In my blockchain investment work (we have invested in six early-stage projects, including bloXroute, Enigma, FalconX, NEX and two stealth projects), I have been struck by the fact that decades of progress on applying the scientific method to entrepreneurship (e.g., experimental design, lean startup, design thinking), as well as decades of established governance modeled, are being effectively blown up by Initial Coin Offerings (ICOs).
Steve Blank and Eric Ries popularized applying the scientific method to startups in an incisive fashion with the publishing of their books, Four Steps to the Epiphany and The Lean Startup, respectively. These became canons for entrepreneurs around the world as they embarked on the journey for product-market fit.
With blockchain startups raising over $5 billion in 2017 and over $12 billion through the first three quarters of 2018, it appears that this discipline of staged experimentation and fundraising is being discarded.
Harvard Business School professor Ramana Nanda and I spent some time on this issue in an article we published last week in Harvard Business Review called “The Hidden Cost of Initial Coin Offerings”. In it, we outline 3 defenses of large ICOs, some of the downsides they present and how they constrain the team from executing successfully on their mission. We hope it adds to an important debate on startup staging and experimentation in the context of this exciting, emerging funding mechanism.
We are big believers in community-building. We have invested heavily in it as a firm, contributing to the ecosystem in various ways that are consistent with our values (e.g., fostering diversity in tech, supporting women entrepreneurs and immigrant entrepreneurs). And we have invested heavily in it across our portfolio companies. Our insight a decade ago that developers were becoming the kings of IT led to a fruitful investment thesis, led by my partner Chip, around developer driven adoption and community building (as exemplified by our investments in MongoDB, Codecademy, Crashlytics and Firebase).
For the last few years, we have been applying this thesis to our investments in blockchain and crypto. Blockchain-based startups share many of the same characteristics as developer-driven startups. With these companies, sustainable competitive advantage is built through a loyal community of supporters who contribute to the project and feel ownership over its success. Because of token network effects, a Blockchain startup has the opportunity to create ardent supporters that literally have a stake in the project in ways that MongoDB and other open source projects could never do.
On the eve of our second portfolio company completing an Initial Coin Offering, we gathered the community managers of our five Blockchain startups and – together with our advisors, MongoDB’s Meghan Gill (first nontechnical hire and head of community and demand generation) and OpenX’s Scott Switzer (founding CTO of the largest open source advertising exchange network) – to share best practices in community-building in the context of crypto. Here’s what we learned.
Provide An Amazing First-Time Experience
MongoDB is a complex, scalable database for sophisticated customers. But their design goal was to provide an amazing out of the box experience – holding themselves to the standard of being able to download, install and make use of the product in under five minutes. Crashlytics founder, Wayne Chang, likes to refer to the initial product you release to your community as the Minimum Lovable Product (MLP): a product that is “so intuitive, so satisfying to use, that your customer base can’t help but tell someone about their experience.” Focus on triggering an emotional response, Chang advises, with a narrative and small surprises that compel the user to appreciate that you are thinking of them and their needs.
Jump On An Existing Wave
One of the most important pieces of advice we heard from our community-building experts was the value of latching on to existing communities that already have momentum behind them. NEX, a decentralized crypto exchange, has latched on to the City of Zion community (a non-profit the founders started to support the NEO ecosystem). MongoDB latched on to the NoSQL movement. OpenX latched on to the rise in programmatic advertising. If you can frame your work in the context of an existing trend or platform and then establish your presence in the communities and academic environments where that trend is flourishing, you can put yourself in a strong position to ride someone else’s wave and not be forced to generate all the kinetic energy to support your platform by yourself.
There’s No Substitution For Presence, Especially The Founder
Megan advises, “There’s no magic bullet when it comes to community building. You have to be consistent and always available on line – wherever your community wants to interact with you.” This presence has been challenging for blockchain startups as there is already tremendous fragmentation in communications channels. Discord, Telegram, Slack, Twitter, Reddit, Stack Overflow and many others are all very active forums for different segments of your community. And, if you want to jump on an existing wave, you need to be active through all those channels in the communities of others as well. The team from Enigma (a scalable privacy protocol that enables “secret contracts”) talked about their heightened sense of urgency in being organized to answer questions that come up online immediately. As OpenX’s Switzer put it, “Being available to communicate with and respond to the community is one of the biggest jobs I have as a founder”. Enigma recently created an Ambassador Program in order to help scale the presence of their small team. Ambassadors have their own channel and private calls with the founders to get briefed on the product roadmap and upcoming releases. Enigma built their own scraper / web crawler to track all the questions that come from the different forums and loads them automatically into their issue tracking platform, Jira. BloXroute (a network-based scalability solution for blockchains) is focused on attracting a deeply technical community at this stage in their roadmap and so have put out more technical content to match what their community might be looking for.
In watching our blockchain-based startups evolve, we have come to appreciate more and more the importance of a subtle skill on the part of founding teams in crypto. They not only need to have the usual compelling vision, unique market insight, and execution ability. They also need to be intentional, strategic, capable community builders.
Thanks to Samir Ghosh, Meghan Gill and Scott Switzer for their contributions – as well as Tor Bair (Enigma), Kevin Flynn, Carla Paiva, Giuseppe Stuto and Nissa Szabo.
When I first wrote Mastering the VC Game, Satoshi Nakamoto had just issued his seminal Bitcoin white paper. At the time, no one could have imagined the transformative impact the invention of Bitcoin and the blockchain would have on the venture capital industry.
With the invention of Ethereum and a Turing-complete platform that allowed for smart contracts, startups could suddenly raise money ahead of delivering products from a crowd of investors, not just a universe of a few hundred venture capitalists. Last summer, I wrote about the impact Initial Coin Offerings (ICOs) were having on the venture capital industry. This summer, I am amazed at how quickly the science of token-based fundraising has evolved and the hybrid of VC, crowdfunding and crypto token economics best practices that have emerged.
Last summer, one of my portfolio companies, Enigma, completed a $45 million ICO with only three employees and a (very well-written) white paper. Like many companies at the time, they had only raised a total of $1 million in a prior seed round and had yet to deliver any software to the market. At the time, they were not alone — startups raised more capital in ICOs than in venture capital rounds last summer. As of this writing, over $10 billion has been raised in ICOs since their invention in 2016. The money seemed to come so easily that aggressive entrepreneurs seized the moment.
Those days are gone. As William Mougayar correctly observes, “the only token that matters is the one being actually used.” The SEC has stepped in with some strong, cautious guidance and both professional and retail investors, although still enthusiastic about blockchain and crypto, are showing a bit more caution.
Today, a new playbook is emerging for startups who wish to follow best practices in fundraising in a post blockchain world. To understand the contrast to the pre-blockchain, you first have to understand what the best practices playbook looked like previously:
Financing Playbook, Pre-Blockchain
Seed round: $1–2m. Raise from a mix of smart, value-added angels or seed funds. Pre product-market fit. Build the team and deliver an MVP in order to run some experiments to test the customer value proposition. Run a few go to market experiments and perhaps a business model / pricing experiment. Hit some important value-creating milestones, such as early customer revenue or at least engagement.
Series A: $5–10m. Raise from a professional, series A firm. Complete the product, round out the team with some commercial executives (first salesperson, first marketer) and get to product-market fit. Begin developing a repeatable, scalable business model. Stand up a growth team.
Series B: $10–30m. Raise from a professional, series B / growth stage firm. Execute on your repeatable, scalable business model. Expand beyond the initial product to deliver multiple products in adjacent areas. Expand internationally. Build a senior executive team that includes a head of finance and a head of customer service / operations.
Series C: $30–60m. Raise from a professional, pre-IPO firm with a good, credible brand to assist in the IPO process. Work towards a profitable, scalable business model. Execute well across multiple products, multiple channels, multiple geographies. Complete some M&A to expand your product footprint. Build a strong, independent board and prepare for IPO.
In a post-blockchain world, the playbook has changed dramatically from the pre-blockchain world and also has evolved from the go-go days of last summer. Today, the market has become more discriminating, forcing companies to be more deliberate and professional. Here’s what the best practices playbook looks like now:
Financing Playbook, Post-Blockchain
Seed round. $1–2m. Raise from value-added angels and professional seed funds, particularly those with strong reputations and credibility in the crypto community. Include in the seed round terms a token conversion option, allowing equity holders to convert into tokens at their election (following a vesting schedule) if the company’s business model is more focused on token value creation (utility, security) than equity value creation (revenue model, cash flow). This option tends to be anchored on a pro rata ownership share of the equity. In other words, if an investor were to own 10% of the fully diluted shares, they would have an equity conversion option on 10% of the tokens that are held by the company in treasury post-ICO. Build the team and articulate a product roadmap in the form of a technical white paper. Focus on writing code and building out a testnet (i.e., public beta). Ideally, leverage existing platforms (e.g., Ethereum, Cardano, NEO) to minimize the amount of new code required. Link your vision to a secular trend in the space and enlist thought leaders to publicly endorse you on Twitter, Reddit, Medium and at conferences.
SAFT or SAFE-T or SAFTE. $3–6m with a pre-defined “launch valuation rate” (i.e., crypto valuation cap at which the dollars convert to tokens) as well as a discount. The labels the different lawyers might use are somewhat fungible, but this investment agreement is typically in the form of an option to purchase future tokens or equity with professional investors that are a mix of traditional VCs and crypto funds. This agreement looks very much like an offering document nowadays (due to recent SEC guidance), with many provisions that you might find in an IPO boilerplate, but is explicitly not a registered security but rather a carefully-worded agreement to purchase a non-registered investment security. Entrepreneurs attempt to raise enough from smart money (and ideally good brands to assist in the ICO) to go beyond the technical team and add a community executive and investor relations / business development. Issue the testnet and perhaps even release an initial component of code on the mainnet (aka the live blockchain) — not the entire product roadmap, but enough to get a community of developers something to play with and get excited about. Build out your community infrastructure (Telegram, Slack, Reddit, Twitter) and have your community manager recruit and engage with two types of members: developers (most important) and investors (secondary but still critical). Expand and publicly publish the multi-year product roadmap and vision. Prepare for ICO.
ICO. $20–200m. The range is wide, but most top-tier ICOs are aiming for a crypto market cap of $100–300 million which would place them in the range of 50–150 top tokens (as of this writing, #50 is trading over $300 million and #150 is trading at $70 million according to CoinMarketCap). Thus, if they are selling 50% of the tokens, they might be raising $50–100 million. At this stage, a decision needs to be made as to whether the project meets the Howey Test, and is thus aiming to be a utility token, or should be a registered security. More and more blockchain projects are leaning towards the full offering and registration requirements consistent with a security token offering (known as an STO) due to the SEC’s recent guidance. The team needs to be a more fully formed team — not quite as mature as the IPO team (e.g., no CFO required) but ready to handle developer recruitment and support, have a point of view on the business model, a full treasury and finance function (what will you do with all that money? how will you maintain security? what are your treasury policies? how much tax do we pay on the ICO proceeds and when is that tax due?) and a fledgling legal function to assist with compliance. And a real product needs to be delivered or very close to being delivered, where customers and developers can actually evaluate the quality of the code (it is all open source, after all).
These points of evolution are a good thing. They are causing startups to slow down, be more professional and responsible, and deliver real code that has some real utility — not just a well-written white paper and an active Twitter account. Some companies may skip the SAFT step and still go right from a seed round to an ICO (e.g., our portfolio company NEX is in the midst of doing that), but it takes a pretty special team to deliver a large enough number of milestones in that rapid a fashion. Most companies are going to take 2–4 years to be fully prepared to journey from inception to ICO/STO. Considering the median age of an IPO company over the last fifteen years is eleven (our company, MongoDB, just completed it in ten and it seemed breakneck!), this time compression is still an amazing development for the future of innovation.
Many open questions remain and there is much more work for entrepreneurs and investors alike to sort through. One of the trickiest, for example, is incentive compensation. We have had decades of experience with stock option grants to employees, complete with vesting schedules, acceleration provisions and various exercise price processes and mechanisms. What is the right incentive compensation structure for token-based startups? Is there going to be a vesting schedule and, if so, for how long? What are the tax implications? If the token is a registered security, how will the issuance of securities as employee compensation be handled?
It is an exciting time for both entrepreneurs and investors in the post blockchain world. I suspect that the next year will bring similarly rapid and unanticipated developments and evolution!
Each year, I join my friend Ed Zimmerman (lawyer, super angel, wine enthusiast and raconteur) at his annual Venture Crush First Growth conference (fka First Growth Venture Network) to talk about product-market fit with early-stage entrepreneurs.
Each year, I try to think anew about the topic, reflecting on some of the lessons and research related to my entrepreneurship class at Harvard Business School.
Below is this year’s version, complete with a new framework for thinking about the three kinds of experiments all pre product-market fit startups must undergo: Consumer Value Proposition experiments, Go To Market experiments and Business Model experiments.
New graduate? Jump on board one of these high flying companies
Graduating students hungry to dive into the startup community (aka StartUpLand) often struggle to select the right, specific opportunity to start their career.
Each spring, I provide a comprehensive list of exciting, growing, hiring startups–both private or recently public–that are worthy of consideration as places to start or continue a career in StartupLand. The criteria for being on the list is subjective but is a mix of fundraising (typically > $10m in the most recent round), scale (typically > 50 employees), momentum (typically growing revenue or users > 50%) and hiring (typically > 10 open reqs, including a number of entry-level positions that would be a fit for recent college or business school graduates).
Once you have reviewed this framework for deciding what you’re looking for, this post will give you a list of over 500 companies to research and approach.
As usual, the list is compiled and organized based on location since I believe in selecting a geography to plug in to (and contribute to) a community and ecosystem. I received fantastic input from angels, entrepreneurs, lawyers and VCs across the world, helping me pressure test and compile this list (note: Flybridge portfolio companies are in blue). I recognize that the list contains no companies from India or China. I hope to cover those geographies in the future but just didn’t feel I had good enough intelligence at this time. I’d also point folks to Stanford’s Andy Rachleff’s terrific list, which he publishes each fall with a similar theme (albeit more Silicon Valley focused).
I’m sure I made many mistakes and omissions, which are all my own. Feedback welcome!
UT: Bamboo HR, Canopy Tax, Domo, Health Catalyst, HireVue, InsideSales, Instructure, Lucid Software, Observe Point, Pluralsight, Qualtrics, Solution Reach, Workfront
That’s it! Special thanks to all those who provided me with anonymous input as well as my colleague, Caroline Constable, who did most of the heavy lifting to help me in compiling this list. Again, feedback welcome!
I love S-1s. I know I am weird but S-1s are loaded with great nuggets of insights about business models, company performance and have fascinating stories embedded in the sometimes turgid prose.
Dropbox has been one of my favorite startups for many years. I have taught a Stanford Business School case on Dropbox in my HBS class on Launching Technology Ventures for many years regarding their scaling their sales and marketing operation. We also teach an early stage case on Dropbox to all first year students at HBS. And a few of my former students joined the company early and became key executives over the years. So, when the Dropbox S-1 came out yesterday, I was excited to read through it and see what I could learn. To be clear, I am not an investor in the company and don’t own any shares (as far as I know!)
In short, Dropbox is a cash machine and possesses a magical business model. Anyone who concludes otherwise doesn’t understand the difference between cash flow and GAAP and the power of negative churn. Let’s jump in.
Is The Business Model Working? Yes!
Dropbox has a magical business model and the data in the S-1 proves it. The company reports that “we generate over 90% of our revenue from self-serve channels”. Think about that for a minute. The free product is so attractive that it drives massive adoption and the conversion from free to paid is so obvious and smooth (more usage leads to more storage leads to paid product) that the company has a customer acquisition engine that derives from a simply great product and a compelling value proposition. Forget sales and marketing, at Dropbox, the product itself is a massively effective and efficient customer acquisition machine.
Does it cost too much to service all these free customers? Happily, Dropbox is following a cost curve of declining storage and cloud costs. Gross margins have soared from 33% in 2015 to 54% in 2016 to 67% in 2017. If a CEO tells you she is going to increase gross margins from 33% to 67% in two years on a $1 billion revenue business, you would check her in to an insane asylum. Dropbox did it easily.
The other magical part of the Dropbox business model is that it’s so darn viral. Every time I share a Dropbox document to someone, they need a Dropbox account. Every time they set up a Dropbox account, it drives more document sharing and storage. And the cycle keeps going. 100 million new accounts in 2017 is another stunning number, proving that the viral machine continues to work well despite what some may worry is a growth saturation point.
Cohorts and Negative Churn
The other compelling part of the Dropbox business model is the power of negative churn (i.e., revenue from your existing customers, on a net basis, are growing not shrinking) and the behavior of its cohorts. We see this similar behavior in one of our enterprise storage portfolio companies, Nasuni and our database software company, MongoDB. Every year, the company starts with a customer base that grows 20–30% per year on a net basis. Thus, if you theoretically fired the entire sales force and shut down all marketing activities, these companies would still grow 20–30% per year.
Dropbox’s cohorts are behaving in a similar fashion. There is a chart buried on page 63 of the S-1 that tells the story. Cohorts of customers are growing rapidly months after signing up for the service. The January 2015 cohort grew to 2x the monthly subscription amount paid two years in. The January 2016 cohort grew to 2x the monthly subscription paid after 20 months. And the January 2017 cohort grew to 2x the monthly subscription amount paid after 10 months. In a word, wow. When cohorts are getting better over time, that dramatically, something very right is going on.
But What About the Losses?
Now I know many of you are wondering — if the business model is so magical, Jeff, what about the losses? The company reports a net operating loss of well over $100 million in 2017. How can you reconcile these incongruous data points?
Many business reporters don’t seem to understand that GAAP net income is a meaningless measurement for a subscription-based business model. Dropbox users sign up for an annual fee and pay in cash up front and then the company recognizes that revenue over the entire year. Further, there are massive non cash charges that hit the income statement, such as stock-based compensation. What you really need to examine is free cash flow.
Page 67 tells the free cash flow story. The company’s free cash flow has gone from negative $64m in 2015 to $137m in 2016 to $305m in 2017. Think about that for a minute. Here you have a company growing at over 30% year over year in top line revenue that is able to achieve a positive swing of nearly $400m in annual free cash flow over two years. And they did this while improving gross margin by 34% points. Again, wow.
A few other things struck me as interesting. After raising so much in private capital, most founders can expect to own 5–10% of their company in aggregate. According to the S-1, CEO/founder Drew Houston owns 25% and his co-founder, Arash Ferdowsi owns 10% for a combined 35%. Drew and Arash built a company from zero to $1 billion, raised a ton of money, and still own over a third of it. If Dropbox ends up being worth over $10 billion, these guys will each become billionaires on paper while still retaining complete control over their company. Amazing.
Another fascinating thing to me is that it has taken 11 years since inception to get to this point. I’d be shocked if Drew wasn’t still CEO of the company for many years after the IPO. Thus, building real businesses takes a long time, even if your business model is magical and you hit every major platform trend just right (i.e., massive secular shifts to cloud, storage, big data and mobile in the case of Dropbox).
Final fun tidbit: the company dumped $11 million in cash and stock into the Dropbox Charitable Foundation at the end of 2017. An interesting use of free cash flow and a nod to interesting initiatives ahead.
When I teach the Dropbox case at HBS, I end the class with a checklist of the business model elements of the company: strong virality, strong network effects, recurring revenue model, high gross margins, negative churn, low customer acquisition costs. I guess that’s how you get from zero to $10 billion in market cap in ~ 10 years.
Last week, I delivered a presentation to Harvard Business School students on how to raise your first round of capital from angels and venture capitalists. The presentation is a derivation of my book (Mastering the VC Game) and my experience as an entrepreneur and venture capitalist. Enjoy!