Is The Quest For “Software Margins” To Blame For Twitter’s Trolls, Facebook’s Russians and YouTube’s Fake News?

Nothing gets an investor’s heart racing like the phrase “software margins.” It’s shorthand for the concept than businesses which are primarily bits (not atoms) have some very attractive characteristics: fixed development costs, economies of scale in deployment & servicing, and “winner take most” markets with pricing power. The resulting impact is very profitable, fast-growing success stories with high gross and net margins. Dismissing a company as “nice but doesn’t have software margins’ is the “yeah, nice personality I guess” of venture investing.

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Photo by Bill Jelen on Unsplash

So if you believe that in order to access growth capital and consistently trade at a high multiple as a public stock a company needs to maintain the margin-profile of a best-of-class software company, what might be the tradeoffs?

Well, maybe you focus engineering efforts disproportionately on growth and revenue-generating projects. And perhaps you see Sales & Marketing as necessary but every other non-product function – Policy, Customer Support, HR – as margin sucking cost centers.

Could Facebook, Twitter and YouTube spend more money on faster responses to abuse reports, more accurate content review tools, better ethics training for engineers, more manual investigations of identity theft and fraud? Sure. Would these lead to better products despite being fundamentally non-scalable? We can debate whether the answer is between “partially” and “substantially” but the impact would certainly positive.

Will we find that there were types of technology businesses which we thought had “software margins” but were understaffing customer support, content moderation, and policy enforcement because managing a global social network is just fundamentally different than selling expense software into the Fortune 500? These are questions not proposals, but when I look at some of the struggles my favorite consumer tech companies are facing, I do wonder if the requirements to fit a certain margin profile are one of the structural constraints to solving their issues faster.

Venture Funds as Products. What We Changed for Homebrew III.

“What did you change about Homebrew III to better fit ‘seed phases’ versus seed rounds?” a fellow VC asked me after my previous post. That’s a great question! One consistent LP complaint I hear about new’ish fund managers is that they forget a bunch of fund construction and portfolio modeling decisions are connected. The amount you raise, the average check size, your follow-on strategy, the fund staffing and so on — these aren’t single points but instead need to all be driven from one’s mission and strategy. For Homebrew, we’ve optimized for a product offering that will appeal to our target customers (founders) and maximize spending our time being hands-on supporting startups. So if you look at each of our funds as a version of a product release, what’s new or different about Version, errr Fund, 3.0?

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Actually not much. We’re still working with a very small group of institutional LPs, making a target of 6-8 investments each year during the seed phase, and keeping the partnership tight. But there was one non-traditional request we had and which our LPs agreed to support. We lengthened the initial investment period as well as the fund itself. In simpler language, Satya and I anticipate making more total investments in this fund (~32) than we did in the previous two (20 and likely ~25 respective), while not fundraising again until ~2022 (versus a more typical cycle of raising every three years or so that many < $200m funds employ). To execute this strategy we decided that ~$90m was the right size for Fund III. Here’s our thinking behind these figures:

  • Seed phases require patience and we don’t want companies to try and raise their Series A before they’re ready

When a VC is fundraising one of the stats they like to present to LPs is the quality and size of follow-on in the portfolio. For a seed investor like us that would mean “How many companies have raised a Series A (or later) and how good [brand name] are the investors leading those rounds?” This can sometimes consciously or unconsciously cause a VC to feel pressure to get their investments into their next round and marked-up in order to show momentum. In the first two Homebrew funds we’ve not always seen a correlation between speed of subsequent fundraising and long-term durability of company. Especially with founders who are in markets where they start earning revenue very early in a startup’s lifecycle, they sometimes choose to “fund” their business using this revenue and then go out when ready for a Series A. Creating a longer fund cycle for ourselves is consistent with the spirit with which we want to engage the founders we back and reduces the potential for mismatch between our incentives and theirs.

  • Larger, longer fund gives us a better shot to hit our recycling goals

Ok, as if this entire discussion wasn’t inside baseball enough, if you don’t know what recycling is, first read Brad Feld’s post. Since recycling depends on cash flow a larger fund with a longer deployment increases the odds that we’ll get capital back from early exits that we can redeploy. We’ve generally got a recycling target of ~110% and minimally want to get to 100% invested.

  • Time diversity is our friend

Simply put, we believe four years is better than three for achieving time diversity at the seed stage. Optimizing for spanning cycles of ups and downs, new ideas and models, etc. Being able to make enough investments to survive expected mortality rates and focus on durable outcomes.

  • Time spent helping Homebrew investments is better than time spent fundraising for Homebrew

While we’ve been VERY fortunate to always have relatively straight-forward fundraising processes there’s no denying it does take some time that, if we’re being short-term greedy, we’d rather be spending with our portfolio and new founders.

Of course, while that’s what we’re optimizing for there are some secondary consequences of this strategy which ultimately impact Homebrew.

  • More fees in the near term but harder to get to our target returns multiple given increased fund size

We’re long term greedy – for us the economic rewards of success come after our founders and LPs get paid, but that’s a feature not a bug. So the fact that a larger fund gives us more capital to spend on Homebrew operations upfront (which might include an increase to our salaries) is fine but it’s also essentially a loan we’re paying ourselves since we pay this money back to our LPs prior to sharing in the upside of the fund. And to get to a target return of 4-5x net, it means we need to return 5 * $90 million (ie $450m) to our investors. And if you assume ~10% ownership for Homebrew, well, you can do the math on exit value requirements.

  • Need to remain disciplined with regards to check size and follow on decisions

If you raise it, you spend it. That’s what we tell to founders who take on a big round with the idea they’ll stay judicious in how they use the capital. Satya and I are pretty thoughtful about this stuff and since we make decisions by consensus, this one doesn’t worry me but we’ve noted it as something to keep an eye on.

  • Fund IV will be raised off data, not momentum

Fundraising for VCs is always a bit of “remember how good we’ve been” plus “look how good we seem to be doing now” plus “here’s why we’ll well-positioned for the future.” There’s a certain cynical aspect of me which believes the fat middle of “just ok” VCs are in some perpetual game of fundraising when the above three attributes are just enough to get a fund done – ie timing the fundraise. By pushing Homebrew IV out a bit, I think we’re amplifying the idea we’ll be raising off results, not just momentum. Of course we think this’ll be to our advantage but… 🙂

  • Our J Curve and early IRR may look worse than other funds

Another inside baseball issue (read about J Curves) but since our LPs are pros who care about cash on cash returns, understand our strategy and generally are seeing lengthening time to liquidity in venture, we aren’t too worried about this.

So, that’s basically what we’ve changed about Homebrew III compared to earlier funds in order to support our belief of Seed Phases. We document this stuff publicly because it helps collect feedback on our thinking and in the spirit of collaborating with other new fund managers.

For Fundraising, Seed is No Longer a Round, It’s a Phase

Want to know the biggest challenge Satya and I faced when announcing Homebrew’s third fund? How to describe the moment in time we seek to invest. “Early stage” has been coopted by billion-dollar VCs who try to shoehorn a $10m ARR SaaS company into their idea of risk capital. And the verbal gymnastics of some founders! “We did a pre-seed, followed by a seed, then a bridge and an A. Now we’re raising an A-2 to scale. But it’s definitely not a B – that’ll come in 18 months.” What?!? Makes me wish we’d just adopt version numbers, a la software releases – Round 1, Round 2, Round 2.5 and so on.

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But ahead of the industry solving this problem, we had a blog post to publish. So, what to say? We decided on “seed phase” because now more than ever, we believe seed isn’t a round, it’s a period of time where you are starting, learning and iterating to a business that has proven its core value proposition and raises a Series A to begin scaling. Why does this matter to founders (and to us)? A few reasons.

1. Asking founders to prematurely perfectly forecast the amount of capital they need to get to a Series A is an unnecessary constraint

When we invest in a startup we expect aspects of the roadmap will change, heck, if it doesn’t I’m suspect they’re not taking enough risks or aren’t running the right experiments to get the data they need. Why should I expect premature precision in budgeting and forecasting the capital requirements? Of course a CEO should be thoughtful and disciplined when it comes to their cash and early stage startups don’t usually die because of lack of funding but rather lack of ideas and output. At the nascent point where we invest I’d prefer a CEO to be absolutely correct about their focus and directionally correct about the economics it takes to get there. You should get multiple bites at the apple if things are going well.

2. Series A investors are increasingly looking for derisked companies and willing to pay more for momentum

While there still exist conviction-based VCs, many more are momentum-based. That is to say, evidence of a startup being a potential outlier is worth a lot more to them. Why? Well, the long path to liquidity means many GPs don’t have much capacity open and the cost of getting stuck with a mediocre company is high (sucks up capacity and a competitive blocker for other investments). Later stage capital markets seem to be more willing to pile into perceived “winners” so the Series A VC can draw a path to where the next few rounds will come from. A result, the more mature the vertical (SaaS, commerce as examples), the less interested a Series A VC will be in an investment that just checks the boxes – ie it’s not about simple milestones. Which also means….

3. Startups are raising more total dollars, in various configurations, to get to the point where a strong Series A can occur

Many of our most successful investments have raised 2-3 rounds of capital before going out to do a Series A, in various configurations, in order to build not just product-market fit, but a real company! They’ve gone to market for a Series A that’s happened quickly and from a point of strength because they’re a real operating vehicle, not just six months of heat. This was the case with Lumi, who closed a very competitive Series A led by Spark. While the total amount they raised during their seed phase wasn’t out of line with a single larger round, they traunched it in a way to accelerate when necessary without taking all the dilution upfront. Call it whatever you want – a pre-seed followed by a seed followed by a seed-2. I don’t care – those are 90% marketing terms.

4. Founders benefit from having a financing partner who will write more than one check into the seed phase when necessary or desired

Homebrew will write multiple checks into your seed phase when it makes mutual sense. We’ve participated in pre-seeds and then led seeds. We’ve led a seed and then doubled-down to help a company go even further before heading out to the markets for a Series A. We don’t need outside validation because we’re investors of conviction. So yes, whether you’re raising your first $500k or multiples of that or your last $1m before a Series A, we want to chat with you.

So founders, whether you work with us or not, Homebrew’s belief is that seed is a phase and increasingly having an investor of conviction who can back you through the entirety of the phase is a competitive advantage. 

[Inside baseball: our goal is to concentrate our dollars in 6-8 investments per year because that allows us to concentrate our time and sweat too. For Fund 2 so far that’s looked “typically” like ~$1m of your first $2-3m raised, but we’ve done several pre-seeds, participating in rounds < $750k and then putting more into your seed. We’re agnostic and can work with you about pros and cons of different approaches. And yes, there is such a thing as “too early” for us, but that’s based on type of company, not stage of development. Will write a separate post on that…]

SoCal Stunners: Why Homebrew Has Gone South

There’s a question we ask ourselves when investing in a startup outside of the Bay Area: is their location a positive for the company? We believe great companies can be built in many locations – not just beloved Silicon Valley – but we do want to articulate *why* a specific company benefits from its geo. This can be based in the founders (strong hiring relationships locally), the local industry (access to customers, partners, talent) or academic hubs (research, talent).

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Our second Homebrew fund, the one we’re currently investing out of, has three Southern California startups, all of which are absolutely better, more durable companies being based where they are versus if they had started in the Bay Area.

Joymode (LA), Lumi (LA) and Shield (San Diego) each take the DNA of their home cities and imbue their companies with a sense of purpose. They’re amazing technical teams without being myopically focused on just their engineering capabilities. Outside of the echo chamber, they’re all taking innovative approaches to their industries. None of the CEOs are playing – they aren’t doing this just because their friends and neighbors have started companies.

Homebrew was fortunate to lead their seed rounds and they’ve all gotten far enough to attract a next strong fund – Naspers for Joymode, Spark for Lumi and a16z for Shield. It’s clear that SV capital will come South when the idea is big and the team is formidable. So we’re happy to continue being Day One investors for founders building in LA and San Diego.

 

What Happens to Farming When Water Is 10x More Expensive & Labor Is Scarce?

I haven’t written much about Homebrew’s investments in the agriculture space but there are two of note, and both are based on beliefs which might be controversial to some.

  1. Our global food supply chain still functions as if water is free and limitless.
  2. Our global food supply chain assumes that cheap labor is available wherever and whenever needed.

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Climate change, consumer demands from a rising standard of living, and shifting political attitudes towards immigration, have put both water and labor very much at risk, especially when you look at the arc of the next 10+ years. But you don’t have to wait a decade to read about dramatic changes afoot. Chad faces a security and humanitarian crisis very much linked to a pivotal water resource drying up. Cape Town creeps towards its “Day Zero” drought where the city will be out of water. Our beliefs about water supply and where crops will be grown informed our investment in Bowery Farming, now one of the leading indoor vertical agriculture startups. Bowery uses no pesticides and 95% less water to grow its leafy green crops in industrial-scale urban facilities.

Even when you can grow, can you harvest? In the UK, tonnages of food is rotting in the fields as a result of changed migrant labor patterns post-Brexit vote. But you don’t need to look thousands of miles away. There are actually crops here in the US constrained by labor supply — highly manual (and arduous) jobs which can’t attract enough labor, even paying 2-3x minimum wage. Because of this we’ve invested in a startup company here in the Bay bringing a combination of robotics and computer vision to the fields (they’re still in seed mode but will be ready for a Series A before too long 🙂 ).

Satya and I both believe there’s lots more innovation to come in agriculture and the global food supply chain. If you’re working in this area and think we could be good early stage funders for you, please do let us know.

We Don’t Talk Enough About Money In Silicon Valley. No, Really.

“Look, I’m incredibly thankful for this industry. It made me a millionaire.” The person seated across the table from me went through a series of facial microexpressions as I said this — surprise, disgust, analysis and finally, calm. We don’t really talk about money in Silicon Valley. At least not in public in a personal way with near strangers. We *speculate* about people and wealth a shit-ton – based upon a company’s last fundraise, based upon current stock price, based on the market price of BTC – but we don’t really talk our own situations, challenges, learnings. When a notable exception occurs – Jason Hirschhorn’s post about selling his first company – it really sticks for me as important. Don’t values and community come from sharing experiences and being vulnerable together? I think so but then why am I getting nervous about writing this post? This is a fraught area of privilege, assumption, envy, fragility. I’m told I’m in a position of power even if it doesn’t always feel like it. I know I’ve got some reach for what I write, at least within a narrow community.

Over the past 20 years in San Francisco I went from negative net-worth grad student to Silicon Valley “Middle Class” (the 2%) to running a venture fund that, if we do our job, will ultimately put me in the 1% or better (in California the average annual household income of the 1% is an astounding $1.4m+). Over my career I’ve benefited from being in the right place at the right time, from being born TallWhiteMale and from working hard. 21 year old Hunter would be very happy to hear how 44 year old Hunter ended up, even if 44 year old Hunter is still a bit insecure.

[Deep breath] There are five conversations about money I’ve had with zero to a handful of people in private that I’ve been wanting to write about. [Another deep breath]

1. The Big Money Ball Bounces Semi-Randomly, Or At Least It Can Feel Like It

One of the things that’ll kill you is equating wealth with self-worth and constantly comparing yourself to your peer group. The money ball bounces too randomly around here and because of outsized returns from new ventures, being at the right company in the right role during the right few years can be worth $$$$$. Even though your equity is unlikely to make you rich, there are plenty examples of when it does to extraordinary levels. And it doesn’t always end up in the hands of diverse, hardest working or ethical people. We can – and should – continue working on changing that system, particularly with regards to pay gaps between the genders and between whites and underrepresented populations. But at a personal, human level you can’t let this eat you from the inside. Ensure you are treated fairly – never let an employer take advantage of you, make sure to get guidance on compensation, don’t be afraid to negotiate – but take a zen-like approach and reject envy. There’s always going to be some dumbfuck who lucked into a multimillion dollar payday. Don’t waste your energy on him.

2. Knowing There’s Another $20 In The Bank Never Stops Feeling Good

It would be an exaggeration to claim I’ve personally known poverty, but I have had zero dollars in my checking account and a negative net worth. It feels shitty even if the anxiety experienced was only a fraction of a percent that true struggle brings. It leaves a mark, one that you don’t forget. The easiest way to translate my own emotion is this: when I go to an ATM and take out a few $20 bills, there’s an accompanying endorphin surge tied to knowing there are many other $20 bills there for me if I need it. It’s like a low rent version of that Oprah story where she keeps a million dollars of cash on hand just to know she’ll never be poor again (or something like that).

What’s the takeaway from this parable? Just to realize that people experience – or are searching for – economic security in different ways based upon their own personal histories. And this influences in an emotional, sometimes irrational way, the types of decisions they make. When I hear “just start a company, you have nothing to lose” know it won’t ring as true to the realities many founders come from and what they need to overcome. Which brings me to…

3. Many People Are Supporting More Than Themselves. And Many Self-Made People Had Safety Nets.

I was lucky – my parents saved money for my college before my dad’s job disappeared in  a corporate downsizing. That salary never came back. Having four years of school paid for in full already put me in rarified air especially as I met more and more classmates who were drawing major student loans to make their education possible.

Now, as an adult, I also see people who are supporting their parents, or their siblings, a nephew, and so on. The compensation needs of these folks might be different than a 24 year old who still has some help paying the rent. It’s why we counsel founders to understand the situation of a potential employee when designing a compensation package (in ways that remain legal and appropriate). Because maybe someone needs a little more stability in the short-term to make the transition possible. And you lose out on great talent if you can’t at least have these conversations. Don’t assume everyone can just eat ramen and sleep on vesting options. People will make sacrifices to work at your startup – seed companies don’t (and shouldn’t) pay the same cash comp as a Google – but if you’re “one-size-fits-all” then you’re less likely to build a diverse team.

4. How Do I Give My Daughter A Great Life But Instill Values & Appreciation?

I signed my daughter up for the major airlines frequent flyer programs when she was born. Might as well start earning free tickets right? The other day she received a mailing to participate in a private test drive event for the new Volvo SUV. My five year old apparently has the marketing profile of a 32 year old upper middle class mom!

Caroline (my wife) and I raise our daughter in SF because we want her to have a sense of community. Caroline is especially important here through her day job leading Twitter for Good (Twitter’s philanthropy and volunteerism effort) and a myriad of personal nonprofit activities. We do a lot of things to expose our kid to the idea of service, to generosity, to diversity. But she also eats organic blueberries and has too frequent Amazon deliveries of books, arts & crafts and Lego kits.

San Francisco has real challenges in its growth but I get sad when I hear people talk about how they don’t want to raise a kid here because of the homelessness and inequality. These are what we need to take a hand in solving! We don’t shield our daughter’s eyes from it; we answer her questions about sidewalk tents. But still, she’s been to Hawaii three times already. Did I mention the organic blueberries – $6 for six ounces – what the fuck!

I’m open to suggestions on this one. We’re just trying our best to instill compassion, work ethic and citizenship.

5. At Some Point It’s About Giving It Away

This afternoon a second-time entrepreneur told me he, at founding, gave most of his equity in his current company to a nonprofit he cares about. That it motivates him each day more than if he was just creating an outcome for himself. I LOVE THIS!

It feels like something is changing – people around me are giving more to political causes, putting their name next to causes. At the fringes I’m hearing more people take pride in their philanthropy and exert social pressure to their peers to donate. Am I naively optimistic? Are the next generation of bitcoin millionaires going to look to buy fifth cars and third homes? Or will we have more people like Halle Tecco and the anonymous Pineapple Fund?

Personally, I’ve got a number in my head – if I can bank that amount everything else is going towards philanthropy. Today, as a family, our charitable and political donations are between $15k-$30k annually. That’s down a bit from when I was vesting Google stock quarterly and could donate appreciated shares, but it’s still an ok percentage of our combined annual salaries. The tech sector is in a privileged position – can our generosity match our accomplishments?

[exhales]

Ok, those are the five $ conversations I have in private or have been afraid to have at all. Not sure I used all the right words or framed all the issues correctly. If there’s something I can learn more about or expose myself to a broader point of view, I’m open to feedback. Thanks!