… as an asset class.
(Note: for this article I am referring to equity crowd-funding exclusively. Not Kickstarter-type pre-orders)
Crowd-funding has a lot of potential at a high level. It promises increased efficiency in the marketplace as worthy startups may be able to raise money faster and simpler than through traditional channels.
However, crowd-funding faces an inherent quality challenge that may be insurmountable. If the funding platforms cannot attract the best deals, then investors will not make any money. If investors do not make any money, then the models are flawed and will eventually fail or adapt.
Let’s discuss the quality challenge.
Consider an early stage company - and assume they have 2 choices, pursue crowd-funding or raise VC money.
The crowd option brings - simplicity, speed, low cost, transparency, and, in theory, means taking money from anyone willing to write a check.
The VC option brings longer cycles and more meetings, but also provides greater control, secrecy, better access to networks, deeper pockets, and experience and advice.
Which path will the highest quality deals choose? The crowd funding platforms are well aligned with what low quality startups are looking for. And high quality startups will primarily continue to raise money from top-tier VCs. Consider the following issues:
High quality startups don’t enjoy diligence (nobody does), but they’re certainly not afraid of it. Their numbers are great, and they know it. Their customers are thrilled with the service and highly engaged. Their team is exceptional and they’re happy to provide references.
Low quality startups, in contrast, may be wary of the diligence process that comes with VC investment. They may prefer a website’s process that’s based on a static presentation, social proof, and team bios.
High quality startups choose their investors carefully, because they view their company’s equity as precious and they will only give it out if people can add value beyond just cash. Their rounds are oversubscribed; they have to turn away investors. When it comes down to picking investors, the crowd will quickly be pushed out.
Many startups may choose crowd-funding as a path to pursue, but I fear that they will choose that path for the wrong reasons. They will choose that path because it’s easier and faster, not because they really want those individual investors involved in the company.
High quality startups usually stay quiet and focus on building killer product (at least in the early days). They shun press until they know they are ready for it. They view press in the early days as meaningless blips of traffic and the potential to invite competitors. Raising money on a website surrenders your secrecy. If startups want to stay quiet, crowd-funding is not an option.
Let’s look more broadly at later-stage equity financing. Assume a startup has started to really take off and now they want to raise a $40M round. Do you think they will turn to the crowd and manage working with 1,000+ investors. Or will they find a firm or two that’s willing to write some really big checks. If I were in their shoes, I wouldn’t want the burden of dealing with thousands of different individual investors.
Crowd-funding today is just a solution for the first funding round of a company. If a startup comes back to a crowd-funding site for a later round, it most likely means that they can’t find anyone to write a really big individual check – and probably for good reason.
Everyone wants to focus their energy on product and customers and build the best business. I’ve never met a good entrepreneur that was excited about spending time on fundraising. Crowd-funding promises to be low-effort fundraising. However, the best startups also have low effort fundraising. VCs approach them. They don’t approach VCs.
Marketplace for Lemons
Everyone should be familiar with the concept of The Market for Lemons. Basically, when you have information asymmetry in a marketplace – everyone must assume that items in the marketplace are of average quality. Therefore, people will list items of low quality because the market will overvalue them. But, people will not list items of high quality, because the market will undervalue them. It’s a critical concept for marketplaces.
Equity crowd-funding as a broad asset class is similar to VC in that it seeks to take a stake in early stage startups and hope for big liquidity events down the road. However, both of these asset classes are dependent on a relatively small number of home runs to make solid returns. These home run cases will rarely be open to investment from the general public… and therefore, crowd investors will lose money. As a result, crowd-funding sites will eventually be in trouble. Right now, they’re at the Peak of Inflated Expectations, but I suspect that they are headed for the Trough of Disillusionment.
Unless… crowd-funding sites adapt to be highly curated and controlled – and focus on brokering introductions and facilitating transactions and less on direct online investments. AngelList is a phenomenal platform. They understand these issues better than anyone and they are building tools to foster exactly these types of interactions. They allow startups to be highly selective about who they accept as investors. And therefore, they will be successful… but their marketplace will look strikingly similar to the way the world works today. Talented investors with strong networks get access to proprietary deals and make money… and the rest of the crowd does not.
Footnote: equity crowd-funding may work much better in other verticals, like real estate investing, small business lending, or things like CircleUp’s vertical – consumer goods companies. It will work better there because the small businesses in those spaces have fewer options for fundraising – and therefore the marketplace will suffer less from the quality problem.
I mean this is just ridiculous. I spent 10 minutes trying to find the right Advil for me - I’m sure it really makes no difference anyway.
Could probably cut the number of SKUs by 10x, make the experience 10x better, and each store would be 1/4th the size.
I recently wrote an article for the WSJ Accelerators covering 4 major turnoffs during pitches.
Here’s the full article on WSJ: Keep It Simple.
It’s not demo days. It’s not AngelList. It’s not lawyers or bankers. It’s the stuff that happens behind the scenes.
Due diligence calls.
I recently led a $2M Series A investment for my firm, Sigma West. It’s in a company that’s building a killer analytics and engagement platform (still private, announcement to come soon). I met the founder of the company (let’s call him “Andy”) about 2 years ago when I was doing due diligence calls on another analytics company. I was looking for info about how gaming companies were building their analytics tools and what they thought of the various 3rd party solutions out there. I knew a friend of mine had gone to be a PM at a prominent gaming company - so I asked him who was in charge of analytics. He referred me to Andy.
When I called Andy it was on the pretense of seeking his advice and information in an important investment decision. It was a back channel reference. It was not made by the company we were looking at, but it was made via a trusted mutual friend. This sets the stage perfectly for a completely open conversation. The other important note is that Andy was a clear rising star in the company, which is why he was leading a very important department like analytics. On the first call with Andy he told me candid and detailed feedback and problems with every vendor on the market. It was information I just hadn’t heard before. It was clear and succinct. He clearly had a phenomenal grasp of the space and had a crystal clear understanding of what these gaming companies really needed. He was years ahead of the rest of the pack in terms of his thinking. During the call, he also told me about some problems with the company we were looking at, and he explained to me why the system he built internally was significantly better. I believed it.
So, I was interested to learn more. We met for a sushi lunch in San Mateo. We spent most of the time talking analytics - talking about the system he had built. I was blown away. I had already looked at a dozen companies in the space, but nobody was doing what he was doing with his internal tools. At the end of the lunch I picked up the tab and asked Andy if he’d thought about going out on his own. I encouraged him to pursue building his technology for others and founding a company himself. I told him to call me if he ever did.
Two years later, he called me. And I invested.
This deal came through a back channel diligence call. I believe that these calls have two very significant benefits that make them good sources of deal flow.
1) Pretense - in normal meetings with VCs and entrepreneurs, someone is always selling. Selling puts people on the defensive. Nobody wants to be sold to. In diligence calls, it’s quite the opposite. It’s a trusted mutual connection for the open exchange of information. The conversations tend to be very candid and opinions are shared freely. Nobody is trying to impress the other person - and as a result, both people are impressed.
2) Quality - any introductions for diligence calls are typically made to the smartest person about a particular subject. It’s not necessarily the CEO of a company, more frequently it’s the uber-smart director or VP that knows a subject at a deep level. People are inherently very good at assessing relative knowledge in other people. If you ask me for a contact who is very knowledgeable in tax issues, or legal issues, or freelance marketplaces, or the solar industry — I will have a specific and immediate response for each one of those. I will refer you to the best person I know (assuming I think it’s a valuable use of both people’s time). The same goes for any back channel reference intro.
Due diligence calls are an important part of deciding whether or not to invest in a company. The best diligence calls tend to be through back-channel references and intros. These intros are made to very high quality people and you start the call with a strong pretense to establish a good relationship. You’ll get a bunch of good information, and as a nice added bonus, the person you’re talking with may be about to break out and start a company. And when they do — you have the inside track.
The lesson for me as a VC is to treat every person you talk with as if they could be the next founder that you’ll back.
In the press and on home pages across the web you see metrics like 100,000 expert freelancers or over a million sellers or “adding 3,000 new users per day.” Those all sound great, but they are irrelevant to the health of a marketplace company. The press and other VCs still eat them up though, and that’s why you keep seeing more of them. There is a much more critical metric being overlooked because it’s just not as glamorous.
That metric is the number of full timers.
What sounds better to the press and investors?
100,000 experts or 100 full-time experts.
I’ll take the 100 full-timers, but I think most others would go for the big numbers.
Take a look at successful marketplaces:
- eBay has power sellers.
- Etsy has the 10k club - for sellers that have sold over 10k items.
- Uber has full time drivers.
- Rev has full-time transcriptionists.
oDesk’s core user base in the beginning was a very small (about 50) number of php programmers in Russia that we quickly employed nearly full-time. I chatted with almost all of them on a weekly basis. When they were under-utilized, I would work my ass off to find them a new client so they could continue working full-time through oDesk.
Full timers define the health of the marketplace. The 80/20 rule is in full effect here. Marketplaces need a metric to indicate how many people are really heavy users of the platform. In labor marketplaces, you can think of it as the people that are relying on the platform for their primary source of income. Those people will be incredibly motivated to help the company, to increase their earnings, and to invest in their online reputation. In contrast, if you don’t have people that are relying on you for their primary income, you’ll have a very fickle audience. They will not care much about their online reputation, they will not drive turnaround times lower, and they will be disintermediation risks. They won’t open your emails, they won’t participate in your community forums, they won’t give you product feedback, and they won’t be telling all their friends about the platform.
It’s the full timer who will do that.
You can also be sure that if you ask the full timers the Sean Ellis question, “how disappointed would you be without the <marketplace>?” — you’d definitely get the answers you’re looking for.
Second, look at the issue of utilization rates. When I was in consulting, I had to maintain an 80% billable ratio. Same goes in labor marketplaces. But, you need to work with the supply side to help them achieve the high utilization. Make sure you have enough demand to support your network - make sure they can spend most of their time working and earning. In many cases, you need a surprisingly small number of providers to support the demand.
In the past couple days I’ve had chats w two successful marketplace entrepreneurs. I was amazed to see that one of them had only 12 individuals on the supply side supporting a 32k monthly business. He knew every one of their names and new that one was having some health concerns. They were all part of the family. In another conversation, Chris Waldron from TakeLessons shared that he included every provider in the network in a bi-weekly town hall meeting. They were treated just as he treats the full employees of the company. This could only happen with a complete focus on the core full timers of the business.
To judge success, a key metric should be determined for the business - maybe it’s # of people earning more than $500 per week, or # of people working more than 30 hours per week. I bet Uber has phenomenal metrics in this regard for their drivers. Every driver I’ve talked to says they get all their business through the platform. If they had instead added 1000s of drivers before they had the demand to support them - all of the suppliers would lose interest very quickly.
So, the next time a VC asks “how you are going to get the providers” - just tell him that’s the wrong question to ask.
I love anything that lowers the customer effort. The best companies in the world are on a constant quest to make things easier. Trader Joe’s has made a very simple innovation to the standard Express Lane.
a) counting the items that you’ve selected to see if you’re under the 14 item limit, and then deciding which items to put back if you’ve accidentally selected 16 items.
b) know if you’re carrying a hand basket.
I recently finished reading Antifragile from Nassim Nicholas Taleb. In short - it’s amazing. Easily makes it to my Top 10 Books Ever Read list. Everyone should read it for business and for life. It unifies Wall St bailouts, Silicon Valley’s success, why restaurants are good, and why the Paleo diet is best for your body.
What does antifragile mean? - It means things that gain from disorder.
Or as wikipedia says:
"Simply, antifragility is defined as a convex response to a stressor or source of harm (for some range of variation), leading to a positive sensitivity to increase in volatility (or variability, stress, dispersion of outcomes, or uncertainty, what is grouped under the designation "disorder cluster"). Likewise fragility is defined as a concave sensitivity to stressors, leading a negative sensitivity to increase in volatility."
So, I’ve reflected on my time at the early days of oDesk and what we did. I believe we were doing some practices that were antifragile, we just didn’t have a good way to describe it. Obviously, Taleb is far more eloquent and intelligent than I am.
We had some sayings in those early days:
- Throw stuff against the wall and see what sticks.
- Break sh!t.
- Play whack-a-mole
- Fast fail.
- Try before you buy.
- Be more experimental.
All of these things have elements of being antifragile. It’s also basically at the heart of the Lean Startup movement. Embracing failure and learning by observation tends to be better than lots of theorizing about the best strategy.
If I were in a startup now, I’d constantly be thinking about how to make the businsess antifragile. How to make mistakes and learn from all of them. How to make sure that all employees have “skin in the game.” How to create a culture of rapid iteration and experimentation. How to limit downside and maximize upside potential.
Now - go read the book and Be Antifragile.
Everyone knows that the best way to approach VCs is through an introduction. Mark Suster points out 4 obvious channels for introductions: lawyers, recruiters, portfolio companies, and other entrepreneurs. There is also other VCs and angel investors. But, from a VCs perspective, all intros are not created equal. There is a huge difference in my level of excitement for a startup based on the person that makes the intro.
The point of going through an introduction is widely understood: VCs get tons of pitches and going through an intro is a good first-pass filter. I take meetings with almost all introductions that are made to me (fire away). But, like I said, I place my own filter on the quality of the referrer.
Here’s a little inside peek into the way I think about it:
The questions are:
How good is the deal flow of the referrer? Do they hang out in elite circles? Or are they fishing from the bottom of the well. The quality of the referrer’s network is usually proportional to the quality / success of the referrer. If the referrer has had great success, chances are their network is damn good. In addition, seeing a lot of deal flow tends to increase the referrer’s judgment. As a species, we’re really good at determining relative strength and poor at determining absolute strength. So, seeing lots of deals means that you’ve seen enough data points to understand which ones are the best, and hopefully you’re helping those companies out with introductions. This criteria is far more important than how well I know the referrer. I have some great friends that make intros, but I don’t necessarily respect their judgment about startups.
What is the incentive of the referrer? Introductions are the social capital of the valley. What’s in it for the referrer? I want purely intrinsic motivation. If the intro is coming from an existing investor, it may be great, but they are also protecting their investment. If it’s coming from a lawyer, they are probably on the startup’s payroll. If it’s coming from another entrepreneur who is just a friend, the motivation is to improve social capital by making quality introductions on both sides. I like it when intros don’t have any financial incentive attached to them.
So, the 2 key things that matter when I assess the intro:
- Quality of Referrer’s Network (their deal flow)
Disclaimer: I sincerely hope that nobody is offended by the following statements. These are simply my candid observations from the past couple years. These statements are all broad generalizations, of course there are exceptions. I hope to continue receiving deal flow from all of these groups, so please don’t step sending intros. :)
I took a stab at charting out introduction quality on this 2x2 matrix. The most interesting finding for me was the VC introductions. It’s possible that the conventional wisdom about VC introductions is wrong. (conventional wisdom is that VC intros always beg the question ‘why didn’t you invest’ and therefore are a deal-killer) If a VC that hasn’t invested in a company refers a deal to me, I have to believe that 1) they see a lot of deals, 2) there is some reason they passed, and 3) the motivation is to strengthen future co-investor relationships. In order to strengthen relationships, you obviously need to send quality introductions. Therefore, I have to assume they passed because it wasn’t a fit for industry, stage, or competitive reasons, but not because they thought it was a bad business.
Let’s look at a few categories in more detail:
Lawyers - I value these fairly low. Lawyers are paid contractors for a startup. If I’m paying someone and I ask for an introduction to people they know, they’re somewhat obligated to do it to preserve the paid relationship. Also, since they don’t have the benefit of seeing a lot of the same type of company, they are not great at judging the relative quality of each one.
Bankers - these are the worst. If you hire a banker to try to help raise an early round, it’s the kiss of death. It reeks of desperation since you can’t get intros without paid help.
Recruiters - I rarely get these, probably because I don’t know that many recruiters. I think they fall into the same camp as lawyers though.
BD folks - these are interesting. Take for example, a BD director at Salesforce working on the Force.com platform. They see a ton of startups building apps on top of their platform. They have inside information about how well these apps are performing in the marketplace. They have a good instinctive sense of what their customers will adopt and what they will not.
VCs - As I mentioned above, I think the conventional wisdom might be wrong on this one. Of course, if everyone believes it then it doesn’t really matter. VC intros that are looking for co-investors or follow-on investors can be really good intros. I believe there probably should be more VC to VC intros when someone is passing on a deal and it shouldn’t carry as much of a stigma as it currently does today.
Angel investors - depends all on how much I respect the angel investor. Have they done good deals? Are they making the intro because it’s a deal they’ve done and it’s going south? Or because it’s a deal they’ve done that’s doing well and is a unique intro to me because of my expertise. Is it an angel investor that’s in a ton of companies or is it an angel investor that does a few, focused investments (the latter is better).
Entrepreneurs that we’ve passed on - We passed. There was a reason. These are still usually good and my second favorite source of intros, but it’s a mixed bag. If the entrepreneur knows me well, there’s a good chance that I was quite interested in the startup and have a lot of respect for the referrer. If I’ve only had one meeting with the entrepreneur, chances are lower that it’s a strong intro. You could ask why we passed and that will give you a good hint of whether or not you should ask for an intro from them. Overall, these are my second favorite source of introductions, just be aware.
Entrepreneurs that we’ve invested in - Well, this is kind of obviously the best. I saved it for last. We clearly love the entrepreneurs because we invested. The motivations are very “pure” - they don’t want to send poor quality introductions and will usually apply the strictest filter. Whenever possible, try to go this route.
So, my final thoughts: From the entrepreneurs perspective, just know how which introductions are the most powerful and act accordingly. From my perspective, I welcome all introductions and almost always take the meetings, but the referrer does have an influence on the “starting point” for the startup. Great introduction - I’m already excited. Poor introduction - I still need to be convinced.
Over the last 8 years I’ve been either responsible for or involved in product management at a number of different startups. I think I’m ok at product management — hopefully I’m better at VC. I’ve made many good product decisions over the years, but I now realize the biggest mistake I’ve made over and over again.
It is summed up simply as “Let’s give consumers choice.”
It is surprisingly easy to fall into a trap of offering too much choice. When we were building out features, there would be healthy debate about which options to offer and the pros and cons of each choice. Frequently, we lacked good customer data to choose only one option so we offered both to see which one customers adopted. In other cases we thought we were doing a great job of capturing the voice of the customer. We were getting feedback like I “I love your product but I really wish you offered it in green.” So we’d say “great, let’s make it in green too.” Or we’d get a really big enterprise customer calling on us and they requested just one little change to the product… So we’d build out a custom option that would allow a different configuration by each user account. On another occasion, I’ve used a checkbox on order forms to offer premium services. It’s easy to make an argument for it — some customers specifically asked for the premium services and we could capture more revenue from them. Why wouldn’t we offer that premium service?
The paradox of choice is a pretty well-known concept, and of course I know about it too. Basically, too many options cause higher levels of inaction and stress. I recently read on Farnam Street (my favorite blog), about how the president reduces choice in his life because humans are only capable of making so many choices each day. So, he’s eliminated mundane choices in his life. He only has 2 color suits: blue and gray. Asking customers to make choices adds stress and pain to the experience. I now summarize this as: More choices = more customer effort = lower satisfaction = lower organic growth.
But, it’s not just that. Having this as a strategy causes further problems in startups that may not be as obvious initially.
1) Offering low quality. Why not just provide the best? But you might say its too hard to figure out what the best is. You might say it’s hard to tell which option is best for which consumer. I’d say too bad. Make some tough choices and pick what to focus on. If I use Yelp to pick a 4-star restaurant and it turns out to suck, I’m going to be disappointed with both the restaurant and Yelp. I will not admonish Yelp of guilt in the matter just because they are a directory. Yelp would be more useful to me if I simply never saw bad restaurants.
2) Inability to course-correct. Let’s say you offer 3 options. 60% choose option A, 25% choose option B, and 15% choose option C. Then later you decide that you’d like to focus more to provide a better experience. So, do you just cut option B and C? Not an easy decision to make. Practically speaking, there will be some discomfort with taking away an option that your valued customers have chosen. This makes it more difficult to make the right decisions for the company.
3) Less control of liquidity. For any marketplace business, you want to be able to optimize liquidity. You want your best suppliers to be busy all the time on your platform - that will create the best overall experience with your company. It’s part of a framework we’ve developed for marketplace quality: attract, screen, optimize, retain, expel. Optimize is a key step. All of the best suppliers should be able to dedicate all of their time and energy to your platform. They should not work to get jobs or sell products. Look at the App Store. The App Store is very highly curated and contains a Featured section which gets a tiny number of apps a massive number of downloads. Now look at Craigslist. It’s one of the most amazingly resilient companies I’ve ever seen, but I still think its doomed because it requires tremendous effort on the user’s part to find the best apartment / job / etc. If you’ve made a strategic decision to offer choice, it paralyzes you on the optimization step. You can’t make decisions that favor one supplier over the other even though it’s the right thing for the business and the consumer. If you’re set in your ways about giving consumers choice, you would never have a Featured section.
4) Inability to go Mobile - this concern has surfaced in the past couple years as traditionally dominant web companies try to make the move to mobile, and in many cases, fail miserably. I believe several have failed in the switch because they’ve tried to simply replicate their web experience on mobile. The problem is that the web experience had too much functionality that made the mobile app experience overly complex. This migration problem opened the door for companies like Flipboard and Instagram to storm in and create a better mobile experience because they are focused on one, and only one, use case.
Oh and one final point, who the hell wants to maintain all those options and keep them working for users? Everything gets easier when you’re focused on as few choices as possible… Marketing, development, QA, customer service. Everything.
I was running online marketing… my main goal was user acquisition. We were doing quite well against that goal through SEM, SEO, social, and optimizing NPS for word of mouth growth.
Over the years on the marketing team, I’d end up in conversations about our mission statement or our positioning statement and I would usually groan a little bit. We’d spend hours going back and forth over existential questions like “who are we” and “why are we doing this?”. I wanted to leave every meeting where we talked about the pros and cons of a single word for an hour. I found it to be distracting from my core goal and so I didn’t spend much time thinking about it. I didn’t see how it would help me achieve my goals. Now that I’m in VC I have seen the real purpose of the mission statement and I never understood it back then.
A mission statement is critical for recruiting.
Maybe this is obvious to people already, but I had never fully internalized how critical it is to recruiting world-class talent. A-players have lots of options and need more than just extrinsic motivators to take a job and dedicate their life to it. They need strong intrinsic motivators as well, a strong sense of purpose. How motivated do you think Zynga employees are to copy the latest hot game and optimize the hell out of virtual pigs and goats? See Zynga’s brain drain.
Now that I examine more companies I see the mission statement as a substantial differentiator. If a company can clearly articulate their mission, they have a huge edge on recruiting. Look at some of the statements on the career pages below.
Facebook - Make the world more open and connected.
Tesla Motors - Tesla’s goal is to accelerate the world’s transition to electric mobility with a full range of increasingly affordable electric vehicles.
McKinsey - Enabled development of cutting edge vaccines.
Votizen - Help us repair democracy.
Inkling - We’re going to change the way an entire generation of people learns.
Twitter - We’re connecting people everywhere to what they find most meaningful.
What do they have in common? They all talk about a mission that makes the world a better place. What’s your mission statement? Is it something that people will rally behind? Is it a cause that will fire people up? It better be if you want to recruit the best.
I’d love to hear your mission statements in the comments.
PS - Just for a little contrast, it’s funny to look at NASA’s career page that begins with “Our work ranges from the everyday operating of our facilities…