Top of Mind: Jay Hoag of TCV

Last November, wireless equipment maker InPhonic went public, giving one of its biggest investors, Technology Crossover Ventures, a $152.6 million return on the $56 million investment it had made in the company just 18 months earlier-a 2.7X return.

It is a familiar scenario for late-stage investor TCV, which has enjoyed enough big hits in its 10-year history-Netflix, Expedia, and RealNetworks among them-that its mere involvement in a company opens doors and improves its odds of winning.

“We spend a lot of time and money beating the bushes for uncovered gems,” says Jay Hoag, who co-founded TCV in 1996. “There are investments we make where we don’t have competition at the time. Other times, we’re able to convince a company that they should do business with us rather than someone else thanks to [past deals], like Expedia.”

In certain situations, he shrugs, “success begets success.”

Hoag talked with VCJ about the growing popularity of late-stage investing, the apparent slowdown in the IPO market and what TCV considers and optimal investment.

Just 10 VC-backed IPOs started trading in the first quarter, compared with 12 in the first quarter of last year. What’s your sense of the market right now?

Well, Nasdaq was off 9% in the first quarter and bankers are sensitive to that. Also, the liability of being a public company has created less of a sense of urgency to go to market. That’s saying nothing of the $2 million to sometimes $4 million that companies have to spend to get through all Sarbanes-Oxley requirements. It’s a lot of money to spend on administrative costs when it could go to R&D.

So what’s a late-stage investor in a not-so-robust IPO market to do?

Actually, the market is giving us the opportunity to fund companies. The size and stage of the companies that we’re investing in is substantial. We’re able to back companies that are saying, There are a bunch of things that I want to do before going public,’ and that are turning to private financing in the meantime.

Does that mean that competition for you is heating up?

There’s a set of folks that we fairly consistently see, like Summit and TA Associates and General Atlantic. Occasionally, we’ll see an earlier stage investor, like Sequoia [which co-invested with TCV in dating site eHarmony]. Benchmark and Highland have done some late-stage things. How that fits their model, you’d have to ask them, though overall, I’m surprised that there haven’t been more players focused on late-stage.

Why is that?

Post-bubble and post-bust, I think a lot of firms have asked what are their core strengths, where do they make money, and so a lot of early stage folks who may have invested in later stage said, our bread and butter is early stage, let’s do that. On the other hand, the buyout world seems to be getting ever bigger in terms of assets. I’ll tell you, too, it’s a lot harder than it looks.

It looks pretty lucrative to me.

But there’s risk in over-generalizing any part of the food chain. Buyout firms do benefit from IPOs, but if a bank’s money gets more expensive, they’ll be losing money. And while you might have a lot of firms targeting the same market opportunity in early stage, there are some people who do a phenomenal job in the early stage arena. Technology is very unforgiving. Most companies aren’t great investments. A small number of successful companies endure and wind up being incredible investments. Regarding early stage vs. buyouts, though, everybody doesn’t win or lose.

Things have changed, though, haven’t they? Some of the rounds we’ve seen recently, and that TCV has participated in, have been utterly enormous. That $110 million round with Sequoia in eHarmony last fall was pretty stunning. Then in February, you made two more huge investments: $108 million alongside Mayfield and Accel in Webroot Software, and $250 million alongside Summit Partners for LiquidNet Holdings. Why is that much money necessary?

Our view is that we’re going to be the largest outside investor, and within limits, we think more is better.

So much of those rounds is about paying off the founders, though, right? Aren’t you concerned that they’ll have less incentive to run their companies well once they’ve been rewarded for their efforts?

In some cases, there has been a secondary component, yes. [The founder of] InPhonic, for example, asked for partial liquidity for the management team. There’s no simple answer regarding how much is too much for founders, though. If your view is that the money will discourage them from living, eating, and breathing the company’s success, it’s a bad thing. If you’re providing some liquidity to the team to actually allow them to sleep at night and perhaps occasionally take more risks regarding how they manage the business, that’s a good thing. If there’s a secondary component, we sit down and go through the specifics. We want to know how much per person and gauge whether it’s likely to change the company.

What makes a deal a bad deal for TCV?

When we lose our investment.

Did you look at the Fastclick deal?

We did take a look at it and we passed. We didn’t like the valuation on the private financing.

What kind of ROI does TCV consider optimal? What’s the best ROI you’ve ever gotten?

A We target 3X to 5X our return within three to five years. Generally, we’re shooting for at least a 40% IRR. The highest multiple of cost we’ve received so far is our 56X return in our investment in Ariba. [TCV was among nine firms that invested $16 million in Ariba in its second and final round of VC-backing. Its shares skyrocketed following its IPO 18 months later.]

What’s the longest amount of time that TCV has ever held onto a stock before making a distribution-and what was the result?

We’ve held many investments for a long time after their IPOs. It’s part of our model. A few examples: We sold Lynk Systems last year after being an investor for eight years. We’ve distributed some Netflix but own most of our stake after seven years. And for one of our first deals, Memberworks, we didn’t distribute any shares for approximately six years.

How well do you know the people that you back? Are you ever tempted, just a little bit, to piggy-back off the research of the early stage investors who have vetted a management team?

We never piggy-back. One of the benefits of late-stage investing is that we can talk to customers and former customers. Through our network, we can triangulate on other non-customers. We can usually talk with a number of competitors. We’ll usually send in someone to do accounting and financial and sometimes technical due diligence. We may also run background checks on executives.

What about relying on your gut?

I think gut-level instinct about someone often make the difference between successful and unsuccessful investments, especially in assessing if the CEO himself or herself has terrible people instincts. In late-stage, you’re really betting on the CEO, and I find the best interactions are with CEOs who are forthright about the positives and the negatives going on in their business. It makes for a much better relationship.

Sometimes TCV invests alone. Why?

Actually, we typically invest between $15 million and $40 million in a company, not enough to take control but enough to make us a very large minority shareholder, especially if we’re the only team investing at that point in time, meaning our transaction size grows. As for when we go it alone, I’ve always believed that you have to have courage and conviction, and if we totally like something we’re totally comfortable being the only outside investor.

Sounds like you prefer it that way. When do you bring in someone else?

If the transaction is beyond our means, we might turn to a small player who we’d like to bring in. North of $100 million is too much [for us to invest in one company].

How do you decide when to back a company? What’s your criteria?

The rounds are all very much case specific, though we’re never going to invest a large sum of money in an expansion-stage company. The typical company over the last 15 months that’s attracted our attention is an outfit that’s approaching a $15 million run rate and is quite profitable. To a significant extent, today’s late-stage firm’s risk-reward ratio is very attractive. You’re investing in a company that has built substantial value, in terms of profitability, their customer base, and so forth, which gives you a lot of downside protections.

What sectors do you like?

We’ve obviously been looking across the e-commerce landscape for a long period of time. We also have a number of investments in financial services technology right now [including alternative trading system LiquidNet and Thinkorswim, an options brokerage firm]. But unlike early stage guys who might be investing in a trend that won’t hit the radar for a few years, we invest less thematically.

Where do you get most of your deal flow?

From everywhere. We have eight partners and one executive-in-residence who is someone who might take board seats on TCV’s behalf or might ultimately join a portfolio company. We also have one principal, two vice presidents, and 10 associates who round out the investment team. All of us go to trade shows and industry conferences. We scour the Web. That’s how we do outbound deal sourcing. We also have the typical inbound sources: our friends, former executives, lawyers, accountants, you name it. It could be someone at Starbucks.

I think a lot of people imagine late-stage investors in their offices, with their heels kicked up and the movie Wall Street playing on a flat-screen in the background. Does that bother you?

I don’t think that’s true of entrepreneurs because we all interact with our CEOs and teams a lot-every day in some cases. And I know they find the interaction to be of value. Early stage venture guys will let you think that [their job] is really hard, that they’re doing all of the heavy lifting and that with later-stage investing, you’re waiting for the check to come in the mail. One, that’s not true, and two, later-stage companies translate in a wide array of challenges and opportunities like expanding the board and partnering opportunities-all of which, as a VC, you are highly involved in.