1. Know What The VC Likes To Invest In

One of the metrics we track is the broad industry segments of the startups we review each quarter.  We like to categorize startups by the industry they fit in, and as you can see from the chart below, our primary focus has been on five key areas.

As an entrepreneur it is important to know what categories a VC focuses on. The two categories that you don’t see on our list are Cleantech and Medical Devices. We don’t invest in these two areas, and yet we still receive requests to look at startups that fall into those categories. Take a quick glance at the portfolio and website of the VC you are potentially reaching out to; if you don’t see any investments that match your industry, you’re most likely better off spending your time engaging with firms that actively pursue companies in your respective field.

2. Know Where The VC Looks For Great New Companies

We focus heavily on which types of individuals send us the best deals and what the average quality scores are of the companies they send us.  We break this out by source type and quality score based on our 10 point initial review scale. For an explanation of our initial review scale please see our prior blog post here.

Of our five new investments in 2011, three came from other VCs, one from another entrepreneur, and the last from our outbound efforts on AngelList.  The takeaway for entrepreneurs: the way you are introduced to a VC really matters.  If another entrepreneur, VC, or industry contact whom we have a relationship with asks us to look at something, chances are fairly high that we will look at the opportunity.  Like a lot of firms, we do not do take many meeting requests that come to us via a cold email (inbound).  While it isn’t a guarantee that a VC will invest, gaining a “warm” intro will often get you the first pitch meeting.  We recommend cross-checking your contacts on Linkedin and figuring out which of your colleagues or advisors may know a VC that you would like to meet with, then asking for an introduction.  This simple act will pay dividends in terms of making it to the next step of a pitch process.  If you don’t have an extensive list of contacts, the other options include going to conferences, demo days, or using AngelList to get your foot in the door.

1. Know The Right Time to Contact (and When Not To Contact) a Potential VC

We try to get back to every entrepreneur with feedback.  The vast majority of the time we unfortunately have to say no, but we try to let the entrepreneurs know our honest reason(s) for passing on their company – at the very least they will walk away with one VCs candid objections and incorporate what we hope is useful feedback as they build their business.  We also measure the days it takes for us to respond to entrepreneurs we meet with during the course of the year, and the days outstanding for 2011 are below.

Given the number of companies we see it sometimes takes time to understand a given opportunity, discuss it internally, and provide candid feedback to an entrepreneur.  We have found that many entrepreneurs appreciate the constructive feedback.  One thing we have noticed that doesn’t work with almost every VC is frequent emails requesting to know the status of “where they are at” in terms of making a decision.  If a VC really likes what you are doing, they will be quick to respond. Unfortunately, the common practice of many VCs is to go radio silent.  While this can be frustrating for an entrepreneur, doing some initial qualification of the firms and the individuals you are targeting up-front can help mitigate against being caught in this type of void.  When following up to check on the status of a review, we also recommend including any significant company updates you might have (closed X customer, increased revenue by X), or if your funding round is becoming oversubscribed and you want to give a courtesy note with the timing of the round closing.  Nothing impresses us quite so much as execution and communicating progress to VCs while they are evaluating a funding round not only demonstrates the viability of the company’s business, but can also engender the sense that if we (or any other VC) don’t jump on a given opportunity, then we might lose out to another VC.

We hope this gives you an idea of how to think approaching and engaging a VC.  Feel free to give us any feedback or ask any questions you might have.

We wanted to share some of Becky’s insights since, as the saying goes, that’s where we’re going to spend our time (and in our case investment dollars as well):

• Use of data from the Internet is still evolving in ways we can’t fully appreciate (yet) – We’re all familiar with Web 1.0 (i.e. static electronic pages we read that were similar to what newspapers and magazines provided).  Then Web 2.0 came along which allowed two-way communication with millions of users (hello, Facebook!).  Web 3.0 (aka the semantic web) is happening right now.  It’s when machines encode all the data on the web and derive meaning from it.  This is the focus of Netbase (www.netbase.com), one of Thomvest’s portfolio companies.

What comes next is…wait for it: Web 4.0!  This evolution of the Internet has the ability to use billions of different sources of data to predict what will happen next.  In other words, sentiment precedes outcome.  For example, some start-ups are experimenting using Twitter to predict what the stock market is going to do next (http://bit.ly/GQftJd).  A team of California researchers recently concluded this approach was 11 percent more accurate than other computer models.  There are mutual funds being creating using just such an approach (and based on how some mutual funds have done over the years, it’s hard to imagine they could do much worse).

This isn’t a new concept – financial analysts have been trying to do this for decades using competitive analysis and sharing information (“buy on the rumor, sell on the news”).  What’s different now is machines can help them do this faster and better than anyone could imagine 5 years ago.

• “Big Data” is being used in new and compelling ways by business and agencies –To quote The New York Times when talking about Big Data, “Big analysis….(is) looking at information in novel ways to find new patterns for prediction.”  So once you’ve got all your Big Data, what do you do with it?  Here are three different ways to get something valuable out of it:

• Modeling Using Algorithms – This is the one all the engineers love at first sight and is called the “Karman Filter” (http://bit.ly/TQiMg).  An example of this would be what the military developed to predict where a missile would be in the very near future (i.e. minutes) using real-time data in order to shoot it down (one of Ronald Regan’s favorite ideas for his Star Wars defense initiative).

• Application of Neural Networks – If you’ve ever rented a film from Netflix, you’ve already seen this in action.  Ever wonder how they know what movie you’re going to want to rent next?  Netflix uses individual data from millions of movie lovers to detect patterns on what you would like to see next.  If you don’t think that’s a big deal in terms of what Netflix was willing to pay to improve it by just 10%, check out the story about the $1 million prize awarded to a team of super geeks at The Netflix Challenge (http://bit.ly/BNvzQ).

• Prediction Models – This approach (similar to how the stock market works) takes all available data and uses it to value something.  It’s not just for trading stocks or bonds.  There’s a site called “Hollywood Stock Exchange” (www.hsx.com) that uses this type of modeling to allow users to buy and sell virtual shares of celebrities and movies with a currency called The Hollywood Dollar®.  Companies such as Ford are using this type of modeling to determine what consumers want in their cars.

Of course, there are skeptics to the whole concept of using Big Data to predict the future.  As Daniel Rasmus declared in a recent edition of Fast Company, “Big Data can’t make you smart, pretty or rich.”  While it’s true that all models have limitations and predictions can sometimes become self-fulfilling, my personal prediction is these types of models are going to become more important to all of us in the future.

If you’d like to see more of Becky’s presentation from SXSW, check it out at http://slidesha.re/wdOAWU.

I would like to share seven guiding principles you can apply to use social media to build your business:

1.) Listen and Respond To The Voice of Your Customer – Social media gives your business team unprecedented access to your consumers in terms of what they are saying about your Brand online. That still requires actively making an on-going effort to listen and understand what they are saying, and then respond in an appropriate and authentic way.

The good news is (at least for a small business) you don’t need to spend a lot of money to follow this conversation. Examples of free and inexpensive tools for monitoring online conversations include:

• Google Alerts (Internet mentions)
• Addictomatic (numerous sources)
• Hootsuite (Twitter)
• Reading Facebook wall posts (for your Brand as well as your competition)

2.) Strategy First, Then Execution –Social media is very easy to get started for your business; the hard part is making your social media program relevant and impactful over time.

Therefore, before beginning a Facebook Fan Page, Twitter account, YouTube channel, corporate blog, etc., you need to answer some fundamental strategic questions:

i. Who are you trying to influence and connect with?
ii. What is your overall business objective?
iii. What are your social media goals (metrics)?
iv. What are your key social media platforms/channels you plan to use (rationale)?
v. What are your initial plans to get started?

Even though there is a strong temptation to “just get on with it”, your business (as well as your customers) will be much better off if you take the time to make sure you have a well considered social media strategy before you begin implementation.

3.) Less Is More – There are hundreds of social media channels, platforms and options available right now (with more choices coming online all the time). At Thomvest, we have a front row seat to get an early look at many of the ones being developed here in Silicon Valley.

Despite all of these wonderful and tempting choices, your business cannot and should not be in all of them! Your team and business do NOT have the time, money or people to be effective on a multitude of social media platforms. Nor is it necessary. Success in social media means you don’t have to outspend your competition: you simply need to outthink them.

This starts with understanding your target audience:
i. Where do they use social media?
ii. Where is your message going to be relevant?
iii. What type of content is your target audience interested in?
iv. What are you willing to invest in for the long term and be “best in class” in providing the right content at the right time with the right social media channel to your target audience?

If you spend the time to be selective in what social media channels you want to focus on, this will pay off big time in terms of making sure you get the right message to the right audience at the right time.

4.) The Power of “And”- Social media doesn’t operate in a silo. It’s part of an overall “ecosystem’ of information your consumer uses. There is increasing importance being place on integrated marketing in which you need to determine how you are going to balance your paid, owned and earned media.

That means you need to figure out the best way to leverage your social media plans (such as Facebook, YouTube, Twitter, etc) with your other key marketing communication channels.

One of our portfolio companies, NetBase, did a great job of this recently. The company put together a webinar with Brian Solis, an expert on social analytics. By using Twitter they were able to have conversations with interested users and increase registrations for the event.

5.) Mobile Goes Global- The biggest trend in social media for foreseeable future is going to be continued growth in mobile devices (i.e. smart phones, tablets) that continues to grow even faster than the experts predicted it would.

Your business needs to ensure your social media plans take full advantage of this by being there for your customer at the “moment of truth” (i.e. when they need your Brand’s products and services) as well as invest in the right resources and plans to make sure you have what your customers are going to need from your business (i.e. by using your mobile website, apps, content, etc).

6.) Measure What Matters – It’s easy to “drown in the ocean” of social media data as well as trying to decide on which tools to measure this data. It’s important for you to decide early on what are the critical few metrics that you’re going to want your team to focus on and how you’re going to gather, report, and analyze this data.

A common mistake many social media teams make is thinking “more is better” , which leads to overwhelming their management team with way more information than is needed. The social media metrics you should select will depend on who is going to be using this data. For example, while the social media team may be very interested in monitoring the number of Facebook fans a Brand has, senior management might be much more interested in metrics involving how engaged consumers are in the Brand’s Facebook fan page since that is probably a better predictor on the impact these consumers are going to have on the business over time.

Netbase has invested a lot of time and effort in calculating and tracking “net sentiment” for a brand or issue over time. Here’s an example from Netflix, a brand that had a tough summer with some pricing and service decisions they made, but it looks like they are now starting to recover:

7.) ABT: “Always Be Testing” – Social media is changing every day….what works today might not even be relevant tomorrow (not to mention new platforms and ideas that are being created). That’s why it is so important to “keeping the test pipeline full” in terms of continuous learnings in social media. You can do this in a variety of ways, including:

a. New channels
b. New ideas
c. New content and promotions

It’s been my experience most tests fail. That’s perfectly all right and should be expected for two reasons: a.) you would rather fail on a small scale rather than a large one and b.) when you do discover a “winner”, you can confidently put a lot more resources behind it when you roll it out since you’ve got a much better idea on how it will perform in the marketplace.

Good luck on your journey with social media. It’s a very exciting time to be in business today with all of the new social media options at your disposal. With the right strategy and planning, you will be amazed at what it can do to build your business and strengthen your customer relationships both now and in the long run.

We’d love to hear your thoughts on any of these principles (either agreement or disagreement) as well as any others you’ve developed.

To find out for ourselves, we created an AngelList account and began looking at startups that fit our early stage focus on B2B companies. When a startup makes a profile on AngelList, the listing is vetted by Naval and Niv, AngelList’s co-founders. If it makes the cut, the startup is categorized by industry, and then introduced by email to investors whose preferences match the company. Since creating the account, we have asked for introductions to 24 founding teams (the majority of which we met in person), offered competitive term sheets to two companies, and invested in one that we found particularly impressive called FlashSoft.

FlashSoft claimed that its software could boost server performance 3-5x by sending “hot” data to solid state flash drivers and “cold” data to disk drives. While at the time the company didn’t receive interest comparable to the buzz surrounding some of AngelList’s consumer web startups, it seemed to us that if the team could deliver on their lofty claims, FlashSoft could develop a very large business.

After a good initial meeting, we proceeded to do our homework on the company. We found that customers couldn’t stop raving about FlashSoft’s software in our due diligence calls: they had done extensive testing and found that the product lived up to its performance claims. As part of our review of the company, we also asked technical experts at Avalanche Technology, another Thomvest portfolio company, to meet with the team and confirm the potential we saw in FlashSoft.

Following our diligence process, we gave FlashSoft a term sheet and led its Series A investment, excited about the company’s future. After everything was complete we asked Ted Sanford, FlashSoft’s co-founder and CEO, about his experience using AngelList. Ted told us that AngelList’s team had given him coaching on how to list FlashSoft’s profile and navigate the funding process. The listing on AngelList had helped Ted get a sense for which investors were interested in what they were doing, and led to multiple term sheets. In the end, we were fortunate that FlashSoft chose to work with us based on our experience in the industry and our interactions with Ted and the rest of the team.

Since the investment, the team has seen strong traction among customers and partners, and has continued its leadership position in the space by releasing Linux, VMware, and Windows versions of its software. Flashsoft was also the first software company ever to make it on Storage Search’s Top SSD Companies and has had positive reviews from various analyst firms including 451 Group.

Today we are pleased to announce that FlashSoft has been acquired by SanDisk. We believe that the combination of FlashSoft’s software and SanDisk’s hardware will mean great things ahead for customers, partners, and for the teams at both companies. For our fund and for our co-investors, our 10-month partnership with FlashSoft has led to a solid financial return on our investment. Our experience has demonstrated that AngelList is democratizing the way startups receive funding, and we’ll continue to search the site for great teams to invest in.

We wanted to reflect on seven major consumer trends we believe will drive continued growth and change in this multi-billion dollar category:

1.)  Consumer Electronic Device Usage Is Converging – Consumer electronics (which we’ll refer to as “CE” for the balance of this blog) devices are increasingly being used on a 24/7 basis.  If you’re like most workers and consumers, you don’t want to have to carry around separate devices for your work and personal life.  While IT departments are always rightly concerned about security of corporate data as their top priority, they are increasingly recognizing workers want the same utility at work from CE devices they can get from their favorite consumer devices (such as an iPhone or iPad).

This has led to the rapid adaption of such CE devices as tablets and smart phones for use in restaurants, hospitals and offices.  This trend will accelerate in the next 5 years as more IT teams figure out a way to allow this to happen without compromising their corporate data integrity.

2.)  Consumer Expectations for CE Are Increasing – Remember the 2002 Steven Spielberg film “Minority Report” that featured Tom Cruise waving his hands in the air to move his computer data around?  We’re getting closer to this reality every day.  There’s an increasing variety of new ways consumers interact with CE devices, including:

• Voice commands
• Touch screen
• Facial recognition
• Projectable keypads
• Body movement (such as Kinect)

While there are some innovations featured in “Minority Report” we hope stay in the realm of science fiction (such as insect robots and crime prediction software), we’re looking forward to what is going to be a continuing wave of new creative ways to interact with our devices and data.

3.)  Apps Are A Key Growth Driver for CE Devices– “There’s an app for that” is more than an advertising slogan…it’s the truth.  There will be an estimated 70 billion downloads of apps on an annual basis by 2014 – that’s an average of 10 apps per person on the planet. This exponential growth of apps is driving the popularity of tablets and smart phones.  We think the biggest advantage of apps is they can be used at the “moment of truth” (i.e. when and where they are needed by a consumer).  The biggest downside risk many of us have already experienced is to become overwhelmed with too many app choices.   Becoming the next “must have” app will remain a dream for legions of developers but consumers will continue to benefit from their hard work.

4.)  Ongoing Sales From Selling Premium Content Will Be Critical To Long-Term Profits In CE – Creating and maintaining premium prices for CE devices (i.e. Bang & Olufsen) is almost impossible today.  Selling premium content and getting a piece of every sale is going to increasingly be where the real market battle takes place.

King Gillette discovered over a century ago it’s more profitable to sell razor blades than the device that holds the razor. What Steve Jobs did by creating iTunes and what Jeff Bezos is doing with Kindle Fire is a key to long-term financial viability in the CE category. That’s going to be true for all the major CE players as well in the 21^st century where the term “Blade Runner” is going to take on a whole new financial meaning.

 5.) Aging Boomers Will Be An Increasingly Important Influence On Future CE Devices – A newly minted 50 year old now occurs in the U.S. on average every 7 seconds.  Among all age groups, this 50-54 year old segment was the fastest growing during the past decade, increasing by 55%.  This “over 50 year old” demographic is already the fastest growing social media user segment.  This demographic target should be a top priority for CE manufactures and marketers since they have more discretionary time and money compared to younger consumers.

We believe CE design and ease of use aimed specifically at an older demographic group is going to become more important in the next decade.  You can already see it happening with some recent CE product launches:

• Wireless scales that measure your weight and alerts family members wirelessly if your weight has gone up or down by a certain amount.
• Motion detectors with sensors that track whether a family member has fallen, opened a pill bottle, used the bathroom excessively at night, wandered out of the home, hasn’t stirred for hours, or forgot to turn off a burner on a stove.
• Mobile phones with a hidden keypad with very large buttons, an amplified earpiece, and a panic button on the back that automatically dials five preprogrammed numbers when triggered.

We all like to make fun of the TV commercials featuring The Clapper (“Clap on!  Clap off!”), but we believe as the average American gets older, as a country we are going to need to be all kinds of innovative CE devices that can do a heck of a lot more for us than just turn off the lights.

6.)  Consumers Want Integrated CE Home Solutions – While no one we know is looking to install a version of HAL (the computer from “2001” that had self-image and control issues) in their homes, we think we will see a lot more innovation in the next 10 years in how our homes become integrated into a “whole house” solution that features:

–      Wireless controls

–      Energy efficiency

–      Manage communications and security

–      User friendly (voice commands or smart phone enabled)

–      Easy to maintain and update

7.)  How Consumers Buy CE Matters A LOT More Than Where They Buy – Our sympathies goes out to the “Big Box” retailers in the U.S. today.  They are under increasing pressure to make their economics work.  It won’t be easy.  They are getting increased competition and continue to lose market share to e-commerce and emerging “mobile commerce” players.

In addition, there are more and more consumers who go to their local stores to shop in person, whip out the price scanner on their smart phone to comparison shop, then buy online based on best price (often with free shipping).  This is leading some of these retailers (such as Best Buy) to consider sub-leasing some of the existing retail space they’ve got to help bring down their overhead.  That will help some but won’t be nearly enough to ensure their survival.

The real winner in all of this for now will be the consumer since they now have at their finger tips the information needed to make a well-informed CE purchase decision as well as continuously lower prices on what they buy.  The long-term question is whether this retail environment can last since if enough “brick and mortar” places can’t make their economics work, consumers won’t have the luxury anymore of checking it out the latest CE device in person at their local store before they make a purchase decision.

In summary, despite the on-going economic doldrums we’ve all been in, consumers still remain very passionate about their favorite CE devices.  The past 5 years have seen an explosion of innovation and strong global growth in various CE categories, which I don’t think is going to slow down anytime soon.  The winners in this space are going to be the ones who do the best job staying on top of and effectively responding to the rapidly changing consumer trends we’ve discussed in this blog.

What do you think?  What consumer trends will be key drivers for consumer electronics in the next 5 years?

Final due diligence

After the initial review and discussions with the Apsalar team, the next step was to bring the rest of our team up to speed with the Company and to continue the due diligence process.  We craft an internal investment memo to clearly explain the investment opportunity and to ensure that we have done the work needed to fully understand the company’s value proposition and market position.

Topics that we typically cover in our investment memo include:

1. Investment Summary
   • An overview of what the startup is trying to do, how much we are proposing to invest, what we think the total eventual capital required will be (including our portion), what percentage ownership that might leave us with, and what type of exit we might expect for a successful company in the market being considered.
2. Team Description
   • Who are the founders and leaders of the company?  Have they had success with their previous endeavors?  Does the team demonstrate enough tenacity and willingness to learn in order to become successful?
   • What is the culture of the company?  Is it an engineering- or product-driven organization?
3. Market
   • Who are the primary competitors?  Are they large existing companies or other start-ups?  What are the competitive advantages of the company being considered?
   • We usually create our own analysis of the startup’s TAM (Total Addressable Market), which is used in turn to get a sense for how large of a company the entrepreneurs might be able to create if their product or service is successful in its market.
4. Comparables/Potential Exit Pricing
   • Has there been other M&A activity in similar segments of the market, and if so, on what multiples did it sell (revenue, EBIT, strategic value, traction, etc)?  To give you a better sense for this, we’ve included the sample we used in our Apsalar investment memo:
5. Operations
   • Required headcount.  In particular, what sort of engineering talent, sales and marketing resources will required in order to scale?  How quickly does the company burn through cash?  How well do they understand the key metrics for measuring their own business?
6. Financial Performance
   • We generally build upon models that the startup management team gives us, or generate some rough estimates on how we think the company could grow.  While it is difficult at an early stage to come up with concrete revenue estimates, the exercise helps us to focus on the key levers that will determine the performance of the company and help us figure out what happens when they are tweaked.  For example, if a company relies on CPC or CPM advertising revenue, we can model the impact of a price change.
   • When thinking of the downside, we often think it is wise to assume the rule of 3 when evaluating a startup’s financial forecast.  Namely, that building a successful company will take three times as long, require 3 times more capital, and generate only a third of their forecasted revenue.
7. Merits
   • Concise statement of why we like the company
8. Issues/Risks
• What could derail the startup?
• Call notes -These are in effect the ‘raw data’ from reference calls we’ve made with customers, partners or industry experts.

During the preparation of our Apsalar investment memo, we continued to have discussions with the team, customers, and contacts who were experts in the company’s industry.  In the case of Apsalar, these discussions continued to build upon our initial enthusiasm for the company and the team.  Our reference checks for Apsalar made us comfortable not only with the investment but also swayed us to propose a higher pre-money valuation than we would normally offer such an early stage company.

Negotiating terms

After debating the pros and cons of investing in a startup, the group usually comes to a consensus opinion.  If we decide to move ahead, the next step is drafting a term sheet to present to the company.

The two things that matter in term sheet negotiations are control and economics.  For the first, we generally make our term sheets founder-friendly, and this is especially helpful when a startup receives interest from others in their financing round.  Throwing in severe terms makes it less likely that you will be viewed as a partner or will even be chosen as an investor.  For example, we typically do not include a full ratchet anti-dilution because we find it to be too draconian , and we do not pressure founders with exploding offers that forces them to make a quick decision.

Valuing an early stage company is typically more art than science.  Often market supply/demand and how much interest your funding round is receiving will dictate the way the conversation goes.  Some VCs get to a valuation number by working backwards from a targeted percentage ownership that they generally like to receive and use that as a basis for how they think about valuation.  Given our unique structure (we are investing our own funds, and don’t need to raise outside capital) we are typically more flexible in this area and focus on being part of a great company rather than how the specific ownership percentage pans out.  That doesn’t mean we won’t negotiate or try to get a fair deal, it simply means that we won’t necessarily get caught up over fighting for an additional 1% ownership of a company or balk if we don’t meet a certain ownership threshold.  The foundation for understanding how these proposed economics will impact a startup is the capitalization table (cap table).

We built this cap table to provide a blueprint for founders to help them envision what the ownership of their startup might look over a number of financing rounds.

Thomvest Sample Cap Table –

Depending on who you ask, there will be a multitude of opinions on what a standard or optimal capital structure might look like, and while we did put some round numbers that we think reflects the progress of an average startup’s capital structure, the numbers will change drastically depending on the circumstances of the specific company being considered, the market conditions, etc.  A few of our assumptions:

1. We assumed that option pool increases would occur after a financing round closes, and that 50% of options are granted between each financing round.  It is important to note that the timing of an option pool increase may change, and could have a big impact on the valuation of your startup.  If you are interested in learning more, we would suggest reading an excellent article by our friends at Venture Hacks.
2. We assumed that Angel investors did not follow on in subsequent rounds.  Sometimes Angels will exercise their pro-rata rights or increase their commitments, but more often we see Angels who are content with keeping their investment restricted to the seed round.
3. We assumed that a company would take venture debt and bring aboard a strategic investor in the later stages of their financing rounds.  Current venture debt interest rates are quite favorable, and we have seen a number of our companies take non-dilutive financing to fuel their growth.  In addition, strategic partners may provide an additional sales channel or value once a startup is established.  At the same time, some companies have grown substantially without taking venture debt or a strategic investment.
4. We left in our own analysis at the bottom so you can see how a VC thinks of their ownership over time in relation to their total preferred and fully diluted ownership percentage.  Not only can this be used to determine what would happen in the event of an exit, but we also use it to determine our voting rights.

While explaining the nuances of cap tables could take up a few blog posts on its own (feel free to ask if you have any specific questions), we wanted to include an example as it played an important role in our discussions with Apsalar.

We decided to do something unconventional and asked Michael Oiknine, Apsalar’s CEO, to come down to our offices before presenting a term sheet.  We took a similar cap table, plugged in the past numbers for Apsalar, and then put in theoretical values for the current financing round with a comparison analysis of how the pre-money and other items affected the founder’s and Thomvest’s outcomes in the event of an exit.  We projected this on the wall, talked through it with Michael, and changed the model with his input on the fly while discussing certain ways to structure the financing round.  At the end, we came to an agreement on terms that both parties felt was fair, and emailed the model to Michael and the company’s lawyer for review.  We followed up with a term sheet that was signed by both parties a few days later.

Rounding out the investment syndicate

During our discussions, we emphasized the importance of leaving a meaningful allocation open for other investors.  If Thomvest was very aggressive on trying to maximize its total ownership percentage, then it wouldn’t leave a meaningful piece for other angels and VCs to join the round.  We were happy to finance more of Apsalar round and even gave Michael the ability to call an additional amount of capital from us if he desired.  However, both Michael and Thomvest felt that building a strong syndicate for the company would be beneficial for everyone.

We tend to prefer to syndicates with other VCs to give startups more collective networks and experiences.  We supplement the existing VCs that a startup has received interest from, and the network of VCs that our team has, with some digging in research databases to screen for the most active investors backing startups in the relevant industry.  In Apsalar’s case, we were fortunate to have both Battery Ventures and DN Capital join the syndicate.  Both firms bring great collective experiences to the team. When we met with Steve Schlenker from DN Capital, we were impressed with his knowledge of the overall gaming landscape and the specific ad monetization challenges that publishers faced.  Many of these insights came from having investments in successful publishers such as Digital Chocolate and Shazam.  Battery Ventures brought a range of experiences with ad networks from their backing of BlueKai, ExactTarget, Freewheel, and Omniture to name just a few of the many companies they’ve helped build.  In addition, the company also had the support from the team at Founder’s Co-op, who had supported the company at the earliest stages both financially and through mentorship.  We were quite pleased at the prospect of working with such a knowledgeable and experienced group of investors.

We hope that these two posts give some insight into how a VC thinks and acts throughout the entire fundraising cycle.  The process may differ depending on the investor; some might agree to fund you over coffee where others might be painfully slow.  We spend a great deal of time digging deeply into a startup’s team and business once we are genuinely interested, and we encourage founders to do the same in respect to their potential investors.  We encourage founders to read an investor’s blog, check out their social media accounts, find startups they invested in that failed and set up reference calls with the founders of those companies so you can see how the VC acts in bad times as well as good, and spend time with the partner that is actually going to be on your board to see if you get along.  While you might be able to pull your entire funding round together in a matter of weeks, you’ll be working with the people backing your company for a number of years.

Our first contact with Apsalar came through an entrepreneur whose previous company we had invested in.  He served as an advisor to Apsalar and told us about the company because he felt there might be a good fit.  We had an initial call with Michael Oiknine, the founder and CEO, where it quickly became clear that he knew the space and appeared to be on to something big.  That led to a series of further calls and the proverbial pitch deck landing on my desk.

In any given quarter we are typically looking at upwards of 80 companies that have been referred to us by people in our network.  Given the volume, we try to apply a simple rating system to help us consider which startups are a good fit with our investment focus.  After doing an initial scan of pitch documents, I generally rate companies on 10 rather loose criteria as a litmus test to see if there is a good fit:

1. Early Stage (most of our investments fall under Seed/Series A/Series B)
2. Geography (we spend a lot of time with our startups so the focus is on Silicon Valley)
3. Industry Fit (is it a market we understand and can give helpful assistance in?)
4. Competition (size, strength, reach, and technology differences of other industry players)
5. Business Model (has to be one that we believe in)
6. Momentum (user traction, partnership agreements, and industry recognition)
7. Market Size (focus on the size of the total addressable market for the problem being solved)
8. Defensibility (this can be IP, specialized skills/knowledge requirements, any unfair advantage)
9. Team (what are their past experiences, domain knowledge, and group passion/chemistry?)
10. Bill Dodds Wow Factor (named after a Thomvest veteran, this is the “did it have that additional ’umph‘ that gets you excited about the company?”)

While this list isn’t perfect or comprehensive, it generally allows us to quickly test if there is a good fit with Thomvest.  There are exceptions to the rule, but going back over a year’s worth of prospect data, there has not been an investment we have done that hasn’t scored in the top tiers (8-10).

It’s rare that a company gets full points on this scale for an early stage startup, and Apsalar was one of those rare cases that scored a perfect 10.  The team was raising their first institutional round, is located in San Francisco, and is doing mobile and software: three quick points on our simple litmus test.  The mobile analytics space seemed to be competitive, but no one had done effective mobile behavioral targeting, giving the company a first-mover advantage.  We were able to analyze the business model and felt good about the strategy going forward.  Apsalar’s momentum was the hockey-stick you hear about but don’t often see.  The team had worked together for 10 years doing behavioral targeting online with their prior company that had a successful exit.  This gave them the skills in addition to protectable IP around the methods for their mobile code.  The Bill Dodds Wow Factor is a bit hard to quantify, but it can come from ridiculous traction, beautiful design, an entirely different take on how to do something that we wouldn’t have thought of, and so forth.  Apsalar’s growth ramp was stunning, the visualizations of their data were slick, and the way they wanted to implement behavioral targeting had a unique approach that we hadn’t seen.

We knew that investing in Apsalar was going to be very competitive, with the company already receiving term sheets from other investors.  We crammed the review process into one week, in what can only be described as the VC equivalent of a hack-a-thon. More than a few sleepless nights were filled with solidifying our market overviews and forecasts, cranking out financial models to test startup assumptions, and doing back-channel reference calls.  We like to know a great deal about the people we are considering working with, and usually spend a good amount of time sifting through Linkedin, Quora, Twitter, and Google to get to know them better.  Linkedin lets me see who we mutually know and can lead to good reference checks.  The trail of a CEO’s Quora account history shows how they are thinking about their business, the types questions they spent the time to answer/upvote, and feedback that their opinions are receiving in the tech community.  Their Twitter presence gives a glimpse into topics they generally cover and what kind of audience they tailor messaging toward: some use it as a networking tool, others chronicle their startup’s progress, and others transcribe notes about things they find interesting.  A simple Google search can yield some surprising findings as well.  We found a defunct blog that the CTO wrote circa early 2000s that covered everything from book reviews to deep packet inspection.  It gave us a sense for the brainpower behind the operations and led to some good topics for discussion once we met.  We also found an old blog from the founding team’s first company that detailed their unpleasant experience with another venture firm.  It allowed us to focus around the specific ways we partner with startups to reassure that history wouldn’t be repeating itself if the Apsalar team chose to work with us.  Michael seemed to appreciate the efforts we had put into assessing the team and their approach. This helped us move the discussions further given the competitive dynamics involved with the financing round.

After getting a good sense for Michael and the Apsalar team, we met up at their offices in SF.  The chemistry was great, our first hour-long meeting was very informative, and there was a great balance between really explaining what they were doing and the vision going forward.  Don Butler, one of the Managing Directors here at Thomvest, and I walked out of that meeting feeling very positive on where they were headed.  Once we shared our experience with the rest of the team, the real work began.

The next phase of diligence for us usually includes coming up with a comprehensive list of questions and asking references for feedback.  I try to generally think of reference checks in 3 categories: Personal, Market Landscape, and Company-Specific.

Personal

We wanted to find out how good the team is, how they have behaved in certain situations, and what it is like to work with them.

Who: Contacts from the CEO, individuals in our network, and former team members and investors

Why: The team is key, and if they sued their past investor or bailed on the company as things were going south we would rather find out before jumping into a long-term partnership with them.

For Apsalar: We had meetings with two well-respected angel investors that had invested their own funds in the company, spoke with another few that knew Michael personally, and the checks all came back positive.  In their prior company Kefta, the management team stuck through thick and thin until the company got to the point of being acquired.  This showed us just how resilient the team was.

Market landscape

We like to speak with individuals who a) can tell us about how they see the industry evolving, b) have visibility into the competition, and c) can tell us where they plan to spend their dollars if they are potential customers of the company.  This generally answers some of the bigger questions regarding how large we think a potential startup can become and what challenges it will face along the way.

Who: Startup CEOs, industry analysts, research articles, and industry luminaries

Why: We aren’t operating countless hours day-to-day in every industry, but there are numerous individuals we trust who are.  Some of the more interesting fact checks have come out of conversations with them.

For Apsalar: I attended a mobile conference and spoke with various publishers and experts.  One of the individuals I was fortunate enough to get to know was Trip Hawkins, the founder of EA and Digital Chocolate.  Given his long history and current role in both gaming and mobile, he was very insightful and gave me some great feedback on mobile analytics and where he saw the industry going.  Many of the publishers Michael gave us had booths at the conference, and I was able to ask them what analytics services they used and where they thought the future of mobile advertising was headed.  I kept a running Dropbox of all the mobile advertising and gaming research we could find along the way, which our team was also evaluating.

Company-specific

How is the product, the customer service, where are the gaps in product/market fit, if they were running the startup how would they adjust the strategy, what is the technology differentiation?

Who: Customers, technical experts, and industry contacts met at various mobile conferences

Why: This is the bucket that we emphasize most heavily, specifically when speaking with customer references.  We have had some calls where the customers can’t stop raving about a product even after we try to get off the phone…That gets us excited and has led us to be a part of some great companies along the way.  We also don’t always have the expertise to do a deep analysis on the technical feasibility and sometimes bring in someone who has extensive knowledge of a particular space or technology.  Sometimes these experts give strong reviews coupled with a “do you mind if I co-invest alongside you…”  That acts as a positive signal and gets us excited about a company.

For Apsalar: Each publisher whom we spoke with put Apsalar’s offering above the many competitors they had benchmarked against, and were very impressed with the speed at which they were able to onboard the analytics offering.

In order to reduce eye fatigue, the next post will discuss how we came to a decision as a team, the details of how our negotiations went, and how we closed on a group of investors to work with as part of our investment syndicate.

The results:

Mobile for Physical Goods

P2P Services

Mobile for Physical Goods

These services allow you to buy tangible goods with your mobile device. Except for Dwolla, they all rely on your credit card so they are not truly new payments networks, just new ways of leveraging old payments networks. On the whole, the usability and traction are better than their P2P counterparts. Starbucks’ offering is notable to the extent that it combines loyalty programs and coupons into its service, becoming your mobile Starbucks wallet. This is a preview of what I expect the market to move toward eventually (minus the tie to a single merchant like Starbucks); Google’s recent acquisition of Punch’d and American Express’ partnership with foursquare indicate that the big players are looking for ways to combine deals, loyalty programs, and location awareness into a single wallet solution.

Square

Square comes much closer to the mobile payments ideal than any offering that I tested. Purists will point out that Square still relies on the old payments networks (Visa, MasterCard, etc) to actually make the payment, but from the end-user’s perspective this is an entirely new, awesomely convenient way to pay for things. Once everything is set up, all you need to do is take out your phone, launch the app, select where you’re buying something, and then tell the cashier your name when it’s time to check out. It’s just as fast, if not faster, than cash or a credit card, it (usually) works smoothly, and it just feels like you’ve arrived in the future. Even though this is the best experience by far, it still has some notable limitations.  Adoption depends on merchants using Square’s POS system, and even in the Bay Area few do.  In addition, you need a separate card for every merchant, and the interface gets cluttered and slightly less easy to use once you get beyond a certain number of merchants.  As one merchant I talked to noted, this product is best if you’re a “regular” somewhere, but if you’re always adding new places to your card case it gets less user-friendly pretty quickly.

The app does a decent job listing nearby merchants, but I look forward to better mapping features in future updates. Signing up is simple: once you pay with a credit card at a participating merchant, you click on a link in your SMS receipt to set up an account. The card that you used becomes your card for future tabs, although you can add another card and use that instead.

Starbucks Card

Starbucks was the first major retailer to roll out a mobile payments option, and their solution works well. Once you register a physical (or electronic) Starbucks card, you pull up a barcode when it’s time to pay and scan it at POS after the barista has taken your order. The timing is about the same as a credit card (assuming you don’t have to sign) and faster than cash if you need to get change. It is accepted at almost every Starbucks location, and the app helps you find locations near you.

If you visit Starbucks on a regular basis, this is a great option: you can set the card up to auto-refill from a credit card when the balance dips below a certain amount, Starbucks’ loyalty program rewards are pretty good (free flavors, free refills, discounts, free drinks after a certain number of purchases) and you don’t need to carry around an extra Starbucks card in your wallet.

Dwolla

Unless you need web design services or a quote for a new pool, Dwolla’s mobile offering for physical goods won’t be very useful for  users in the Bay Area. Dwolla launched Spots as a revolutionary way to pay for things, but the execution in the two major tech hubs, San Francisco and New York, is sorely lacking. I couldn’t wait to try out the app because the demos look clean, the P2P side works well, and I appreciate the fact that Dwolla does not rely at all on existing payments networks. However, when I tried to find ‘Spots’ nearby, there was nothing that I actually needed or wanted to buy.

I’m sure Dwolla is working hard to improve their merchant base, but I don’t understand why they would launch with the paucity of merchants in these tech hubs: how many people saw their coverage, joined, and then left once they realized there was nothing they could buy that they wanted? The direct to bank account solution is a great way to approach the problem (apart from the set-up burden), but execution in the physical space will be necessary to compete successfully with PayPal for consumer adoption.

TabbedOut

TabbedOut does exist in the Bay Area, but only at one restaurant (Tres Agaves Tequila Bar). Tequila is great, but I almost never find myself down near the ballpark in SOMA, and in a few weeks of daily life would never have come close to being able to test the service without a substantial trek out of my way. So, while TabbedOut sounds like a great platform and has great reviews, I (and probably most other Bay Area residents) won’t get to see for ourselves until it rolls out to a wider merchant base.

P2P

P2P payments services mainly come in handy in two instances: transfers planned far in advance and often recurring (rent, utilities, etc. sharing among housemates) or transfers needed instantaneously (settle a quick bet, split a bill at dinner). Mobile is particularly suited to the latter, and thus we judged these services mainly on how easy it is to use them spur-of-the-moment, in cases where you would usually use cash or an IOU note.

In general, all the services are easy to use in this case if you already have an account set up with them: all require a fairly extensive registration process that isn’t easy to complete on a small touchscreen, and getting money out when its sent to you invariably requires your bank account information. Unfortunately, most people don’t have an account set up, and it’s hard to convince them that it’s easier than just having an implicit IOU or using cash. This gives PayPal a unique advantage: because it is used on the internet, more people already have PayPal than have any other service, which makes them more likely to actually like the idea of using PayPal mobile. I expect this network effect to be the deciding factor in this space: user experience is essentially interchangeable (good once you have an account-all services have almost exactly the same number of screens involved in a transfer), but nobody I know wants to set up extra accounts that they use just for cash transfer when other services let them buy from merchants, too.

Venmo

Venmo is probably the best mobile P2P service I came across, and is the only one I would seriously consider using instead of cash. It has a great interface that facilitates quick transactions, and it’s easy to load your account from your credit card. They also have the best social integration: weekly updates cover your friends’ activities, the Facebook/Twitter integration is easy and flawless, and it’s easy to broadcast each payment across your networks.  You can even designate trusted friends who can pull money from your account without your permission. If you expect to be transferring money back and forth between Venmo accounts, there’s no need to attach a direct deposit bank account, and all you need is a credit card to initially load the service.  In addition, this is the only service where all transactions are free.

PayPal

If you already use PayPal pretty consistently, the app is easy to use and allows you to do both peer to peer transactions and make mobile web purchases. However, the integration with Facebook and other social networks is limited, so sending money to a friend who doesn’t have PayPal is slightly more difficult. If you send money from a credit card instead of your bank account or PayPal balance, the fee is 2.9% of the transaction + $.30 US, which can be assumed by either party (sender is the default).

Dwolla

Not at all suitable for quick payments unless you already have it set up because adding money to the service requires authenticating your bank account, which takes time, and there’s no option to add a credit card. The social integration is good, so it’s easy to pick people to send money to, but to redeem payment the recipient must also enter their bank account details. If Dwolla were useful for something apart from peer to peer transfers, this wouldn’t be an issue. But when there are no Spots in my area, and most of my friends already have PayPal, there is little incentive to create a Dwolla account for paying my share of the PG&E bill to my roommate. The flat $.25 fee per transaction (can be assumed by either party but receiver is the default) is low, but Venmo and PayPal’s equivalent service are both free.

Obopay

I attempted to create an account with Obopay but, despite entering my debit card number and SSN, was told that my existence couldn’t be verified.  The same thing happened to my friend who tried to use the service. While it is important that these services maintain security standards to avoid misuse, the method Obopay uses seems unnecessary and hurts usability. I don’t have a credit card (only debit linked to my bank account), nor do many of my friends, which means that Obopay requires us to fax in a copy of our driver’s license in order to use the service. When there are plenty of other secure services out there that don’t require this, why should we be bothered to scan and fax our licenses to settle a $40 dinner bill?

Thoughts

As NFC moves into more phones and POS systems, more services will be as usable as Square’s and phone payments should become a viable alternative to credit cards especially for small purchases.  I expect this to be a necessary catalyst for P2P transactions to really take off: right now most people don’t have any payment system installed, and have no desire to add an app and hand out credit card info just to split a utility bill or bar tab.  However, if everyone is using their Google/Apple/Square/PayPal wallet for transactions with stores, then sending over a few bucks for coffee won’t require anyone downloading a new app and adding account info.  Of course, this means trouble for those services that hope to exist solely as P2P platforms.

It started for me with the taco truck…

What’s so special about the taco truck above?  It’s a taco truck offering free tacos to the employees of one of our portfolio companies.  Sponsored by a real estate firm.  For those of us that were working with startups in the late 90s, I remember these kinds of freebies.  It hasn’t reached anything like the excesses that emerged towards the end of the tech bubble – I still haven’t seen any over-the-top launch parties yet – but it’s still caused us to wonder where we are in the tech industry cycle.

Our sense is that we’re back to what in effect feels like 1998, and have at least two years of good times for entrepreneurs ahead.  To go beyond the anecdotal evidence and our own hunch, however, we wanted to see if the data on the public and private markets supported our general sense of where things were – it does.

To begin with, the number of U.S. startups receiving financing on a quarterly basis is on par with what we saw in 1998 as well as when the startup ecosystem was expanding in the 2006/7 timeframe.

U.S. Startups Receiving Financing, 1991-2011

Source:  Thomson Reuters (2Q11 figures incomplete)

The increasing number of startups getting financed has coincided with an increase again in the amount of funding going into the venture funds themselves.  Once again, we see that we’re back on par with both the 1998 and 2006/7 levels.

U.S. VC Fundraising, 1991-2011

Source: Thomson Reuters (2Q11 figures incomplete)

The increase in funding of U.S. venture funds comes at a time when we’ve seen the number of venture-backed companies going public starting to increase as well.  And here again we find the current environment looking similar to both 1998 as well as 2006/7.

VC backed IPOs – Volume and Post Offer Median Valuation

Source:  Thomson Reuters

So the current environment looks a lot like how it looked in both ’98 and ‘06/07; why does it feel more like the former than the latter time to us?  It’s a combination of what we see in the early stage venture business as well as in the public markets.  Valuations have been trending upwards, and the public market – which provides a clear signal to so many participants in the food chain – appear willing to take risks again.  The public markets now appear to have a tolerance for risk and a willingness to buy into companies that might not have been able to go public just a few years ago.  While the volume of VC-backed IPOs is on par with what we saw in 1998 as well as in 2006/7, the companies these days tend to be earlier in the path towards profitability and look on that measure more like they did in ’98 than in the late 2000s.

To get a sense for this, look at the three tables below – these show the top 10 IPOs by market cap for the first half of each of 1997, 2007, and 2011.  The largest IPOs of 1998 were typically smaller companies (by market cap) that had yet to turn profitable.

By 2007, the largest IPOs were now typically companies with two to three times larger market capitalizations that were already profitable.

Finally, as we look at today’s IPOs, the companies that have been the largest IPOs by post offer market capitalization have even larger capitalizations and yet are once again typically not yet profitable.

What this tells us is that while the companies going public today are much larger companies than in 1998, we’re back to seeing large market capitalizations assigned to companies that are still on the way towards profitability but not yet there.  Yes, the companies are definitely different and better this time – they’re larger, built on much more solid foundations, and have been around for longer periods of time – but that doesn’t change the fact that we’re back to the majority of companies going public being ones that are not yet profitable.

There are of course a number of other differences between the market in 1998 and today’s market:  unemployment is sky-high compared to back then, the economy hasn’t recovered to nearly the same levels of growth as was the case then, and so on.  But our experience tells us that we’re looking at another two or so years of expansion in the early stage tech environment.  To us, we’re expecting some of the same factors (both for the good and for the bad) to re-emerge for entrepreneurs:  easier access to funding (but also increased competitiveness as more companies targeting the same markets get funding), increased salaries for talent (and increased employee turnover as more key employees are sought by competitors), and so forth.  What’s concerned me is that we’ve already heard some of the larger VCs talking about “pushing out” as many long-held portfolio companies onto the public markets as possible.  Let’s hope that the public markets keep looking for quality over quantity – otherwise we risk seeing the IPO window close once again and seeing the entire financing ecosystem for start-ups slow down.