/seed, early, and late stage deal volume all fell by approximately one-third. It’s important to put this decline into context, as VC investment year-todate is still even with 2011.
The second quarter of 2012 registered the most VC financings of all-time for a single quarter, so a pullback should not be too alarming. Furthermore, activity had increased 30% from 4Q 2011 to 2Q 2012, which has led some to speculate that VCs took advantage of the summer months to recharge before a push at the end of the year.
VC deal flow has been on a general upward trajectory since the beginning of 2011, but the total amount of money invested through VC deals has been trending downward since 1Q 2011.
A contributing factor has been that angel and seed stage deals have grown from 17% of financings in 3Q 2011 to 23% in 3Q 2012, while the typically larger late stage financings have contracted from 36% to 31% during the same period.
On a yearly basis, it will be difficult for 2012 to surpass the record-breaking numbers posted in 2011. Still, deal-making has been strong despite the disappointing 3Q figures, and 2012 could still prove to be the second-best year for VC investments by both deal count and capital invested.

Industry Rundown

It should come no surprise that the IT industry accounted for the majority of VC investment during 3Q 2012, representing 50% of deal flow and 48% of the capital invested. The proportion of VC money flowing into the IT industry has steadily been rising since dipping to 33% in 2Q 2011 and now sits at its highest level since 3Q 2006.
One of the most significant trends in VC investing has been the increasing prevalence of deals being executed in the B2C space, particularly in the earlier stages. Since 1Q 2009, B2C has expanded from 14% of VC financings to 20% in 3Q 2012. Over the same period, B2C grew from 10% to 16% of capital invested. For the first time ever, B2C now accounts for a higher proportion of VC deals (20% through the first three quarters of the year) than the Healthcare industry (17%). However, Healthcare companies continue to attract significantly more
dollars as the bulk of the industry’s financings come in the later stages.
Renewable energy and clean tech are commonly thought of as a prime spaces for VC investment, but the data tell a different story. Investors closed just 16 Energy deals totaling $298 million in 3Q 2012, representing a measly 2% of deal flow and 5% of capital invested.

VC exits

At first blush, the quarterly exit numbers seem abysmal with a 75% drop-off in capital exited from 2Q to 3Q. However, the quarterly comparisons for exit activity are a bit muddled due to the $16 billion Facebook IPO in 2Q. With that deal removed, the decline in capital exited is a much more tolerable 8%. Still, exit volume did fall substantially from 113 deals in 2Q 2012 to 96 in 3Q. The outlook is much better when looking at the data on a yearly basis; 2012 has already broken the record for most capital exited with $35.5 billion and the  final exit count should be on par with the two preceding years. Corporate acquisitions continue to be the exit method of choice for VC companies, but the exit strategy has fallen to 72% of activity, the lowest level since 2Q 2007. IPO activity declined slightly in 3Q, but 2012 has already seen 36 VC-backed IPOs, which is the highest total for the first three quarters of a year since 2000.

Private equity firms have increasingly been turning to the VC space to source deals and set a new record (42) for VC-backed company buyouts in the first three quarters of 2012.
While VC investment activity is driven by IT, the industry plays an even larger role when it comes to exits. IT companies have accounted for 57% of exit volume and 78% of the capital exited through the first three quarters of the year.

PitchBook_VC_Rundown_4Q2012