LP Quarterly Letters
We are trying something different here, publishing the letters we send to our LPs each quarter.
Each quarter, we circulate a variety of updates and thoughts to our fund's investors. We break them down into three sections:
- The Front Line
- The Portfolio
- The Finish Line
Because it would be inappropriate to share the specific performance updates of Starting Line's portfolio, we are only publishing the first section, "The Front Line." Our hope is that it provides some additional insight into the trends we're following and how we think:
ON SHADOW MARKETS
Consensus opinion has long suggested that the best investments are made by betting into large addressable markets; as the logic goes, they offer known and provable demand, and, as the back of the envelope math goes, even capturing a tiny 1% of a $100 billion market yields the ever illusive billion dollar company.
Except that the aforementioned consensus is at best imprecise, and at worst, simply wrong.
Good companies are built into large markets. Extraordinary companies are built into markets that don’t yet exist. But could. And should.
“Could” and “should” is where we spend the majority of our time discovering and identifying opportunities for Starting Line. I’m deeply proud that many of our early investments had functionally no addressable market to speak of – as of a year ago (a) the market for video shout-outs didn’t exist for Cameo (b) the market for cryptocurrency collateralized loans didn’t exist for Unchained (c) [redacted], and the list goes on. In the past six months, we’ve seen the market for personalized video messages from celebrities grow substantially; it’s my hope that markets for our other early investments similarly materialize.
Smart money appears to share conviction that this is not a delusional approach. In a 2015 interview as part of Linkedin’s Speaker Series, Benchmark Capital General Partner Matt Cohler noted the following:
“What I don’t look for in investments: a lot of entrepreneurs talk about ‘big markets,’ and if anything, I think a big market is a bit of a red flag. Because if something is really a big market, it’s probably going to be pretty hard for you, this underfunded startup, to get into any sort of position of strength in that market. You’re going to be one of a bunch of fish swimming in this giant ocean and there’s probably a bunch of sharks and boats there too and it’s going to be very hard to thrive.
I actually much prefer things that look like small markets, but that you can look at and say, imagine what the intersection of this entrepreneur and this product and this model, imagine what it could do to change and reshape this market. A textbook case from the generation we’re in is Uber where early on a lot of people looked at Uber and said: well, how big can that really be? Taxis and limos? That’s nice.
Uber has radically changed and reshaped the way people think about transportation along with a lot of other things. So that’s the type of opportunity where you can imagine a future where you’ve grown and changed and reshaped the market, that’s far more exciting to me by far than a big market.”
Danny Rimer, General Partner of Index Ventures, whose firm over the past few years has grown from a relatively obscure European fund into a must-visit SF early stage firm (Dropbox, Slack, Bird, Farfetch, Discord), shares this belief around small or non-existent markets. From a recent, 2018 interview:
“As much as Amazon is well positioned on the mainstream, when it comes to niches, we think that Amazon is not particularly well positioned to go after it. Part of it is because you’ve seen the service and what they’re trying to do and they’re really just trying to capture the main populace that is going to be online with more generic product that you need on a day to day basis. When it comes to areas of passion and cult following, that’s not something that Amazon focuses on.
I think that if there’s something we’ve gotten wrong repeatedly, it’s to underestimate the sizing of specific niches. What we tend to forget is that when you’re connecting most of the world’s population, there are going to be niches that just explode in size as a result of having everyone that’s interested in that particular area connected. And so if we’d really thought about market sizes, we probably wouldn’t have done some of the best investments we’ve ever done.
I’ll never forget investing in Etsy and folks saying that’s crazy – they’re already 250,000 merchants online, all these arts and craft stores, how many more can there be? Well, I think we’re at 3 million and counting. So Etsy’s the perfect example of how niches can explode into much larger opportunities when you connect them online.”
Matt and Danny are actually making two nuanced points across a similar theme; Matt, that underdeveloped (and seemingly small) markets can quickly materialize when matched with the right product/model, and Danny, that consumer niches which instinctively seem “non venture scale,” can frequently become venture scale as they proliferate. But the takeaway from both is similar: make contrarian bets on the categories that others deem to be uninteresting.
This aligns with a statement I recently heard from Benchmark Capital General Partner Bill Gurley: “false negative is where all the pain is in this industry.” Specifically, that passing on a deal that ultimately returns 100x, due to lack of imagination, is the cardinal sin of any fund manager. Gurley considers himself a student of Matt Ridley, author of The Rational Optimist, forcing himself to always ask: what could go right?
I can’t promise that we will always get it right at Starting Line. But I can promise that we will always ask ourselves that same question: what could go right?
THE HYBRID FUND OF THE FUTURE
A mere seven months ago, I tweeted the following:
In retrospect, I was embarrassingly wrong.
If you’re curious, here’s what Buffet had to say in the attached video:
“I would say there’s no one here that can understand some new internet company. I said at the annual meeting this year that if I were teaching at business school, on the final exam I would pass out the information on an internet company and ask each student to value it…and anyone that gave me an answer, I’d flunk.
I don’t know how to do it…but people do it every day. It’s more exciting. If you look at it like going out to the races that’s one thing, but if you’re investing – investing is putting out money to be sure of getting more money back later at an appropriate rate. And to do that, you need to understand what you’re doing it in, you need to understand the business. And you can understand some businesses, but not all of them.”
Buffet is one of my heroes – brilliant, articulate, passionate, but more importantly: consistent, charitable and high integrity. And if someone is your hero, you should take the time to truly internalize their message. In retrospect, Buffet’s message wasn’t that internet companies were scams, it was that any notion of “valuation” had become decoupled from any observable foundation.
My reaction, back in May, was wrong in that it unintentionally ascribed to the “new paradigm” narrative that I have tried to dispel, including in last quarter’s update. Let’s be clear – crypto is a new asset class. It trades on different exchanges from other assets and its returns are materially uncorrelated from equities such as the S&P 500 or even safe haven Store-of-Values such as gold. But, importantly, that doesn’t mean it’s a “different art.”
Investing is about entry points and exit points, and no difference in “asset class” can substitute for that reality. Entry/exit requires an acute perspective on expected value – upside versus downside – which is a calculus that admittedly got entirely lost during the crypto mania of 2017. Ethereum, the largest smart contracts platform (a global, decentralized database) traded up, touching a $150B market cap, or, for comparison’s sake, roughly the same valuation of the most storied and tested database companies in the world, Oracle and IBM.
Crypto is exciting, but I concede that in spite of some valiant efforts, no one really has a clue how to value it. At the same time, it would also be naïve to assume that these platforms do not have any inherent value. Most investors agree that the absolute smartest engineers in the world have and continue to gravitate towards blockchain focused products. Tens of millions of people now own cryptocurrencies and these platforms represent the largest, organically scaled peer-to-peer networks in the history of…humanity? To suggest, as Nouriel Roubini does that these large social movements are the “mother of all scams” and represent no underlying value is patently absurd.
Which seemingly leaves us at an impasse: these new assets ostensibly have value, but it’s functionally impossible to scientifically assess how much.
It’s a good thing there’s a proven solution for this type of uncertainty: early stage venture capital.
Traditional early stage venture capital is predicated on a simple proposition: find asymmetrical risk and reward opportunities. These most commonly materialize as risking one times your money for the opportunity to return 25 times that check. The investments Starting Line typically makes, often at $4/6/8/10 million valuations fit this mold. In the vast majority of cases, these businesses are not literally worth their early stage valuations at the time of funding. But those valuations are still a workable function of the opportunity to return many times principal.
As technology proliferates all aspects of the emerging economy, whether that is consumer packaged goods, brick & mortar retail, healthcare, or even crypto, there are an increasing number of asymmetric risk/reward opportunities that may well not look like traditional software bets. I am a strong proponent that if a company’s P&L and velocity of growth appear venture scale (read: high multiple), and my job is to find asymmetric upside opportunities, I should make that investment irrespective of whether the opportunity is in software, CPG or crypto.
Over the past 12 months, valuations in the crypto sector have declined precipitously, with every single major cryptocurrency down 80-99% from their all time highs. A few, although by no means all, can credibly fit into this asymmetric framework. For example, a digital currency with a large target market, hundreds of thousands of holders, that has continued to hit product timelines, but which trades at market capitalizations under $10M, very likely has asymmetric upside.
It’s a long way of saying that it’s unclear to me that venture capital funds will continue to generate outsized returns by focusing exclusively on one niche of the broader technology ecosystem. I suspect the best firms will begin to evolve (many, such as a16z, have already begun evolving) to more broadly invest in asymmetric innovation, irrespective of its underlying category.
ON MARKET DISLOCATIONS AND GENERATIONAL ANAMOLIES
Several weeks ago while watching a Netflix documentary with my wife, I began thinking about Netflix’s extraordinary growth over the past decade, and, in particular, a widely circulated short thesis authored by famed short seller Whitney Tilson in 2010. In that letter, Tilson noted the business was built on unsustainable content licensures that would never be repeated and would kill their margins:
“The bulk of Netflix’s current movie content is from two deals: one struck in 2008 with Starz and one this August with Epix, which is owned by three studios, Paramount Pictures, Lionsgate and Metro-Goldwyn-Mayer.
The first major deal, signed in October 2008, was with Starz, giving Netflix access to approximately 2,500 Disney and Sony movies for a mere $25-$30 million annually, a small fraction of what Starz originally paid the studios and what Starz charges TV operators. Under the current contract, Netflix is paying Starz less than 15 cents per subscriber per month for its content vs. the $2-$4 per subscriber per month that TV operators typically pay Starz.
We assume that Starz didn’t see Netflix as a potential competitor at the time – Netflix was much smaller and did very little streaming – and viewed the $25-$30million as found money. Also, Starz was taking advantage of a loophole in its contract with Disney and Sony, neither of which anticipated that Starz would re-license their content. All of these factors that led to Netflix getting a sweetheart deal are now gone – Starz, Disney and Sony have woken up to the value of their content and the threat that Netflix poses – so Netflix will either have to pay up or lose the Starz content when the contract expires in 10 months.”
In fact, Tilson was right; Netflix paid up for multiple content deals over the following 12 months and is now the largest content producer in the world. Yet, the stock has appreciated nearly 2000% since then.
What Tilson failed to appreciate at the time (he did cover his short nine months later) was that great businesses are often built on generational anomalies. Extraordinary entrepreneurs hone in on market dislocations – often temporary due to changing macro factors – and exploit these dislocations for as long as they persist. Even as those macro factors change, businesses that were able to leverage dislocations to provide a fundamentally new and differentiated experience often continue to sustain. Those dislocations enabled them to aggregate a large amount of customers, data, relationships, and other moats that no one else had.
It reminds me of my personal investment in Flyhomes (made prior to launching Starting Line Fund I), one of the fastest growing real estate brokerages in the country, which recently closed a $17m Series A led by Andreessen-Horowitz. The founders saw their friends continually losing home bids to all cash, no contingency offers in hot real estate markets from foreign investors or HNWIs. They built a product to combat that pain point, which functionally converts any home bid into an all cash, no contingency offer so that middle class prospective buyers are able to compete in the Country’s hottest real estate markets.
When they were raising their seed round, the most common questions they received from seed investors were: isn’t this a product that only works during real estate booms? What on earth do you do when the market turns, foreign money dries up, and no one needs your product anymore? Why would customers come to you then? In that state, wouldn’t you have to compete on the same playing field as every other brokerage in the country?
What Flyhomes understood was that they didn’t need a decades long bull market to build a big business. They needed 24 months, maybe 36 months. Because they are able to provide customers with a radically different, 10x better experience that solved such a major pain point, they just needed some time – though by no means forever – to aggregate thousands of 5-star reviews, thousands of happy customers, and strong word of mouth referrals. What that business would look like in a different macro environment is unclear – but it would likely have a significant edge as it sought to reinvent itself: a high NPS brand, large amount of data, and a broad base of customers.
Many of today’s unicorns share a common generational anomaly at their core: a historically low cost of borrowing money. Many Fintech businesses such as Opendoor, Avant, SoFi, Even, Borro and more have been able to leverage their scale to borrow large credit facilities, arbitraging it against an end consumer’s (or business’) effective rate, which they still find competitive.
Interestingly, not all generational anomalies produce long lasting value. The “flash sales” boom, defined by largely defunct poster children Fab.com, Gilt Group and One Kings Lane was an outgrowth of the 2007-2009 great recession. As consumers pulled back discretionary spending during the recession, retailers and manufacturers nationwide found themselves sitting on large inventories of product they were unable to sell, subsequently liquidating them to flash sales providers who in turn flipped them at 50-70% retail discounts to consumers, right as the economy began to rebound. These businesses grew at unprecedented rates over a 2-3 year period and quickly sold through many years worth of inventory backlogs.
But as the economic environment continued to improve into the 2010s, the flash sales providers had a fundamental problem: merchandising. They could still procure product – just not good product. It turned out that although they had aggregated large customer bases, their customers associated them with deals on name brands, not deals in general or even more broadly, shopping. These businesses did ultimately maintain some terminal value – just not much; Gilt Groupe was acquired by Hudson’s Bay for $250M, One King’s Lane for $12M by Bed Bath & Beyond, while Fab.com was a zero.
Let’s be clear: I do not consider myself prescient enough to spot these market dislocations and generational anomalies myself. Ultimately, Starting Line’s success is dependent on obsessive entrepreneurs to observe these changes and find the data to support their intuitions. I authored this section to more clearly define for each of you the types of qualities the fund looks for in entrepreneurs and the types of market dynamics that are primed for investment.
ON CRYPTO AND THE FUTURE OF DECENTRALIZATION
Bitcoin may have retreated from its extraordinary peak of $19,800, but its presence has only increased in the public discourse. Anecdotally, it is the number one question I receive from both current and prospective investors.
The fund’s outlook on cryptocurrency remains fairly straightforward:
Cryptocurrencies, in spite of media hype to the contrary, are software/code at their core and therefore, where applicable, should fall within the purview of a traditional venture capital fund.
Just as the internet re-empowered consumers by removing information asymmetries, cryptocurrencies will re-empower consumers in areas where they are subject to asymmetries of power/regulation by decentralizing those agencies.
Two concrete examples are as follows: by removing the opacity of prices, quality and fragmented markets, the internet enabled businesses such as eBay and Yelp to exist and thrive. Consumers, who had previously been limited to fairly localized information and knowledge, could make decisions around price or quality based on a global, wholly transparent understanding of the market, not a local understanding. This is why, for instance, the baseball cards you likely collected in the 1990s are worth far less than you’d believed at the time; it turns out there was a glut of supply of most cards, but that supply/demand was deeply imbalanced in any given city or card shop. Without a transparent market, most consumers simply relied on the anecdotal prices published by Beckett magazine. Once true market dynamics were revealed, demand could never satiate supply.
In today’s environment, normal consumers and citizens are mere price takers, vis-à-vis financial institutions and governments. Consumers have minimal input on what is considered legal, just, or even the use of their tax dollars. So too they have de minimus control over their relationship with financial institutions: capital requirements, borrowing rates, solvency, risk, etc. Arguably the two largest influences on civilization – money and government – are functional autocracies. Yes, consumers have “choice” – they can vote for their representation and can elect to patronize an alternate bank – but their influence on these systems holistically is rather marginal; they are always dependent on a third party to ultimately enact policy.
Cryptocurrencies and decentralized applications have the potential to be the single largest transformative force of our lifetimes – flattening and decentralizing both money and government – and we are on the precipice of this fundamental change.
All that said, the Fund’s perspective is that these innovations are still software, and, as such, deserve to be evaluated and valued similarly to early stage software businesses. From an investment perspective, the historic crypto bull run of 2017 rendered most of these protocols grossly overvalued by any valuation methodology. In my opinion, the bull run was typified by new entrants and amateur investors arguing that these tokens represented a new paradigm – and as such could not be valued by traditional methods. There is some truth to that: utility tokens and cryptocurrencies do not reflect revenue or earnings. But their value is still dependent on something deeply familiar to early stage technology investors: adoption curves and use cases.
Over the past eight months as the crypto markets have retreated substantially, many projects that I felt had venture scale potential have seen their valuations correct from $100M+ to sub $5M. As such, Starting Line Fund I will consider token opportunities if and where valuation of crypto projects is more on par with those of other early stage digital businesses. In fact, the fund has begun to selectively accumulate a position in a cryptocurrency that reflects the core thesis of the fund: enabling the 99% access to products and privacy typically only available to the elite class.
Because of the illiquidity and volatility of small cap crypto markets, these positions will never initially represent more than 1% of the fund size.
CONSOLIDATOR VS CONSOLIDATEE
Over the past six months, the feedback I have routinely received from the fund’s Advisory Board on deals deep in the pipeline is: how likely is this startup to become a consolidator in their category versus a consolidatee?
What does this really mean? In many venture scale categories from fashion to fintech to food, the ability to raise upstream capital is materially contingent upon whether a company is perceived as likely to be the dominant brand and acquirer in their space – even if the current product or customer base are sub-scale. Why is this important? Because in today’s early stage venture markets, which feature an abundance of capital and relatively low barriers to launch products, every good idea or macro change inspires a dozen startups that are roughly similar. Therefore, each investment must pass an additional hurdle: can this Company achieve enough scale in a short period of time to become a consolidator?
This concept is an intriguing evolution in early stage investing in that it reorients much of what I observed in the mid 2010s. Of course every investor has always desired large outcomes, but during those years, investment mandates tended to be increasingly focused on metrics, cohort analyses, payback periods, etc. It’s not that granular numbers don’t matter – they should and do – but it appears that early stage investing is also reverting back to its fundamentals: does this management team have the acumen and experience to hire 100s of individuals and make multiple acquisitions in a short period of time AND is the category predisposed to enable strong velocity.
I suspect that many investors, myself included, fell into a similar trip during the late 2000s and early 2010s. As Facebook ads and Google SEM enabled startups to experiment with low cost marketing efficacy, businesses began to define themselves by their numbers. (This is in contradistinction to my experience in agency/brand marketing from 2004-2009 where much of my job was about idea generation, project execution and earned media.) For a period of years, startups focused more on their CAC/LTV than they did their concern for whom their customer actually was. This was even codified in Dave McClure’s Startup Metrics for Pirates, which featured the subtitle: “The Only 5 Numbers That Matter.”
As usual, Bill Gurley was both above the crowd and ahead of the crowd. In his seminal 2012 piece “The Dangerous Seduction of the Lifetime Value Formula,” he argued that the obsession around customer acquisition costs and customer life-time value was misplaced, not because they aren’t important numbers – they are – but because the management teams espousing their significance were clueless as to the actual value of their customers. It’s because they viewed these customers as mere metrics that they had lost sight of them being real organic people with differing incentives and actions who do not exist in a vacuum. And dogmatic adherence to these metrics precluded these operators from thinking creatively about their business.
Gurley’s piece was certainly damning of company operators, but it was also true of investors. For a period of time, many investors (myself included) began to ascribe to strong early economics a level of permanence which was unrealistic. In fact, strong early economics actually increased the likelihood that competitors would crowd into the opportunity, inflating costs for all parties and slowing the velocity of growth for any given business.
It is for these reasons that every investment opportunity must be viewed through the lens of: how likely is it that this company and this management team will become a consolidator in their category. Companies with good metrics but facing headwinds from competitors with bigger balance sheets and better product teams will be unlikely to find the financing to survive. Big outcomes, those that generate a 10x+ return to LPs, are increasingly unlikely to come from “good businesses;” they are far more likely to come from category consolidators.
There is a fundamental macro shift developing in the venture markets that is worth focusing on: the increasing access to liquidity.
My entire career in venture capital has been defined by illiquidity. Coming out of the great recession, the IPO markets effectively closed, and the abundance of private market cash (and historically low cost of capital) enabled companies to defer public offerings, and stay private in perpetuity.
During this decade long period since 2008, investors in early stage venture have become habituated to expect 10-15 year cycles of dry illiquidity. And although the 2007 venture vintage – which includes firms such as Uber, Airbnb and Dropbox - is extraordinary on paper – funds raised since 2011 have been dismal in generating realized returns over that period. In spite of the record amount of MicroVC funds being raised (500 since FY 2012), many non-institutional LPs have left the market, waiting to see if they ever get liquid from their venture portfolios and retreating to more comfortable asset classes such as real estate and yield focused alt assets. This feels like a mistake.
I am seeing macro shifts developing that have the potential for generating record high levels of early liquidity for early stage fund managers. And if I’m right, it’s my sincere hope that I can begin to bend the liquidity curve forward substantially for my investors. I’m not capable of predicting whether this is a paradigm shift or merely temporary, but it very well could be sustained, and I’m excited by it. Here’s why:
RISE OF THE MEGA FUNDS
More than half a dozen bulge bracket venture funds have raised their largest funds since the dot com boom in the past 12 months, and in some cases, their largest funds ever. This includes: Sequoia Capital with $12B, NEA with $3.3B, Lightspeed with $1.8B, General Catalyst with $1.38B, Khosla Ventures with $1.4B, Battery Ventures with $1.25B, not to mention Softbank, investing out of a $100B venture fund, and the list goes on.
These funds are looking to deploy their capital into what is already the most competitive and highly commoditized sector of the venture ecosystem: growth equity. Sure, each fund will sell a worthwhile narrative on their respective advantages, but at the end of the day, much of the valuation bloat in later stage venture is a result of an abundance of commoditized capital
Raising larger funds forces a subtle shift on fund managers as they work to deploy that capital. Venture managers have historically prioritized their cash-on-cash (gross multiple) returns and consequently graded businesses on their potential to deliver 3-5x+ returns. Mega funds, however, and their associated LP bases, are changing this constitution: prioritizing returns on an IRR basis. To do that effectively, managers must approach investments from a liquidity first perspective.
That is a benefit to early stage managers who traditionally have worked closely with entrepreneurs for a period of 3-5 years to groom them for growth equity, only to re-start the 10-12 year fund clock when these growth equity firms enter the cap table. If, as I suspect, growth equity returns to its roots of guiding for shorter hold, high IRR returns, that will have a positive effect in creating liquidity faster for early stage managers who are dependent on these upstream firms to drive exit windows.
There is a second, more immediate consequence of these mega funds: secondary liquidity. As funds look to put increasing amount of money to work, there is more opportunity than ever before to take money off the table in subsequent financing rounds to enable the growth equity funds to hit their ownership targets and for management to preserve dilution.
Anecdotally, I’ve been asked half a dozen times in the past quarter regarding three separate investments whether I’d be interested in “taking something off the table.” Very often, early stage funds will prefer to preserve their ownership and elect not to sell when given the opportunity; those who know me are aware I’m highly biased to swing for the fences as well. But this shift in capital concentration is likely to endure for at least the next five years meaning that The Starting Line Fund I should at least have optionality in procuring early liquidity at the Series B and Series C stage of early winners.
For the past decade, multiple attempts have been made to create liquid trading markets for private company shares. Many may recall version 1.0 of these efforts, which I refer to as the “broker dealer phase.” Firms such as Second Market and Sharespost who facilitated direct share sales from employees/investors to private buyers. Version 2.0 was defined by the likes of Equityzen which pioneered a collateralized forward contract enabling early employees/shareholders to get liquid on 25-50% of their shares, without ever formally transferring the shares - using the remaining shares as a security collateral. Although many expect Carta (formerly eShares) to launch a trading market for secondary share sales of private companies, they have not yet provided guidance; therefore, in spite of the share sale leniencies presented by Regulation D, no real-time liquidity option has developed for shareholders of private market companies. In theory, this has yielded an “illiquidity discount” for shares of private startups.
I hypothesize that securitized tokens will change that in the coming 2-3 years.
Just this month, Harbor, incubated by David Sacks’ new studio, Craft Ventures, closed $28M from Founders Fund to build a regulatory approved series of smart contracts that can be hosted by exchanges and traded by individuals, without any fear of violating securities law. What this means in practice, is that any private security – issued only to accredited investors – that has not commenced any additional share sale in the prior 90 days, can be freely traded with other accredited individuals. After a full year, those tokens (previously shares) may be sold at will to the general public. Harbor has made a strategic decision to focus its launch on tokenizing real estate interests – which are historically difficult to fractionalize – but it’s only a matter of time until they turn their focus towards private market startups.
In February, Polymath, backed by a who’s who of advisors from the crypto industry, raised $59M to build a strikingly similar KYC/Reg D compliant blockchain. Securitize.io offers anyone the opportunity to tokenize a company or fund. More efforts are on the horizon as well.
According to Regulation D, any startup that has not issued a new round of financing in the prior 12 month period is free to tokenize its existing equity – assuming all tangential regulations are met – and begin the free trading of its shares.
Will this become commonplace? I have no idea. Is it good for Boards of Directors to have the option? Absolutely.
Further, there’s one additional nuance. Alongside tokenizing existing equity, there is another tokenization option available to companies: issuance of utility tokens.
A utility token is one whose value is pegged to the future usage of its application or service – and is dislocated from the formal equity valuation of a corporation. Nearly every corporation in the world is capable of issuing some variant of a utility token against the services it offers. Utility tokens currently operate in a very unclear regulatory environment: SEC Director Jay Clayton initially suggested that all utility tokens were unregistered securities, later suggested that some could pass the Howie Test, and just last month the state of Wyoming formally greenlit utility tokens as a form of property.
Most blockchain analysts do expect utility tokens to become increasingly commonplace. So the real question is what happens to the value of a company’s equity if it issues a utility token against the forward value of its services? Eden Shochat, General Partner at Aleph notes:
“If the company depends on value creation via the appreciation of token value and doesn’t get paid for providing a service, it won’t have revenues. If the company sells off [the tokens it owned through the initial issuance] — and thus holds no tokens at all — the company is value-less to you, the founder and your Angel Investor. None of its shareholders own anything.”
You should read his full piece in Forbes, Attention Founders: That ICO is About to Dilute You Too. It’s an interesting intellectual argument that emphasizes that issuing utility tokens pushes the equity valuation of a business into its tokens. The equity of the parent thereby becomes valueless, save for the value of any tokens it may hold as the issuer. It’s actual quite logical: in traditional markets, the value of equity is merely a derivative of future cash-flows and a company may therefore choose to transition its parent at-will from holding the value of cash flows to the value of utility tokens.
In review, a utility token issuance may be recommended by a Board of Directors at will to re-orient a business’ value away from its cash flows and towards a de facto future market around the value of its services.
I recognize that was complex. But the whole synopsis is that whether it’s through (a) shorter hold periods at the growth stage (b) traditional secondary sales to growth equity firms (c) tokenization of securities or (d) utility token issuances, multiple macro forces are simultaneously conspiring to re-imagine the expectation of liquidity for early stage startup investors. It’s a trend I am extremely bullish on for The Starting Line and its LPs and I will plan to provide guidance in the future if those tailwinds shift.
I’d be remiss if I didn’t discuss my location in the heart of the Midwest given the recent media focus on the intersection of venture capital and the heartland. It started in March with the following Kevin Roose piece in the New York Times, Silicon Valley is Over Says Silicon Valley, a summary of a three day bus tour for San Francisco VCs through the Midwest, which noted:
"But a funny thing happened: By the end of the tour, the coastal elites had caught the heartland bug. Several used Zillow, the real estate app, to gawk at the availability of cheap homes in cities like Detroit and South Bend and fantasize about relocating there. They marveled at how even old-line manufacturing cities now offer a convincing simulacrum of coastal life, complete with artisanal soap stores and farm-to-table restaurants.
“If it weren’t for my kids, I’d totally move,” said Cyan Banister, a partner at Founders Fund. “This could be a really powerful ecosystem.”
These investors aren’t alone. In recent months, a growing number of tech leaders have been flirting with the idea of leaving Silicon Valley. Some cite the exorbitant cost of living in San Francisco and its suburbs, where even a million-dollar salary can feel middle class. Others complain about local criticism of the tech industry and a left-wing echo chamber that stifles opposing views. And yet others feel that better innovation is happening elsewhere."
Many took issue with the piece, painting the bus tour as a voyeuristic retreat for “coastal elites,” who didn’t actually care about the non-coastal cities they were visiting. Dan Primack of Axios noted that any suggestions of a mass exodus from San Francisco was grossly overblown:
Just two weeks ago I told J that I could see us being happy living in Vermont. Then we drove home from our ski vacation.
This isn't to say the bus trip, and similar excursions, don't have an impact. They do, in terms of coastal investment dollars flowing into Midwestern startups. And there is data to suggest that California-focused funds no longer generate most of the top returns. But investing ≠ relocating.
Brad Feld at Foundry Group also opined that the narrative had passed the point of sensibility:
The hyperbolic headlines are once again accompanying the articles about Silicon Valley…Silicon Valley is not over. Over 100 years since its notional inception, it’s a fascinating and amazing ecosystem.
But, he noted, there is a lasting takeaway worth digesting:
But it’s also not the only place you can create technology companies. I’m sitting in a hotel in New York and, according to a recent article from Bloomberg, New York Will Never Be Silicon Valley. And It’s Good With That.
The real story is that you can create startups, and thriving startup communities anywhere. Imagine the NYT article was titled “In a Moment of Introspection, Silicon Valley VCs Realize That There Are Tech Startups Outside of Silicon Valley.” Nah – that wouldn’t get as many clicks.
As with most of life, the truth is somewhere in the middle. I actually participated in the trip, invited by one of the trip’s organizers (and Starting Line fund advisor/investor) , Roy Bahat, founding partner of Bloomberg Beta - and was the only non-coastal VC to travel with the group.
It wasn’t lost on anyone that the vast majority of self-selecting participants were emerging faces in the venture world - the new generation in their partnerships - and more open than their predecessors to sourcing innovation outside of San Francisco. Further, I witnessed no hubris; rather, I experienced firsthand a deep intellectual curiosity and openness to dialogue with real people across the country.
It’s reflective of a larger macro shift at play. When I officially entered the venture world in 2012 and began developing friendships at coastal funds, my efforts in Chicago were considered, at best, “cute.” Sometime in 2016, that began changing. Friends from bulge bracket coastal funds – that had otherwise humored me because they liked me (I presume), but were generally ambivalent about non-SF deals – began proactively reaching out to establish monthly calls or quarterly deep dives, hoping that I would serve as a de facto outsourced deal scout for a wide radius they couldn’t cover. Those conversations have only increased in the past twelve months and several of those firms are now investors directly into Starting Line.
Winning deals in venture is as competitive as its ever been, and the signal to noise ratio is at historic lows. The generational opportunity that I am trying to execute against is becoming a rare trusted signal – even outside of the Valley - in a sea of chaos. Although venture is not a zero sum game, I do believe that material rents will accrue to the firms that can create a moat around brand, trust, and results. I am confident that my early track record in helping to identify and invest in high velocity winners such as Spothero, Hungryroot, and Flyhomes are a strong step in that direction. It’s also the reason I’ve made it a point to dedicate my time towards events and conferences that are non-Midwest focused, and that demonstrate The Starting Line’s thought leadership on a national scale, such as The Marketplace Conference, where I was the only non-San Franciscan to lead a session amongst a sea of 300 attendees:
Operating in the Heartland is a fundamental asset and I wouldn’t want to be anywhere else. But location itself is not a sufficient differentiator: it must yield sustained trust. It’s one of the variables I expect each of you to benchmark me and Starting Line against. If we’re failing, it’s imperative that you call me out.
ON CRYPTO AND GOLD RUSHES
Only time will tell, but my intuition (supported by the anecdotal) is that an enormous amount of young talent has left the venture capital ecosystem for the greener (maybe) fields of crypto and the emergence of token funds.
I empathize with that seduction: 50% intraday swings and 15x annual moves are exhilarating in a way that the slow and steady grind of venture capital is not. Crypto is truly a digital gold rush, far more democratized than even the dot com era, with barriers to entry as simple as internet access and a credit card.
Several of my exceptionally talented friends have opted to leave their existing venture firms to pursue the token economy. For some, it is a deeply authentic pursuit and the culmination of years spent obsessing and evangelizing a nascent technology to anyone who would listen. For others, it is unapologetically a money grab.
Irrespective of the authenticity behind these pursuits, I think there’s a chance that this exodus becomes reflected in the venture asset class in 3-5 years. If, as I suspect, a real number of exceptionally talented, ultra ambitious associates and senior associates, even principals – the future of their firms – are being swept into the crypto wave, it follows that there will be a multi year experience gap and general softness in the traditional venture market down the line.
It’s very unclear to me if this is a near term opportunity that can be capitalized on. At worst, it’s an observation worth tracking. At best, it’s a tailwind reducing some competition in the fight to win the best deals. Time will tell.