Swan Farming Part II - It's Really Powerball.

Paul Graham had a very interesting post up today on Black Swan Farming

Go read it here.

If you didn't read it - I'll summarize:

1. Venture investing is hard because the return distribution is so skewed toward outliers that it is almost impossible to tell which those will be.

2. Great ideas often lok like idiocy at the beginning

3. You don't know if you've won until after they've drawn the numbers.

For those of us who have been investing for years, much of this is a rehash, but a great one written by a very thoughtful investor.

Point One:

It should come as no surprise that the return distribution in venture is far more fat tailed than one would typically expect. After all, what is seed stage investing across a ton of companies but the purchase of a lot of lottery tickets. While one can predict the outcome of a single company based on the founders, the idea, the marketplace, the opportunities for exit etc... - the ability to predict the next Google / Facebook simply does not exist - and more than the ability for me to pick the winning powerball ticket with certainty.

And yet, that Powerball distribution is what we seen in seed stage across a large portfolio. One winning ticket absolutely dwarfs all other outcomes. More people play Powerball than invest in seed - and despite the average persons desire to see Gaussian normal distributions, people participate in fat tails twice a week.

Of course, as the saying goes - You've Got To Be In It To Win It

Point Two:

It is very rare to make great returns betting with the crowd.

You need to be early, and you need to be willing to be alone and wrong.

Oh yeah, and you need to be right.

That pretty well describes point two.

Just betting against the crowd is not enough - because more often than not -the crowd has it right. It is only by looking at things in a different way than the crowd, and seeing the possibilities that you can get those big outcomes.

Point Three:

Graham goes into great detail about funding as a measure of success and how he doesn't do this with the YC classes.

Methinks he doth protest too much.

I don't know Paul, and by all rights he is doing a great job and is incredibly well respected - but as a complete outside to his world, and from the press coverage we are already seeing, it seems as if the purpose of YC (or any other incubator these days) is to be able to jack up the proce of your next round. Lots of posts on this - but the main point is this: you really don't know if you are winning until you have won - and winning is a long term game.

VC is a long tailed asset class with an enormous amount of volatility in it.

Go back and read the Black Swan and Taleb will suggest these sorts of investments paired with super safe bond portfolios.

Not a bad suggestion

Michael Moritz

I've never met Michale Moritz and I don't know Michael Moritz - except through the reputation he has earned through years of exceptional returns at Sequoia.

Reading that he was stepping back due to an incurable disease reminds me not so much of Steve Jobs (I'm sure we will see quite a few comparisons there) but of Lou Gehrig stepping back from one of the great teams of all times.

And like Lou Gehrig, Moritz is already in the investing Hall of Fame.

While the absolute numbers at Sequoia have kept it at or near the top for long term returns, it is how they have generated these returns that is most impressive to me.

For years, Sequoia, under Moritz, has been a proponent of long ball investing - knowing that they would strike out a lot - but understanding that when they hit the ball out of the park, they would score a ton of runs (see the initial Google investment - or YouTube)

While many firms preach this sort of investing mantra - few have followed it with the discipline of Sequoia.

Moritz an his partners have  managed to extract the correct risk reward ratio across their portfolios - whereas others have not gotten nearly the reward on their winners (the risk is always the same in every case - a goose egg)

As an investor you simply have to understand the relationship between risk and reward and size your investments accordingly. Moritz and his partners have.

And that's the difference between the hall of fame and an under performing asset class over a career.

Who Are Your Customers?

At Raptor, we have the privilidge of getting to meet with a ton of great founders every day - and listening to them speak about their passions, and how they are going to turn these into great businesses.

On Friday we had a serial founder in the room and we were discussing why he had made certain decisions so far at his nascent company.

What he said was this:

"The most important decision a start up can make is to choose its customers. Once you do that, most of the questions and decisions answer themselves."

Pretty good advice that stuck with me all weekend.

when I came back around to it - I thought of all the companies that we have seen that have succeeded and those that failed - and this focus on an initial customer set seemed to be a reasonable common ground.

Simple and easy

So: who are your customers?

Why Most People Are Grinfuckers - The Flipside Of Brad Felds Post Today

Brad Feld has an awesome post today up on his site

Check it out here.

It feeds off another great post by Mark Suster, which you can find here.

So here's the retort to these: most people are grinfuckers and however noble the cause, you're probably not going to change that.

Let's take a hypothetical example

Parent: " Isn't my daughter the cutest thing in the world? So precocious isn't she?"

Now you have two options here

1.Smiling, you say: "She certainly is." And then you move as far away as possible as quickly as possible

2. Or staring straight into the other parents eyes you calmly say: "Actually your kid is a monster - some form of sub demon belched forth from hell. I've seen blocks smarter than her and her behavior makes you question how she's survived to this point" And then you run.

Truth is, most people don't take criticism well - particularly when they are emotionally vested in the area you are providing constructive criticism.

And if you are a VC - it can be doubly hard.

Because in that position, you are going to say no most of the time - and some of those times you are going to be dead wrong.

Truth is, in a competitive world, you are sometimes competing for the right to invest - very few investors can choose any deal they want. So how you deliver bad news is sometimes as important in building your reputation as how you act in the deals you are doing.

We recently turned down a company that we had done a reasonable amount of work on. When I communicated with the founder, I laid out 5 points that led us to pass - and hopefully those five points were taken as constructive criticism that will make that company stronger.

And guess what? We might be wrong about those five points. Or we might be right about them and the company changes and succeeds and we get another shot at investing. At that point, will the founder think, wow those guys were spot on and I'm glad they turned me down and criticised those five things? or will he simply think, those guys rejected me - the hell with them!

More often than not - it is the latter rather than the former

People generally want to shy away from negative reactions. That's just human behavior writ large.

I'm with Brad whole heartedly. I'd far rather hear honest constructive criticism from someone who has an interest in making me better at whatever I am doing - than a smile and a handshake and in the back of their mind their thinking - yeah that DeMott guy is an ass.

George R.R. Martin puts it very well in Game of Thrones when Tyrion the Imp says:

“Most men would rather deny a hard truth than face it.”

And that's why grinfucking isn't about to stop.

Facebook: The Bet You Are Making At $100B

So Facebook finally filed their long awaited S-1

You can get it here

At the highe end of the price range implied, Facebook will be valued at a cool $100B.

ONE HUNDRED BILLION DOLLARS!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

Bill Gurley from Benchmark has an interesting post up as to why the price range makes sense. Given that Bill and I have similar backgrounds - both of us worked as equity research analysts at First Boston back in the 90's - we spent a ton of time on this stuff and his arguments are cogent. Read them here.

I have a slightly different take on the matter - which is to look at the company with an eye toward expectations.

Last year, the company produced $3.7B in revenue and $1.75B in operating income. Adding back depreciation and amortization of $323M you get EBITDA for the company of almost $2.1B. Capital Expenditures exceeded D&A by about $300M at $600M so you have a situation where new capital expenditures are exceeding D&A - so adjusted and normalized - EBITDA is probably a normalized $2B or about 55% of revenue - a fantastic number.

The question is just what are you paying for when you invest in Facebook at a $100B market cap.

Let's assume that your required rate of return or hurdle rate is 10% per year and your holding period is 3 years.

Thus, in 3 years, Facebook would need to be valued at something like $133B for it to be worth purchasing today.

And what combination of factors could lead to this?

Assuming the company improves it's EBITDA margin to 60% (not unrealistic as it scales revenue over cost) and a roughly 20X EBITDA valuation, you would need $6.6B of EBITDA or $11B in revenue - about triple from the 2011 number.And that would be a 2015 expected number - so they really have 4 years to get there.

Is this possible?

My guess is that it is.

This would represent a 33% annual growth rate in revenues, and currently the company is growing at over 50% - so clearly within the realm of reason.

The Facebook ad platform has not been nearly optimized like Google's has - and as people add more interests and more information to the social graph, Facebook should be able to do a better job of targeting advertising to individuals. Better targeting means higher CPM's, and higher CPM's lead to higher revenue.

Now all that said, it's not an easy task - and you are making a bunch of assumptions - but that's what valuation is all about.

At Raptor Ventures, we're not in on the Facebook bonanza directly, but we are partnered with Graph Science, a Menlo Park based company that specializes in Facebook ad optimization. If Facebook is to grow revenues by over 33% per year for the next 5 years - someone is going to have to help optimize all of that traffic here and abroad and Facebook will be under intense pressure to do so more quickly. We like derivitive investments on Facebook's growth - and are super happy with our partner Raymond Rouf and his team. If the expectations even come close to coming true at Facebook - we think we will have found a real winner in Graph Science, and I suspect there will be a ton of other winners in the ecosystem.