What the F just happened and what am I going to do about it?

By Jules Miller

Originally posted here on LinkedIn on July 7, 2015

Wow, the last two weeks were a wild ride for the venture capital industry. There were public accusations on the record, lots of shocking shakeups, and a seemingly never ending series of blog posts on Medium. New information continues to pour out at a blistering pace, and many are now left with their head spinning.

One thing is abundantly clear: this is a pivotal moment in time for Silicon Valley and startup/investor communities around the world.   

Rather than focus on what happened or why, I’d like to focus on what we can do about it. Specifically what I can and will do about it as an investor, entrepreneur and member of the global startup community.  

While it’s extremely important to to speak up against injustice and hold people accountable, and I am in awe of the brave souls who have done and continue to do this, I choose to focus on the future. Many of the best entrepreneurs have a bias toward action, and JFDI is my own personal and professional mantra. So as a small step forward in the healing process I am making the public statements below, and holding myself accountable, on what I will personally do to be the change I wish to see in the world.  

What the F Just Happened?

For those who haven’t been following, a quick synopsis to get you up to speed:

Just a week and a half ago, The Information posted an explosive story with 6 women - 3 on the record - accusing Binary Capital Managing Partner Justin Caldbeck of sexual misconduct. People had a lot to say about this (here, here, here, here, here, here, hereand many more). A lawsuit was filed by a former employee claiming that she resigned due to the sexist culture and that the Binary partners actively threatened her ability to find new work. Also, while Caldbeck was an Associate at Lightspeed Ventures, Stitch Fix founder Katrina Lake accused him of sexual harassment. Lightspeed’s reaction was to require her to sign a non-disparagement agreement in order to prevent them from sabotaging her next round of funding...a deal that Lightspeed wasn’t even participating in. Thankfully, Binary’s LPs took swift action and voted to dissolve the fund early last week - within just 5 days of the story breaking. 

To me, the most disturbing thing was a demonstrated pattern of (alleged) behavior specifically focused on Asian women over the course of 10+ years. This seemed to be an “open secret” known but overlooked by employers, LPs and other VCs.  

People seemed to be waiting to see whether this incident would be quickly forgotten as a slight blemish on the VC industry with the continuation of business/bias as usual, or whether it would herald in a real, and desperately needed, change in culture.

Then The New York Times article came out on Friday with several more women naming multiple investors, including high profile folks like Chris Sacca - who cast a pre-emptive strike acknowledging his bad behavior and suggesting ways to make up for it - and Dave McClure - who resigned as GP of 500 startups due to being “a creep,” with more than a dozen allegations of sexual misconduct mostly directed at women of color. There were some truly awful apologists, and a reminder that the degree of harassment matters, with disturbing details.

It’s still early days, but I am hopeful that this moment in time has created momentum that will usher in dramatic, lasting, positive change. We are now in a post-Binary world.

My Personal Experience

For anyone who’s been working in the tech or venture world, this behavior was not a shock. It’s not just Caldbeck or the other investors named recently - unequal treatment of women and people of color is a pervasive problem in the venture capital industry. I’ve been hearing these types of stories and seeing them first hand for the past 13+ years. Most people in the tech industry know it’s a problem and talk openly in private groups but, until now, few have been brave enough to talk about it publicly for fear of it destroying their career, their company, and their ability to ever raise capital. 

As a former founder who raised money for my prior company, I have personally experienced two specific incidents of sexual misconduct during the fundraising process, in addition to hundreds of small, daily examples of being treated differently than male founders in a way that I believe was detrimental to successful fundraising. These "million paper cuts" - highlighted often by the brilliant Yin Lin and Lisa Wang at SheWorx - are often worse than the overt examples of harassment and stem from a culture that is not willing to reprimand this behavior. I would often joke that “one day I’ll write a book, but right now I just need to focus on closing this round and building the business.”

I knew that calling out the inappropriate behavior would have been the right thing to do, but there was always a fear of retribution, of getting blacklisted, and of not raising the capital my company needed to grow. So I overlooked it. When you put everything you have – your time, your money, your career capital – into a business, you’re willing to deal with a lot of pain to make it successful. The uncomfortable comments, propositions, discounting of ambition, etc. are just a few of the many painful things women entrepreneurs deal with when building a business. However, I was always very aware that the overt and subtle acts of sexism on a near-daily basis were things that my male counterparts did not have to deal with.

There is solid research that investors treat women founders differently, ask them different questions, talk about them differently, and are impacted by physical appearance. This directly leads to fewer investment dollars going into female founded companies and dissuades many women entrepreneurs from seeking venture capital. It is important to note that this is not just male VCs - women VCs engage in the same damaging behavior (though usually with fewer overt sexual advances). There is also a wealth of data (here, here, here) showing that women-led companies are, in fact, a smarter investment. There is a clear gap in the market.

What I Will Do About It

This type of behavior and the culture that supports it is a big part of why I joined LunaCap Ventures, a NYC-based fund that provides both venture debt and equity financing to early stage companies with women, people of color (POC), and military veteran founders. We also proudly have a team that represents the diversity in which we invest. I’ve dedicated my career to solving the problem highlighted in the news of the past two weeks, not because I think this behavior is atrocious and needs to stop (I do), but because I’ve seen first hand that there is an enormous opportunity to fund exceptional founders who are not receiving funding. These investments offer tremendous potential upside to investors.

“A little less conversation, a little more action please.” -Elvis Presley 

The 9 actions I will personally take:

1. Invest in Women:

I will use my privileged role as a professional investor to provide capital to as many amazing women founders as I can within the current structure, thesis, and return thresholds of LunaCap Ventures. I will also invest in women-founded companies as an angel investor in companies outside of the LunaCap thesis. 

2. Make More Women Founders Massively Successful:

I will actively help the amazing women founders in my portfolio to grow their businesses by rolling up my sleeves to help them with whatever needs to be done to make them massively successful. This includes actively helping them to raise follow on funding, ideally from funds who hold the same commitment to decency and diversity. I believe that the best way to convince VCs to invest in women is to show them the money to be made. More massively successful women entrepreneurs will also create more women angel investors, VCs and serial entrepreneurs. 

3. Remove Barriers:

Many founders who come from diverse backgrounds simply don’t have the same access to investors as the archetypal “Stanford CS bro.” There is generally a requirement to get a warm introduction from someone a VC knows, and generally an extremely high quality senior contact, or the investor will not take a meeting. I believe that this puts diverse founders at a disadvantage since their networks of investors and successful entreprepreneurs may not (yet) be very strong. As a result, I will no longer require a warm introduction to seriously consider an investment opportunity.    

4. Create a Whitelist:

A blacklist - such as the one created by Y Combinator - can be helpful to know who the bad actors are, but I think a whitelist of good actors is even more helpful. I will publish a public list of venture capital funds I’m aware of that have a woman General Partner. This can serve as a resource for LPs to know who to invest in, for entrepreneurs to know who to raise money from (why should we be making money for ass holes?), and for other VCs to know who to partner with on deals and/or try to recruit to their own teams.

5. Be Transparent & Report Publicly:

I will report publicly on a variety of diversity metrics for our portfolio at LunaCap Ventures, going beyond simply tracking founder diversity but also a broader list of metrics and “softer” self assessments. This isn’t an exact science and I will learn how to do this better with practice, but I will start. 

6. Create Standard Metrics:

I will help to create a standardized framework for VCs to report on portfolio diversity. It’s early days, but the initial work is already starting on this thanks to the self-organized “Inclusion Crew” of nearly 60 investors from the Kauffman Fellows program, where I’ve recently joined the newest class. This group authentically and passionately cares about being part of the solution and is tackling a variety of initiatives supporting diversity and inclusion (add your suggestions here).  

7. Provide Support:

I will actively listen to founders who have experienced some form of bias or harassment during fundraising, or in the general course of building a business, and do whatever I can to help. 

8. Engage in Dialogue:

I will engage in dialogue with people who do not believe sexism in tech/VC is a problem, normalize it, or acknowledge that they may be part of the problem but don’t know how to change it. I’ve already had several private conversations and welcome more. 

9. Stay Woke:

Even when the media attention to this topic dies down, I will continue to make diversity and inclusion in tech and VC a priority.  

This is what I’m doing. For entrepreneurs, VCs, LPs, and anyone in the startup community, I encourage you to think about what you can do, commit to do it, say it publicly, and JFDI.

The VC Landscape

By Paul Capon

Where is the VC environment heading and how do you avoid getting caught up in the pitfalls?

Today’s venture capital environment is more robust than ever before. Business school graduates are turning down consulting and investment banking offers from top tier firms in hopes of joining or creating the next Facebook or Uber. Hollywood is producing shows and movies like Silicon Valley and The Social Network, fueling the hype and interests of budding entrepreneurs. I greatly support the entrepreneurial spirit, and applaud folks who take a bet on themselves to create something and add value to others. I do, however, caution investors and entrepreneurs that over the next 3-5 years, returns to traditional VC’s might take a hit and access to capital will prove to be more difficult to come by. I have outlined the trends below and discussed what I believe their impact to be on the industry at large.

 1) Increasing number of startups entering the scene

According to the National Venture Capital Association (NVCA), in 2009 the number of companies looking for first round institutional investment was ~1,010. In 2014 this number grew to ~1,500. While there is much debate around the cause of this growth, advances in technology, access to capital, and the millennial mindset play a big part. Today it’s easier and cheaper than ever to create your own website, market your product, and support your back end needs. Companies such as WeWork, and other co-working spaces further facilitate this growth by enabling companies to establish themselves without the traditional high cost of office space and other associated costs. Mix this with investors fighting among each other to invest and you’re off to the races. Lastly, as a millennial, many of us were told our entire lives that we could achieve anything we want, do what makes you happy and the money will follow. As the millennial generation joins the work force, their motivation and personality tend to favor the structure (or lack thereof) provided in the startup environment.

2) More capital in the VC markets

 In 2003 the total venture capital investment was $19.7 Billion. In 2014, this number grew to $49.3 billion (NVCA). With interest rates at an all-time low, institutions and individuals are seeking to deploy capital in the equity markets. Additionally, to facilitate the already aggressive demand in the space, platforms such as Seed Invest, Funders Club, and Kickstarter have increased the exposure of deal flow, and greatly eased the ability to invest in start-ups as an institution, but more importantly as an individual accredited investor. The combination of the current economic environment and an increasing number of ways to invest in the VC asset class, has led to the large available pool of capital we see today.

 3) Exit opportunities and numbers for VC backed companies have not grown. Leads to a surplus of companies and lower exit opportunities.

In 2010, the number of venture-backed exits were 525, and fell to 459 in 2014 (NVCA). Exits, whether it’s through the M&A market, IPO, or private buyout, are needed for funds to eventually realize a return for the later stage VC’s. For the VC industry machine to maintain its returns, the number of exit opportunities would need to increase to match the corresponding number of companies entering the pipeline. As this mismatch between entry and exit persists, a higher percentage of companies will fail to exit and as a result, lower the returns to the VC industry as whole.

 Putting it all together

While we will not encounter the same losses as we did in the dot.com bubble, there will be a hit on the industry return because of this imbalance in the VC environment. Because there are more companies entering the race, and more capital justifiably or unjustifiably funding them to later rounds, fewer companies are falling out of the race when they should be. Since the number of exit opportunities hasn’t increased to meet the exit demand, a larger number of companies will reach a stage in the race where they will compete for fewer exit opportunities. Companies that are not able to exit successfully will hurt the returns for the industry as a whole. Portfolios are doing well so far because the capital available in the market enables companies to raise follow on rounds at higher valuations. I argue that many of these valuations aren’t based on the actual fundamental performance of the company, but rather based on the surplus of capital in the investor market and competition to join the deal. If the exit opportunities don’t increase to meet the next wave of companies looking to exit, I fear that the capital markets will pull back, and send a shock through the funding pipeline. Companies that were unjustifiably carried through the funding rounds will be hurt the most, along with the VC’s that backed them and LP’s will look elsewhere to deploy their capital.

 How do you avoid this?

As an investor, I see a number of folks set on seeking out the next Facebook or Instagram, and investing at ridiculously high valuations that I find hard to justify. Valuations are based on over idealistic and aggressive assumptions. “If we get 100MM users we can do…XYZ”, that’s a big IF. While some companies may succeed with this model, it lends itself to an all or nothing game. Either you reach the critical mass of users to generate revenue through selling data, advertisement, or any other revenue stream associated with user numbers or you don’t. As an investor, I try not to invest in these types of companies, and tend to focus on the companies that have revenue associated with an actual product and sustainable cash flow.It’s harder for these types of companies to be overvalued, and if the capital availability dries up, companies that fall in to this category will be better positioned to continue forward.

In closing, I’m not advocating that everyone pull out of the start-up world, and predicting doom and gloom. I am just trying to highlight the trends that are materializing and providing food for thought. I do suggest that if you decide to invest, you carefully think about the types of companies you want to invest in, and highlight that the sexier, great idea (shiny object), may not be the best investment in the long run. The start-up environment is here to stay and unlike the dot.com bust, it is founded on a number of well-established companies with great business models and actual products. Just be cautious when hearing these incredible valuations and ask yourself if the company truly deserves it, or if it’s a company that should have dropped out of the race.

Venture Debt Vs. Traditional Venture Capital

By Paul Capon

What’s My Valuation?

Over the past 6 years, interest rates have remained at historic lows, fueling the economy with cheap capital.  Low fixed income yields have pushed investors to search for high returns in the riskier equity markets.  This unbalanced risk-to-reward ratio has ballooned already over-capitalized private equity and venture capital markets; inflating valuations and producing a bubble. 

Moderate risk-taking investments provide the capital foundation for innovation, economic growth, and prosperity. Mispriced risk, however, can be catastrophic.  Overcapitalization is driving the inflated valuations and oversized investment checks that are prevalent in today’s market.  To make matters worse, a number of additional catalysts will lead to a sell-off and loss in the VC industry within the next 2-3 years.

Overinflated valuations are the largest catalyst. These valuations resist rebalancing due to the illiquid nature of VC investments.  VCs often invest in companies that have never generated profits (or even revenue in some cases).  The capital invested is typically through investment instruments in the form of convertible notes or straight equity.  Investors’ capital is generally locked up for a period of 5-10 years and turns liquid only when equity positions are bought out.  Until then, an investor’s only metric for investment performance is based on either priced rounds or comps.  

Conventional VC pricing methodology is flawed, with incentives that are improperly aligned and a process that provides no counter-weight to create valuation equilibriums. Most priced rounds typically consist of additional investments from similar (and/or existing) investors at each round, and it is in the interests of both new and existing shareholders for the valuation to increase at each capital event.  

Actual numbers

The going market rate for a new company’s valuation with an idea (pre-revenue) is in the $1 - $5 million range.  This means, a company looking to raise $200K to build its first line of code would part with 4-20% of its equity.

Let's assume that same company, one year later, is successful and can show sales of $500K and an annual burn of $300K - it looks at raising an additional $500K.  The company compares itself to another company in a similar space and industry that shows the same economics and raised a $500K round at a $6 million valuation. Our company points to that valuation to justify the price of their current raise and, additionally, argues why they are better positioned to justify an even higher valuation, enabling them to retain more equity for the same raise - the deal gets done at an $8 million valuation.  Current investors (excluding dilution), would mark their investment as having doubled in one year.   Our company, with sales of $500K and a loss of $300K, it is now valued at $8 million; all due to the current state and structure of the VC financing market.

Keep in mind that no cash has actually been returned to any investors and no sale has been made for full price.  In this case, the sum of the parts does not equal the whole. This is the fundamental problem and it will come back to haunt many of these companies and VCs at the end of their investment period.

Why invest in losses?

Let’s go back to the fundamental elements present in today’s economy: low-interest rates due to government intervention led institutional investors to allocate capital towards riskier assets, generating larger returns to justify their fees.  It is a seller’s market, in favor of companies raising capital, and because recent historical valuations continue to grow “on paper”, investors are willing to invest at astronomical valuations regardless of a company’s economics. 

To make matters worse, many platforms enable both accredited and non-accredited investors to invest in companies they never talk to, meet, or understand.  These platforms will carry out the due diligence on your behalf and offer you documents if you ask, but they are also incentivized to promote transactions to feed their revenue model.  For many novice investors, the “invest in 10 companies and 1 win will cover my loss” mentality is enough to deploy capital on recent historic valuation performance; the same valuations we just learned are not necessarily a function of a company’s economic performance.   Betting on a self-fulfilling prophecy where the first company to walk the path becomes the benchmark only reinforces the cycle and dilutes the next investor.  

Snowball effect

In order for all investors to get their money back and actually realize their perceived returns, there has to be an exit or buy-out at that final valuation.  Companies are approaching private equity groups, the IPO market, and potential acquisitions proudly waiving a $100 million valuation and expecting a check.  While a few companies will make it through and justify their valuations, many companies will not come close to having the revenue, cash flow, or profitability to warrant such an exit value.  Private equity funds and larger companies are correctly questioning valuations and only bidding a fraction of the asking price.  

What is the result? A company on paper that showed growth for 7-10 years with an ending valuation of $100 million ends up selling at $50 million, creating a huge loss for the investors.  This will most likely affect later-round investors, who are usually the ones writing the larger checks.  Once this happens VC firms will struggle to redistribute capital to their LP’s, forcing a sell-off of other portfolio companies and creating a snowball effect throughout the industry with large selloffs at discount prices. 

The case for hybrid growth capital

LunaCap Ventures’ investment thesis enables us to generate yield and return capital regardless of paper valuation, all while maintaining exposure to the potential upside of the VC world.  LunaCap invests with a hybrid growth capital instrument.  We provide a non-convertible term loan with multi-year amortization and equity participation, typically in the form of warrant coverage.  The term loan, and regular payment requirement, simultaneously filters for companies that prioritize cash-flow and provides our economic foundation.  It enables our investors to receive cash yield on their capital allocations to LunaCap. The term loan mitigates risks with a short term maturity, and as protection, often sits senior on the capital table – providing downside protection.  Additionally, our warrant coverage is generally 5 times smaller than the equity a company would have to part with in a conventional VC investment of comparable size, yet helps drive an average LunaCap return commensurate to that of early stage investing. 

On the company side, overall cost of capital is much lower than the classic VC model when accounting for the value of the 80% equity retained.  For LunaCap, this provides the most important filter.  If the company believes they are going to do extremely well, then our debt instrument becomes very cheap.  If the company does not believe they are going to grow, then we are expensive and it may not make sense to take our investment.  As a rule of thumb, if you don’t believe in yourself as a company, I don’t think we should be partners in the first place.

Averages and exceptions

There are about 500 active VC firms in the United States and a number of top VC firms will continue to enjoy great success. In general, I caution one should understand the value of the company assessed before investing. Make sure the valuation is justified on its own merits and not because someone else is willing to invest at the presented terms and valuation. You can do well riding the wave for a bit, but that is a risky game to play.  I love the start-up space and highly respect any VC firm or individual willing to take a bet on a team or company.  I have full faith in my colleagues and peers who are fund managers and investors across the industry; they are investing with good conscience and a deep understanding.  However, it is also important to highlight the dynamics and forces in play, informing investors’ decisions for both their benefit and that of their portfolio companies.