The IPO window is essentially closed, and the venture industry is contracting. This is, we believe, the best environment for building durable companies. The single most consequential technology event of this year was not any IPO but a digital music store launched in April by a computer company — quietly resolving an argument about content business models that the industry had been having for five years.
On the IPO Window That Will Not Open
Eighty-four IPOs priced in the United States this year. The peak year, four years ago, produced four hundred and fifty-seven. Capital that would once have flowed automatically to public-market exits is now being deployed elsewhere or held in reserve. We belong to the second group. There is more cash on our balance sheet at year-end than at any point since 1998.
The reduction in IPO activity has been read by the financial press as a problem the industry needs to solve. We do not read it that way. The previous cycle's IPO volumes were, in our view, an artifact of capital flows rather than of business maturation. A market that produces four hundred IPOs in a single year is a market that has lowered its admission standards. The current market has raised them. We expect, when the window does reopen, that the cohort of companies passing through it will be qualitatively stronger than the cohort that passed through it three years ago.
Several of our peer firms are, this year, returning capital to LPs because they cannot deploy it productively. We do not have LPs to return capital to. The capital we are not deploying remains on our balance sheet, growing slowly through Treasury yield, waiting for the conditions that justify deployment. We have rarely been more comfortable with our structure.
On the Music Store That Quietly Solves a Five-Year Argument
The April launch of a digital music store, priced at ninety-nine cents per track and integrated with a popular music player, did something the industry had failed to do for half a decade — make legal digital distribution easier than the illegal alternative. The economics matter less than the lesson, which is that consumers do not migrate to "the right" model on principle. They migrate when the right model becomes the path of least resistance.
This is, we believe, one of the most important consumer-software lessons of the decade. For five years, the music industry, the technology industry, and a long list of well-funded startups had been trying to solve the digital-distribution problem with rights-management schemes that respected industry economics. Each failed because the user experience was worse than the freely available alternative. The April launch succeeded by reversing the priority — the experience came first, the economics followed.
We have been adjusting our framework for evaluating consumer companies accordingly. Friction is the variable. We are now asking, of every consumer-facing product we evaluate, whether the founders have prioritized the easiest version of the experience even when doing so is operationally inconvenient. The companies that will compound, we believe, are the ones that have. We have declined two investments this quarter on this basis alone.
On the Founders Who Have Stopped Pitching
The companies we have backed in the past year share a property we did not initially recognize as significant: their founders did not pitch us. They described their businesses as if we were thinking about acquiring them rather than investing in them. The conversations were factual, slightly impatient, and indifferent to whether we participated. We have come to believe that this disposition — a quiet seriousness that does not require enthusiasm to function — is one of the most reliable signals we have ever encountered.
The disposition is rare in our experience because it is, in normal market conditions, structurally disadvantaged. A founder who refuses to pitch is a founder who will not raise capital from the median venture firm; the median firm needs the pitch in order to underwrite. In a contracting market, the supply of capital and the supply of founders shift in our favor — the founders who would not pitch us in 1999 are now willing to take a meeting in which we ask the questions and they describe the answers. We are taking those meetings.
On Three Companies We Wrote First Checks For This Year
Without naming them, we will say this: each of the three was funded in conditions that, in 1999, would have been impossible. The valuations were rational, the founders were patient, and the market we were entering was, in two of the three cases, contracting rather than expanding. We have rarely been more confident in commitments that, by the standards of the previous cycle, would have been considered conservative to the point of error.
The first is operating in a sector that lost approximately seventy percent of its public-market value over the past three years. The recovery thesis is not that the sector will return to its 2000 peak; the thesis is that the durable demand within the sector is half of what the peak implied, and that the supply of competitors has fallen by ninety percent, leaving the survivors with structurally better margins than the cycle peak ever delivered. We expect the company to be unrecognizable in size by 2008.
The other two we will discuss in future letters. We will say only that we have, this year, written checks the size of which our 1999 selves would have considered timid. The 1999 self, we are increasingly confident, was wrong about what made a check meaningful.
A Closing Note
This year is the kind we were founded to invest through. We will not be sad when it ends, but we will also not pretend that what comes next will produce decisions of the same quality. The good vintages, in our work, are the ones that arrive when no one wants them. We have rarely felt more wanted by founders, and rarely felt less wanted by capital. Both feelings, we believe, are signals we are doing this correctly.
The Partners
Winzheng Family Investment Fund · December 2003