Monday, September 22, 2014

The Entrepreneurial Value Chain

I've been spending a ton of time lately on activities that don't obviously have much to do with my actual "work" -- which in its broadest description includes anything and everything needed to help Pacific Northwest founders build big software companies from scratch.

Whenever I catch myself wondering why I'm doing something -- or better yet, explaining to my partners or our LPs what I'm up to -- this is the best explanation I've come up with...

Almost any work can be visualized as a point in an extended value chain, with a cascading series of supplier inputs enabling the work coming in one side, and one or more layers of customers or buyers of that work going out on the other. 

We may only have direct control over the activities that happen within the four walls of our business, but the overall quality of our work, and our ability to realize a return for efforts, are massively dependent on both the upstream and downstream players in our value chain.

"Supply chain optimization" is one of those wonky, conversation-killing topics that's sure to get you thrown off any fashionable guest list, but it's also one of the most powerful and overlooked sources of strategic leverage in business. Some of the most valuable companies in the world -- including Apple, Amazon and Walmart -- have built wide moats around their business in large part due to their obsessive focus on supply chain management.

So what does a geeky manufacturing and logistics discipline have to do with running a seed fund?

When Andy and I started Founders' Co-op back in 2008, we knew we'd have to do a lot more to build our business than sit back and wait for the deals to come to us. Each of us had moved to Seattle from a more vibrant startup city -- Boston for Andy and the Bay Area for me -- and Seattle suffered by comparison on every front but one: the depth and quality of local engineering talent.

We didn't even know what we didn't know about running a venture fund but we figured we could do some good -- and hopefully make some money along the way -- by trying to make Seattle a better place to build a company.

We started by aggregating a bunch of fellow entrepreneurs and angels as investors in our first little fund. Not only did this give us more money to work with, it also dramatically expanded our network for deal sourcing, due diligence, follow-on investment and mentorship for our portfolio companies.

With our first fund raised, we began scouring the Northwest for promising young entrepreneurs to back. In some cases, the companies we invested in were already up and running; in others, we had to play a more hands-on role in developing the thesis, building the team and validating the market in order to put our money to work.

As fun as it was, it didn't take long for us to realize that co-founding companies in order to back them wasn't the most scalable way to build a venture business.

Luckily for us, Brad Feld had been an investor and board member in Andy's and my first Seattle project together (a failed experiment in local-social search we named Judy's Book after Andy's mother-in-law). Brad and David Cohen created Techstars just as we were getting Founders' Co-op off the ground, and after seeing it in action we became convinced that the Techstars model could help solve our supply problem in Seattle by programmatically boosting both the number and quality of "investable" startups in the region.

Techstars is now the #1 startup accelerator in the world, and Techstars Seattle is in its fifth season as the global organization's Cascadia outpost. As Managing Director of the Seattle program, Andy spends a huge amount of time each year on Techstars-related business, and in the past few years I also took an "official" (but unpaid) role on the Techstars Seattle team. The program is funded by a broad coalition of Seattle investors (Founders' Co-op included), but none of the funders enjoys any special rights with respect to the companies that pass through the program.

All the participating funders are committed to Techstars Seattle for the same reason -- it makes Seattle a better place to be a software entrepreneur.

Over the years, Andy and I have both added other activities to our to-do lists with even less obvious benefits to our core business:
Just last week we announced our most recent (and most ambitious) "value chain" project yet -- a four-way collaboration among Founders' Co-op, Techstars Seattle, UP Global and the University of Washington called Startup Hall

The big idea here is to use a physical space (the former home of the UW Law School) to bring together the region's #1 educator of technical talent (UW) with the world leaders in entrepreneurial education (UP Global) and startup acceleration (Techstars), plus the region's #1 seed-stage venture fund (Founders' Co-op).

It wasn't clear to any of us how Startup Hall would benefit our organizations directly or in the short-term, but it was abundantly clear to all of us that it would remove friction at several key points in the regional entrepreneurial value chain -- and that the long-term systemic benefits to the region would raise the tide for all of us in ways we couldn't predict.

I'm grateful to everyone who has played a part in these efforts to extend and strengthen our regional entrepreneurial value chain -- not just the usual core group of investors and entrepreneurs, but increasingly including our region's most forward-thinking political, academic and non-profit leaders. We still have much to do to make Seattle one of the few undisputed leaders in global innovation, but we've come an incredibly long way in a short time and I can feel the energy and momentum building here like never before.

Thursday, July 24, 2014

The one thing you can't teach an entrepreneur

Startup founders are like sponges.

You basically can't be an entrepreneur if you aren't relentlessly curious about people, technology, business and culture -- constantly remixing those ingredients in your head to find new and better ways of doing things.

Because they're so intellectually agile, founders can learn almost anything if exposed to the right vectors, whether it's high-performing peers, experienced mentors, academic environments or direct trial-and-error.

But there's one thing that can't be taught -- and I know because I keep hoping to be proven wrong about it and making the same mistake over and over.

My work as a startup investor isn't focused on companies, but on founders: helping extraordinarily smart and creative people reach their full potential as creators, builders and leaders. Whenever I meet someone with the intellectual and emotional capacity to be a founder, I want to do whatever I can to help them realize that goal.

But there is an awkward truth about successful founders -- awkward because it can manifest in decidedly ugly and antisocial ways. At the deepest levels of their psyche, often hidden even from themselves, they have a hunger that they can't control.

This hunger goes by many names -- ambition, competitive drive, the will to win -- and it's hard to talk about because it is formed around a hard kernel of insecurity and shame. 

For every successful founder I know the story is the same: somewhere along the way someone important to them told them they weren't good enough and would never amount to anything. The anger and self-doubt embedded in them by that searing experience becomes a nuclear core fueling their relentless drive for the rest of their lives, long after they have proven the doubters wrong.

Founders who learn to bank and control this fire are among the most productive and effective people in the world. Those who fail to master it self-destruct as their hunger for domination leaks into their personal relationships and poisons their capacity for empathy.

But no matter how brilliant a founding team is, if one member of that team doesn't carry this uncomfortable burden, that startup's odds of success go from low to infintesimally small. 

It can't be taught -- in fact it would be wrong to try, because it would require inflicting deliberate emotional damage on another human being. Though risky, it can be added, by bringing in additional founders or early hires who carry necesary the emotional scars. But if it's not baked into the culture at the most fundamental level, no amount of investor, mentor or board support can infuse a startup with the unstoppable force needed to overcome the indifference, hostility and scorn that the world piles on anyone who dares to try something new.

Founders aren't born but made, first by the hurt the world gives them and then by their lifelong fight to forge that hurt into something beautiful and strong.

Tuesday, June 24, 2014

The Valuation Stack

A few weeks ago I was invited to speak to a graduate accounting class at the University of Washington. Although most of the students in the class had already accepted offers from one of the Big 5 accounting firms (which mostly work with larger companies), the professor wanted to give them a little exposure to early-stage finance before sending them on their way.

We covered a range of topics in the discussion, but the one that clearly generated the most interest -- and puzzlement -- was early-stage valuation. In a world of balance sheets and cash flow statements, the idea that financial investors would accept a valuation that wasn't built from financial data was surprising, and even a little shocking, to this class of trained accountants.

As strange as it seems to investors in later-stage companies and public markets, there is a kind of logic to the valuation path for high-growth startups, but it often has more to do with where you are in the "valuation stack" than anything intrinsic to the company being valued.

How is a startup like a shirt?

The analogy I used with these accounting students -- a useful (if overly simplified) way of describing how the system works -- was to compare a private company to a consumer product sold at retail.

When a shopper picks a t-shirt off the shelf at Nordstrom, it has a price tag attached that reflects the manufacturer's recommended selling price (or MSRP). But what that price tag doesn't show is all the activities that went into making that shirt, the vendors and suppliers who participated in making it, and the layers of both cost and margin that have been applied to the product as it made its way through the value chain.

The entire startup financing ecosystem is like a retail value chain. The public markets (as well as late-stage / strategic M&A) are the equivalent of the retail shelf -- the final sale that comes at the end of a long and winding journey through seed, Series A, B and C (and often deeper into the alphabet), growth equity, and mezzanine / "crossover" finance.

Because most high-growth companies consume capital (meaning they spend money faster than they make it in order to accelerate growth), fundraising success is the achievement that unlocks a company's ability to progress to the next level in the value chain. Each step up the capital markets "stack" reflects a judgment by investors that your company stands a good chance of making it all the way to the retail shelf. Conversely, a company that isn't able to raise is implicitly being judged by investors to be unlikely to progress far enough in the stack to allow them a risk-adjusted return on their investment.

Most venture returns are driven by the companies that make it very high in the stack, and especially the ones that make it all the way to retail (IPO). But since most early-stage companies fail, and only a small number are acquired for  a significant gain, investors also build a risk premium (or markup) into their valuation assumptions for the next raise as compensation for the risk of failure.

In early stage finance, valuation is driven much more by your relative position in the valuation stack than any measure of "intrinsic" value.

In a previous post I argued that venture fundraises "come in twos" -- meaning that every current raise contains a set of embedded information about the expected terms of the next raise. The most fundamental information about any given venture raise -- and the one that has the biggest impact on valuation -- is *not* the actual merits of the company's founders or market, but rather the current position of the company in the valuation stack relative to the expected "retail price" the company will be able to command when it finally makes it to the public markets.

Investors and founders who try to over-optimize on any given fundraising event -- pushing valuation too high or too low relative to norms for that stage -- can effectively kill their chances of getting to the next one (thereby halting their progress up the stack). Dilute the founders too much and you undermine their incentive to deliver the superhuman effort required to carry the company forward. Price a deal too high and you leave no risk premium for investors between the current round and the next one, killing their incentive to make the bet. Every fundraise must strike the right balance between the needs of new investors and existing shareholders for the game to continue.

Unsurprisingly, the mechanistic logic behind this system is jarring to the human beings actually participating in it. Every company is a unique and every founder is extraordinary, not just raw material stuck at an intermediate stage in some abstract retail supply chain. But if you're ever wondering why some companies progress through the venture financing ladder and others don't, the answer can often be found in the logic of the t-shirt: no matter how many steps there are in the value chain, it has to make sense for every participant, at every stage of the process, to help get it to the retail shelf.

Wednesday, May 28, 2014

Talent > Capital: How regulators can *actually* promote entrepreneurship in Washington State

I'm a firm believer in Brad Feld's ecosystem model of innovation, and -- in addition to my day job as an investor at Founders' Co-op -- also serve as a volunteer board member for the Washington Technology Industry Association and Chair of the City of Seattle's Economic Development Commission.

In both roles, I'm often asked what government can really do to help entrepreneurs.

The first idea that most people outside the entrepreneur community start with is tax policy, on the assumption that entrepreneurs are economic actors and will respond to economic incentives. My response always surprises them:

Startup founders don't give a shit about taxes.

Of course this isn't strictly true. Nobody likes paying taxes, and given a choice we'd always rather pay less than more. But what I mean is that tax policy -- at least at the city and state level -- is such a trivial consideration in the face of the many existential risks an early-stage company faces that it just doesn't rate as an important variable for most entrepreneurs.

So if entrepreneurs don't care about taxes, what do they care about?

The world is currently awash in capital seeking return; to a first approximation, money is not a constraint in the innovation business. What *is* in short supply is the pool of talent with both the elite-level technical skill required to prosecute innovation, and the entrepreneurial + creative capacity to pursue innovation outside the confines of traditional employment.

If talent is the scarce resource, what can government do to increase the supply of talent?

In the (very) long term, the clear answer is to support transformative change at all levels of our education system, from K-12 through college. But that solution -- as critical as it is to our nation's future -- is so long-dated that it simply doesn't factor into the strategic thinking of anyone building a company today (apart from those courageous entrepreneurs that are actually trying to fix education from the outside).

But there is one regulatory change that that has been shown to have a significant positive impact on the availability of high-performing technical talent to the innovation market: invalidating the enforceability of non-compete agreements for departing employees.

California, the highest performing innovation ecosystem on the planet, outlawed noncompete agreements back in 1872. Massachusetts is in the middle of a public debate on the topic, with strong support from Governor Deval Patrick in favor of making a similar change. And recent academic research has provided an increasingly airtight case for the economic benefits of this policy change. Here's an excerpt from the most influential paper on the topic, from Alan Hyde at Rutgers:
"States that do not enforce noncompetes have more startups, venture capital, growth, investment in human capital, and patenting... Enforcing noncompetes also creates social waste of employee talents, as most affected employees are unable to work in their areas of expertise ... The time has come for law to join those states refusing to enforce restrictive covenants, and to restrict employer claims that departing employees will disclose trade secrets."
Washington State -- like California, Massachusetts, New York and Texas -- is one of the few U.S. states with the demonstrated capacity to play a leadership role in the global innovation economy. Unfortunately, Washington State law currently supports the enforceability of non-compete agreements. And our two largest and most important technology leaders -- Amazon and Microsoft -- have demonstrated their willingness to sue departing employees to enforce them.

So the next time someone asks you what the public sector can do to foster innovation, don't let them walk away thinking tax policy is what matters -- remind them that talent, not capital, is the key ingredient in innovation, and ask them to help strike down the enforceability of non-compete agreements in Washington State.

Tuesday, May 6, 2014

Our investment in Smore -- Digital marketing for the 99%

I'm excited to report that we just closed a new investment with some old friends.

Smore is based in Tel Aviv, but two years ago they came to Seattle for the summer to participate in TechStars. Gilad and Shlomi had never built a company before, but they were two of the most talented makers we'd ever met and we agreed to lead their small angel round before the program was even halfway over.

They moved back to Tel Aviv after TechStars -- mostly because the U.S. makes it so hard for talented young immigrants to stay -- and settled into a steady pace of customer and product development far from the west coast echo chamber. While this was a bummer for us -- we loved having the Smore guys in our Seattle office and our regular Google Hangouts with them weren’t quite the same -- it turned out to be a great move for Gilad and Shlomi.

Smore's mission has always been to take the mystery out of digital marketing for the 99.9% of humanity that doesn't live inside the tech industry bubble. 

Getting away from the noise allowed them to really hear what regular people were saying about finding customers online:

  • "It's just too hard and I don't know where to start." 
  • "I don't really want a fancy website, I just want more customers to walk in my door." 
  • "I'm doing a bunch of stuff but I have no idea what's working and what's not." 

Building simple, beautiful tools for these people is all Smore has focused on for the past two years. They haven't hustled press, they haven't fundraised, they haven't hosted tech meetups or tried to get on the front page of Hacker News.

So what *did* the Smore team do, if they weren't keeping busy with all the activities that seem to consume most young founders?

  • They built and shipped constantly, learning about their customers through an endless set of experiments in running code. 
  • They got over half a million people (and counting) to sign up and promote something -- a local event, a real estate listing, a product or a local business -- with a beautiful online flyer. 
  • They gave those people simple and effective ways to spread the word about their flyers, driving millions and millions of prospective customers to visit them every month. 
  • They figured out what kinds of services people would pay for, how much they'd pay, and how to keep them coming back for more. 
  • They built a profitable business -- adding a steadily increasing layer of recurring revenue each month -- based purely on organic adoption. 

Gilad and Shlomi entered TechStars as gifted makers, and their obsession with digital craftsmanship will always be the core of their firm’s culture. But two years of heads-down company-building helped them hone new skills and insights about how to turn beautiful product into real business value. As soon as they felt ready to flex those new muscles, we jumped at the chance to lead the raise we're announcing today.

I don't expect Smore to suddenly start behaving like every other startup just because they raised a little money. They’ve always done things their own way and this raise just gives them a little more space to be themselves. All I know is that it’s going to be both beautiful and useful, and that’s an excellent place to start.

Thursday, April 10, 2014

Tripling down on Cascadia

I’m happy to announce that we just closed $10 million in fresh capital for a new Founders’ Co-op fund to help build the next generation of world-changing software companies here in the Pacific Northwest.

This is our third fund and, while our values and approach will remain the same, we’ve upped the ante in a few important ways that reflect how much Andy and I have learned since we started Founders’ Co-op back in 2008.

1. More Money

This will be our biggest fund ever -- counting both closed and committed dollars it’s already twice the size of our 2011 raise and with the potential to be more than three times as big (the fund is capped at $25 million). Not only can we now back more great early-stage companies, we can also play a more important role in their journey along the increasingly long and winding road to Series A (and beyond). This is the capital markets gap we set out to fill when we started the fund, and we’re now in a position to do that job right.

2. More Brains

Andy and I are proud of what we’ve built together as a team of two. But they aren’t making any more hours in the day and the Northwest innovation ecosystem keeps getting stronger, so we knew this time around we’d need to find a way to do even more.

Luckily for us, local super-angel Rudy Gadre was thinking along the same lines and -- after many long conversations about the kind of firm we wanted to build, and the kind of impact we wanted to have -- it was clear to all of us that joining forces was the right answer. As of today, Rudy has officially joined Andy and myself as a full investing partner in the fund.

Rudy isn’t just bringing his considerable brainpower to Founders’ Co-op, he also opens up a whole new facet to our investing work. Having played early leadership roles at two of the consumer web’s biggest success stories -- Amazon and Facebook -- Rudy adds a deep understanding of the consumer opportunity to our partnership’s established strength in the enterprise, allowing us to say ‘yes’ with confidence to an even larger set of early-stage companies.

3. New Partnerships

Last time we raised a new fund we added an important new partnership with TechStars, one of the world’s leading startup accelerator programs. This time Founders’ Co-op and TechStars Seattle are joining forces with the University of Washington -- the region’s top research university -- and UPGlobal -- the world leader in entrepreneurial education -- to create Startup Hall, a hub for high-performance startup activity in the heart of Seattle’s University District. The City of Seattle has made the UDistrict a centerpiece of its economic development roadmap and the Startup Hall partnership will play a key role in transforming the University’s backyard into Seattle’s next great innovation neighborhood.

4. Bigger Dreams

Over the past six years we’ve been lucky enough to invest early in some of the Northwest’s most exciting startup success stories -- companies like Simply Measured, HasOffers and Urban Airship. We’ve also seen great local companies like Tableau and Zulily make it all the way to the public markets, adding more strong independent tech leaders to our local ecosystem.

Everything we’ve learned as investors, mentors and troublemakers in our regional startup community has convinced us that the Pacific Northwest is one of the best places in the world to build companies that matter -- economically, socially and culturally. We admire every entrepreneur who has the courage to strike out on their own, but as a fund we’re on the lookout for teams hungry and foolish enough to think they can build the next world-changing company right here in our own backyard.

We wouldn’t be able to do the work we love so much without the trust and support of many, many people in our region and beyond. We’re thrilled to have another fund’s worth of shots on goal, and we want to thank the dozens of friends and fellow entrepreneurs who have trusted us with their money, and the even larger number of founders who have invited us to join them as partners on their own entrepreneurial journeys. We wouldn’t be here without you, and we never forget that we work for you.

Let’s do this.

Tuesday, March 18, 2014

Foreign Direct Investment

Today one of our earliest Founders' Co-op investments -- Simply Measured -- announced a $20M Series C led by Karan Mehandru of Trinity Ventures. Last year the company raised an $8M Series B, led by Ethan Kurzweil of Bessemer Venture Partners. Not long after that round closed, we also participated in the first-ever raise for HasOffers, a $9.4M Series A led by Rich Wong at Accel Partners.

Beyond being great fundraises for world-class teams, what do all these fundraising events have in common? They represent important "foreign direct investment" wins for the Seattle innovation ecosystem.

We're delighted whenever a strong local company completes a successful raise -- whether we're investors or not -- because it increases the odds of yet another tech leader being built in the region. A healthy innovation ecosystem requires a critical mass of strong companies at every stage of development -- thousands of early-stage startups, hundreds of growth-stage companies, dozens of mid-market companies, and several global giants -- to provide a liquid and resilient market for talent and entrepreneurial wealth creation through both good times and bad.

With the collapsing cost of software innovation, a great software company can be started almost anywhere there's a concentration of talented makers. But scaling a tech company to a dominant position in the global economy still requires massive injections of capital, and the capital markets are as concentrated as innovation markets are diffuse.

The only "full stack" capital markets functions for growth companies in North America are Sand Hill Road (for innovation-based companies) and New York (for later-stage companies of all kinds).

Building a great company anywhere begins with talent, mentorship and seed capital - ingredients available in almost any major city. But making innovation a systematic, scalable engine of long-term growth requires strong direct access to at least one of the major money centers for innovation finance.

Talent is sticky -- people like to live in vibrant urban centers that feed both their careers and their social and intellectual lives -- but money flows more easily, and it flows most quickly and in greatest quantity toward opportunities most likely to produce the biggest returns.

We're lucky in Seattle to have a history of massive entrepreneurial wins -- once-fragile startups that grew into massive, publicly-traded companies that dominated their categories and produced life-changing wealth for their founders, investors and early employees. But a key tenet of business (and sports) is that you're only as good as your last game, and past performance is no guarantee of future results.

A city's ability to attract "foreign direct investment" -- strong fundraises led by well-regarded partners from leading firms in the major money centers -- is a leading indicator of its future success as a global hub for innovation.

So congratulations to Simply Measured and HasOffers -- and Zulily, Tableau, Avalara, Smartsheet, Socrata, Inrix, Apptio, Porch and every other Pacific Northwest startup that has attracted major injections of "foreign direct investment" from the money centers of innovation finance. You are laying the foundation of our region's future -- making it clear to the global capital markets that the talent is here, and the smart money is beating a path to its door.