Q&A with First Round Capital’s Josh Kopelman

First Round Capital, a four-year old venture firm based in suburban Philadelphia, is so far among the most active Internet investors of 2008. It has backed 17 new startups, and is tied only with Draper Fisher Jurvetson, a much larger fund.
As 2008 winds to a close, and the National Bureau of Economic Research officially declares a recession, I thought it made sense to check in Josh Kopelman, who founded First Round and whose past accomplishments include cofounding the companies Infonautics Corp., which went public in 1996, and Half.com, which sold to eBay in 2000. I wondered where he thought Internet investing might head from here, and how he plans to approach 2009.

The economy is in a tailspin. Where does it make sense to invest online right now?

The deals we think are the most attractive now are capital efficient and somewhat counter cyclical. Mint Software [whose personal finance management technology First Round first backed in 2006] is a perfect example of a counter-recessionary business, one to which people are turning as they focus on their portfolios and saving money.

We’re also looking at things that are transformative in terms of where revenue is generated, and that shrink the market. In 1992, for example, the number one educational reference tools were costly encyclopedias, which constituted a $1.6 billion market. By 1998, though, encyclopedias were barely a $700 million business because Microsoft’s [online encyclopedia] Encarta was being given away with every PC.

Another example of a company shrinking the market is Jingle Networks, whose 1-800-FREE411 directory service business is shrinking what is now an $8 billion industry.  Consider that a full 6 billion calls get made to 411 every year, at an average price of $1.25, and 80 percent of the time, the call is made for a business’s name. Why should pay consumers pay for that information over the phone when online, hotels and locksmiths are paying $1 to reach customers? Jingle is shifting the model and freeing up tens of millions of dollars in the process. 

That is great, but how often do you come across businesses that are remaking existing industries into more efficient ones? It seems like a tall order in 2008.

It is hard. We see about 2,300 deals a year, and if we see two shrink-up-market deals, we’re very happy.

What else do you find attractive right now?

Another question we’ve asked ourselves is whether we think there’s too much advertising inventory in the ecosystem or not enough. If you think not enough, then you fund content companies. If you think too much, then you fund companies that are trying to improve the quality of existing inventory. We think there’s an oversupply, so we’d much rather focus on ways to take that glut of inventory and make it better than to find ways to create another billion page views for a site. [Representative investments this year include New York-based 33Across, whose technology attempts to identify influential online users, and Invite Media in Philadelphia, which analyzes advertising within social networks.]

Have you made a concerted effort to move away from the consumer Internet, generally speaking? I noticed a number of Internet companies in your recent portfolio are more enterprise focused.

Historically, about 40 percent of our investments are enterprise, and looking at this past year, we’re 60 percent, so I guess the answer is yes. [Laughs.] We’re not abandoning [the] consumer [space]. One of the companies I’m most excited about is [online education market startup] Knewton, which we backed with Accel. We think there’s a real opportunity to transform the test prep market by moving it out of strip malls and giving students a better level of service and a more personalized experience online, and at far less cost.

Will you slow down the pace of your investments, given the uncertainty of the economy right now?

We haven’t slowed down yet. We raised our [$125 million] fund in Q1, so we’re sitting on a large amount of dry power. We’ve invested less than 5 percent of the fund so far.

How is the recession impacting your work then?

We used to be able to count on what I’ll call just-in-time follow on financing, meaning that we could give a company six to nine months of financing, specify what milestones we wanted to reach, then after rolling up our sleeves, they’d go on and raise the next round. Historically, that worked very well or us. In fact, for every million dollars we’ve given a company, more than $30 million has followed.

But right now, we don’t think it’s prudent to count on just-in-time follow on funding. We’re not changing the size of our investment as a result but the size of the round. So before we might have funded $700,000, and the startup raised another $300,000; now we’ll say, let’s put in $700,000 in a $2 million round.

I think [angel investor] Mike Maples used to joke that $500,000 was the new $5 million. Well, 18 months is the new nine months. Companies need more time to validate their hypotheses and validate traction.

Are you any more focused on revenue than traction than in the past?

We’ve always focused on capital efficiency. In 2008 investment, our average burn rate before the crisis hit, at 14 ot 15 of our companies, was under $100,000 a month. So to some degree, I feel like we’re in a pretty safe place. We’re not putting first rounds into companies that are going to build a $200,000 or $400,000 a month burn. That said, we used to be able to fund a company and we knew what the bar was that they had to clear. Now, you have to have ABC plus.

Does the “plus” mean revenue?

It really means validation of business model. I wouldn’t put a dollar amount on it. Companies don’t need to make $500,000 a month to get funded, but they have to demonstrate how they are going to make money and to prove that they already are [making money].

How has who you’re competing against changed, now that the economy has turned?

[Venture capitalist] Fred Wilson wrote, and I agree, that in boom times, a lot of the  later stage funds move into earlier stage investing, and in bust times, they increase their reserves and go later stage. Also, angel investors are drying up. Most of them are worth 50 percent less than at the beginning of this year and they don’t have liquidity. Both create opportunities for us.

Has your deal flow changed at all as a result?

No, we’ve now worked on 70 deals, and our entrepreneurs have networks and even people who’ve pitched us and we haven’t funded refer deals our way. We still get referrals from traditional venture funds, too. We’re explicitly designed as a seed stage fund, so follow-on rounds are built into the process; we’re not taking deals away from them. In fact, the number one reason VCs give to entrepreneurs when turning down a deal is that the entrepreneurs are too early. The follow-up question entrepreneurs ask the VCs is: if we’re too early for you, who should we be talking to?

What about how much you’ll invest in a company? Has that changed, or will it?

I don’t think so. We have yet to invest more than a million dollars in an initial round, or to reserve $2 million to $3 million more [for the life of the company].

I also think we’ll write as many checks — 15 to 20 — next year as this one. Early-stage entrepreneurs will have fewer sources of seed-stage capital. That’s a great opportunity for us.