20 Questions with Dave McClure of 500 Startups: Part I

Dave McClure, head of a venture capital fund in California called 500 Startups, gave a presentation at King Abdulaziz City for Science and Technology‘s BADIR incubator in November of 2013 in which he gave an overview of the evolutions and ecosystems he saw in the world of venture capital, then answered many candid questions from audience members.

If you’ve ever wondered how you can achieve a 300% gain to your venture capital portfolio while most other angel investors lose money, or just how companies like 500 Startups can give away so much money knowing that most start-ups fail, keep reading.

This article will cover the first 10 of the 20 main audience questions Dave answered.

Introduction: Evolutions and Ecosystems

Dave began by talking about some of the changes he has seen over the past 5 to 10 years in the global technology and Internet ecosystem that will make investing in companies easier.

These changes included:

Reduction in cost of building both software products and companies, at least in the early stages
Less capital required to get to market for software-based products
Increasing market access to global customers as a result of increased Internet penetration
Increasing ability to make payments online (credit card and alternative)
Improved delivery and logistics systems
Rise of online platforms with 10 million+ users (translating to increased access to customers)
Rise of incubators and companies that teach start-up best practices to employees (e.g. Google, Facebook, LinkedIn, PayPal)

According to Dave, this is especially good news for developing markets, who stand to benefit from all of these changes.

He explained that there have been many recent phases of change, summarized as follows:

The dot-com crash (2000 to 2001): Reckless investment in the Internet sector caused the number of start-ups to spike, then crash when many start-ups couldn’t live up to irrational expectations
The dot-com recession (2001 to 2004): Not much investing took place, but start-up founders who emerged had more carefully-laid plans
The housing bust (2008): After real estate prices and demand for financial services related to real estate inflated, severe real estate price drops created a ripple effect that slowed down the pace of investing in the technology sector
The recovery (2009 to 2010): Capital availability recovered, with returns reaching similar valuations, and similar amounts of money being invested in the market
The rise of incubators and accelerators (2004 to present): First Round Capital started investing in companies at the seed stage in 2004, soon followed by the Y Combinator pioneering the modern incubator model in 2005, and leading into the recent advent of billion-dollar funds that provide support services like corporate business development and recruiting (e.g. Andreessen Horowitz)
The rise of AngelList (2010 to present): Dave said that AngelList, an online platform that connects start-ups, angel investors, and job seekers looking for start-up jobs, is “probably responsible for at least $100 million worth of capital syndication per year”

Dave also shared his personal journey, which is worth reading in his own words in a blog post titled late bloomer, not a loser. (I hope).

He then went on to talk about 500 Startups’ growing global reach, with an office in Mexico City and 5 team members in India, China, Southeast Asia, and Brazil. Dave added that they hoped to spread to Eastern Europe and the Middle East in 2014.

“Of the 600 or so companies we’ve invested in, probably over 150, maybe close to 200, are not in the U.S., or at least the companies have presence outside the U.S. in some way or form,” said Dave. “We’re very bullish on markets in Latin America, in Southeast Asia, and more recently, now also the Middle East.”

The 4-year-old 500 Startups has invested in more than 40 countries, now including 5 investments in Jordan and 1 in Turkey, and was “working on a project here in Saudi” at the time this presentation was given.

Finally, Dave briefly explained the nature of Silicon Valley’s venture capitalist ecosystem, sorted by different levels of capital:

Half-billion to 1 billion dollars: Funds that manage multiple vehicles, like Greylock, Sequoia, and Andreessen Horowitz
100 million to 500 million dollars: Traditional venture capital funds
Under 100 million dollars: Often called the “seed fund” level, and sometimes mistakenly called super-angels (although the organizations themselves are not angel investors), micro-VC funds operate at this level
Under 10 million dollars: 500 Startups, angels, and incubators operate at this level

Dave predicted that crowdsourced funds will be the newest addition to this environment, providing funding at the ground level through platforms like Kickstarter.

He also pointed out that, as in a typical ecosystem, these different levels are not actually in competition with one another.

Having covered the basics, Dave then began taking questions from the audience.

1. How do venture capital returns compare to returns from the bonds and equity markets?
“I would probably say bonds and equity markets are a much safer bet than venture capital, unless you know that the person running the venture capital fund is particularly exceptional,” said Dave.

According to Dave, the average bond trader and equities trader is likely to substantially outperform the average venture capitalist.

2. What separates you from most venture capital investors, allowing you to achieve a 300% gain to your portfolio while most angel investors lose money? Do you have special investment criteria?
“I’m really smart and special and sexy and… I’m tall and handsome and…” Dave joked, chalking his success up to special traits, but after the laughter subsided, he explained his strategy. The fact is that, by investing in more companies than the competition, he has more chances for a big win.

Most investors are trying to target very specific investments. They are looking for start-ups with big ideas and big names behind them, but most start-ups, even popular ones, are more likely to fail than succeed.

Therefore, Dave prefers a long-run approach to angel investments. Similar to Vanguard‘s strategy, which rocked the investment world by following the market indices, 500 Startups spreads their investments over many firms, balancing out risk and reward. Thus, 500 Startups can capture the direction of the tech market at large: up and up.

3. At what phase does a start-up get initial funding?
Dave said that, while plenty of people have great ideas, they don’t necessarily have the experience to turn those ideas into monetized products. He’s careful to add that, in all but the most extreme cases, the start-up must have a product to be worth investing in. For Dave, good ideas aren’t enough.

He admitted to occasionally investing in a start-up just because one of the members of that start-up “had previous product success,” but said it was rare.

4. How do start-ups find you?
At first, friends and past colleagues would come to Dave with start-ups that needed funding, but now, his business gets many letters and applications through the website AngelList. He laments that this parts of his business model doesn’t scale well. It was much easier to find good investments when 500 Startups was smaller.

“We get, for each accelerator class, over 1,000 applications, and we select about 25 or 30. So, we have to do a lot of screening, and most of those are not that great…”

He explained that it is increasingly hard to find good investments, but because of his business model, he only needs a small portion of the companies to pay off from the first round of investments. At each stage of investment, they will give more capital to the businesses that are doing well, furthering their stake in those companies.

5. How do you manage these investments once they’re made? Are you on the boards of these companies?
Dave said he remains very hands-off. Most of the companies 500 Startups invests in will fail, but they don’t need to micromanage their investments because they make many different types of investments. This is not only a lower-cost way of doing business, which means less overhead for 500 Startups, but it also makes for happy start-ups.

Dave added that keeping start-ups happy is key to keeping the few that will succeed. If you scare them away, you’ll only be left with losing investments.

6. Do you have a guarantee in place to recoup costs?
According to Dave, there is no guarantee that any single investment will succeed, and he doesn’t need that anyway. What makes his model for investment so unusual is that he truly is betting on the long-run. As long as a few companies succeed, and succeed significantly, he doesn’t have to worry about each investment.

7. What’s the timeline like for big and small exits?
“The small exits probably happen in the first 2 or 3 years, and the larger exits probably happen, I would say, between years 3 to 7,” said Dave. “So far, we’ve seen 3 large exits that are over $100 million. Those companies were between 3 to 5 years old.”

8. In the U.S., are exits taken at a loss the norm, or do many allow you to exit with your original capital?
Dave said both situations happen, along with the possibility of ownership without an exit. On the whole, exits are probably not profitable enough to be worth dealing with, according to Dave.

However, the fact that about 1% of investments provide returns of 50x to 100x keeps the game going. Dave explained that if he could get 1 out of 20 companies to provide 20x returns, and 1 out of 5 companies to provide 5x returns consistently, 500 Startups could bring in steady returns.

“Every once in a while you’ll get the black swan event, which isn’t predictive,” added Dave. “But one of the companies we invested in, or I invested in, 5 years ago, called Twilio— I invested over a $3.5 million valuation, the company is now worth over a half a billion dollars and it might go public, we’ll see. I don’t think we can predict for those outcomes. I certainly don’t think I’m smart enough to select for those outcomes. But if I’m making a lot of investments, I’ll have a better shot at getting one of those.”

9. Does 500 Startups always get fixed equity for the first stage of investment?
“If we are investing in the accelerator companies, yes, usually about 5 percent,” said Dave. “If we’re investing in convertible notes, the structure of those is such that there’s usually a cap, which means we’ll have a minimum ownership structure, but it’s not determined until it converts to equity, and it may never convert to equity.”

However, he pointed out that 500 Startups isn’t focused on ownership, but on finding an attractive valuation entry point. At the accelerator stage of investment, that’s about 1 million USD, while at the seed stage, it’s around 3 to 5 million. Dave estimates that 500 Startups tends to enter at about the 3 million USD valuation mark.

10. Why doesn’t 500 Startups focus on the public markets and IPO markets?
Dave said that those areas make up a smaller percentage of the overall market. According to him, mergers and acquisitions give bigger returns.

He argued that this could be an advantage for emerging markets. Today, many of the tech companies being acquired combine 80% knowledge of an existing business model (tech or offline) with 20% Internet marketing knowledge. So, as offline businesses incorporate tech features, like allowing customers to order online, and the e-commerce environment as a whole enjoys improved payment gateways and logistics, these offline businesses will become more attractive to U.S. and European companies.

If you like what you’ve read so far, check back on Saturday morning for 20 Questions with Dave McClure of 500 Startups: Part II.

Here’s a sneak preview of the questions Dave answered next:

  1. Will U.S. and European countries only be interested in Middle Eastern companies if they offer fraud protection?
  2. What happens to accelerator program participants who don’t find investors?
  3. Does 500 Startups bring in external investors to pick among the graduates?
  4. What about the entrepreneurs who no one wants?
  5. What happens when you have to make the hard decision to remove someone?
  6. What are the most important things you’ve learned from your mistakes?
  7. What opportunities available in the Middle East should entrepreneurs focus on?
  8. Has 500 Startups faced regulation issues internationally?
  9. If you’re risk-averse, why did you come to Saudi Arabia?
  10. What are your predictions for the mergers and acquisitions market and IPO market in the Middle East?

See you on Saturday.

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