Monthly Archives: February 2013

Delighting your users

I recently had the opportunity to catch up with Brian Wang, the CEO of our portfolio startup Fitocracy. We talked at length about Fitocracy’s future plans and their strategy to continue to delight their users. Fitocracy is an amazing example of a startup that works relentlessly to make sure that its users remain happy and keep coming back to use the service. From the outside, you might think that a startup that lets you track your workouts would have low engagement levels. After all, who wants to perform their workout, let alone track it?

Fitocracy breaks all the reluctance and tediousness that people have come to associate with fitness. And the way it does this is simple. In addition to monitoring their own progress, Fitocracy’s seven hundred thousand users are able to share their achievements with other users. This has created an unparalleled sense of community reinforced by the friendly competition that motivates each Fitocrat on their quest to achieve their fitness goals.

In fact, the sense of community is so strong that Fitocracy users regularly organize meetups in their home cities to engage with their fellow Fitocrats in real life. This is why Brian traveled from Fitocracy’s New York headquarters to San Francisco last week. He was attending the local Fitocracy meetup. Other recent meetups have taken place in cities like Houston, Toronto, New York, and Washington DC. Most importantly, these meetups are fully initiated by Fitocracy users themselves.

Fitocracy’s focus on delighting its users is also why it recently won Mashable’s Health and Fitness award. Fitocracy has been patiently iterating its product so that each feature is designed with a clear customer need in mind. Overlaying this customer centric approach to product design with the glue of a supportive community has positioned Fitocracy as the leading social network for health and fitness. Best of all, Fitocracy is just getting started. By retaining its singular focus on helping its users achieve their fitness goals, Fitocracy has the potential to develop into the world’s leading platform for fitness content.

Startups’ war for great talent

I’ve spent the last week focused almost exclusively on recruiting for our West coast portfolio startups. On any given day I’ve met between 3 and 5 candidates interested in joining a tech startup. Given the needs of our startups, the focus has been on engineers and business development professionals. Among the over 20 candidates that I’ve met so far, I’ve been very impressed with 6 and referred them to our entrepreneurs. Let’s see if they feel the same way. Although a candidate may be very talented and motivated, it’s also important that there be a personal fit with the existing team. It’s up to our entrepreneurs to decide if this is the case.

Taking a step back from the meetings, I have two key takeaways. The first is that there are a lot of people working in large companies, especially in fields like technology and consulting, who want to join a startup. They want the greater responsibility that comes from being part of a smaller team, and the greater personal satisfaction that comes from seeing a clear link between your efforts and the performance of the organization. They’re also willing to take a step down from their former compensation to accommodate the tighter budgets that startups have to work with. Although there is the additional upside of a small equity allocation, this shows an intrinsic motivation that prioritizes the startup experience over the financial outcomes that it may produce.

The second takeaway is more important. Although the first takeaway may suggest that it’s a great time to be a startup because you have a large pool of candidates to choose from, this isn’t the case. While there are a lot of people who want to join a startup, there are large differences in the level of their skills. The excess of candidates among which startups can pick their employees comes hand in hand with a shortage of the great candidates that are necessary for a startup to succeed.

Especially at the early stages of the company, the first few hires outside the founding team can have a big impact on the outcome of the startup. This includes not only the specific engineering, business development, or other skills that they bring to the table, but also their influence on the company’s culture. This is why I only refer candidates who I trust because I have worked together with them in the past, I can see myself working together with them in the future, or who come strongly recommended by people I trust. While startups’ war for great talent may be fierce, the costs of lowering your standards simply for the sake of filling in a role are too great.

Support your entrepreneurs, don’t burden them

The relationship between an entrepreneur and venture capitalist can take many forms. From the VC perspective, I am friends with some of the entrepreneurs we’ve backed at Romulus and have a professional relationship with others. Since we don’t take board seats at our seed stage startups, our interactions are almost always informal in nature. They result from either the entrepreneur reaching out to us or vice versa. 
For those entrepreneurs who I am close with who need specific help at a given moment, there are times when we interact as frequently as multiple times a week. At the other end of the spectrum are those entrepreneurs who I don’t hear from for over six months. Although this may seem like a long time, we make each of our investment decisions with complete trust in the entrepreneur’s ability and motivation to execute. Before an investment, I always ask myself whether I would be able to sleep at night if I didn’t hear from the entrepreneur for six months. If the answer is not a comfortable yes, it’s wise to not invest.
Since my goal is to be involved only as often as the entrepreneur likes, I prefer to let entrepreneurs take initiative in reaching out to me. The entrepreneur already has enough on his plate trying to grow his startup. He doesn’t need the additional burden of managing each of his investors on a weekly basis. This is especially true at the seed stage, where a funding round often includes anywhere from 2 to 10 other angels or VC’s. Instead, the best entrepreneurs resourcefully identify which investors can help their startup reach a specific goal, and leverage these connections at the right time.
That said, some entrepreneurs are more active than others in soliciting input from their investors. They send all investors regular update emails showcasing the progress of their startup and making specific requests. Others go one step further and reach out to individual investors who are best positioned to meet a particular need. For example, I often receive requests to be introduced to a potential employee, customer, or supplier who an entrepreneur sees I know on LinkedIn.
The entrepreneurs who reach out less often have a good reason for their actions. As surprising as this may sound, things may simply be going well at their startup. In other cases they may be relying more on other investors who are able to add greater value to the startup given their domain knowledge and network. 
However, there is always the chance that the entrepreneur could actually use the help but hasn’t had the time to reach out, or isn’t even aware of how you could add value in a specific area. This is why, as a VC, I always try to place myself in the entrepreneur’s shoes. I think of what they might need at a particular time and how I could meet this need. I then call them or shoot them an email letting them know I’m available and suggesting a specific way in which I can help out. I’ve found that including a specific input I can provide is better than making an open-ended offer as it shows greater commitment to following through on the offer.
Sometimes the entrepreneur doesn’t need help at that moment. Sometimes they welcome the help but are in crunch mode and you agree to reconnect at a later date. And sometimes they discover that your offer could really add value to the business right now. Regardless of whether the entrepreneur takes you up on your offer, I’ve found that they always thank you for your support. Being in the trenches is tough enough. Sometimes a simple show of support is all that’s needed to keep going.

Why participating preferred stock investments require a higher valuation than common stock

I was recently discussing the pros and cons of different financial instruments as a means to investing in startups with a late stage investor. At the seed stage, investments are generally made in the form of convertible debt or common stock. At later stages there tends to be relatively more certainty around a company’s cash flows so there is less incentive to delay the valuation to the next funding round. As a result convertible debt investments which serve this purpose are rarely used in later stages. In addition to common stock, later stage investments are most commonly made through participating preferred stock. The main difference between participating preferred stock and common stock is that the former provides investors with a debt-like return prior to sharing the proceeds of an exit according to each investor’s common stock holdings.

A numerical example may help clarify the difference. Let’s say an entrepreneur raises $5M at a post-money valuation of $20M. The investor now owns 25% of the company. Assuming that there is no future dilution, if the investment is in the form of common stock, the investor will receive 25% of the exit value. If the investment is made through participating preferred stock, the investor will receive his $5M principal plus dividends before the remaining exit proceeds are split 25%-75% between the investor and the entrepreneur. The participating preferred stock can also carry a multiple. For instance, a 2X participating preferred stock investment of $5M will return investors twice their principal plus dividends, so $10M plus dividends, before the remaining proceeds are split.
Ignoring dividends, in the event of a small exit of $25M, the investor receives his $5M principal plus 25% of the remaining $20M. The investor’s proceeds are $10M and the entrepreneur earns $15M. Effectively, the investor takes home 40% of the exit value while owning 25% of the company’s shares. If the investment had been made as common stock, the investor would earn $6.25M, leaving $18.75M for the entrepreneur. 
In the event of a large exit of $100M, the investor takes home $5M plus 25% of the remaining $95M. So the investor’s total return is $28.75M, which leaves $71.25M for the entrepreneur. Effectively, the investor takes home 28.75% of the exit value while owning 25% of the company’s shares. If the investment had been made as common stock, the proceeds would have been split $25M-$75M.
As these examples show, the larger the exit, the smaller the difference between the actual share ownership of the investor and the share of the exit proceeds that he takes home. The goal of participating preferred stock is therefore to provide the investor with sufficient compensation in the event of a small exit. One consequence of this is that the investor is more willing to support smaller exits. He is therefore less likely to pressure the entrepreneur to take unnecessary risks in order to create a home run scenario. This can serve to better align the incentives of the investor and the entrepreneur.
Another way to look at the difference between participating preferred stock and common stock is from the perspective of the entrepreneur. Since an entrepreneur always earns more from an exit if the investment is made in the form of common stock, he should demand a higher valuation for a participating preferred stock investment. A savvy investor can exploit these dynamics to differentiate himself from competing investors and secure a lower valuation for himself. Specifically, by making an entrepreneur with serious home run potential a common stock offer when other investors are demanding participating preferred stock, the savvy investor can justify a lower valuation and still win the deal. 
For example, if the investor believes in the $100M exit, he can offer a common stock investment of $5M for 28.75% of the company, which values the startup at $17.4M, while still remaining competitive with participating preferred stock investors valuing the startup at $20M. In the event of an exit greater than $100M, the additional 3.75% ownership that the investor secures as a result of the common stock offer will be much more valuable than the insurance provided by the participating preferred stock.

Looking for marketplaces that encourage repeat online purchases

Online marketplaces are revolutionizing the way consumers buy goods and services. By offering consumers greater choice, more transparent quality, and lower prices than offline transactions, they continue to steal share from offline sales. However, not all marketplace businesses are the same. Common attributes which differentiate online marketplaces include the number of consumers in the business’ target market, the average basket size, and the extent to which repeat purchases are made. For example, eBay, which connects sellers of everything from clothing to electronics to collectibles with buyers, is targeting a larger market than Etsy, which does the same only for handmade design items. The average basket size on Expedia, which connects airlines and hotels with customers, is greater than that on eBay. Finally, repeat purchases are greater on Just Eat than Expedia because we eat more often than we travel. The combination of all of these factors helps determine how attractive a marketplace is from the perspective of market size.

However, in addition to these fundamental factors, there is one more which is a critical predictor of the success of an online marketplace: the degree to which repeat transactions take place online. As customer acquisition costs through online marketing channels rise, it becomes increasingly important to increase the lifetime value of your existing customers by having them conduct repeat purchases. And since online marketplaces only generate revenue when a transaction is conducted online, it is very important that these repeat purchases also be made online. And therein lies the differentiating factor. Certain marketplaces naturally encourage repeat online purchases, while others are much more likely to see repeat purchases conducted offline.
So what determines whether a marketplace will experience repeat purchases online or offline? The answer lies in the buyer’s primary motivation for visiting the marketplace. More specifically, is the buyer looking for variety or quality? In each marketplace, buyers are looking for a mix of both variety and quality, so it is the extent to which they seek each attribute that determines how likely they are to make repeat purchases online. For example, buyers visiting Expedia clearly value variety more than quality. Although they may have a favorite airline that they prefer traveling with, if quality was their primary determinant they would book directly from that airline’s website. Instead, they choose to visit Expedia because it offers a variety of airline options at different prices. The desire to compare prices is an important driver of a buyer’s demand for variety. On the other end of the spectrum, buyers visiting Serviceninja, a marketplace for home improvement services, value quality more than variety. Their goal is to discover a carpenter who meets their quality standards. Although they may use Serviceninja to find this person, if they are satisfied with his performance they will use the same carpenter in the future. They will no longer need to go to Serviceninja to explore other carpenters. Repeat purchases will take place offline and Serviceninja will not be able to earn revenue from these future purchases.
If you’re an entrepreneur looking to build an online marketplace or an investor looking to back one, you’ve likely paid careful attention to the need for repeat purchases among your target customers. However, it’s equally important that these repeat purchases take place online. This doesn’t mean that you can’t build a successful business otherwise. For instance, although your online retention may be low, you may develop an incredibly efficient and low-cost customer acquisition engine. Or you may find a way to earn revenue from repeat purchases even if they take place offline. For example, you could try selling packages consisting of multiple purchases to your customers upfront. Just be aware that this will be an additional hurdle that you will need to overcome.