I’m observing that IRR is a metric that is becoming an increasing focus in venture, replacing fund return multiple as the key metric of success. I understand the draw of IRR, and – as a fund draws to a close – there’s no question it’s an important metric. LPs have plenty of options for where to put their money and IRR is an easy way for them to compare how their money grows across various investment options and a convenient way to determine whether they believe they’ve been adequately compensated for the relative risk and varying degrees of liquidity available to them across different asset classes.
BUT (and you knew there was a but here given the post title…) it’s a poor way to compare the relative performance of funds early, and even into the mid/later, stages of a fund’s life. But that doesn’t seem to be stopping funds or LPs from touting IRR as the gold standard for evaluating relative fund performance. This is a mistake. Interim IRR is much too easily manipulated and in some cases incents behavior counter to the long-term benefit of LPs (and GPs). A few examples:
- In an up market, IRR values quick capital deployment. Whether we’re in a full correction or not has yet to reveal itself, but for the years leading up to 2022, the market for all things venture was extremely strong. That was great for companies needing to raise increasing amounts of money and fun for investors who often saw companies receive large mark-ups relatively quickly after raising their last round. How many of those valuations will hold remains to be seen, but that kind of market clearly advantaged funds that deployed capital very quickly. Gone was the J-curve (named because often early fund returns are negative – mostly due to fees that drag down NAV prior to initial company write-ups). In markets like this, funds that deploy quickly generate markups on their full portfolio; those that show more patience suffer from an IRR perspective as a larger portion of their fund is yet to be marked up by subsequent financing rounds. IRR doesn’t track this and comparing two funds from the same vintage (fund year) without considering how quickly each deployed capital into an upmarket is a mistake.
- Recycling hurts IRR. Recycling is how funds pay back their management fee and invest the full amount of the fund that they raise (consider a theoretical $100M fund with a 2% management fee for the 5 year investment period and a 1% fee for the tail 5 years; that fund would have to generate $15M of recycling in order to cover the fees that they charge investors). In fact, many funds have the ability to invest more than 100% of their fund size (via profits generated from investments). Traditionally LPs have viewed this as positive. The fund is investing profits, the LP is paying fees on what effectively becomes a smaller fund (in my example above, if the fund invests 110% of the fund, LPs were actually paying a 1.8% management fee). This shrinks the gross/net return spread and is good long-term for LPs (assuming in this analysis that the 10% overage invested returns the same or better than the fund as a whole). But this doesn’t help a fund’s IRR. It actually suppresses it in a similar way that investing over a somewhat longer time period does: by putting capital in the ground later in a fund’s life. Better for the overall return, I’d argue, but not for the interim IRR.
- A lot of things change in 10 years. Most funds have a 10-year life. Really more than that, as 10 years is an increasingly outdated vestige that seems for some reason to live on in fund documents, even if it doesn’t in reality. But in any event, the life of a fund is at least 10 years, and increasingly 15 years or more. A lot changes in that period of time. So if you’re considering IRR at year 3, 4, or 5 – especially for Seed and Series A funds – there are a lot of valuation assumptions that in hindsight will turn out to be completely wrong, but which can drive significant IRR (well, not real IRR, since they never materialize, but interim, paper IRR). For example, I was recently on an update call with a fund and did a quick calculation that over 80% of the gain they were showing came from just 2 companies. Both had raised attractive up rounds. Both were valued at greater than 50x revenue (one was, I think, 70x revenue). This isn’t a commentary on either of these companies – they both may end up being great. But there’s a lot of work for these companies (and many, many like them across the venture landscape) to grow into their paper valuations. If you abstract this across the venture industry or asset class (seed stage venture in this particular case) you run the risk of having a few outlier valuations driving what appears to be spectacular IRR. Some of those companies will be successful. Many will not. We’ll know eventually. But not now. [NOTE: After distributions, the typical capital adjusted duration of even an early stage fund is maybe 8 or 9 years; that’s probably a good benchmark for when you can have a reasonable idea of where IRR will land, but even then there are some large late returns that can change the IRR late in a fund’s life.]
So, food for thought as our industry perhaps becomes overly fixated on a metric that is too easily manipulated (we haven’t even talked about how subjective valuations can be). I’m not saying ignore interim or early fund life IRR. Just take it with a grain of salt. Venture is a long game. And long games take a while to play out.
With the markets down significantly, financings (at least at the later stages) slowing down, and inflation and interest rates on the rise, perhaps now is a good time to talk about your burn rate. Hopefully, you took advantage of the robust financing markets of the past few years to put some money on your balance sheet. Perhaps you raised at what historically have been very attractive valuations (we certainly have companies in our portfolio that have raised well, well above the historical averages).
With that as the backdrop, it’s probably a good time to remind you that the amount of money you have in the bank doesn’t have to dictate your burn rate. Your underlying business metrics should.
Dividing the amount of money you raised by 18 or 12 months (a general rule of thumb for how soon you’d want to be back in the market) doesn’t necessarily work if you raised a lot, at a high valuation, and still have a few things to work out in your product, go-to-market, etc. Your burn should be based on the unit economics of the business, the fundamental core metrics of the company, taking into consideration your balance sheet and financing prospects. Particularly as companies headed into budget season at the end of last year, it seemed like there was an almost universal temptation to increase burn in 2022. Maybe it’s the rise of the $100M seed round. Or maybe it’s that the venture world seems awash in money (even despite the broader market pull-back). But there seems to be a feeling of free money, perhaps associated with the trend of decoupling of a company’s core, underlying metrics from their proposed burn rate. There are plenty of companies – and we have many in our portfolio – that are well-positioned to increase burn because they have well-established payback metrics along with a strong enough balance sheet and growth rate to support increased spend. But be careful if that’s not you. It’s unclear how far down the financing stack the current pull-back in public markets will reach, but if history is a guide, what starts with a slow-down in late-stage financings will eventually trickle down to Series C, B, A, and beyond. Looking at how companies raised in the past two years is likely not the best indication of your chances of raising money now (or later this year, or even next year). Hopefully, the markets will bounce back some. But don’t bet your business on it. Instead base your burn on your go-to-market readiness, your ability to pay back your marketing and customer acquisition spend, and a reasonable assumption about where your business needs to be in order to raise your next round of capital. Use time and capital to your advantage, accelerating product development as needed, gaining valuable insight on your go-to-market motion. Then, when you’re really ready to hit the gas, use the money that you’ve raised to do that.
For frequent readers of this blog, you know I’ve written a lot about startup boards including the importance of diversity and being deliberate about how many investors you have on your board (hint: likely too many).
Last month I joined Bolster and compensation consulting firm J.Thelander for a conversation on building and compensating boards in the most effective way possible. This is an important topic, and I wanted to share and emphasize a few insights from the conversation. If you’re interested in watching the full session you can do that here. Much of the data shared by Bolster can also be found in their Board Benchmark report that I wrote about earlier this year.
The role of the independent director is an important (and often under-utilized) strategy for CEOs.
- One surprising thing that Bolster found in their board benchmarking study is that only 1 in 3 private boards today have independent directors. That’s not uncommon for the earliest boards, but it surprised me that overall the rate was this high. It’s a missed opportunity for companies to gain valuable insight, perspective, and network extension.
- Historically, when an investor board member steps off of a board, it has been seen as a negative signal. This is backward thinking and something our industry should aim to fix. Investors shouldn’t have a board seat for life and it’s often very healthy for a company to have some turn-over at the board level (especially among investors) as it grows. More and more at Foundry, we’re stepping off of boards of great companies that we feel have enough other investor board members with huge platforms behind them. Other firms are starting to do the same.
Independent directors are a leading source of diversity on boards.
- Conversations have materially shifted from just talking about diversity to actually doing something about it in the past 12-18 months.
- This includes being open to first-time board members. It’s worth saying that some of the best board members I’ve worked with were first-time board members. There is a bias against taking on first-time board members that is irrational.
- Anecdotally, we talked about CROs and CHROs becoming more sought after for board roles, many of those executives may not have formal board experience but could bring immense value to the table.
Unsurprisingly, private company directors are almost exclusively being compensated with equity so the details of those equity grants are important.
- While option grants have historically been at about a 4-year vesting schedule, the data showed more and more companies favoring 2 or 3 year schedules.
- I think this is a healthy shift and forcing function for conversations about keeping the board fresh (see the points above).
- A majority of these independent directors have accelerated vesting (as they should, in my view). According to J. Thelander’s data (n=123), ~70% of outside members of the board have 100% acceleration of their options. Also, 80% had “single trigger” acceleration so that change of control alone is enough to trigger the acceleration.
Grants vary by stage – or rather total amount raised as stages are becoming less relevant when there are these mega Seed/Series A rounds.
- Generally speaking, an independent board member should get a grant approximately equal to something between a director and a VP level.
- At 3-4 years, you should have a conversation if it makes sense to re-up for another period or not (again, keeping in mind that some turn-over at the board level is actually positive for a business).
Board meeting tactics matter.
- Gone are the days of board meetings every month (for most companies).
- Some of the best board meetings I’m part of share these common traits:
- Material is circulated a few days in advance – and in a consistent format over time – and it’s expected everyone has reviewed it
- Meetings run 3-4 hours with a few planned breaks
- Exec team members are included in part of all of the meetings
- The CEO is clear about discussion vs. decision items
- Varying opinions are welcome
- They cover why, not just what
- Every meeting should have an executive session
- Follow-up items are noted
I wrote a series of posts here on how to manage your board and board meetings if you’re interested in digging deeper into that subject.
I hope the insights above help company leaders be more thoughtful about their board. Used properly they can be massively impactful to a company’s success.
A few quick market observations from dicussions I’ve had with portfolio companies over the past few weeks. All relate to just how a white hot economy has some downside effects on certain types of businesses. Certainly some early warning signs – curious if others out there are seeing the same.
My take-away is that in many sectors of the economy companies quite literally don’t need more customers. They can’t handle the additional load because they can’t hire fast enough and their supply chains are stretched thin. We’ve seen this in digital advertising for sure (and not just in travel and other segments that might be reacting to the Delta variant). Interestingly we’ve also seen a couple of companies – especially those that work with small businesses – whose message typically is: “We help you find and engage with customers more effectively.” The small businesses they target are pushing back and saying that they need more staff, not more customers. Currently, they’re running one, two, or even three-month waiting lists to provide services to their customers. We’ve all seen signs on restaurants that they’re closed or have reduced hours because of the unavailability of staffing. It’s interesting to consider the ramifications across the economy when many industries are at such capacity.
Obvious implications include things like inflation (and we’re certainly seeing some inflationary pressure) but beyond that, I think that the ripple effects are broader than we’re currently thinking about. I wanted to flag it as an unexpected but real consequence of such a hot economy. Certainly not something I remember seeing before (certainly not in this way).
One thing I’m particularly proud of in my career is founding Pledge 1%, an organization that encourages companies to give back to their communities by donating a portion of equity, profit, time, or product to nonprofits in its community. It was bold idea from the beginning and I’m happy to see that more and more companies are taking the pledge (we’re around 20,000 strong now and growing quickly).
Recently, Pledge launched a new initiative, Boardroom Allies, to broaden their network and reach. The Allies program is comprised of an alliance of VCs who have committed to unlocking $5 billion in new philanthropy over the next five years by helping their portfolio companies set aside equity for social impact prior to liquidity events. You can read the full announcement on Business Wire here. What’s particularly exciting about this initiative is the fundraising goal and timeframe. It’s an aggressive approach and I’m both proud and heartened by the resolve of the VCs who have made this commitment. These including my partners, Brad Feld and Ryan McIntyre, as well as many other VCs from around the country and the world. Pledge 1% has outlined their resources, strategy, outcomes in this blog post about Boardroom Allies.
I encourage you to check it out and consider and either becoming a Boardroom Ally or by taking the pledge. It’s easy and a great way to make a lasting impact in your own neighborhood.
The Kauffman Foundation published an article last week that my New Builders co-author, Elizabeth MacBride, and I wrote about the inspiration for writing the book and – related – about how our systems of finance and support need to evolve to meet the needs of today’s entrepreneurs. One of our biggest inspirations and favorite New Builders is Danaris Mazara of Sweet Grace Heavenly Cakes. Sweet Grace was born in 2008, as the Great Recession ripped through the United States, particularly affecting working-class communities like Lawrence, Massachusetts where Danaris lives. She can identify the exact minute the bakery was born. She had $37 in food stamps to her name. “What are you going to do with $37 in food stamps?” Danaris asked herself. Danaris believes in God, and at that moment a divinely inspired thought came into her head: “Make flan.” From that beginning, her business was born.
Based on our research and the conversations we had in the course of writing our book, we believe there are countless potential Denarises out there. We need to find them and support them.
There’s a forgotten history of entrepreneurship in America, which includes many more women and people of color than is generally recognized. And the rates today at which women and people of color are starting businesses have accelerated to the point that, today in America, white men are now the minority of business owners.
The demographic shift is due to the growing diversity of our country, but also reflects some special conditions that make startup life and small business ownership especially appealing to women and people of color. Given the economic needs driving them, we’re seeing a surge in business starts post-pandemic.
Lacking the entwined systems of finance and mentorship that supported past generations of (white, male) entrepreneurs and that still over-index in support of a tiny subset of businesses in the tech world, today’s entrepreneurs face almost insurmountable obstacles. Entrepreneurship in America has been on a slow decline for the past 40 years but very few people in the mainstream notice this trend.
But it is the decline in the broader world of entrepreneurship that is a crack in America’s identity as a land of opportunity and innovation. Innovation doesn’t come soley from white men educated at Ivy League schools. Innovation comes from giving a broad swathe of people the opportunity to create businesses that drive economic growth.
We believe the fastest lever to give people like Danaris the wherewithal to start companies is a well-designed system of finance that provides capital, as well as the emotional and social support entrepreneurs need. According to Kauffman Foundation research, beyond the 1% of startups receiving venture capital financing, only about 17% take any outside financing at all. The key is getting the same level of robust financing to the remaining 83%.
There are four promising directions in finance innovation that would help the vast majority of entrepreneurs who aren’t getting funding. There are many more to consider, but these would be a good starting point.
- Financing at scale. Large technology platforms, like PayPal and Stripe, have the potential to touch many businesses but the rates charged are higher than those found at banks, and they fail to offer the kinds of other support that are arguably even more important to success. If they were to become leaders in the movement to help New Builders, it would have to come about because of a mindset shift among their executives and the largely white men in their networks: that businesses started by women and people of color are not inherently riskier than the companies created by men, and that New Builders are not environmental, social and governance (ESG) investments. And these executives would need to accept their responsibility for creating a more inclusive and equal society.
- Create a new capital class. Empowering more people to see themselves as investors and lenders would unlock more capital at the grassroots level. How could this function in communities and Main Streets in America? It’s not clear yet but we believe there are innovations to be had in enabling more people to invest in startups. If more people think of themselves as investors, they will create demand for new financial products.
- Connecting investors with Main Street. Community loan funds have existed for decades, enabling community-minded institutions and wealthy individuals to put money into funds that in turn provide capital and support for businesses. Are there ways to scale these funds or turn them into an asset class? There are already signs that technology is at work in this space, as a handful of new companies, like Mainvest outside Boston, build platforms that help people who aren’t necessarily wealthy, invest in companies in their communities. The regulations in this space are still onerous, however.
- New Builders helping New Builders. One of the most promising developments coming out of the increased social justice awareness in 2020 has been a focus on getting more capital into the hands of Black and brown innovators in finance. The $100M fund-of-funds partnership between the Kauffman Foundation and Living Cities is one example of this.
The New Builders is in many ways a call for people who now control capital in our country to do what they do best: innovate new financial products to create and serve a new market. We should be asking ourselves how we can adapt to the new generation of people who are starting businesses today.
There are hopeful signs. While the most powerful members of the capital class can seem short-term and indeed are often deeply motivated by profit, they want to be ahead of the game. The future of the economy clearly lies with New Builders, who are more diverse in terms of their background, but just as capable and lofty in their dreams as any generation of entrepreneurs before them. I have faith that we’ll find new and creative ways to help them succeed.
I don’t often write book reviews here on VC Adventure, but occasionally I read a book that I feel so strongly about that I feel compelled to write about it. The Power of Giving Away Power is exactly that kind of book – it’s exceptional.
I’m fortunate enough to be friends with the author, Matthew Barzun, who has a fascinating and varied background. He was an internet entrepreneur, the US Ambassador to the U.K. and Sweden under President Obama, and was the National Finance Chair for Obama’s 2012 reelection campaign. More importantly, he is an incredibly thoughtful and compelling person. He puts all of these qualities and more into his new book, The Power of Giving Away Power, where he debunks some of the myths of classic management theory and hierarchical thinking in eloquent, humorous, and compelling ways. The book resonated with me deeply. As I thought about various leaders that I’ve known over my career, I realized that many shared the leadership traits that Matthew talks about in the book. I would strongly recommend picking up a copy. Whether you are managing just yourself or thousands of people, everyone will find useful lessons in this breakthrough book.
Nietzsche has so many famous quotes it’s sometimes hard to choose just one (most have heard that which doesn’t kill you makes you stronger although I suppose few realize that it was the German philosopher who first penned it). My favorite, perhaps, is: there are no beautiful surfaces without a terrible depth. I like it in particular because in many ways it describes Nietzsche himself. His writing is often beautiful, but with a depth that sometimes takes time to fully recognize.
In their new book, The Entrepreneur’s Weekly Nietzsche: A Book for Disruptors, Brad Feld and David Jilk pick out some of their favorite Nietzsche quotes and form chapters around business lessons from them. It’s a brilliant construction and one that adds context and meaning to Nietzsche and his writing. You’ll recognize many of the contributors to the book – Reid Hoffman wrote the introduction (I didn’t realize that Reid studied philosophy before turning to technology as a career), and many entrepreneurs contributed chapters (I wrote one as well, in fact).
There are many lessons to be learned from the last year – of the importance of connections to those around us; of how fragile our economy is – especially in certain sectors; about what’s really important. One of the most important to me was the power of slowing down. I’ve always known this – and strove to create space in my life to do it (often failing). But Covid forced it in ways that were unexpected. Especially from this perspective, the timing of The Entrepreneur’s Weekly Nietzsche is perfect. I’ve had a pre-release copy for a few weeks now and it’s how I start my day: quietly contemplating a Nietzsche quote and considering its meaning for my personal and work life. Thank you to Brad and David for this gift.
I hope you’ll consider buying the book and trying a similar routine. Nietzsche isn’t a philosopher to be devoured. Rather, his writing is meant to be contemplated and considered. The Entrepreneur’s Weekly Nietzsche is a wonderful, guided way to do just that.
I’m really excited about an upcoming event that my partners at Foundry have put together that will build upon the discussion we’ve been having around New Builders in some critically important ways. Senator John Hickenlooper and Congressman Joe Neguse will join Denver entrepreneurs Makisha Boothe, Founder of Sistahbiz Global Network and Lorena Cantarovici, Founder and CEO of Maria Empanada Restuarant. We plan to dig deeper into why politicians like to talk about small businesses but rarely enact meaningful policies to help them (and increasingly seem to be favoring policies that support larger businesses at the expense of smaller enterprises).
The event is free and will be held on Tuesday, May 18 at 1pm MTN / 3pm EDT / 12pm PDT. You can register here. And, of course, if you haven’t read the book, it will be a great primer for the event. You can find information on how to pick up a copy here.
I hope you can join us!
We had the opportunity to talk with many great entrepreneurs doing research for our book, The New Builders. I was struck by how thoughtful, determined, and gritty they were. As most readers know, the book focuses on entrepreneurs from a diverse set of backgrounds – people that truly represent the next generation of founders in the United States.
One of the trends that we observe in the book is that the rate of entrepreneurship among older Americans is actually quite high. In fact, across all age groups, the fastest-growing group are entrepreneurs 55 and older. There are a number of interesting reasons for this that we talk about in the book. And we tell the stories of handful of older American entrepreneurs to help highlight these trends. One of my favorites was Fred Sachs who founded and eventually sold a lumber company as well as a commercial door and hardware company. He’s also my wife’s cousin, once removed (that’s her dad’s first cousin)!
Initially, Fred planned on retiring but his hobby of growing wheat on his farm near Alexandria, VA turned into a new venture selling flour to regional bakers. Grapewood Farm now produces a variety of organic small grains and stone ground flour to customers across the Mid-Atlantic region.
We highlight his story and the importance of older Americans in business in a piece in nextavenue that we just released this week. I hope you’ll check it out and see why our nation’s focus on Silicon Valley being the seat of innovation is not entirely on the mark.