Jason Mendelson On Venture Capital
Jason Mendelson, co-founder of the venture capital firm Foundry Group, recently co-authored “Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist”(John Wiley, 2011) with his partner Brad Feld. Mendelson is intimately familiar with the music and tech industries. Before joining Foundry in 2006, he was both a merger and acquisitions lawyer and a software engineer. Mendelson, a former professional drummer, confounds any stereotypes and offers a unique perspective on music enterprises and the entrepreneur-investor relation.
MBJ: Can you explain what the Foundry’s Group role is in the industry?
JM: Foundry Group, of which I’m one of the cofounders, is a venture firm based in Boulder Colorado. We have two funds – each have $225 million – and we’ll be raising our third fund some time in the near future. We invest in software and IT companies all over the United States. About a third of our companies are in California, a third are in Colorado, and a third are everywhere else, including New York, Seattle, Boston, Portland, and Austin. We’re four guys who are equal partners. We started the fund in 2006. We’re known for investing in Zynga (Angry Birds). Admeld is another one of our successes. Most venture firms will say, “We invest in SaaS (Software as a Service), or we invest in storage, or whatever.” Instead, we diversify our investments horizontally using a thematic approach with a horizon of ten to twenty years.
We work as a team and don’t look at music companies as being just about the music. The two that we’ve invested in – Topspin and Next Big Sound – utilize a technology infrastructure that people don’t necessarily know about, but affect how things work. Topspin is a direct-to-fan marketing and merchandise-selling platform for bands, and Next Big Sound is a service that mines the Internet for all sorts of music data that enables artists and managers to make informed business decisions. What these companies do doesn’t necessarily have to apply to music. The tools that they’ve created can be used in other industries, and we’ve found that particularly interesting
MBJ: You recently returned from SXSW. Did you see anything there that interested you?
JM: I started going to that festival about five years ago after we had made the Topspin investment. At the time, all of the music companies were targeted toward the consumer, i.e., find your favorite band, make a fan page, and have an app that you can take to concerts and upload photos. They were all about the fan, and I’ve always been weary of targeting fans. As everybody knows, the music business has changed dramatically. It’s gone from selling music to selling other things and using music a vehicle for those sales. Bands are going straight to fans with no intermediation. ‘Fans’ are sort of a fragmented market. We decided to invest in companies that target the bands and the record labels as clients. Many of the new companies at SXSW are now targeting the business of music itself – the makers and not the end user.
MBJ: Why the B2B focus now?
JM: People are realizing that going after consumers is risky. Many startups have this consumer-targeted mentality, but are now out of business. They brought fire to the natives, and the natives were like “What do we do with the fire?” The music industry is, in a way, late to the game. It’s not that much different than the story of Billy Beane and baseball—the bigger attention paid to stats and metrics led to a lot of resistance from the sport’s old guard. The mindset “we’re baseball guys and we just know how it should be done” is the same as the old refrain “we’re music guys.” After the industry declined, this changed and a B2B focus is now helping.
MBJ: Are you perhaps seeing a new breed of music entrepreneurs who are succeeding with the help of venture capital?
JM: I think that the early digital music entrepreneurs, from 1999 to 2003, were fans of music who were passionate about it, but didn’t understand the business of music. They were able to raise venture money because everybody did back then. But coming out of the dotcom bust, music was mud. If you were running a music startup, all of the venture capitalists turned you away because they didn’t believe that digital music would make money. My partner, Ryan McIntyre, and I have always been interested in music. By 2003, we noticed that Napster and Pro Tools were changing the business forever. For instance, making a record, which used to cost up to millions of dollars, could now be done at home. We talked to entrepreneurs like Ian Rogers of Topspin and Alex White of Next Big Sound, and wanted them in our camp. Now, there are a lot more entrepreneurs like them. Today, the successful entrepreneur typically has a business background and is a super-fan of music, not a former musician who started a business.
MBJ: You have tried to educate the public about venture capital deals. Why did you do this?
JM: A traditional venture capitalists was an old American white guy. An entrepreneur would bow and beg to get money from him. If it were tendered, the venture capitalist would show up once a month at a board meeting and tell the entrepreneur what to do (even though that was the only exchange in a month). At the end of the day, he was mostly interested in walking away with his cut. There was no level playing field or information sharing. Neither was the Internet there. Whatever deals a venture capitalist offered were dependent on who the entrepreneur knew or not; there was no uniformity at all. In my opinion, it was kind of a dirty business.
When the Internet came about, it attracted more entrepreneurs. Some of them eventually sold their businesses at a profit and became venture capitalists. Before the Internet, there were maybe three hundred venture firms. Later, there would be as many as fifteen hundred we’re talking about massive growth. As a result, there were a lot more investors coming into the venture capital market who were inexperienced and greedy. Both the returns of the venture industry and its reputation hit a rock bottom.
MBJ: So, how did you go about it?
JM: Sometime in early 2004, my partner Brad Feld came to me with an idea. He said we should start a blog that uncovered many of the trading secrets of venture capitalists. Brad felt we would be performing a service and doing the right thing. I was hesitant at first, and he told me to sleep on it. The next day I had made up my mind: the subversion was brilliant. Why not? We started writing about term sheets, i.e. the final contract between a VC and an entrepreneur. We exposed the motivations of venture capitalists and contrasted them to the motivations of entrepreneurs. We showed what a good deal might look like for an entrepreneur. Instantly, we had a big audience. I remember we would get calls from professors at Harvard, Yale, and Stanford thanking us for finally providing them with teaching materials on venture capital. Entrepreneurs would thank us too. And, of course, we got angry emails from other fellow VC’s!
With the benefit of time, what we did appeared to make a lot of sense. The startup ecosystem is really the only true bright spot that we have in the economy right now and the US job economy needs it badly. Getting the right information out for business innovators and explaining how the funding process should work better for all the parties, both investors and business founders, is now a priority.
MBJ: What’s the size of the venture market now?
JM: We’re almost getting back to where we were in the late nineties. I would say there are about five hundred dedicated venture firms now. Music is really a small part of the venture market. But I’d have no problem doing a dozen music deals provided that their business fits into one of our chose investment themes. [Authors’ Note: Currently, venture deals are worth about twenty billion dollars a year, of which likely less than three percent is for music enterprises; a typical first round of music financing is in the single digit millions.]
I’ve noticed that more VC firms have been started in Japan and, especially, in emerging markets like China, India, and Brazil. Europe doesn’t seem to have as many. It is not such a friendly environment for startups, because their stricter employment laws, which prevent quick hiring and firing, run against investors’ interest in getting the best people aboard.
MBJ: Tell us about some of the changes you see in the financing of music.
JM: There is a shift from corporate to venture funding, which some entrepreneurs might find liberating. Today, regardless of whether you do-it-yourself or seek some kind of investment, the significant factor is that the cost of creating new business and new technology has dropped a hundred fold. I remember when I started in the venture capital business in the late nineties. It cost maybe five million to launch a website. Now you can do it for thirty dollars! There are companies today that have done extremely well on just half a million, but back in the nineties it would have taken thirty times that. Since a lot less money is needed now to get a business off the ground, the entrepreneur is able to retain much more control and still be successful. Apple was able to make a killing with iTunes and still give away seventy percent to the labels, artists, and publishers.
MBJ: What about musicians?
JM: On the musician’s side it’s changing, too. In the old days, you got a record contract, you got an advance, you had to pay back that advance, and you may or may not have seen any money depending on how much your record sold and how your deal was structured. Digital tools, and Pro Tools, allowed bands to handle more of their own business. They have had some success.
There’s a new model that has emerged within the last twelve months. It’s the idea of a ven- ture fund focused solely on bands. The concept is similar to a 360-deal. There are at least two venture funds that I’m aware of that offer seed money to bands. Investors pay for recording, marketing, and other costs and get a certain percentage of all revenues for a set amount of time. When they bow out, the band gets to keep everything they make afterwards. These venture funds have been started by old A&R guys who go out and scout their own talent.
I don’t know how this model will work out, but I find it fascinating. There’s been a lot of study on what makes a successful venture firm, and this new music-space could turn up some interesting research. For instance, one school of thought suggests venture investments in a few reliable businesses; another argues for smaller investments in a whole slew of companies in the hope that a few will make it. There is an optimal portfolio of companies for the right sized venture fund.
MBJ: How does a Fund look at licensing issues in music?
JM: When you deal with music companies, there are businesses that don’t need licenses, businesses that do need licenses and have them, and businesses that need licenses but are operating illegally. I’ve seen all three types get venture funding. As a venture capitalist, I love businesses that don’t need licenses, because you’re not beholden to anybody taxing your business.
When we started looking into music investments, we had businesses come up to us whose main selling point was the fact that they had agreements with all four major labels. Given the way technology was going, I never thought that a licensing deal was a longterm asset. It’s hard for me to get my head around license-based models like Spotify and Pandora. Pandora has not done that well since going public. Licensing terms are pretty draconian right now, but I think they’ll come down over time. I’m not opposed to investing in a license-based model, but it would definitely require some extra consideration.
I won’t touch a business that should have licenses, but doesn’t. I think it is theft. Unfortunately there are firms who have funded such businesses, and we all know who those businesses are because they keep getting sued. I was a lawyer for a company that invested in Napster early on and I advised them against it. There’s this sentiment amongst a lot of people in the tech industry that they don’t need to pay attention to intellectual property laws. Personally, as a former musician and lawyer, I think it’s stealing.
MBJ: Young entrepreneurs wish to protect their original business idea. What is your take on non-disclosure agreements?
JM: If you ask me for a non-disclosure agreement, you show you really know little about my business and it is a disincentive for me to invest in you. I get a thousand business plans a year, and maybe thirty of them will look just like yours. If I sign a non-disclosure agreement for you, I would be setting myself up to get sued after I invest in a similar business (you could assume I entered into that business after stealing your idea).
Our reputation is important and we don’t trade information.
MBJ: How should music entrepreneurs think about approaching investors like you?
JM: Most entrepreneurs think a lot about business strategy, which is good. Ironically, they spend little time thinking about fundraising. They’ll send bulk email pitches, or they’ll go to events hoping to meet their knight in shining armor. What they don’t realize is that targeting the right money guys for their company would probably help them more. Do some research. Maybe it would be a good idea to look into who has invested in similar companies. We’re all online. As a venture capitalist, I don’t want to see something that everybody else has seen. This is because everybody has taken a look and passed on it either because it’s a lemon, or they’ve all seen it, liked it, and now there’s a term sheet war and an unrealistic valuation. I don’t want to be a part of that. In order for me to have a successful business, I need to be able to find proprietary deals and cultivate relationships that are close to me and captivate me.
If you’re an entrepreneur, send letters to a few venture capitalists who you’re really excited about and want to know. Craft materials specifically for them. I answer every email that says, “Dear Jason, I’m a former drummer and I’ve started this company.” A guy sent me a picture of his DW drum set the other day after he saw a picture of mine that I posted on twitter. How am I not going to send this guy a reply?
Jason Mendelson, VC
by Peter Alhadeff & Aaron Gottlieb