Joi Ito's Web

Joi Ito's conversation with the living web.

Doc just blogged about a thought I just had too. If the big print media put their archives online and made them crawlable and linkable, I bet their page rankings would go up. It's really the links between the archives of the blogs that gives blogs so many links. The solution to googlewashing is probably more about getting other forms of journalism published in a more link-friendly way than filtering the blogs.

Wrote a not-so-organized entry about our investment process...

I thought it might be useful to describe the venture investing process in the context of the recent discussion about transparency. Firms have their own processes and some of the details may vary, but generally speaking, most VC's probably have a similar process. Also, I've only been doing this for three years. I've been an entrepreneur for about 10. I've learned a lot over the last three years and think I've become much better at venture investing, but still have a lot to learn...

First, the principles. Buy low/Sell high. Funds have some "life" of around 6 years where they need to "exit". The point is to buy shares of companies for a low price and be able to sell them to someone at a higher price before the end of the fund.

During the bubble, people often invested on the "greater fools theory" which was the theory that there was always someone more stupid than you and that as long as the hype continued, you could sell your shares for more money to the next more stupid guy. This is VERY dangerous way to invest and luckily doesn't make sense anymore.

Buy Low

1 - Understand the business better than anyone else so you can determine that there is less risk than others might perceive. This will allow you to buy at a higher price.

2 - Ask for a lower price because of the value that your firm will add to the business after the investment. The "smart money" story.

3 - Be first. Find the deal first, sign a "no shop" and get a letter of intent (LOI) signed quickly so an auction doesn't start jacking up the price. This is sometimes in the interest of the entrepreneur as well since the auction process is a long and tedious process that sometimes ends up burning out the business and doesn't always lead to ending up with the best investors. If the entrepreneur plans to continue to raise money, getting the highest price isn't as important as closing quickly with a good investor and building the business.

3 - Negotiate. Push to get better terms in negotiation. Negotiation always occurs at some level, but since both investors and entrepreneurs can always screw each other at any point, the relationship between the investor and entrepreneur is essential. In a buyout where there is no relationship after the transaction, it's easy to play hardball since you don't have to work together afterwards, but in venture investing hard negotiations can often lead bad blood, hurting the business and lowering value. The "tone" is often set by the entrepreneur and it's sometimes counter-productive to go in hard when it's not necessary. Having said that, some VC's are EXTREMELY tough. So, my advice here, know your opponent and don't be tougher than you have to, but be prepared to fight to protect your interests if you have to.

Sell High - The Exit

Exiting is always tough, especially if you like the company. It's important to have an "exit strategy". Is the company likely to be acquired? Is the company likely to go public? Who are the probably acquirers? Are there comparable acquisitions? What were the valuations? The exit scenario and the comparable acquisitions or IPO's and their valuations help you determine what sort of multiple on the invested money you might get out and when. This number and the probability of getting to such an exit determine the current valuation of the business. Valuation for big companies with steady cash flows is sort of mathematical, but for venture businesses where "the probability of such an exit" is such a squishy number, valuation is really more flexible and based more on comparable than on discounted cash flows.

Deal flow

Deal flow comes from many sources. My best deal flow comes from introductions. That's why I'm excited about LinkedIn. Introductions from people who value my time are generally filtered and recommended to me with information that helps me understand the "angle" quickly. I find that non-solicited pitches have a very low signal to noise ratio and I unfortunately have found very few deals this way. I find that blogging is a great way to meet people "in context" and reading the blog of a potential business partner is a great way to get to know them. This context is a great way to filter for quality, I think.

Another source of deals is other VC's. Some VC's want to hog a round and crowd out all of the other investors, but many VC's share deals for a variety of reasons. Sharing deals lets you share due diligence, management, expertise in building the business and risk. Usually there is a "lead VC" on any deal who takes responsibility for the due diligence, negotiation of the terms and most of the risk. In cases where we are brought into a deal by the lead VC, it's less likely I'm going to be blogging about it since we're probably locked up immediately by an NDA and I haven't gone through the discovery process.

It's important to note that since buy low/sell high is the key, not all deals are obvious. Great companies are often over-priced and don't make sense from an investment perspective. Sometimes really boring companies or companies doing very poorly can be great deals if there is an exit scenario where you know someone would pay a lot of money to buy your shares.

The single most important criteria for a good early-stage deal is the quality of the CEO and the team. Investing in technologies or "market opportunities" without a good CEO is a key to disaster. Having said that, you need core skills/assets, uniqueness, a real market opportunity and a business plan that makes sense. Finally, the valuation has to make sense.

Valuation

Valuation is based in part on the risk involved in the business. There are clear milestones that decrease the risk in any business. Risk usually decreases as each milestone is hit. A typical series of milestones might be: team on board, competitive analysis and due diligence of business plan done, technology developed and prototype shipped, first customer signed, cash flow break-even, evidence of geometric grown in revenues and a scalable business, buyer/IPO in sight. From the perspective of the entrepreneur, it's better to take the minimum amount of money necessary and raise money as risk starts to decrease since the entrepreneur can demand a higher valuation and be diluted less. The problem is, raising money takes time and energy away from the business so you want to minimize the number of times you have to raise money. Also, since there are fewer investors around these days, often new investors will dictate the valuation and terms and will "wash out" the earlier investors if the earlier investors are not able to participate in following round. Although the market seems to be stabilizing a bit, it's still very risky for a small fund like ours to invest in a company that might require a lot of additional money since we could be "washed out" by future investors.

Investment Committee

Most funds have some sort of investment committee. Different funds have different rules. Some require unanimous agreement by the members, some vote and require some sort of majority. Our committee consists of myself, our chairman Jun, Paul and Richard representing our investors and the deal team. We generally try to get a consensus.

The Process

Deal flow is tracked and we always have a pipeline of possible deals. Most early stages of the process involve someone taking a look at a proposal or trying to put together a deal based on a theory or a person we would like to work with. As the thesis of the business and structure of the deals start to take shape, the deal gets discussed a bit internally and we allocate resources for due diligence. We will usually try to sign some sort of "no shop" agreement with the company so that we feel comfortable spending money on due diligence without fear that someone will come in and take the deal away. The due diligence process can take a lot of time and can involve building the business together. As a deal structure starts to take shape and the investment becomes likely, we put together a "high-focus memo" for investment committee. It's basically a summary of the deal with a checklist of items. We also start working on the term sheet which is a list of negotiating points. We usually try to brief the investment committee on deals as they begin to take shape. Once the high-focus memo is done, we have an investment committee meeting. Often the group discusses additional due diligence items and possible alternative structures. Often a deal will cycle through investment committee several times until people feel comfortable with the deal. Once investment committee is comfortable with the company, valuation and structure, we sign the term sheet. The term sheet is usually a non-binding letter, but I have never signed a term sheet that we did not follow to the letter. After the term sheet is signed, the lawyers draft the agreements. There is usually another round of negotiations on legal issues that aren't covered in the term sheet. If the term sheet is done well, most of these issues are not major. Once the documents are done, we sign, fund and announce.

Terms

The terms in the term sheet usually reflect common practice in the VC community. These practices are always changing to reflect changes in the market or styles of investing.

Usually money is invested in convertible preferred shares. Convertible preferred shares are shares that get a return before the common share in the event of a liquidation or an acquisition. There is usually some sort of trigger for the preferred shares to convert into common stock such as an IPO or a valuation milestone. Convertible preferred shares allow investors to give a higher valuation to a company with no assets because it prevents the common shareholders from liquidating the company and running away with the money before building the business.

Often the legal fees for the transaction are charged to the investee with some sort of cap.

There is usually some sort of protection from dilution so that the company can't sell share for a lower price and dilute the investor easily. Having said that, if the company really needs money and the current investors aren't willing to put money in, the new investors can easily negotiate away such anti-dilution terms.

---

Having just written this entry, I realize that it's a kind of rambling entry. Since I'm not sure how interested people are going to be in this entry, I'm going to post it as is since I'm too lazy to edit it. If people find it interesting, I may go back and edit it and maybe put it in my wiki.

due diligence and VentureBlog are two good VC blogs.

Although Anil is very different in person in real life, most bloggers blog in their own voice. At dinner with Markoff and Dvorak, we talked about how many journalists have a different professional persona and are actually much nicer in person than they are online. (Dvorak can be almost as rude in person as he is online. ;-P ) Dvorak deconstructed some of the ways that journalists will write to get a rise from the community and how disarming it is to meet some of the critical journalists in person. In fact, they said that Andrew Orlowski's not such a bad guy in person.

I write in my own voice, but I've developed sort of a thick skin from years of being flamed in Japan and in the US so I actually think some of the silly criticism is actually funny and flattering. Bloggers probably take criticisms more personally than journalists who play "the game" through their avatars. It's more painful to be slammed when you are speaking in your own voice.

Don't know how relevant this is, but this thought about avatars came to mind after reflecting on dinner with Dvorak and Markoff where we were all laughing about our critics and thinking about how my readers/community were maybe more upset about Orwlowski's silliness than I was. I am very grateful for people defending me and pointing out things that would be politically incorrect to say myself. Having said that, I'm not taking Orlowski's attacks personally since at one level, I think it's a game/joke. If Orlowski's actually serious about what he's writing, then I just feel sorry for him.

As they say, "Don't attribute to malice, that which can be explained by stupidity." and "Don't attribute to stupidity, that which can be explained as a joke."

From left to right: Mary holding "Tetris", Brewster holding still shrinkwrapped copy of "Visicalc", Larry, Bettina, me and Glenn
Had dinner with Brewster and Mary, Larry, Bettina and Glenn at the Foreign Cinema. First time at the Foreign Cinema. Cool place with good food. Nice open feeling, loved the wide selection of oysters. Also, both dinners so far this trip were organized using OpenTable.com which I saw for this first time.

Brewster arrived with a box full of very old software. He had just finished testifying about why DMCA was preventing him from breaking copy protection on old software that he wanted to archive. The DMCA affects our lives in lots of ways and we need more people like Brewster to point out the stupidity of such laws trying to prevent legitimate activities for the sake of protecting the position of a few big media companies. What's scary for me is that Japan is trying to put together their own DMCA in a "me too" kind of stupid way. The problem is, we don't have people like Larry and Brewster in Japan and I can only image how much work it's going to be to fight it there.

Met Glenn, the Executive Director of the Creative Commons for the first time today. Enjoyed our conversation very much. He was supportive of my position on the guarantee issue with regards to the CC license. (I guess he should be.) He told me that Glocom, where I recently gave a talk on Emergent Democracy, was working on localizing Creative Commons for Japan. That's GREAT! I was worried that the Japanese would end up continuing to with that "Free use label" for webcontent stuff that the Ministry of Culture was doing.

Talked about the idea of using the Creative Commons Conservancy in the standardization process where it might act as a repository for assets like domain names. I had talked about this with Robert Kaye and Musicbrainz. I'll write another entry about this idea after I flesh it out a bit more, but I'm pretty excited about it.

Talked a lot about how smart Aaron Swartz was.

I wish my jet lag would go away so my brain cells didn't start to check out at the end of these dinners. Maybe I should stop drinking when I travel. Hmm...

One more thing: We talked about Larry's push to get a bill passed to have a $1 fee to keep a copyright 50 years after publication. This put put A LOT of stuff into the public domain and is very hard to argue against and seems extremely practical... you would think. Well, it's harder than it looks. He needs our help.

markoffdvorakdin.jpgHad dinner, talked about blogging and had more dinner tonight with John Dvorak of PC Magazine and John Markoff from the New York Times. Markoff and Dvorak are about as different as they come, but are good friends and make a really funny pair to have dinner with.

Dvorak said he wanted to start a blog. Both John & John are anti-bloggers, but I agreed that Dvorak would be much more convincing if he was critical after having blogged. We talked about Andrew Orlowski and the attention he has been giving my blog these days. We discussed the importance of lunches and dinners in the journalistic process and discussed Andrew's journalism. One amazing thing about Dvorak is that he can be talking about the food, wine, the owner of the restaurant, Orlowski's writing style and Apple Computer all at the same time. Sometimes I got confused about whether Dvorak was talking about Orlowski's writing or the food. I think Dvorak would make a good blogger.

We talked about googlewashing and I agreed to link to Dvorak's site often to help increase his google page ranking. ;-) We talked a lot about the importance of thick skin and a sense of humor.

Update: Andrew Orlowski's current web page. I linked to the old one because that's what came up first on Google. Sorry. Noticed that Dvorak was on Andrew's list of "Stuff I like"