This story originally appeared in Maclean’s.
Albert Wenger is a partner at New York-based technology venture capital firm Union Square Ventures, an early investor in Silicon Valley success stories that include Twitter, set for an anticipated $1-billion IPO, and Tumblr, which Yahoo bought for $1.1 billion in June. It’s also invested north of the border, in Toronto-based online storytelling site Wattpad and Waterloo smartphone messaging service Kik. Wenger stopped in at the new startup accelerator OneEleven (which shares a downtown Toronto office with Google) on Oct. 23 for a public discussion on the state of the Canadian tech sector, how the internet is changing the face of education and health care and why the death of privacy is a good thing.
His conversation with William Mougayar, founder of Startup Management, has been edited and condensed.
Lets talk about the Union Square Venture thesis. It’s known for pinning down the large networks of engaged users very, very early on.
When we look at the internet we see a technology that has some very interesting characteristics. It’s global. It’s instantaneous. It’s free. It’s connected. It’s ubiquitous. Those five characteristics of the internet are different from any other technology that’s come before us. We spend a lot of our time thinking: What does this make possible that wasn’t previously possible? We’re very much trying to find things where you’re not using the internet or mobile to do something 10% cheaper or 20% faster, but where you’re using it to do something that really could not have been done before. If you think of something like Wikipedia and then you try to imagine how Wikipedia would have done with a fax machine, you pretty quickly realize it simply couldn’t have been possible.
One of the things that this constellation then makes possible is the formation of many, many new networks. We’re particularly interested in finding businesses that have a “network effect.” If you think of historical businesses, manufacturing businesses, if you grow your volume, your unit costs decline. That’s traditional scale effect. On the other hand, network effects mean as your service grows, the value of your service to each participant increases. Where we found a lot of network effects early on was in these networks of highly engaged consumers. We’ve later begun to understand that these network effects exist in other businesses as well.
A business where it may not be obvious that there’s a network effect is a search engine. It would seem you use a search engine by yourself and there’s no network effect. But it turns out every user who uses a search engine makes the search engine slightly smarter, because the user will have given the search engine a query, the search engine will have returned a result set and the user is then making a choice which result to pick. That’s why it’s been very hard for anybody to catch the dominant search engine. So we look for the network effects, not just through the obvious network effect of one person following another person on Twitter, but also through the more subtle network effects that exist at the data layer.
When we’ve approached investing we’ve never said: “Ok we have to do investments in finance.” We discovered that there were certain types of business in finance that seemed to have strong network effects. So [peer-to-peer] lending has network effects, which is that the lenders want to be where the borrowers are and the borrowers want to be where the lenders are. That’s a type of network effect. The more lenders there are, that creates value for every borrower. Additional borrowers create value for every lender. So that has led us into those areas, as opposed to us saying hey that’s an area we should invest in.
Incidentally, we think about geography much the same way. So we don’t roll out of bed and say: Oh we should invest in Toronto. What happens is we find a really interesting company in Toronto or in Waterloo and then we go invest in that. We are usually of the opinion if the company is happy where it is we should fund the company where it is instead of telling the company that it should be somewhere else.
How do you see the challenge with consumer companies where the product that the users use is not the same product that makes the money? Like Twitter and Google: It’s the advertising product that makes the money.
The idea that’s central to some of our thinking about revenue is the idea of a “native revenue” model. It’s best illustrated by comparing what happened in keyword advertising. Google did not invent keyword advertising. A company that came out of Idealab in L.A. called GoTo invented keyword advertising. It was later acquired by Yahoo. Their idea was simple: People are searching for things and so we’re going to let people bid on keywords. It seemed like a very good idea, except that they let anybody bid on any keyword. So the ads that showed up were the ads by the highest bidder, which were often completely irrelevant to the thing that the person was looking for. The great innovation that Google had was that they realized you needed such a thing as a “quality score” and that the quality score should determine how much somebody has to bid in order to place the ad. If the quality score is sufficiently bad you don’t show the ad at all, no matter how much money is being offered. That turned keyword advertising into a native revenue model. Native in two senses: It can only exist inside [a] search [engine]. And if it works, it ideally makes the experience better, but certainly not worse.
Almost any business on the internet, we believe, can have a native revenue model. The sponsored Tweets I see in my timeline right now tend to be from sponsors that I actually care about. That’s adding value. We want to give companies as much time as possible to go find the native revenue model. And that may require many different experiments. The thing about experimenting is that you want to start it early and repeat it often because you don’t know what the right experiment is. But I think there are certain lessons that have been learned now that are repeatable. So the idea that if your content unit is a Tweet, your advertising unit should probably be a Tweet. That is now something that is better understood. If your content unit is a Tumblr post your advertising unit should be a Tumblr post.
Where things sometimes go wrong is that entrepreneurs can underestimate how long it can take, not only to figure out the revenue model, but then tweak it and then build the sales infrastructure and the back-end infrastructure. It’s the hidden part of the product to make it all actually work.
This brings me to the topic of Tumblr [and its sale to Yahoo.] Could it be said that they took it as far as they could inside and had to sell because they were not able to monetize on their own? It is a reality that not all entrepreneurs can take their company as high as they can without help from the outside, or without needing to be acquired?
When you look at a company such as Tumblr and its trajectory, David [founder David Karp] built something absolutely amazing from day one. As far back as when we invested it was already at a miniscule scale, but it was growing very, very rapidly. When you have something like that you’re still faced with a challenge of building an actual company that can deliver all that. In Tumblr’s case that required a couple of different things that needed to be built. One is a massive infrastructure; Tumblr’s traffic is very image and media-rich and its dashboard is actually quite complicated. Then there’s the ad side of the business that needed to be built. I would say Tumblr is an example where the building of the ad side started late and was ramping very, very nicely, but it was still a ways to go before you had a profitable company. In that situation, I think it’s a legitimate choice for an entrepreneur that if somebody comes along and makes a very compelling offer, to say: I sort of know we’re on the right trajectory, but there’s also still a lot of risk involved. And I think David and Marissa [Yahoo CEO Marissa Mayer] developed a very strong rapport and it seemed like a perfect fit from both sides. Otherwise the company would have had to raise more money, absolutely.
Let’s talk about Canada. We’re talking about $500 million invested in soft tech. It’s a lot more than last year. But in New York last month there was $200 million. But about half of the [Canadian] deals had some U.S. venture capital in them. Is that good or bad for Canada?
Our observation is there are a lot of interesting companies being built here. What we believe is that the money follows the interesting companies. People say Union Square Ventures, you helped build the New York ecosystem. But that’s misreading cause and effect. We’ve been successful investing in the New York ecosystem because it’s there and eventually that ecosystem begets itself. When you have an exit like Tumblr there’s a whole bunch of people who make money, which they will then invest in other startups at the early stage, long before we invest usually. It feels to me like instead of looking at necessarily the current gap, it’s more important to look at the trajectory and the trajectory [in Canada] feels like it’s very good.
There’s more! To read the full version of this story, including Wenger’s views on the state of consumer privacy, visit Macleans.ca.
