DST and Y Combinator: A (VC) Industry in Transition

by Scott

This week’s debate over AngelList(background: link, link), and how VC deals are sourced and evaluated, is just further emphasis that the Venture Capital Industry is in transition. The fundamental forces driving this transition have been playing out for a while now: Lean Startups[11.“Cheap revolution,” open source stacks, RoR, etc.], Super Angels, a legit secondary market for private company shares, huge late-stage valuations, and readily available monetization systems[22.Pervasive internet adoption, Google AdSense, Apple App Store.] leading to very high “capital efficiency” and short cycles from founding to break-even.

An event illustrative of this transition is the announcement that financial firm Digital Sky Technologies (DST) will, automatically and on extremely generous terms, invest $150,000 in every seed-stage company that Y Combinator backs. Y Combinator itself, ambiguously understood by the VC community[33.Is it an angel investor? “Super” angel? “Mega” angel? Early-stage VC firm? Incubator?], is yet another marker of the VC Industry in transition.

DST first came onto the Tech VC scene in May 2009 with a huge $200 million, late-stage investment in Facebook, priced at, what was at the time, a wildly astronomical valuation of $5 billion. This investment decision is now widely perceived as prescient because of the rapid increases in internet valuations since then. Case in point: Facebook’s valuation increased 10-fold in 18 short months after that deal, printing a transaction that valued the company at $50 billion in January 2011[44.Because it’s not my point here, let’s set aside the pertinent fact that DST itself priced many of the transactions that have lead to the broader valuation frenzy.].

People however really took notice of the firm when DST announced, in rapid-fire succession, another high dollar investment: $180 million in casual video game producer Zynga[55.An investment in a company unarguably a tier below the industry goliath Facebook, thereby creating a one-two-punch in the valuation adrenals of any VC, similar in effect to 1998′s $400M MSFT-Hotmail acquisition that was then followed by multi-billion dollar deals for much lesser properties.] in December 2009.

Regardless of the ultimate financial results of these two gonzo investments for DST, the informational/sourcing effects have been terrific. The entry of an unknown, Russian-based firm, such as DST, into the clubby VC industry was bound to evoke mentions of “dumb money” and bring comparisons to Japanese golf course buying and mid-2000′s German film funding. But with these remarkable and bold, high valuation deals, DST is now seeing every late-stage and money-off-the-table deal in the market. If you were an existing investor in a hypertrophic internet company wouldn’t you want to “run it up the flag pole” over at DST? Take a spin at that roulette wheel?

The DST/Y Combinator arrangement[66.I first heard of an arrangement of this type when it was being contemplated at Foundation Capital circa 2006/7. I’ll confess to “not getting it” when I first heard it; took me a while to wrap my head around it. ], despite being on the absolute opposite end of the maturity spectrum, also has an interesting informational dynamic and one that says a lot about the evolution of the VC Industry. Yeah, yeah we’ve heard it before: DST “gets access” to promising Y Combinator companies, but it’s more fundamental than that.

Perhaps this is best demonstrated by looking at the deals that defined different eras in the VC industry’s evolution.

Take for example the exemplar venture capital investments in the Classical Era: Arthur Rock with Intel and Apple and Don Valentine with Apple, Oracle and Cisco. These deals are lauded for their foresight and clearly defined the era. But if you look at the income statements of these companies at the time of their seeking venture capital, you would find them startling mature by today’s standards. They had real income from real customers. In Cisco’s first official month in business it had $200,000, in 1986 dollars, in orders. You show these income statements to even the lowliest Non-1st-Quartile VC today and he’d pronounce these deals “a no-brainer.” These were working companies with revenue and profits and the bet was that they would work more. These deals are also admired for the fact this was an “asset class” (small companies, equity instead of debt) that traditionally didn’t have access to capital, especially equity capital.

The deal that defined the Internet Era of venture capital was the Netscape deal. The bold bet here was that you could grab the company even earlier in the working phase. There didn’t necessarily need to be actual profits or much revenue.  This was a large shift in mentality.  If, through some insight, you could see the “working company” in there, and the market went your way by growing enough, you could have a blockbuster deal. Netscape, even in it’s earliest days, was a “working company.” Netscape had a large installed base of NCSA Mosaic and was targeting the large and extant PC software market with $50 boxed retail versions of it’s PC software[77.Originally to be named “Mosaic.”]. The insight was calling this early, but essentially it was the same bet: we have a working company and we think it’s going to work (much) more.

The deal that defined the Google Era of venture capital was, appropriately, the Google deal. The legend is that Andy Bechtolsheim met with Ph.D. students Larry and Sergey and was so moved that he wrote out a check to “Google, Inc.” for $200,000 on the spot with no terms and heedless of the fact that “Google, Inc.” had not yet been incorporated. There was no target market (search was crowded and dead), no known revenue source, and, hell, no legal entity. The bet now was: we are so early that this company isn’t working at the moment, but through some divination we hope to see that a market or revenue source will appear and make it work.

We’re entering the Post-Google Era now, defined by a dramatic acceleration of this movement towards earlier and earlier investment, and from decisions about Working Now/Work More to decisions about Not Working/Start Working.

This is a fundamental and qualitative shift in the VC industry. From an investing standpoint, this investment decision is just a worse one to be making; the possibility set is unbounded, there is less information, and the tools for communicating that information are poor.

There has been much hand wringing of late that Venture Capital as an asset class has negative returns. This is attributed to greater competition among an increased number of Venture Capital firms. This is part of the picture. Returns are not being eroded a bip at a time by a more perfectly efficient capital market, with firms slicing closer and closer to the “true” valuation of startups. Rather, increased competition has pushed the focal point of the action into a qualitatively different decision—a qualitatively worse decision.

I cannot stress enough that these two decisions, Working Now/Work More and Not Working/Start Working are categorically different!

This distinction is actually the topic of a book I have been working on for several years. I call this the Explore/Exploit dichotomy[88.Think the distinction between drilling for new oil wells or investing in a refinery.]. From an organizational dynamic and decision-making perspective, our tools for Exploit decisions (spreadsheets, growth rates, sales forecasts and targets) are much more developed then our tools for making Explore decisions.

Going back to Venture Capital: a big part of the VC industry is an informational problem. The information you need for these two distinct investment decisions varies in character and amount, and truthfully, the type of person, skill and background you need to gather and evaluate this information is different as well.

The traditional VC investment process: 1. Meet unknown management team; 2. Entertain a pitch; 3. “Look at the space”; and 4. Gut check and decide, is very limited. The tools for Exploit decisions have high commensurability; you can take a financial model to any investment banker in the country and they’ll understand it fully. When Venture Capitalists of yore were looking at the financial statements and forecasts of working companies, the traditional VC investment process did a decent job of communicating information across “the canyon that separates” two people (or organizations).

In this new era, however, that process is woefully inadequate.

The DST/Y Combinator arrangement gives DST access to the full HD feed from these companies and entrepreneurs over long periods of time, so when the company does need capital, DST will have an informational advantage that no traditional VC can touch. Absent one of these companies jumping straight to financial performance that it can then shop to outside VC’s, these companies will look impossibly early to an outside VC compared to what it will look like from DST’s vantage point. Yeah a VC firm might outbid DST for a Series A or B, but they will, almost by definition, be taking a flyer[99.And don’t underestimate the “lazy-factor.” Hey, busy CEO: DST is on the phone with an “ok” deal, or do you want to go out and start dialog with 10 VC firms to try to get a “good” deal?].

This move looks even smarter when you fully contemplate just how quickly companies can go from pre-revenue to extreme profitability these days. They essentially never pass through the point where the traditional VC is waiting, staked out, to understand them before their valuations become easily quantifiable and relatively expensive. “Fully valued” is the term.

How are traditional VC’s going to respond? I think the answer is largely: they won’t.

In the tech blogosphere there are a lot of calls for venture capital firms to “get with it,” understand Lean Startups more, be more entrepreneur friendly and get their hands dirty. But if you look at who staffs venture capital firms, a large segment of the industry is comprised of firms staffed by ex-investment bankers and other financial-types. In the expansion of the number of funds in VC industry, firms such as these proved to be good at fundraising because ex-investment bankers have proven themselves to be responsible with large amounts of capital, they understand the investment return needs of pension funds/institutional investors, and they have backgrounds/credentials that are commensurable within the fund commitment investment decision making process of these institutional investors[1010.Think of Goldman Sachs on a VC GP’s resume as a Moody’s AAA rating.].

VC firms with this DNA just can’t adapt to these new deals, nor would the partners be much interested in doing so. Many VC firms staffed with financial-types will adapt to the new era in some manner or another and deliver decent returns while others will simply exit the market[1111.Eventually—when the institutional momentum and 10-yr fund lifespans have run their course; the VC equivalent of the heat death of the universe.]. Just do not expect them to transform themselves into some shade of Y Combinator, it just won’t happen.