Metamorphic Ventures Internship The Business of Venture Capital Ryan Kuhel
Over the course of this semester, I have interned as an analyst at a New York City venture capital firm called Metamorphic Ventures. Metamorphic Ventures invests in startup and early stage technology businesses executing an investment strategy in a category they have coined called “transactional media.” “Transaction media” is the convergence and intersection of digital media, commerce, and infrastructure both online and offline. Increasing powers of communication technology, storage, and computer processing have created new opportunities for commerce that were not previously possible. Yochai Benkler, a professor at the Berkman Center for Internet and Society at Harvard, has characterized an economy governed by high fixed costs for creating and distributing media and information as an industrial information economy.1 An industrial information economy makes commercial interactions between a network of decentralized consumers prohibitively expensive. The improvement in computer processing, storage, and communication technology reduces the fixed costs associated with producing and distribution information. This economic environment is characterized as a networked information economy. In order words, older forms of communication technology prohibited people from efficiently selling and consuming various goods and services. Digital communication technology can create new opportunities for transactions by enabling a decentralized network of consumers to efficiently engage in commerce. Marc Andreessen, a famous technologist who helped build the Netscape browser, has described this phenomenon as liquification of markets. The apartment and home rental platform Airbnb has liquefied the real estate market by enabling apartment and homeowners to rent out their rooms to travelers. The Uber peer-to-peer transportation platform has liquefied the transportation market by connecting a network of drivers to riders. The
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Postmates delivery platform has liquefied the delivery market by connecting consumers to a decentralized network of delivery people in New York City and San Francisco. Metamorphic Ventures aims to invest and partner with emerging companies that are liquefying markets, making commerce more efficient, and bridging the gap between online and offline commerce. During the course of my internship, Metamorphic Ventures raised a $70 million fund. This has allowed Metamorphic Ventures to aggressively pursue partnerships with emerging technology companies in the transactional media space. The combination of inexpensive cloud storage available through Amazon Web Server or Heroku, sophisticated web frameworks like AngularJS and Ruby on Rails, and relatively easy access to capital has enabled many aspiring entrepreneurs to enter the start-up world. The entrepreneurs who come to Metamorphic Ventures are generally looking to raise a SeriesA round, which is usually around $1.5 million in funding. The Series-A funding allows these start ups to hire a sales team, recruit more software developers, and quickly capture market share. As an analyst, my job is to meet with entrepreneurs, learn about their companies, and prepare internal due diligence reports for the associates and partners to help guide them towards potential investment opportunities (more on due diligence later). The due diligence is used to decide whether the firm should consider investing in a startup. Every Monday, the entire firm meets to review the due diligence and decide what companies are worth investigating further. In addition to financing start-ups, Metamorphic attracts many entrepreneurs because of the network of advisers and limited partners that can provide essential strategic partnerships and sales channels. Metamorphic acts a framework to connect startups to companies like AOL, The MLB, Conde Naste,
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and The Home Depot, among others. In order to maintain strong relationships with these brands, the analysts will prepare reports for the limited partners on emerging technology sectors like wearable devices and Bitcoin. During the internship, I have prepared due diligence for over half a dozen companies. In most cases, an entrepreneur would come to the office to pitch their venture to the associate and I would take notes. Afterwards, I would work with other analysts to prepare a due diligence report for the associate (again, more on due diligence later). The associate would consult with the analysts, follow up with questions, and report to the general partners who would ultimately decide whether or not to continue the investigation and make an investment. There were a few cases where I ran the meeting, took notes while an entrepreneur pitched (without the help of an associate), and then prepared due diligence on my own. At these times, I was fully responsible for reporting to the associates and partners. This was exciting, and educational, because I had a great deal of responsibility as an intern. In addition to due diligence, I also prepared internal reports for the limited partners, including a twenty-two page report on wearable devices. These reports required extensive market research in various technology sectors. Finally, I also would help with various other time sensitive tasks such as coordinating meetings with the press as Metamorphic Ventures announced the new $70 million fund. My learning objectives at Metamorphic Ventures were focused on understanding how a venture capital firm operates. How do general partners raise the fund? What is the role of limited partners? How does a fund develop an investment thesis? How does an analyst prepare due diligence? What companies get funded and why? In addition to learning how a venture capital firm operates, I aimed to investigate whether the start-up
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culture was actually challenging the existing capitalist structure or simply accommodating itself to it. While venture capital always has existed in one form or another to support commercial activity, the venture capital industry only emerged as a professional industry in the second half of the twentieth century. Venture capital was limited to those connected to individual patrons. Financial institutions like J.P. Morgan were highly risk-averse and only invested in companies that were already profitable, thereby calcifying existing power structures. Harvard Business Professor and World War II Veteran George Doriot is credited as a father of the venture capital industry. In 1946, Doriot became the founder of the Boston based American Research and Development (ARD) Firm, the first venture capital firm in the United States. Despite criticism from leaders in the financial industry who viewed venture capital as an unusual, and unprofitable, asset class, Doriot successfully financed over one hundred start-ups, including computer companies, medical devices, and desalinated brackish water.2 At the same time, the MIT president Karl Compton was working to combat the notion that science and engineering were the cause of social ills. Compton advocated for a program called “Put Science to Work� to undermine the hostility towards labor savoring technologies by financing a broad STEM education that would create new industries. Doriot and Compton enthusiastically believed that coupling science education –which would be sponsored by the GI Bill- with venture capital financing would engender more economic mobility. The belief that STEM education and easy access to start-up capital will improve economic and political equality continues to animate the start-up ecosystem to this day.
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Evgeny Morozov, a prolific technology critic and visiting professor at Stanford, argues that technology solutionism co-opts political movements without actually helping workers become more autonomous in a capitalist system. Morozov’s criticism is attached to the claims that a technical education can make workers more autonomous and create a new mobile elite of hackers that will be able to deconstruct economic and political inequality. To Morozov, this digital revolution is simply a transition from manual labor to cognitive capitalism, a term used by some labor theorists to describe inequality in a service economy. In a recent New Yorker article, Morozov describes how the hacker culture lacks any real political imagination: “The plentiful recent books that preach hacking as a way of life—‘Reality Hacking,’ ‘Hacking Your Education,’ ‘Hacking Happiness’—express devotion at least to the rhetoric of revolt. ‘Hacking Work,’ a business book published in 2010, announces that ‘you were born to hack’ and suggests ways in which one could ‘hack’ work to achieve ‘morebetterfaster results.’ As in most of these books, our hackers aren’t smashing the system; they’re fiddling with it so that they can get more work done. In this vision, it’s up to individuals to accommodate themselves to the system rather than to try to reform it. The shrinking of political imagination that accompanies such attempts at doing more with less usually goes unremarked.” 3 I respect Morozov’s criticism, but he fails to account from the transfer of political and economic power, albeit incremental, from individuals with financial resources to those with the creative capabilities. I do not think digital technology is deconstructing the existing political and economic order. However, digital technology is unbundling essential products like education, journalism, and entertainment and, through this process of unbundling these products, incrementally enabling workers to become more autonomous.
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I will return to the question of autonomy at the end of this report. Before that, it is important to discuss what a venture capital firm is, exactly, and look at how it operates. Venture capital is a small subset of the private equity asset class. Private equity only makes up about 6% of most institutional investors assets.4 Despite venture capital’s well-documented impact on technology on entrepreneurship, it only gets a small piece of the private equity allocation of resources. For example, a $50 billion pension fund would typically set aside 10% billion for alternative investments. Of the $5 billion, only 15% would go towards the private equity asset class. The $750 million would be divided among 20-50 funds leaving about $25 million for venture capital. The combination of illiquidity risk and poor performance of many firm’s individual portfolio companies keep the venture capital pool of financing relatively small. Venture firms compete for funding from limited partners and limited partners generally favor the few firms that can produce consistent returns. General Partners have an imperative to understand the set of constraints facing various types of Limited Partners to survive in this small, risky, and competitive asset class. Limited Partners are potential investors in venture funds. General partners are the individuals who manage the fund and select start-ups as investment opportunities. Associates and analysts help the general partners research various industries, source potential investments, prepare due diligence on those investments. A Limited Partner can be a pension fund, foundation, corporation, endowment, family officer, or a high-net worth individual. Limited Partners generally have a set of investment principles including the target rate of return and the timeline to reach that rate of return. Many Limited Partners are attracted to venture capital because of the potentially higher rates of returns
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and the general appeal of financing technological innovation and entrepreneurship. There are some companies that are creating venture arms to invest and incubate new technologies that will potentially help the companies create a competitive advantage. Corporate operating funds are an emerging trend where corporations invest in LPs in externally managed venture funds.5 These corporate funds aim to create a framework that will help larger corporations become agile enough to leverage technology being developed in the start-up ecosystem. All these various types of Limited Partners will perform fund due diligence, just as venture firms perform due diligence for start-ups. Fund due diligence is a set of criteria used to evaluate a potential fund investment. LPs can evaluate a venture fund against four criteria: team, strategy, investment terms, and market dynamics. First, the investors want the General Partners to have significant investment, entrepreneurial, and domain expertise. Second, Limited Partners will assess whether the fund has a unique and thesis and an unfair advantage to source investment opportunities. Finally, Limited Partners will evaluate whether marco-drivers are aligned with the fund’s investment thesis. While all these criteria are important to Limited Partners, the most important criteria is the success of the firm’s portfolio. Limited Partners seek to reduce risk by investing in high performing funds. Metamorphic Venture’s successful investments in Indiegogo and Sailthru have attracted many Limited Partners and enabled Metamorphic to raise a $70 million fund. The terms of a LP-GP relationship require an alignment of financial interests. General Partners need to be able to match the Limited Partners desired rate of return within a given timeframe. The terms of the relationship are structured in the limited partnership agreement. The limited partnership agreement attempts to address six main
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business objectives. First, agreement describes the basic financial structure including the fund size, management fees, minimum contributions, and GP commitment. Second, it describes the restrictions on the flow of investment. Third, it determines how the GP will make investment in start-ups. Forth, it will describe the allocation of profits and losses. Fifth, it will describe the management and governance of the fund. Finally, it will deal with legal, taxation, and regulatory issues. Once the fund is raised, the General Partners hires a team of associates and analysts to help source potential investment opportunities that are aligned with the firm’s thesis. The goal of due diligence is to evaluate a start-up’s direction, execution, and traction. When preparing a due diligence report, I ask questions about the product, team, market, and traction. This framework is a guide that provides a series of critical questions to guide my research. After working on a due diligence report, analysts at Metamorphic will discuss a start-up’s defensibility against competition. Due diligence should provide the firm with information to make an informed decision about whether to pursue a potential investment opportunity. The research is obviously never perfect. A famous quote attributed to Dwight Eisenhower seems to capture the due diligence process: “In preparing for battle I have always found that plans are useless, but planning is indispensable.” Due diligence will not be able to predict a company’s future success, but it is important to use the due diligence framework and take risks. Before seeking venture financing, a start-up will typically incorporate to reduce exposure to liability, deploy its resource efficiently by minimizing taxes, and provide its founders with flexibility to manage the company as it grows. Incorporating a business separates one’s personal assets from the company’s assets because a corporation is
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considered a separate legal entity under United States law. While a LLC may be appropriate for a start-up during the development of the product, it is not suitable for venture capital financing because of tax restrictions on the funds venture firms tax exempt partners. Many venture capital firms raise money from tax-exempt entities such as pension and profit sharing trusts, universities, and charities. If a venture capital firm invested in an LLC, the non-profit entities would incur unrelated business taxable income. A C-corporation, on the other hand, allows for growth potential through the sale of stock that, unlike an S Corporation, is not limited to the number of shareholders. A Ccorporation is also a separate legal entity that reduces liability for directors, officers, shareholders, and employees. Many start-ups select a C-corporation when they hire new employees because it allows for deductions for health insurance and fringe benefits. A significant advantage of forming a C corporation is the ability to issue different classes of stock. Start-ups could issue preferred stock to investors and common stock to management and the employees. Preferred stock holders enjoy the benefit of liquidation and anti-dilution. So if the company fails, the preferred stock owners will have liquidation preferences. Unlike a LLC, a C Corporation is taxed both when profits are earned and when profits are distributed to shareholders as dividends. However, a startup’s employees are also shareholders in the company so earnings can be paid as salary or as compensation to shareholders who work for Start-up without being taxed at the corporate level. The earnings that are distributed to shareholders that are not for services would, however, be taxed as dividend income to shareholders. Start-up will need to form a C corporation to be capable of being financed by a venture capital firm. The downside of forming a corporation early on is that a start-up would have been able to deduct losses
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from the member’s individual taxes as an LLC. However, if a start-up raises a Series-A round from Metamorphic Ventures, a C Corporation is the most suitable type of legal structure. The C-corporation is owned by shareholders, governed by a board of directors, and managed by the CEO. With this in mind, we can examine how start-up evaluation works. There is no simple method to calculate the valuation of an early stage company. Aswath Damodaran, author of the “The Dark Side of Valuation,” writes, “There can be no denying the fact that young companies pose the most difficult estimation challenges in valuation. A combination of factors- short and not very informative histories, operating losses and the big probability of failure- all feed into valuation practices that try to avoid dealing with the uncertainty by using a combination of forward multiples and arbitrarily high discount rates.”6 The drivers of a high valuation are the opportunity to serve an attractive market, established competitive position via market share, a strong team, and a meaningful exit potential within a target timeframe. Harvard Business School Professor William Sahlman has a method of valuation that focuses on minimizing dilution and maximizing exit value. The discounted cash flow (DFC) method tries to account for existing assets and future growth. While these methods help firms account for growth and risk, determining the valuation price is more of an art than a science. Once due diligence is complete, entrepreneurs and venture firms begin to negotiate the term sheet. The two main stress points in the term sheet are economic and control. Entrepreneurs want to maximize valuation, have access to adequate capital to meet and exceed milestones, and avoid losing control of the company. Venture capitalist want to minimize risk and valuation, help the entrepreneur reach financial independence,
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and speed up the growth so the venture can exit. These stress points can be a source of tremendous conflict. The venture capital industry generally looks for companies that will disrupt various industries. It is not surprising the technology is also disrupting the venture industry itself. Decentralized financing platform like Angellist, Kickstarter, Crowdfunder, and Alphaworks have emerged to help start-ups get access to capital. This decentralized funding industry is growing but it has not fully matured. Entrepreneurs value venture financing because venture firms have access to larger pools of capital. Venture firms also provide strategic partnerships to larger companies. While an entrepreneur may be able to raise a Series-A round on Crowdfunder, they will not be able leverage a network of limited partners and companies who will pay to adopt the technology. Therefore, venture firms are adapting by building a network of limited partners that can help them execute on their investment thesis. Metamorphic Venture’s strong network is very appealing to entrepreneurs who want to partner with companies like AOL or the MLB. The venture capital industry is changing as financing becomes more easily accessible. While entrepreneurs have more agency than in the past, venture firms still play an essential role in building new companies. Hearing entrepreneurs pitch allows me to see different challenges that companies face as they grow. I believe that hearing this entrepreneurs pitch is much more informative than reading a Harvard Business School case study, which is popular form of pedagogy in many business schools. Finally, to return to the point of worker’s autonomy in a capitalist system, I believe venture financing is helping start-ups build products that will improve economic and political equality. Consider the example of massive online open courses or MOOCs. Many
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criticize MOOCs for only providing a small part of the college experience. Critics will focus to the importance of a social life in college, the career center, and the campus culture, among other things. College education is essentially a bunch of products bundled together. These products include campus life, a social network, education in the classroom, informal education in the dorm, etc. Entrepreneurs are unbundling these products and making them more affordable. A recruiting platform that helps underemployed people train to work in a sustainable industry and find work can replace the career center. A social media site, like Meetup, that connects people with shared interests in culture can supplement the benefits campus life. A MOOC like Coursera can supplement the cost of classroom education. The aggregate impact of these products will be transforming education to make it more affordable. These products are not perfect and do not need to replace the college experience. These products can supplement the college experience to make education more affordable. One need not romanticize the venture capital industry to recognize the positive impact it can have on economic and political life.
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Bibliography
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1 Benkler, Yochai. The Wealth of Networks: How Social Production Transforms Markets and Freedom. New Haven: Yale UP, 2006. Print. 2 Ante, Spencer E. Creative Capital: Georges Doriot and the Birth of Venture Capital. Boston, MA: Harvard Business, 2008. Print. 3 "Evgeny Morozov: Hackers, Makers, and the Next Industrial Revolution." The New Yorker. N.p., 13 Jan. 2014. Web. 23 Apr. 2014. 4 Ramsinghani, Mahendra. The Business of Venture Capital: Insights from Leading Practitioners on the Art of Raising a Fund, Deal Structuring, Value Creation, and Exit Strategies. Hoboken, NJ: John Wiley & Sons, 2011. Print. 5 R.R. Donnelley Inc. is a printing company that has invested as an LP in the externally managed Work-Bench LLC fund in New York City http://www.work-bench.com/ 6 Aswath Damodaran, “Valuing Young Start-Up and Growth Companies: Estimation Issues and Valuation Challenges� (June 12, 2009). Available at SSRN: http://ssrn.com/abstract=1418687