Inside Story Dave McClure

Startup MGZN got the chance to talk to one of Silicon Valley’s most outspoken venture capitalists, Dave McClure, founding partner at 500 Startups.

Ahmed: So Dave, tell us a little bit about this: how do you see the startup ecosystem in the Arab world, from your experience?

Well, I’ve only been coming for the last year or two, so my knowledge and understanding are still pretty new. We’ve done about ten investments in the region, mostly in Jordan. We met a number of startups through Fadi Ghandour and some other folks, where we were investors. We’ve done a few investments in Egypt plus one in Turkey, and we’re looking at a few in Saudi and Dubai. You know, I’m starting to get an understanding of where most of the market activity is; it seems like a lot of the market is primarily in Saudi and Egypt, and maybe in some of the other GCC countries, as well. Turkey is probably its own market—I don’t know if it’s as connected with the rest of the region, but it’s pretty interesting. I think there are definitely lots of opportunities for expanding. Certainly, Saudi itself is a pretty significant market that most of the region appears to be paying attention to. In terms of where the entrepreneurs are, it seems like there are decently-sized communities in Jordan and Beirut, and probably in Egypt, as well, though I haven’t been there myself yet. Possibly in Saudi—that’s still developing. In the long run, I’m sure you’ll see more entrepreneurship happening out of the region. I haven’t spent as much time here in Bahrain, or in Qatar or Kuwait. A little bit of time in Dubai.

Ahmed: That’s great. This region is certainly booming with startups. We need some more startup education, however. How do you think we should develop an ecosystem in which investors are more willing to take a risk investing in startups?

Well, you probably know there’s as much to be done in investor education as there is in entrepreneur education—in fact, possibly more on the investor side. In my experience, a lot of investors here tend to be coming from more traditional industries, like real estate and a few other places where the returns are a little bit more predictable than in startups. In other words, it’s not common to see a bunch of real estate investments fail, though that has also happened throughout the region. I think what investors are looking for is more understanding about how startups become successful. At the same time, I think it helps to explain to investors that a relatively small percentage of investments work, but they can bring in very large returns. I think it’ll be a combination of educating investors about the process and seeing some larger exits on the entrepreneurs’ side that can build more trust and potential.

Bader: Fully agree. One of the challenges we, along with many other startups are facing is the lack of a proper investment framework in Bahrain. Investors aren’t taking the risk, and to be fair, startups aren’t trying hard enough to be a part of the solution.

Ahmed: During the second-panel discussion, I think one of your investor colleagues said something like 92% of job creation happens after an IPO. You had a comment that perhaps no one was able to hear.

Yes, I was saying that in the U.S., a lot of the IPO market has been pushing out further for a couple of years, so you are seeing investors taking the place of the IPO market. Maybe 10 years ago, a company would have gone public on 50 to 100 million in revenue, and maybe one or two years of profits. Now, I think companies are choosing to stay private longer. They’re taking capital from large private funds rather than going public. In this case, I think what you’re starting to see is that some of these companies IPO much later than they would normally have done in the past, and a lot more job and value creation is happening for private investors rather than for public markets.

Ahmed: You mentioned, I think yesterday, that governments, regulations, and policies can slow down the development of startups. Would you mind elaborating on that?

Well, in general, I think it’s hard for governments to accelerate the process in the right ways; and oftentimes, they may accelerate it in the wrong ways. Sometimes, they can distort the market activity of entrepreneurs, so that entrepreneurs start paying more attention to how to get funds from governments than how to get customers. I think that’s one risk that might happen with government involvement.

Ahmed: You called it grantrepreneurs, I think?

Grantrepreneurs, yes! I don’t think that’s always the concern. Usually, government funding can play a positive role in subsidizing private market selection by providing matching capital to investors. Sometimes, that’s also risky, because they are providing capital to companies just as they’re getting started, and there’s not really much evidence of whether those companies are working.

Possibly, a better place to provide capital would be after a few rounds of funding, when those companies are successful and providing some liquidity for investors who were in earlier. They might not always have to wait until the company gets acquired; they might be able to have government money come in at market valuations that are higher than when early-stage investors came in, and let the early-stage investors get some liquidity on their investment at the higher multiple valuation. This is a pretty advanced concept, so I don’t know if it’s easy to explain to government regulators or bureaucrats, but liquidity and exits are where investors pay attention. If they start feeling like they are making money or getting a multiple on their return investments, they are more likely to continue that behavior. It’s important to figure out not so much how to subsidize the initial investment, although that’s helpful, but how you can support and provide more liquidity for the investors to get returns.

Bader: That’s a fantastic answer. We’re sure this will help those responsible and concerned. A blanket approach, whereby everyone is funded equally and unreasonably, we slowly learned, doesn’t necessarily work as well as it could on paper. Things are changing. A few falls to get up.

Ahmed: What about failure though? You were talking about failure and how important it is to actually try failure. Is it a necessary evil?

Well, I don’t mean that you should fail; what I mean is that you should acknowledge that failure is part of the process, and hopefully that failure is somewhat of a necessary step on the path toward success—at least in the aggregate. Discussing failure and being unafraid to encounter it is important, but eventually, you do need to find enough success so that it is not a loss-making activity. It’s just that when a lot of investors come from more traditional markets such as real estate, gas, and energy, they’re probably not used to the failure rates that are happening with startups. They are aware of the upside potential, but they are not aware of the failure potential, so it’s important to get a more rational level stated with them on what the realities might be.

Ahmed: That also applies to entrepreneurs in this region, as well?

Probably, though entrepreneurs are always going to be crazy, so it doesn’t, necessarily…you don’t need entrepreneurs to be crazier; they will be crazy. What you need is for investors to be willing to take more risk and invest more frequently, and hopefully still do that with an eye toward returns.

Bader: Do you believe startups help boost job creation?

I think the data is not obvious on that, because startups probably start to impact job creation when they get very big; so in the beginning, I’m not sure that funding a bunch of small startups is really going to drive a lot of job creation in the near term. If you get some wins, and those companies start employing hundreds, if not thousands, of people, then it can start to impact job creation. I do think you’re probably spending ahead of the curve investing in companies to get them to levels where they are hiring large numbers of people.

Bader: Certainly. There’s that common, perhaps misunderstood factoid being thrown around that startups create most of the jobs. Maybe it applies under certain conditions or in specific places, but people surely need to be more clear about it.

Ahmed: When and how does the lean startup methodology not work?

Well, just like everything else, it doesn’t work all the time. I think there are definitely some good ideas behind lean startup, and I think applying them to many entrepreneurs is probably useful. Conceiving of how to build businesses based only on lean startup methodology may be a bit narrow. Sometimes, you do have to do a little bit of ideation and concept development before you really provide a product that customers can give you feedback on. There’s not always an incremental path to product feedback that leads to success. I do think that happens a lot of the time, and that lean startup techniques are very useful in many scenarios—it just may not be the case that in all scenarios, it’s a perfect solve. Is that too diplomatic? Sometimes, lean works, and sometimes it doesn’t.

Bader: laughs It’s fine, you’re in the Middle East; everything is diplomatic here.

For incremental innovation, lean startup is a great technique. For breakthrough innovation, it’s not always the best technique.

Bader: Surely, entrepreneurs need to realize that there actually are other methodologies out there. Like every art, there are several working ways to express and produce. The right tools for the right project as they say.

Ahmed: What is the toughest investment you’ve made? Decision making, figuring out if the idea is good or bad?

I don’t know; usually, investments are not tough on the decision-making process side, they’re tough after the fact. Like “Damn, I f*cked that up,” if I didn’t invest in something that got really big, like Uber. Or maybe I did invest in something or put too much money in it, and it didn’t work. Usually, the investment decision itself is pretty quick, and usually I’m very happy and euphoric when I do that.

BADER: I keep reading about how people are not really happy with the Uberfication of services.

Well, I know Uber is a very successful company that I didn’t invest in after the founder asked me to, so I’m kind of feeling like I made a very big mistake. I would think that Uberfication is generally a good thing, if we’re talking about “Hey, here are some big, fast-growing companies.” I think Uber is an example of a really great business idea that is pretty simple in concept. It’s taking driver and car services, providing a high level of customer service, and providing a useful mobile app for geo-location and for payment, so I think it’s a relatively lightweight use of technology for an everyday problem that makes a lot of people’s lives better. In that sense, I think it’s a great business. It definitely has a lot of scale opportunity, and it’s improving the experience for almost everyone—the passengers as well as the drivers.

Ahmed: You’ve mentioned Uber. What other companies came to you for investment? But you didn’t …

What are the big companies that I screwed up and didn’t do?? Probably a lot.

Ahmed: People actually came to you, and they exploded after a while, and you’re like, “Sh*t, I should’ve done it.”

Well, I didn’t do the Airbnb investment; that’s another one I should’ve done. Though at the time, they were selling cereal boxes. Plenty of people, including me, made the wrong decision on that one, so I don’t feel quite so bad. Another was fab.com. Although they have some challenges right now, I should’ve probably invested in that when it was first being pitched. I know the founder, and he asked me a couple of times, and I foolishly thought it was a little too expensive. Obviously, it wasn’t as expensive as it got much later.

Bader: But I think FAB is shutting down or something?

I think he’s going through some challenges with the business. I don’t know that it’s definitely shutting down; I think they’re trying to figure it out. Still, we probably would’ve benefited, maybe in the later-stage financing, in that scenario. There are a bunch of companies I’ve invested in or have not chosen to invest in, and wished I had done differently later. I think most investors probably have many stories of decisions they made in the wrong direction.

Ahmed: How about a successful startup? What is the most successful startup that you are really glad you made the decision to work with?

I think right now the ones that have been the largest outcomes for us so far—the ones that have exited—have been Makerbot and Wildfire. The ones that haven’t exited yet and are doing very well are probably Trilio and Sendgrid and CreditKarma. There are a bunch of others we hope will also have larger outcomes, but the set of companies I just mentioned are probably in the hundreds of millions to maybe half a billion or more in value, so it looks like we’ve made good choices on those. The ones where you get very large success are somewhat infrequent, probably 1%-5% of cases. In our portfolio, we’ve seen very large 50-100x outcomes. More likely than not, most things you’ll invest in will fail or won’t work at scale, and even the ones that do work won’t work that large. That’s why we’ve come up with a pretty broad portfolio strategy for the type of investment we do that really optimizes for a few large wins and, hopefully, a larger number of smaller wins that are still profitable for us.

“When you combine these three things: reduced software development, cost-increased access to customers […] and reduced friction on payments, you start to make it much easier for companies to be successful. 

Ahmed: So far, from your experience, has it been more or less 5% successful investment in return to 95%? 

I think you’d probably get positive outcomes from 20-30% of our portfolio, but I think we’ll get large positive outcomes from probably 10% or less.

Bader: What do you think the challenges will be in the future, when development is cheaper and platforms and capital are more accessible?

Well, I think we’re already in that world. I think we’re already benefiting from the fact that software development is much, much cheaper than it has ever been in the past. We’re starting to take advantage of large, scalable platforms to get access to the customer, though that’s still not perfect. Another area that could use a lot of improvement is payments and monetization. There is still quite a bit of friction, and some markets are not as easily accessible as others. When you combine these three things: reduced software development, cost-increased access to customers via very large platforms (with hundreds of millions, if not billions of users), and reduced friction on payments, you start to make it much easier for companies to be successful. As we see these three pieces of the puzzle play out in different geographies, I think the business of creating digital companies and software startups has a higher rate of success and higher rate of return. You know, the thing that’s really optimistic is that you starting to see smart phone penetration, device penetration, and online financial instruments becoming accessible in a wide variety of geographies, and I think we’ll see probably the rest of the people on the planet get access to those services over the next 5-10 years. I’m very optimistic. A lot of the dynamics we see in more developed markets, like the U.S. and Europe, and even China now, we’re starting to also see in developing markets. I think you’ll see really large groups of customers—individual consumers, small businesses, and even enterprises—become interesting opportunities to work with globally.

Ahmed: You mentioned throughout the presentation that you’re not necessarily interested in seeing business plans. That’s not very traditional. Could you tell us a little more about that?

Well, I think business plans are really more from a mathematical and probabilistic assessment. Business plans have historically been written for traditional businesses, in which that type of business execution is well understood. If I were writing a business plan for a car company or a publishing company or a laundry service, there are other car companies and publishing companies and laundry services I can look at and say, “Okay, here’s how they were executed; if I follow this plan, I might have some success.” Even in traditional businesses, I don’t think most business plans actually end up being what happens; but certainly in digital startups, where the products and services being created are somewhat unknown, having a business plan is over-engineering for future outcomes far beyond anyone’s ability to predict.

Basically, business plans are fantasies and lies created on extremely slight probabilities of some entrepreneur’s ability to see the future. At best, they are an illustration of the person’s thinking about a potential series of events that might occur, and what they might choose to do. While that might be useful to some investors, I think what I would much rather see is: are there concrete examples of you being able to create products that customers want to buy? Are the unit economics for your cost of customers—the cost of production of that product, service and delivery to a customer, and the revenue generated—is that cash flow positive over some period? Can you figure out a way to scale customer acquisition? Most of the things I’m going learn will be through you actually operating the business, and if any one of those things is failing or not working as you predicted, then you can throw that business plan out the window, because you’re not going to know how much time it’s going to take to figure out whether the product you’re building is useful to customers, whether the unit economic will get positive anytime soon, or whether you can scale that business.

The things we tend to write into business plans are included as if there’s a traditional business being executed, with a very common set of execution themes that all work predictably. That is a fallacy and a fantasy! People who believe in business plans are basically reading fiction novels; they don’t ever turn out that way. What we are really doing is understudying a series of laboratory experiments that basically de-risk the factors for business success.

Can you build a product and get it out the door? That’s hard; not everyone can do that. If I can see that you’ve built a product that is actually functional, that’s a substantial level of success that you’ve demonstrated that has nothing to do with a business plan. If I see that you can get customers to use your product and maybe pay you for it,

to me that you have ability to understand what the market needs, and produce a product.

Similarly, being able to generate revenue out of set cost, and the ability to scale that business—these are all things I’m not going to understand from you writing down something about the future. It’s going to be after you’ve actually shown me that you can do it in the lab that I can believe, “Okay you’re worth investing in.” If you have a history of being able to solve these problems, allowing me to look backwards and say, “Oh, what did you accomplish? Did you get that problem solved?” then I’m a believer in your business, and a believer in your ability to execute. If you write an interesting novel, all it’s going to prove to me is that you’re an interesting writer, not that you’re an interesting entrepreneur. This is a very longwinded answer to why I think business plans are absolutely ridiculous!

For digital businesses, where execution risk is high and customer understanding is low, your proof of building your product and getting your customer are a much better indication of where you’ll be going. What I would say is valuable is understanding unit economics and conceptualizing some ideas for marketing and customer acquisition plans, but I’m still going to want to see you execute those plans, and show me that you’ve been successful in the past in executing those plans.

Bader: I wouldn’t see Facebook having a business plan, for example.

I think about PayPal, the company I was working for, and how many times they changed their product completely! They started off with a security software product; then security software product for money transfer on PalmPilot beaming money; then they changed it for e-mail payments; then they changed it into e-mail payments on an auction platform, and then it was really credit card processing, so there were like five different product iterations before they actually found the thing that became a very big success. Even with that, they had to figure out how to build a business model and acquire customers who would generate revenues. They had fraud risk, and other people are trying to sue them, so there was a whole series of events that the company had to go through to really get to a point where there was a mature, stable product that was growing with some substantial revenue. It was certainly not captured in a business plan—or any version of a business plan that was developed. That was a really long answer.

“Business plans—I can go on and on about the whole thing, but it’s just an exercise in entrepreneurial theatre…

Ahmed: No, it was perfect; there’s a lot in it to educate people about business plans. People need to move on. Times are changing.

Business plans—I can go on and on about the whole thing, but it’s just an exercise in entrepreneurial theatre, as I believe Eric Reise used to say. “Here, I’m going to create this thing, and if I look like I know how to create it, then you’ll invest in my company. It’s not really correlated with my success in running a business, except that I know how to write an interesting play.” I’m not trying to test for whether you can write an interesting play; I’m testing for whether you can build a product that people use, and grow it.

Bader: What are some other things you really really hate?

Revenue projections. I think revenue projections are also a bunch of lies! And the fact that investors ask for them: “Oh, you know, that’s not a good enough number.” We’re all creating lies. You know what I think is real? Expense projections that I might actually believe. You may have an idea about how much money you’re going to spend, but you probably have no idea how much money you’re going to make, so I would rather do a historical look-back on revenue than a forward look on revenue. If I see that you’ve actually been growing revenue over the last 3-6 months, then maybe expenses are getting reduced on a proportional basis. Then I’d be positively fine to say, “Oh, okay, this business is trending in the right direction.” But you telling me, “Hey, the line is going to go up to the right?” Okay, maybe it does, I don’t know—that sounds like a good story to me! Where’s the proof of that? Again, if I were just testing for how well you can tell a good story, I know a lot of good storytellers, and they’re not always good business owners or business executors.

Ahmed: Another fantastic answer. Would you consider profitable startups that have low customer acquisition failures?

I wouldn’t consider them failures, from an investor standpoint. They’re maybe not as interesting, from the entrepreneurial perspective. Being able to create a modestly-sized, profitable business is great—actually providing value to yourself and to the community by executing the business profitably. I think we, as investors, take interest if is there an opportunity to scale a business. You may not even scale it profitably at first, though we’d obviously like to be able to see that. In order for us to get a return on our investment, we usually want to see businesses that scale up. Whether they make money profitably right away may not be as important as understanding whether or not it’s a big opportunity. Personally, I’d prefer to generate revenue and make a profit if possible, but sometimes there are businesses in which understanding how to optimize for revenue or profit may not be as important as understanding whether it scales, first. That varies by situation, by category, and by industry.

Ahmed: How about today’s MENA  ANGEL INVESTOR Summit, what did you find was the most interesting pitch?

You know, rather than talk about the most interesting pitch, I think what is useful to understand is: you do not have to be extremely entertaining all the time, you just have to be clear. I think for most entrepreneurs, just being clear about what the business is doing is usually a huge accomplishment. Having an interesting business after you’ve been clear in explaining what it is becomes important; and being able to prove to me, or at least get me convinced that you can build this business, is another option. A lot of times, we really try to be clear when we’re working with our entrepreneurs, in understanding the results and the level of traction they’ve achieved. Usually, this is measured in usage revenue, profit, growth, reduction in cost, an increase in margin, or some other specific metric that shows that the business is trending positively. We like to see businesses described in a way that is very objectively identifiable, showing that something positive is happening. Most businesses start out with a pitch in which they try to explain to you what they’re doing, and most of the time, we don’t care. The place I like businesses to start explaining from is, what’s the problem, and how are you solving it? Here’s the traction that shows you’re solving it in a way that’s growing in an interesting way. Usually, it’s that simple.

In fact, there’s this thing called “traction sandwich,” and what I want to hear from the entrepreneurs is very quick. “Here’s my traction, here’s the problem I’m solving, here’s the solution to that problem, and I’ll demonstrate by showing you my product or telling you a customer story about how we solved their problem.” Then go back to “and here’s my traction one more time, I’m done!” Usually, it’s that quick. The reason I want that traction up front is because it proves to me that you’ve been able to do something interesting. If you don’t have traction, then you want to tell me the problem the customer has and how you’re solving it.

There are two types of pitches: one with traction and one without. As soon as you start telling me the story and not showing me traction, you know what I’m thinking? You don’t have any traction. Because if you had traction, you would be telling me. The traction’s more interesting than the story! Which of these stories is more interesting? “Hey, I’ve got this great product that’s going to solve all your problems” or “I just made 50 thousand dollars last month?” I’m gonna say the 50 thousand dollars last month is probably more interesting. That’s evidence of customers paying you for something! If they’re paying you 50 thousand dollars a month and it’s an interesting story, that’s great; but if it’s an interesting story and they’re not paying you 50 thousand dollars a month, guess which one I really would like to hear about?

“The order of presenting information to investors in my world is usually traction first, customer problem/solution second.

If I don’t hear traction immediately out of the gate, it’s either because the entrepreneur does not understand what investors want to hear, or it’s because they don’t have traction. Both of these things are not good! Ignorance or lack of traction: neither of those are good things. Entrepreneurs get caught up in their story, and they want to tell you this big, grand vision of what they are doing. This is natural. They’re very passionate about their products and services, but from the investor’s standpoint, we want to cut to the chase, right? We don’t want this big, flowery story. We think you’re probably lying to us, anyway; you’re either lying to yourself, or lying to us or both. What we want is evidence that you are not lying to us, and the evidence is: get a product out the door, get customers using it, make money, and scale the growth. These are all objectively identifiable proof points. If I don’t believe you’re lying to me, that shows me your business is making progress, and then it’s like, “Okay, you’ve accomplished something that’s measurably interesting. What was that problem you are trying to solve? Okay—let me learn some more about that.”

The order of presenting information to investors in my world is usually traction first, customer problem/solution second. In fact, it’s problem second and solution third, whereas most entrepreneurs tell the story of the solution first, and then maybe they’ll tell me the problem. If I understand that, maybe they’ll actually have some traction when they get to it. Got it?

Bader: Diplomatic enough.

Bader: Usually, we ask the entrepreneurs we interview what advice you would give other entrepreneurs, or what advice investors would give other investors. What I want to ask you has a little twist. What advice would you give Tamkeen? I don’t know if you’ve heard of them.

This is the labor fund?

Bader: It’s a semi-private organization that help fund startups with a very low-entry barrier to funding and support.

If I understand correctly what they’re doing, they’re providing grants to entrepreneurs. $100k-200k?

Ahmed: Well, in total, yes. But that’s not in cash. What they basically do is subsidize the procurement of essential services, like marketing and machinery for example.

I think their efforts are in the right direction, but what I would probably want to see is that capital is being provided where private market investors are already validating it as an interesting business. I want to see that capital gets provided, either to entrepreneurs or investors, when there is an investor who’s already chosen to put money into the business. What I worry about is government or regulators trying to pick winners when they may not have any subject matter expertise in the area. It’s not always bad; I’m just saying I would rather see the people who are putting the money into these projects as investments be the filter for which deals get the capital.

Ahmed: The thing is, grants are offered to all, so there’s no selection criteria. It’s not like ten people go there, and three of them get it. It’s the entire industry, so anyone with a business.

You’re distorting the market by lowering the cost of goods for everyone, which doesn’t reward the winners. Actually, you’re inappropriately rewarding losers as well as winners, by reducing the cost of the goods and services they consume. This doesn’t help you advance. There is actually a benefit to things costing money, which is that the products that get built are the ones where people can make a profit aside from the cost of running that business. If you start reducing the cost for everyone, then you’ll basically be rewarding companies that are producing ineffective products or services by lowering their cost of operation. That’s maybe a little bit of a different perspective on it, but if I’m trying to figure out which entrepreneur is going be successful, it shouldn’t be the case that there are some pains and costs that they should cover. If I make it too easy for entrepreneurs to survive, to the point where they’re not building well enough and reducing all of their costs, then I’m going be distorting the market by pushing companies that aren’t actually providing useful products or profitable services, and letting them survive longer than they should. Again, it’s a little bit of a touchy issue. You want to help people to get businesses off the ground, but you don’t want to unnecessarily provide capital to things that don’t actually contribute back to job creation or economic return for society. Have some sort of filter for where you provide that capital. In some way, there should be a market assessment of businesses that are providing the most value, and getting access to that.

“You’re distorting the market by lowering the cost of goods for everyone, which doesn’t reward the winners.

Ahmed: I think that’s what they’re trying to do, because they’ve been doing that flat-blanket approach for a few years, and they’ve discovered a lot of flaws and issues with the system. I think they’re reworking it right now, and that’s why we think your answer comes at the right time for them, as well.

Ahmed: Well, that’s all we have. Thank you Dave for the opportunity to talk to you. It was, as expected, fantastic, informative, and very insightful. It was a pleasure and an honor. Enjoy your stay in Bahrain.

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