So, I've created two charts: the first is a bar chart of consumer investment by segment and the second is a heatmap of of sector and stage. I categorized the consumer investments by 10 leading firms over the past 18 months into six buckets of my choosing.
Consumer services and ecommerce represent 70% dollars invested
Consumer services and e-commerce companies are the biggest recipients of investment. Combined, these two segments represent 70% of dollars invested and 60% of deals by volume.
In addition to being the most common, consumer services average deal size is $36M, 50% larger than commerce and social media deals at $24M, implying this segment fetches the greatest valuations.
Consumer services investments have boomed because of the growth of smartphones enabling innovation in transportation and the rise of socially enabled services built on Facebook and Twitter's distribution mechanisms.
Ecommerce has witnessed a surge in investments in the past few years with the rise of couponing, subscription commerce and vertically integrated commerce. Given the challenges of many of these companies, I suspect this trend to reverse.
Series A is the most vibrant stage for consumer investments
Above is a heatmap indicating the number of consumer investments in the past 18 months broken down by Series and Sector. S indicates seed rounds.
54% of investments made by these firms in the past 18 months are Series As. Only 11% are Series Bs. About 22% are seeds (though this figure is likely far too low since many seeds are unreported).
As for category observations, ecommerce and consumer services command the lion's share of investments, as we saw in the chart above. Media and gaming seems to be a category with particularly high follow on fund raising risk.
Early stage consumer investment is bustling
Despite the relatively small sample set of about 270 transactions, the trends are clear. VCs continue to invest in early stage ecommerce and consumer services companies.
Sector explanations - Example companies
Consumer services: AirBnB, TaskRabbit and Uber Ecommerce: Fab, HotelTonight, Warby Parker Social media: Pinterest, Path, NextDoor Media [& gaming]: Tiny Speck, Rovio, Machinima Education: 2Tor, CourseEra
Over the past 18 months, valuations of later stage consumer internet companies have ballooned into the hundreds of millions propelled by enormous user growth. For many of these startups, revenue hasn't been able to keep pace with rising serving costs. It's not surprising that some members of the eight figure valuation club can't raise follow-on rounds at even greater premiums - the economics can be challenging. It took YouTube something like seven years to break-even.
But is this the story for all consumer web? Is the drought of consumer investment capital experienced by the internet monoliths common to earlier startups? What fraction of investment dollars have moved to enterprise?
I've aggregated data from the NVCA from 1995 to Q3 2012 to answer these questions in two charts.
Consumer web's share of all US VC investment is increasing
Historically, enterprise investments have been the bread and butter of venture firms, representing about 52% of dollars invested over the last 17 years. So a focus on enterprise isn't new. Instead, the rise of consumer deals is the trend.
And across all major sectors of VC investment (consumer, enterprise, healthcare and energy), consumer investments are growing their share. Since 1995, consumer deals have on median commanded 14.7% of VC dollars. Through Q3 2012, that share has grown to 16.8%, indicating the consumer venture market is growing or stable.
In 2004, for every 1 consumer investment, VCs invested in 10 enterprise companies. Today that ratio is 1:3.
Consumers share growth is also evident when compared just to enterprise investments. After the bubble burst, enterprise deals outnumbered consumer deals 9 to 1. Since the bottom in 2003-2004, consumer deals have increased their share of venture dollars growing by 250% to about 25%.
Despite these shifts in share and market volatility, there hasn't been a statistically significant difference in the number of investments or dollars invested comparing 2012 investment activity to the past 17 years.
The party is just getting started
Despite the sentiment expressed by Fred and the WSJ about the challenging situation of consumer internet follow-on investments for high-fliers, the rest of the consumer web startup scene seems to be thriving.
Department stores. Computer software. And even education. Products and services are being broken into their atomic units and optimized for price, selection, features and, most importantly, customer satisfaction. This is an inexorable trend that cannot and should not be stopped.
This unbundling is happening. But I'm not convinced it's every consumer's desire to consume media or purchase clothing a la carte. Or that this is the end state of commerce. Instead, the future is a hybrid model. And it's already in market.
In the bundled world, consumers only chose from the products an editor had selected. Editors are paid to sift through the morass of choices, curating a subset for consumption. Department stores, record stores, newspapers, etc.
Unbundling is attractive because it replaces an opaque curation process with transparency. In the unbundled world, consumers can browse every conceivable product.
But in exchange for choice, unbundling imposes massive time costs on consumers. Given access to every product, which one is the best for me? How might I even begin to decide which is the best for me?
Take music. At some point, it takes too much time to discover new music and users stop creating new playlists on services like Spotify and Rdio and become bored with these service.
This is the paradox of choice. For this reason, many opt for Pandora instead which offers a lean back experience of quality music discovery without much effort. But neither is perfect.
Ultimately, the best music service will offer both radio and a la carte. And that's why Spotify launched Radio. Netflix offers a similar value proposition with their recommendation algo and their search functionality for video.
Unbundling shifts the burden of choice from a select few, to the masses, and in so doing, grows the time allocated to the decision exponentially. This isn't the best outcome. Instead, consumers prefer a hybrid. Curated most of the time, a la carte by exception.
Often, as startups grow, they adopt two plans: a board plan and a company plan. By creating two plans and presenting each to the right audience, founders can communicate and motivate their teams effectively.
The board plan is the more conservative of the two. Typically, the founding/management team has a high degree of confidence in the board plan, something like 90% confidence. The board plan's audience is the board. It's often viewed as the commitment the management team makes to the board, so it can be used as a framework for evaluating the team's performance at quarter or year end.
The company plan is the stretch plan, a 70% confidence plan. The company plan is often a roll up of the goals or OKRs (objective and key results) of each individual team. The company plan is the aggregation of the commitment teams within the company. It's useful as a framework for evaluating employees.
In practice, having two plans instead of one or none at all may seem like an additional complication. But there is a tremendous benefit - these two plans set the right expectations for each audience and enable the company to build predictability into the business while still setting ambitious goals.
The alternative, having only one plan that contains the stretch goals for employees and is also presented to the board, is a recipe for stress. In one scenario, the company is consistently missing plan because the stretch goals are presented as high probability. In another, the company is “sandbagging” - aiming to achieve only very realistic goals and not reaching high enough.
Managing expectations only increases in importance as companies become larger. Some publicly traded companies, like Apple, have three plans: the “street” plan, the board plan and the company plan. The street plan has about 99% confidence because investors are the most sensitive to missed expectations.
Setting the right expectations for the right audience can be a powerful management tool for founders.
NB: thanks to Justin Yoshimura who wrote me an email inspiring this post
Over lunch last week, I asked a Redpoint entrepreneur, who had recently sold his company, how his board could have been more helpful to him. His answer surprised me.
He wished the company had built a financial/operational plan sooner.
Building an financial plan is challenging and it is often perceived as a waste of time because the plan can be so inaccurate. Lots of entrepreneurs tell me their plans are just WAGs - wild assed guesses. And to some degree they are.
But, in the words of this entrepreneur, financial planning helped him sleep better at night - even if the plan was a guess. When I asked him why he felt better with a plan in place he outlined three reasons:
Reverse engineer the next round - For most of the life of a startup, the company is targeting a subsequent round of financing and working towards a milestone to underpin the financing. A financial plan helps to determine whether or not the milestones are achievable with the cash in the bank.
Degrees of freedom - Can we hire another engineer? What if we spent $15k on this conference? What is the impact of hiring a VP of Sales? How does this accelerate our out-of-cash date? Does this accelerate our path to the milestone? A financial model helps explore different scenarios - the degrees of freedom a startup has to achieve milestones.
All the arrows point in the same direction - The financial plan is a concise summary of the way a company is likely to be managed. It's helpful for the board to help validate the plan compared to other startups' plans. The plan is also a great way to level set the management team on the plan for the business.
The financial plan may never be accurate. But the accuracy of the plan isn't the point - instead, the plan is a tool to communicate, explore scenarios and successfully manage the company to the next big milestone.
When building a freemium SaaS company or an ecommerce company or any product that requires users to move through a funnel towards an objective, it's important to track this funnel to understand where the funnel can be improved.
But tracking one funnel may not be enough. The aggregated funnel may be masking conversion differences across customers segments. For example, at Expensify conversion rates to paid vary quite a bit across customer size. But the total conversion-to-paid rate hides these nuances.
It's critical to understand each segment well. For each, which features are missing or are too complex? How do they prefer to try and pay for the product? Which acquisition mechanic is the most effective? What marketing message resonates with the segment?
We recently built a segmented marketing funnel at Expensify. These are the steps we followed.
Identify your segments. This can be done through intuition, customer interviews, or data science. I used company size as the first pass segmentation for Expensify, but I intend to explore clustering to see if there are more nuanced segments.
Define the key steps in the funnel: registration, activation, contact and purchase might be an example.
Define other related metrics: the fraction of users that must be upsold through online channels vs inside sales, the average value per customer, the current penetration of the account vs the total possible value of the account.
Run the analysis and see what results come about. If no insights are present, or the data is relatively homogeneous, it might be worth redefining the segments.
Structure the marketing, product and sales team goals around funnel performance.
Great products are like ducks. They are calm above the water but paddling furiously below the water. An entrepreneur told me this quip last week and I think it had great wisdom in it.
In other words great products are graceful. They make something complex look effortless.
Great athletes are the same. So are great dancers. And even great entrepreneurs.
The secret within this aphorism is that success is a grind. It is hard work. It's easier to let it all hang out for others to see how hard work can be. Often we want others to understand how challenging a problem was to solve or how stressful a deal was to close or how complex a product is.
But the people and products who capture our imaginations are the ones who grind like everyone else but remain placid on the surface. These are the graceful ones - the ducks. They make the grind disappear and the results of their work seem effortless as a result.
Once a founder has experienced each of these phases, it's easy to identify the them in retrospect. But companies don't transition from one phase to another in discrete steps. Instead, they morph and evolve fluidly into these phases.
Throughout this metamorphosis, two things must remain constant to keep the startup functional: the vision/mission of the company and the culture of the company. Lacking a consistent vision, the startup can enter a tailspin - with a team unclear on the path to pursue. Without the right culture, teams fall apart.
Both of these are responsibilities are those of the founders. Founders are the stewards of vision and culture. And that's why they are vital to the success of the company at every stage.
Quality of inbound traffic - As part of measuring the cost/benefit of a partnership, it's critical to understand quality of traffic/customers from a distribution partnership, as @jamesreinhart pointed out. Ideally, a startup should collect data on the performance of a distribution channel before entering into a long-term agreement with a partner. Conversion rates can vary widely by channel and lots of poor traffic isn't worth the effort.
Setting the Partnership on a Path to Succeed
Internal dynamics play a huge role in the success of a partnership. With large scale or long term partnerships, an internal champion whose job is on the line is essential for the success of the partnership.
Additionally, it's critical to understand your potential partner's motivations for working together and structuring the deal so that both parties are motivated to cooperate - and that incentives don't diverge with time. Is this a check-the-box partnership or is this a strategic priority for your partner?
Spifs or sales incentives If you are considering a distribution or sales channel partnership, spiffs or sales promotion incentive funds ensure that sales teams working for your partner are paid to sell your product. Without spifs, salespeople aren't going to push your products because they make no extra money. Ideally, your partner bankrolls the spifs. Or the costs are deducted from their portion of the revenue share.
Marketing commitment is a critical focal point for distribution partnerships. Successful partnerships often have marketing performance metrics in the contract. This can be as high level as a dedicated marketing budget or as low level as guarantees on the number of customers/leads. Without any of these terms, the partnership has the potential to flounder in obscurity.
Remuneration - If the partnership requires engineering or additional service level agreements, an up-front NRE (non-recurring engineering) fee from your partner is a common way to finance this work. Ideally, a startup uses this NRE to finance and accelerate development on the product roadmap. NRE payments have seduced startups in the past (including one I worked for). Pursuing NRE as cash-flow at the expense of its roadmap, transforms the startup into a consultancy - not the best outcome.
Other forms of remuneration include revenue share - the split between the parties. And of course revenue guarantees. Guarantees tend to misalign incentives for partners. Whoever is guaranteed revenue can just put their feet up while the partner works hard to make money. Avoid them.
Exclusivity is generally a very bad thing. Large companies try to enforce exclusivity to prevent their competition from working with a startup. Obviously, such an overbearing constraint limits the size of a startup's market.
There are several effective strategies to negotiate against exclusivity: (1) offering exclusivity for a short period of a few months; (2) limiting the breadth of the exclusivity by explicit naming of competitors that startup cannot partner with; (3) framing the benefits of working with multiple partners as a benefit through shared data, shared product features or some other mutual benefit; (4) framing the startup's success as critical to the health of the partnership.
Strategic investments - Sometimes partners like to invest into a startup as part of a partnership. They would like to participate in the upside of the success they engender. The cash infusion is alluring for the startup and typically strategic investments occur at better terms than those of the venture market.
Strategic investments may grant a partner information rights - detailed knowledge typically shared only with the board. Knowing much about a startup provides the partner an effective right-of-first-refusal to purchase the company.
Should an acquisition offer arrive from a third party, your partner will be made aware. This skews the dynamics of an M&A process to the detriment of the startup.
First, the partner will have had extensive access to the company and its assets, which means the partner can price the company better than any third party. A third party would have to be foolish to pay more than the partner. Second, the partner will be made aware of incoming M&A interest and has an effective right-of-first-refusal. They may increase any third party's bid by 5% and win the deal. Messy dynamics indeed.
By and large, I encourage only later stage companies (post-Series B) to consider strategic investments. At later stages, the valuation a company can command limits the ownership a partner will purchase, limits information rights and rids an M&A process of the effective ROFR dynamic.
Breach - Both sides will want a clause that spells out the terms for breaking the partnership. The amount of notice, size of damages, process for restitution and so on should be explicit.
Lastly, it's important to remember very partnership is different. Key points of negotiation vary widely. Having experienced counsel and a strong board is a big help in evaluating partnerships.
When a startup is approached by an established company about partnership, it can be a very exciting time.
Sometimes partnerships change the trajectory of a startup. Other times, the weight of partnerships can crush startups. Servicing a much larger partner's needs with a small team can be a full time job and deprive the startup of any time to advance their independent projects.
When evaluating a partnership, the most important first-pass analysis to conduct is to understand whether in the success scenario, the partnership is worth the effort by comparing the startup's progress to a conservative estimate of internal growth.
Distribution Partnership Example
Below is a chart for a fast growing startup. The blue area measures the userbase which starts at 50,000 users on month zero and grows 15% each month.
Suppose on month one, the startup signs a distribution partnership agreement that guarantees the startup 10,000 users per month for 2 years. But it takes 9 months to complete integration work, set up the marketing campaign and so on.
At the outset, 10,000 users per month is a big deal - an additional third of the user base. But a year later, the partnership is driving only 7% of new users. As a fraction of all users, the partnership has driven 14% of all users. And the value of the partnership decreases with time.
Was the 9 months of integration work worth the effort?
One way to answer this question is to estimate what additional features or marketing initiatives could have been launched using the time allocated to integration. And their corresponding impact to growth.
If our startup could grow 1.5% more per month because we allocated the time to internal initiatives instead of the product, in three years' time the user base would be nearly twice as large - and growth remains under the startup's control.
Skate to where the puck will be
The decision to pursue a partnership is complicated. There are considerations of the increase to brand value, access to new potentially more lucrative customer bases, access to new forms of technology, and many other potential advantages.
But a good first pass filter is comparing the success scenario to a reasonable estimate of exclusive internal growth.