Upside Protection vs. Downside Protection

This is primarily directed at entrepreneurs raising seed or their first round of funding

So often, in deal negotiation with founders, there are disputes regarding a few terms for an investment. Some of these terms are meant to protect an investor’s upside, while others are meant to protect an investor’s downside. I have encountered a number of entrepreneurs who don’t consider the difference, but simply think of each incremental term on the scale of “not founder-friendly” to “founder-friendly”.  

So I think it’s worthwhile to list just two examples below to illustrate the point.

Liquidation preference
If a company is not going to be a home run, where and how the shareholders get compensated matters. A 1x preference means the investor gets their money back, and that’s that. A 2x preference means the investor gets double their money first (before the common stock shareholders — employees — get anything). And so on. I’ve seen term sheets with a 2.5x and even a 3x preference. This is an example of an investor protecting her downside.

Pro-rata Rights
Discussed at length by Mark Suster this week, and followed-up by Fred Wilson today. These rights are what they sound like: allowing an investor to keep their ownership percentage in subsequent rounds of funding. If a company is going out to raise a round at a much higher valuation, the investor has the right to invest more money to keep their percentage ownership in the company the same. Without this right, as a company takes off and takes on more preferred equity, an investor can get diluted all the way down. This is an example of an investor protecting her upside.

Upside protection tends to require more capital infusion from the original investor (hence the discussion referenced above), and is a sign that things are going well, of course. If someone invests in you now, should they necessarily be diluted as you scale? Some entrepreneurs think so, some don’t. But if the investor has the capacity and desire to continue to invest, this allows them to. Some institutional investors don’t ask for pro rata rights, and some angel investors do, but since pro rata usually implies “I will invest more if this goes well”, it’s often the opposite way around. 

This is very different than downside protection, which usually means that the investor gets paid first, or most, when things aren’t going great. Investors who think of each portfolio company as a 1 or a 0 — a home run or not — care less about downside protection. Investors who want to optimize for whatever outcome the entrepreneur ends up with care more. This isn’t as simple as it looks. Many boards of directors have voted down acquisition offers that would have changed an entrepreneur’s life, because they only cared about making a company a home run (even if it meant risking the company’s life). And on the other hand, many investors have extracted cash from businesses that were dying, or walked away with a multiple while the entrepreneur was empty-handed.

If you’re an entrepreneur working on a negotiation, particularly at the seed level, where convertible notes with none of these rights are standard, it’s worth deeply considering the implications of each kind of term.

Eat What You Kill

One of the really interesting outcomes of a firm-based economy — with set wages, central authority, mass production, et cetera — deals with competition and cooperation.

"For the good of the company" is a phrase we all grok, and we have all been faced with a choice where we responded that way before. It means that even though a business decision may not be in my short-term interests, it is for the benefit of the company, which is in my long-term interests. We understand that intuitively, and it’s easy to grasp. But in a free-agency model, that isn’t always the case. 

Think about a purely commission-driven sales team. If you haven’t seen Glengarry Glen Ross, do so, first of all. (Incredible David Mamet play turned into an iconic film with Jack Lemmon, Alec Baldwin, Kevin Spacey, and (an overrated Al Pacino.) These desperate real estate salesmen are competitive to the point of it being detrimental to the company as a whole. Cheating, back-stabbing, and lying may very well help one salesperson close more business than another, so there’s plenty of incentive towards bad behavior. Now, of course, if I am a bad actor while being a salesperson, there is reason to believe that will ultimately be outside my best interests, too, yes, but instant gratification, especially when there is a financial reward attached, is hard to overcome. Of course, this example is extreme, but there are unwanted, anti-cooperative tactics that come along with competitive compensation.

We often talk about the primary benefit to the firm as being the efficiency in production and distribution, but it’s worth noting that there is some efficiency relating to ‘coworker’ relationships, as well. And so, if we have better and more efficient means of production in a p2p, free agency-driven economy, I wonder if the utilitarian benefits to banding together formally need to be adjusted as well… Perhaps one answer to this is a new class of unions and artisan guilds.

Cheat Sheet for Designing Your Life

(h/t Dave Evans)

— EMPATHY
Reflect on the parts of your life where you have felt most inspired, engaged, connected, in a flow state. Just investigate, as if you were looking at a stranger. What do you notice? Write it down. Do it every week, if you can.

— POINT OF VIEW
For example: “Being contrarian and right has generated the most reward in my life” Or “You can never overinvest in your family” This is a placeholder, but try and aim based on what you’ve noticed, on a theme that you could stand behind.

— IDEATE
Throw ideas out there! And I mean more than “join a startup or go to business school” The more radical the better. What would it take for you to join the circus? You always wanted to be a dancer. What’s in the way of your doing that? Leave nothing on the table. “Yes, and” is the only way to respond to any idea in this phase

— PROTOTYPE
Now, this might be the most important part. Among those idaes you’ve generated, don’t choose that which is most ‘useful’ or most ‘important’ or most ‘relevant’. Choose what is most DELIGHTFUL. Which ones jump out at you as the ones that, deep down, are really you? And then go at em! Take a dance class! Spin up an LLC! Bring in some friends and see what you can build! Make, make, make until you are absolutely dizzy.

— TEST
What has changed? Does your point of view tighten? Does it change? Does it withstand scrutiny?

Rinse, repeat.

The Power of Patience

I really enjoyed the fireside chat with Vinod Khosla and the Google founders over the weekend. One thought stuck out to me (and, it seems, to many others).

It’s pretty difficult to solve big problems in four years. I think it’s probably pretty easy to do it in 20 years. I think our whole system is setup in a way that makes it difficult for leaders of really big companies

When someone asked me a few years ago what idea had the biggest impact on me in business, I thought: “beware the local maxima”. And the more time I spend as an investor, the more strongly I feel that way. Quarterly-reporting for public companies puts pressure on CEOs to optimize for short-term revenues rather than long-term, more ambitious goals. But there are many other applications of this concept:

— The investment banker who cuts a corner because it saves him time today, but ends up poorly underwriting a business
— The venture capital investor who invests in a hot category, because she want to juice her IRR, rather than back special founders
— Founder who wants to satisfy the interests of his shareholders today, even though stakeholders are better off if he waited, at least, until tomorrow.

… and so on.

The beauty (and challenge) with the concept “beware the local maxima” stems from two interrelated factors.

— We, as individuals, are highly emotional. Modern economic theory seems to discredit the ‘rational actor model’, which suggests that any individual in a system has a manifested preference for more of a good than less. We simply aren’t rational actors! The instinctive desire for short-term reward is often, in the moment, literally blinding, so we can’t see that one goal distracts from the ultimate goal, even if the ultimate goal is one we know we want.
— In many cases, would we know the “maximum” when we hit it anyway? How would we? Is the concept of an ‘ultimate goal’ flawed in and of itself?

Businesspeople who want to push culture forward, and work on the right things, are presented with a minefield of hard decisions, whose implications are never clear. Sell or not? Hold an IPO or stay private? Cash out early employees? Cash out early investors? Invest early profits in R&D? Build a cash base first? Depending on the circumstances, there simply aren’t easy answers. If you actually unpack the implications of “beware the local maxima”, it is a less obvious directive than it would seem. So what?

The first conclusion I draw, then: great businesspeople are clear about what their values and goals are, so that they can feel confident that they have reached and satisfied them — or, so that they know to wait, even when others think they should be finished. And great businesspeople have educated their emotions, so that their instincts will put patience and purpose above all, because patience is valuable for its own sake.

The second conclusion: for early-stage innovative businesses, the framework for investing in them has been mostly fixed for a while, now (7 to 10 years to create 3-5x returns). This model is meant to satisfy the power law of venture returns, and also the fact that high-growth successes take some time to mature (Facebook founded in 2004, IPO in 2012, 8 years later). But is 10 years even long enough? If patience for patience’s sake really is so valuable, as Bezos and Page both suggest, how can we make venture investing more patient? Because it would seem that we need to.

On The City As Museum

I’m no urban planning expert, but I’m curious!

Short-term rental versus long-term rental seems like a core tension driving the AirBnB question in cities around the world.

For the uninitiated, AirBnB has been conducting an international advocacy campaign to convince municipal policymakers that short-term rentals on their platform don’t actually hurt cities, but instead create incremental income, which is increasingly important in a post-industrial economy. I am an extremely happy AirBnB user. I have both hosted and stayed, preferring AirBnB as a guest because of the uniqueness of the inventory, and enjoying it as a host because of the income it provides. But I admit that I have wondered: what would happen to a world where everybody — owner or renter — AirBnB’ed all the time? While AirBnB offers sublets, I assume short term rentals make up the vast majority of their transactions.* So what would happen if short-term rentals began to dominate the city-living landscape?

It seems as though the pessimistic case for a short-term rental dominated city-living-landscape simply raises housing prices. After all, the conventional wisdom is that renting a space by the day is better business than renting it out by the month. So, presumably, the price per day of any given unit will go up, until it hits a ceiling of “no longer competitive with hotels”. In this case, then, the hotels slowly empty out, and the ‘permanent residential area’ in cities turns into hotels, and the city starts to look like a museum — great to visit, but not much more (except for a very, very select few). And if only owners can rent out their properties, then presumably the ‘very, very select few’ are those owners, and inequality and stratification increases, in the name of some purported “efficiency”. This is, at least, the argument that the detractors and naysayers put forth. And its a compelling one.

But the reality is more nuanced for a few reasons. First, while AirBnB doesn’t necessarily endorse this, many** AirBnB hosts aren’t owners, but are renters themselves, and so they are ‘subleasing’ their properties. And under these circumstances, the economics get more complicated. If every renter can also ‘subrent’ property, then while the price/unit does go up, the revenue/renter also goes up for everybody. And presumably that doesn’t stratify and exclude nearly as much, right? 

Let’s take that thought to an extreme: I have heard of more and more people who have an ‘anchor’ sublet somewhere, but who spend a month in one city, a month in another, and another — and so on and so forth — subletting their anchor to different people for a month, or a week, or a day at a time. In a world where telecommuting, remote working, and ‘working from home’ are more common, does this not mean that while every city becomes a museum, every other city-dweller has a free museum pass? And if I don’t have the money to pay for flights to other cities, perhaps I downsize the apartment in the visiting city, or I visit a less expensive city, and use the excess revenue for travel? Sounds like a pretty fascinating life to me.

This type of reality, while exhausting for some, or biased towards the young, could be a way for people in cities all over to experience the world. But, if I’m understanding the math properly, it only seems possible if AirBnb is more open, not less, if municipalities, landlords, and leases are less restrictive, not more: if the balance of power leans further towards renters, rather than towards owners, right?

Making a city a museum might, on its face, seem like a way to kick people out. But, viewed another way, might represent a more mobile, dynamic future where individuals and families get more access to the world. Eager to hear your POV on this!

*Please correct me if I’m wrong!
** I suspect we’ll never know how many

Considering ‘value networks’

Recently read “The Medici Effect" which I thoroughly enjoyed. Got me thinking.

I worry that value networks aren’t as resilient in the long term. A value network is one that puts the primacy on certain types of values, e.g. “matriarchy” and “religion as the center of family” and “education and job security as the key to a happy life” and so on. They manifest in between the lines of our relationships, transferred psychically from generation to generation, through invisible cues from role models. They are often not intentionally considered, or even if they are, it is done silently, where the impact is more powerful, and participation is more instinctive and automatic. And they tie people together powerfully. Franz Johansson says in the book, your network is what will support you, provide you access to the most resources, provide you with backing in the case of failure, and generally be the tailwind of your career. He also points out, paradoxically, that “networks will promote, support, and highlight ideas that are valued with in it. And it squashes or removes ideas that are not.” This makes sense. After all, a network must strive for self-preservation, in and of itself.

In building a social product for web or mobile, a product designer must consider the set of values that associate with that particular experience, because if the community will start to become sticky and really work, it will be, in large part, because of the value network. In the early days of Twitter, it was very lightweight, and the interactions and behavior that became the most prominent on the site — from the retweet to the hashtag — emerged naturally from the community. Indeed, many platforms will see unexpected behaviors emerge from the community, but Twitter did something really smart in that moment — through the clients that they allowed to flourish — they encouraged that behavior, which suggested that new communication practices on the platform could and would be bottom-up. Now that there are fewer Twitter clients, the platform feels less ‘open’, when Marc Andreessen (and others) Started doing the numbering thing, people claimed that they were “breaking” Twitter. Says who? When the first person did a RT nobody claimed they were breaking twitter, did they? The platform had taken what was an open, experimental, a bit whimsical community, and let it settle into a set of practices which restricted and discouraged behavior that didn’t adhere to those practices. Alas.

As I think about investing, I think about value networks there, too. Looking back on the last dozen or so companies that we have invested in, the majority, with just a few exceptions, were tied to some sort of formal guild or incubator — AngelPad, YC, Techstars, Haxlr8r, et cetera. On the one hand, this is a very good thing for entrepreneurs and the startup community, because those entrepreneurs that have support systems and are organized will have an accelerative effect on each other. They will protect each other from forces outside their network, and they will balance nicely against the capital. But on the other hand, the whole point of transformative innovation is to rewrite rules and innovate in ways that break the mold. While the companies that come out of these value networks are in very different industries, and solve problems in very different ways, perhaps they all think about corporate structure and equity similarly, or about funding similarly, or about hiring similarly — and for true innovative products, shouldn’t those questions be fair game for scrutiny and imagination as well?

I noticed, while trying to sell my piano on Craigslist, that it is an incredibly resilient product, after all these years. My original assumption is that, duh, it’s a liquid marketplace — there are sellers, who attract buyers, who bring more sellers, and so on. Those are very defensible. But my friend Ted suggested that part of the magic on Craigstlist goes further, too: he called it an “open lifestyle marketplace” suggesting that the values that associate all participants on craigslist are dynamic, loose and allow for a lot of flexibility within the form. You can find *whatever* on Craigslist, and you can sell, suggest, and propose *whatever*. A lot of people feel ever-so-slightly uneasy on Craigslist because there is an element of chaos to a platform that is *so* open. But perhaps that’s kind of the magic of it.

Reaching the next 6 billion

Last week, a Forbes article made the news covering Ericsson’s prediction that within five years, there will be 5.9 billion smartphones. That is a truly incredible number, considering there were zero smartphones, to speak of, 8 years ago. But it got me thinking that there is an extraordinary opportunity for the next six billion, and the more I start to think about it, the more excited I am to be an investor. The information economy — and its application and services layer — is part of a tightening feedback loop, and the adoption curve starts to change. Imagine the yellow line to be smartphone adoption in the graph below.

image

When an exponential growth like this one curve covers only 15 years, less than a generation, as is the case with smartphones, there are some odd dynamics that come out of it. First of all, most applications, even the most viral, are on a more traditional adoption curve, spanning a longer time period than the 15 years that we’re seeing with smartphone penetration. As a result, the notion of an early adopter or laggard with respect to any given application is rather confusing. The leapfrog effect is real, and playing out in a couple of industries, as a result.

Over the weekend I thought that this taxonomy would be helpful in understanding the pathway by which the poor and the world’s very poor get access to the world’s resources through the internet. 

Power
First and foremost, access to electricity is the key to the information economy extending to the rest of the world. d.light design has done a wonderful job telling a story about low-cost solar, and angaza design is an exciting new organization that creates financing solutions for solar access. Innovative solutions for access to power will continue to involve solar, but also wind, geothermal, and frankly continuing to mine the oil and gas in the parts of the world where many of the world’s poor are concentrated.

Network

The cellular and internet service providers currently don’t reach the world’s rural and very rural populations, representing 35-50% of the world population (depending on whether you believe the World Bank or Facebook). The economics aren’t there for them, under their current models. Tazca* and a small handful of others like them have taken incredible Skype-like innovations and created last mile networking solutions that will extend the “edge of the network” to every rural cell phone in the world. Drones, low-altitude satellites, and balloons will make up whatever is left over. Facebook has done an incredible job of encouraging big and small companies alike to support this innovative pathway (for obvious reasons). Signals from Djibouti, the National Geographic photo of the year, tells this story.

Credit
Access to capital is one of the greatest challenges of a capitalist system, where the poor are systematically disadvantaged. You need access to information (about how to manage credit) to get access to capital, and you need access to capital to get access to information. Inventure* is breaking the cycle, and creating loan pathways through the mobile device that will allow people to finance cellphones, transportation, and myriad other basic services that give them access to the information economy.

Applications and Services
This is the layer everybody thinks about, but remember that any service can be global from the day it launches, and so thinking about how to attract micro-communities in east Africa, Patagonia, and India all at once represents a fresh set of challenges and opportunities that level the playing field. Fred Wilson’s app constellation idea requires an understanding of youth culture and internet communities that is frankly democratic. There is plenty of reason to think a startup can build an app constellation with as much success as Google, or Facebook.

If you’re a technology investor, you’re crazy not to be paying close attention to this. Peter Thiel said, in his class at Stanford, that there are two forms of progress: zero to 1, and 1 to n. “zero to 1” is vertical/intensive progress: it invents a technology that pushes “man” forward, like a moon landing algorithm, or synthetic biology innovation, et cetera. “1 to n” is horizontal/extensive progress, like putting a laptop in each child’s hand, or extending search technology around the world.

In each of these categories, the technology innovation (zero-to-1) is truly unique and exciting. The future of accounting and credit, adjusting for the explosion of data sets we have access to, the future of energy and power with advances in silicon-based photovoltaics, for low cost distribution, and the “edge of the network” questions, with point-to-point networking hardware and software are all tech. They are intensive and vertical, without a doubt. And with the growth rates that we are seeing with smartphone adoption, and the resulting taxonomy of growth opportunities for the bottom of the pyramid, it’s worth thinking about the fact that you can have “zero and 1” and your “1 to n” at once: you can have your cake and eat it, too!

*portfolio companies!

Community, Community, Community

This is becoming something of a trend for me, which I take to be a good sign for $TWTR: I posted a provocation that I had discussed with someone offline — I don’t remember where — and waited to see what conversation it would spark. I said:

The thinking behind this provocation came from a realization that the network effect seemed to apply particularly to ‘scaling’: that getting big fast, and staying big were two necessary features of it. And as an investor whose thesis weighs heavily on the assumptions around the network, getting big fast and staying big are obviously good things. But community seems different, no?

A community reminds me of the fable of Goldilocks and The Three Bears: my wife and I do not, alone, make a community — too small. The 30 people who live in our apartment do not make a community — too random. The 10,000 people who graduated from our college don’t make a community — too big. It seems there is a unique affinity level, size, and density that is the special recipe to make community. And if a network just grows big and stays big (particularly if its growth and size are a big part of its value), then surely networks break communities, right? 

image

Sarah Judd Welch, founder of Loyal, an agency focused on helping communities flourish, jumped in on the thread, and indulged me in a very interesting conversation:

image

I thought Sarah’s answer was great, and her later point about the Catholic community hit home very nicely for me. A Catholic only really knows the people in her parish — and even then, only a segment of them. She not only shares faith traditions with them, but also the fabric and minutiae of their daily lives, by virtue of being near each other. That isn’t to say that the greater Catholic community isn’t a community. After all, should I go to a church in another city, I could still do what I would do in my home church and be accepted, whether or not I knew anybody. Same goes for the other ‘scaled communities’ Sarah references. In fact, one of my favorite things about Lyft and Uber driver communities is that a driver can just turn the app on, and so once they are part of that network, they don’t need to get a new job every time they go to a new city.

But my question is this: if communities must fragment at scale, which is where I netted out after this discussion, then there is necessary tension between community and network effects, right? So is the only way to resolve it to intentionally break networks into smaller, denser, affinity groups as they grow, to ensure that the magic of community remains intact? After all, as Facebook has demonstrated, the magic isn’t something that will always happen naturally, but needs to be instrumented with conscious product decisions, and ways for people to create the more local segmentation. Even within the Catholic parish, to go back to that example, there is CCD, and the young couples group, and so forth.

While I feel like I’m part of a “tech community” and even a “venture community”, it is also madly amorphous and really I’m only in community with a small group of people within that community — most of it is geographic, but thanks to Twitter (again) that is less true — and I sometimes I actually feel very little affinity to the greater community.

This nuance is nowhere more stark than in my upcoming move to New York. While I imagine I will be embraced, and I’m incredibly grateful to the people who have already reached out offering to hang and to be friends, I also can’t help but wonder if I’ll have search to find my local ‘parish’, where I’ll be in community, just the way I like it.

Divestment and Crowd Power

"Divestment" campaigns are not new. As a South African, born during the heat of Apartheid, that word has been in my vocabulary for a long time.

But for those who are unfamiliar: divestment is, most simply, the opposite of investment. But used colloquially, it refers to political campaigns that encourage financial backers to pull out investments in a certain type of business, because of said business’ ties to political, moral, or social issues. From the 1960’s until South Africa’s first democratic election, almost exactly 20 years ago, college campuses, activists groups in cities, and organizers around the world pressured investors, whether at endowments, in governments, or in private companies, to pull their investments out of companies doing business with the South African government. The work of anti-apartheid activists on the ground, political leaders in exile, and this global divestment trend combined to make a potent force in bringing down apartheid.

Since then, tobacco, arms dealing, and most recently climate change have all been targets of divestment campaigns. Oppressive governments face sanctions from other governments, but also face pressure through divestment campaigns, which are almost always organically developed.

Today, Stanford University announced that it would divest from coal mining companies, what has been part of a mainstay of fossil fuel investments for many institutions for decades upon decades. This came by as a result of pressure from 350.org, from students and alumni of Stanford university, and as part of a global movement to push the university down the moral path to a sustainable, morally aligned future.

Universities are a particularly potent breeding ground for divestment campaigns, because the student body and alumni body are both a built-in community of potential organizers, and the funds that drive a university are largely bottom-up, and certainly vulnerable to public opinion. But as more and more companies become crowd-powered, and the internet forces transparency and accountability onto broader groups of organizations, we can expect much more of this in the coming years.

The implications of crowd power are heady, indeed.

A Thought About Network Effects

It’s a buzzword that every venture capitalist and many entrepreneurs use. But what, really, does it mean?

When it was first described to me, my understanding of the network effect was simply that it was like the telephone — the more people have phones, the more utility of any single telephone in the system. This is a self-reinforcing mechanism that makes for great defensibility in businesses. As I wrote about a while back, there is an example of a negative network effect too, where the value of an additional participant in the system actually worsens, rather than improves, the system for every participant.

There is another part of the network effect, at least as its commonly described. To continue the telephone example: at a certain point, the fact that everybody else uses a telephone is why I want to get one. In this case, the system has something of a snowball effect. The existing momentum and scale creates more momentum and more scale. Some refer to this as the bandwagon effect

Lyft* and Uber are interesting case studies for the network effect, because their dynamics are actually not what meets the eye. While their global brands create a bandwagon effect — because everybody uses Uber in London, I thereby ought to be using it, even if I’m in San Francisco — the local city dynamics have a positive network effect at the beginning, but I wonder if they perhaps actually have a negative network effect as they scale.

As a driver, it’s actually not great for more drivers to be on the system after a certain point, because that reduces my potential earnings. As a passenger, the more people that use these apps, the more likely I am to get screwed during peak hours. This is the nature of most marketplaces, which have to balance the conversion of demand and supply as they grow. But an interesting factor to consider, along those lines, unlike the telephone, which I can’t really switch off of once everybody else is on it, the value of being an UberX driver is tied to the availability of demand (and associated earnings), but there is nothing that functionally ties me to UberX, versus Lyft. The switching costs are very low, and stay equally low even as the system is liquid and dense. As a result, I have heard anecdotally that many UberX drivers also have a Lyft driver account, and switch between them liberally. On eBay, or Yelp, or AirBnB my seller rating is highly tied to my ability to move my inventory. This creates a strong incentive for me to stay on the platform, particularly if I have a good rating. In this way, then, the ‘rich get richer’ and there is a positive network effect tied to the platform’s rating system. Since driver ratings on Lyft and Uber change so often, and resets after a few weeks, building one’s rating from scratch isn’t ultimately that hard, as compared to the other platforms.

Lyft does a very good job of creating community on the supply side (by allowing its drivers to communicate in-between rides, by encouraging online and offline interaction between driver communities, etc.) which creates a positive network effect against the experience of being an Uber driver. I wonder, though, if that means simply that a Lyft driver is more likely to keep the Lyft app open, or if that’s enough of a strong incentive to not even have the UberX driver app.

Anyway, as I hope this post suggests, the nuances of a peer network’s defensibility are not so simple as they may seem.

*Lyft is a portfolio company of Collaborative Fund.

Wait, Is The Corporation Actually Over?

Over the weekend I had an interesting debate with some friends that played out over Twitter, regarding a provocation I threw out there (with this goal in mind!) 

The conversation this spurred was fascinating. In my view, hat tip R.H. Coase*, the firm was the most effective way to run the economic machine in the 20th century (and late 19th) because the steam engine, rise of the railroad, and invention of the manufacturing line allowed for mass production, where mass distribution was financed through a cooperative of workers operating with shared infrastructure. A number of incredible corporations were created through this period, and as they got better at manufacturing and distribution, their productive capacity diversified and their brand engines were tuned (read: General Mills, Unilever, P&G, Merck, General Electric, etc), and public companies grew as the S&P, NASDAQ, and other exchanges steadily marched forward over the years. While the indexes continue to grow, however, the number of public companies has decreased to its lowest number in 25 years. The creative destruction in the Fortune 500 is at its highest level ever.

Meanwhile, 1 in 3 Americans today is a freelancer, and some speculate that the freelancer will represent half the working population in the United States by 2020. The ability to create products has hugely benefited the information era, and you don’t need a manufacturing line to code. And, related, on the internet, distribution is suddenly so much easier. Marketing costs are collapsing (as the advertising industry increasingly moves to the web), and the infrastructure for shipping and distribution is seeing extraordinary innovation these days. It seems the era of mass-production might be ending. Does that mean, then, that the firm is ending, too?

Here is part of the conversation that followed (follow the whole thing, and add your two cents here):

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So the question that Zach’s very smart response left me with was:

Is the firm collapsing because of the inflection point of the transition to the information age, or is a collapsed firm a feature of the information age, in and of itself?

Put another way, Carlota Perez (and others) point out that when there is a technological revolution, the old regulatory infrastructure and modes of production are no longer relevant, there is a period of deep uncertainty, and a fair amount of friction and collateral damage in the process. Perhaps the public company uncertainty, high joblessness around the world, and startling signs of inequality are actually short-term symptoms of the transition to a fully-fledged information economy. But on the other hand, maybe the peer-powered future is here to stay, and the original provocation is true. If it’s the latter, then what happens next? If the means that we have all come to rely on for economic production are no longer the most efficient, what are the implications?

One answer that many have posed is that peer networks (and the platforms that enable them) will inexorably rise, be abstracted from religion, geography, and other old scaffolding, and will exert influence, be sources of production, pathways for distribution, and will represent a model of free agency that looks in some ways similar to the artisanal, apprentice-based models that pre-date the firm.

Another answer suggests that ownership itself (and the types of commerce associated with it) is a function of us not yet knowing how to efficiently allocate resources, and that the sharing economy’s final end is one whereby we access all relevant resources efficiently from each other, with vastly less new production as a result.

But yes, maybe the firm isn’t going anywhere, and just those firms that represented the 20th century are going away, and the new ones simply haven’t arrived yet.

*And Albert.

Carried Interest Dynamics

I’ve heard of a lot of venture firms who do European distribution waterfalls instead of American-distribution waterfalls. I’m not sure where the naming convention came from, but for a quick primer on the difference between the two:

- In a European distribution waterfall, the General Partnership (GP) has to pay back all of the principal drawn down from the Limited Partners (LPs) first, and then they earn carried interest on the subsequent profits, usually of around 20%.

- In an American-style distribution waterfall, the GP may earn carried interest on capital on a deal-by-deal basis, so as soon as a business exits and returns funds, the GP earns carried interest in the profits.

The latter is obviously highly advantageous to the GP: they start earning their profits much earlier — in a 7 year fund, it may be as much as 5 or 6 years earlier — which has a huge impact on an individual’s IRR. While the material difference isn’t usually that different for the LP, it can be wildly different for the GP. Conventional wisdom suggests that in tough times, LPs ask for European-distribution, but in good times, GPs ask for American-distribution. So, what’s the point?

There is a big concern, with the American-style waterfall, that if a GP starts earning serious money too soon, they may have less ‘skin in the game’, and their motivations may change in a way that negatively impacts their ability to invest. “You make money when I make money” is a pretty core tenet to fund management, and a great way to ensure alignment between managers and their investors.**

But on the other hand, with the European distribution, if the GP knows that they won’t see a dime until they’ve returned the whole fund, perhaps there’s a motivation to encourage founders to exit more quickly than they perhaps should… I haven’t seen this play out, myself, but I’ve heard a number of people say that they think that’s a secret motivating factor behind some GP decisions they’ve seen out there — particularly in small funds. And, to make matters worse, the IRS doesn’t recognize European distributions! So you could be paying taxes on carried interest on exited deals that you haven’t seen a dime from! Ouch.

Tough either way. But maybe the downside of the European distribution on how a portfolio performs is underconsidered, at least from what I’ve read and heard from mentors in the business.

Anyway, a little inside baseball, for those interested in the game.

** Andy reminded me to mention the clawback, which is an important feature of some Limited Partnership Agreements, too. There are cases (most, heh) where the fund isn’t actually going to be profitable, but a few early investments have been, and the GP has earned carried interest. In these cases, in the LPs have a provision whereby they can demand the GPs pay back whatever profits they earned, if it doesn’t make the LPs whole. Related to that, there are two ways of thinking of being “made whole” — one is committed capital, one is called capital. Committed capital is “how much we said we’ll give you” while called capital is “how much we have given you”. Many scenarios where these numbers could be different, and most of these scenarios are painful ones…

*** Thanks Eric for getting my head spinning on this.

Organizing the new labor

If, as my fellow investor and friend Albert suggests, speculative investing becomes more common in time, as the “money is top-heavy” edict becomes more pronounced, there should then be more high-risk capital available to fund startups, and as a result, the startup funnel will widen. And in addition, of course, it’s easier than ever to start a company and start to grow it, and the opportunity is attractive to an increasingly global audience of hackers and hustlers. As a result, it’s not unreasonable to conclude, as the Fortune 500 sees more creative destruction, and public companies shrink in number, that the entrepreneur — or, at least the free agent — is the new labor for the 21st century.**

Sara Horowitz at Freelancer’s Union has captured the imagination of a large segment of this growing population — the traditional freelancers — and has created a gold standard for services for the gig economy. The organizers at Peers are working in healthy tension with the sharing economy platforms to provide a voice to the Lyft drivers, AirBnb hosts, and TaskRabbits. And finally, I think the accelerators and incubators are another key component of organization for this new labor. Just like the unions played an incredibly significant part of the 20th century, balancing corporate interests in lowering wages and cutting benefits against the rights of the working class, the incubators and accelerators play an equally powerful part in protecting the interests of the entrepreneurs against, well, us. Transparency in pay, pricing, terms, and a community of like-minded professionals who provide support networks to each other is a critical component of any new labor class.

Coding bootcamps and vocational training programs focused on startup competency are another great piece of infrastructure to this end. While one can’t become a proficient software engineer in a month, or necessarily in three months, training programs that get an individual off the ground with a prototype, or in an early-stage job at a startup move the culture forward, by making the opportunity to participate in this new industry more accessible to more people.

But what of protection against firing? You can’t fire a member of an organized labor group without cause, and in many states that’s by law. But in an incredibly high-risk environment like the innovation ecosystem, how do you create infrastructure for downside protection? Acquihires are part of that trend, and I think those are fantastic, for this reason. I like that Exitround.com is trying to make it easier for that marketplace to transact. But, still, vast swaths of people who are creating and joining startups, hoping to land somewhere interesting as a result of their incredibly hard work are left penniless and without many options. If this ecosystem will really have a cambrian explosion globally, and the value creation will actually be more inclusive and less extractive, this is a key piece of the puzzle. Without it, there’s a strong disincentive for people who aren’t already financially stable, and for those who are yet fail, they are, at best, collateral damage. And that’s a shame.

**You might laugh at the idea of a seed-funded entrepreneur being working class, but it’s worth considering the fact that plenty of seed-funded entrepreneurs don’t have friends and family backing, don’t have savings to speak of, and are earning very, very little while building for product-market fit. Gideon Lewis-Kraus writes really eloquently about it in his book, No Exit. You’re probably just thinking about the seed-funded entrepreneurs that YOU know, who are the exception, not the rule.