Evolving VC

Idea Flow

2008-12-04T12:57:00.000-08:00

I’m reading a lot about how the VC model is dead, and the venture capital industry is drying up. Supposedly, this is caused by the lack of conventional exits and liquidity events, meaning the venture capital funds can’t return cash to their investors. While we are clearly going through a flat spot in IPOs, and the world of acquirers is reduced, I’m not sure that implies the industry is dead. I think it’s just going through a stretched out phase.

In the VC conferences, you see graphs of how much money is going into the funds, how much is being invested in early and late stage deals, how many deals are being done and how many exits are happening. Inside the fund meetings, there is always a lot of talk about Deal Flow: how many deals are we seeing, are we seeing the best deals or the dregs, how many are competitive deals where multiple funds are bidding up the price. And in the board rooms of our investments, we talk about cash flow and burn rates. Everywhere you look, the issue is the flow of money from one place to another, and accumulating in the chosen few winners. It’s all about Flow.

I want to talk about another abstract measure of the new venture business that I call Idea Flow. What is Idea Flow? Simplistically, it is the rate at which new ideas are being generated. And what is it a function of?

Well I think it is partly a function of population growth, and the number of fresh minds entering society from the bottom, for example the number of college graduates. Each young mind is taking a fresh look at the world and seeing it from a slightly newer perspective.

In addition, I think it is also a function of how far we have gone in digesting the last few major revolutions. For example, the concept of the Internet, and frictionless communication at negligible cost, this is a revolution that is clearly still happening. When there are major revolutions percolating through society that haven’t been fully exploited yet, then the Idea Flow rate is probably enhanced.

Finally, Idea Flow is a function of whether sufficient resources are available to gestate these ideas. Maybe this should be a slightly different concept, say Manifest Idea Flow. In other words, maybe just having an Idea isn’t enough. We also need to let it bloom or it’s meaningless.

I’m sure one can identify other contributors to the rate of Idea Flow. My point here is that basic Idea Flow is clearly still growing. The number of college graduates continues to rise each year, and the population continues to grow in all but the most extreme cases of deprivation. And we have experienced at least three major revolutions in the past few decades that are still playing themselves out. Information Technology (computers, memory, programming, AI), Biotechnology (genome mapping, molecular biochemistry, synthetic biology), Communication Technology (the Internet, email, texting, cellphones), these are three overlapping general categories of revolution in process.

I think Idea Flow is the bedrock of the Venture business. Without ideas, nothing can be created. You might as well buy Ma Bell and cash your dividend checks quarterly. The Venture Capital business starts with a couple of motivated entrepreneurs, a problem that needs solving and an Idea.

I believe that in this time of economic turmoil, where cash flow and economic growth and investment capital are down substantially, the bedrock of the Venture Capital business is still healthy. If anything the current turmoil makes aspects of our economy more ripe for disruption. If the old ways are broken, let’s try a new way.

A larger number of bright young minds are emerging each year, and the ground is fertile. And today it often takes less capital than ever before to manifest an idea.

So I’m bullish on the Venture Capital business right now. While others say it is dead or broken, I think it is likely to be even more fertile in the coming few years. Valuations are down and the potential for profit is therefore up. The markets are more vulnerable to disruption. And the public investor is always interested in an exciting story of the future realized. The IPO market in some form will reopen soon, perhaps even in 2009. And large companies will emerge from this downturn with their existing market approaches damaged, and needing new ways to continue growth. They will be acquiring again.

In the end, this business is about Idea Flow, and it’s still healthy.

Episode 5.1. More musing on Exits.

2008-11-24T09:43:00.000-08:00

I’ve been thinking more about exits. It is in down times like these that revolutionary ideas often find traction. During flush times, people are not incentivized to try a new approach --- they just want to keep doing what is working. But when things aren’t working, those same people will be open to a new approach. There is little to lose.

Well, the exit process isn’t working right now, period. New businesses are not being taken to the public markets. One way to look at it is the stock variety you can invest in has remained fixed or shrunk over the past couple of years. When new ideas – new businesses have emerged they have either stayed private or been bought by bigger companies and absorbed.

I have the impression that the public investor has an appetite for flyers, has a desire to invest a small portion of their money in a risky new idea with huge growth potential. It may only be a small portion of their pile, but like the endowments that fund venture capital, the public investor wants to allocate a few percent of their investments to a sexy new idea. I think this interest never dies. And I think it is an itch that hasn’t been scratched recently. In the midst of the market melt down, I propose there remains a latent demand for IPOs. It may be smaller now that in 2000 (much smaller), but it’s not zero.

So here’s a wild prediction: I predict the IPO market will return in 2009. However, I predict it will come back in a new way. The old way involved investment banks running the show and underwriting the offering. Half those investment banks no longer exist or half been consumed and morphed into some new entity with an entirely different business model. I doubt that model will return soon. But there was a lot of experimentation with the Dutch Auction method during the past decade. It seemed to be ideally positioned to maximize benefit for the company and minimize benefit for the investment banks and their inside clients. It worked for Google. But there was a lot of criticism of it subsequently, I suspect driven by those investment banks who didn’t like being effectively disintermediated.

Well I wonder if this model is poised to come back strong in the coming year. Those banks are on their heels and struggling with their own problems. And there has been a subtle change in people’s impression of online finance. Witness the extraordinary success Obama had fundraising online. Half a billion dollars was raised online in this past year’s campaign. I think the public perception of the Internet as a financial conduit has matured. People seem to believe they can trust the Internet as much as the telephone or the television in the conduct of their daily lives.

So I think the idea of a Dutch Auction run on the Internet, with copious information equally available to everyone, is an idea who’s time has come. And I'm beginning to suspect that 2009 is that time, and especially ripe for this kind of revolution. I’m going to try to develop this idea further in subsequent postings.

Who are those guys? What makes a good VC. Final Episode 5

2008-11-15T12:51:00.000-08:00

It’s taken me a few months to get to this fifth installment. I was stalled at first because there hadn’t been a lot of “Exiting” going on in the past year or two. And I had the feeling the concept of Exit was undergoing change. Then we experienced the economic meltdown of the past two months. Like other active VCs, my fund responded by focusing our attention on our current investments, helping them position themselves to weather the downturn. So I apologize to those of you who emailed wondering if I had died or something. No, I’ve just been very busy, and a little reflective on my subject.

The classical view of venture capital is that a VC invests in a company, grows it into revenue and breakeven, and then sells equity in it to the public in an IPO. The exit part is the VC’s can then sell their ownership interest in the startup to that public market of buyers as the company grows in value, or distribute their now-liquid shares to their limited partner investors to sell. Either way, there is a rotation of the early investors out of the stock and new public investors into the stock. In a prototypical case, a venture fund may have put a total of $10M into a startup and owns 25% of it, and later when it goes IPO, that 25% is worth $250M and the VC gets a 25x return on their investment. The buyers in IPOs were typically trying to buy into rapid initial growth from new businesses. Or they were trying to buy in early to a speculative bubble, and get out before it sank back to earth. This is what was driving much of the bubble economy of 8 years ago.

A common alternative to the IPO exit route was getting the startup acquired by a bigger company, a so-called Mergers & Acquisitions or M&A exit. This could directly result in a cash return if it was a cash acquisition, or it could involve stock in the acquiring company that might yield immediate or near term liquidity. When the so-called “IPO window” was closed, i.e. IPOs were not getting done on Wall Street, the acquisition route was the preferred backup plan for VCs. Frequently the IPOs might be failing but large acquiring companies might still be looking for new lines of business or revenue growth from startups. In the past couple of years, acquisition or “M&A” exits have been much more common.

We now live in extraordinary and seemingly unique times. It is doubtful that an IPO market will come back soon. The public market has been burned by a steep drop in values across the board. Many investors will not trust the markets for some years to come. Buying into a speculative IPO of a company with a short track record in a new market may be too much to ask of investors. There has clearly been a flight from risk, but unfortunately no risk-free place to turn. Many argue that the smaller, nimbler, trendier companies will recover more value as we come out of this downturn, but I’m not sure that will apply to IPOs.

Why do Venture Capitalists need Exits in the first place? Because they are the opposite of Warren Buffett, they are constitutionally unable to be in it for the long term. They raise their funds by making a promise to their limited partner investors that they will return much greater value to them within 10-12 years and more desirably, in 5-7 years. VCs can be seen as relatively short term, high risk investment agents for their LPs. They (hopefully) intelligently direct an endowment’s money to the best early stage investments, and relatively quickly hand back a liquid return.

I’ve been reflecting on the best way to do that in our current economic climate. Some pundits have argued that the VC world has fundamentally changed, mostly because the traditional exit strategies have become untenable. How do you invest in a start-up and get to liquidity so you can distribute to your LP investors if there is no IPO market and a seemingly limited number of acquirers. The joke around the Silicon Valley was the only exit strategy was a “GYM” strategy, i.e. sell to Google, Yahoo, or Microsoft. But there is a limit to what even these companies will buy, especially in these times, and especially if it Microsoft buys Yahoo.

So I’ve been pondering alternative exit strategies or holding actions until the traditional exits come back. For example, I have the impression that in a lot of markets there are too many startups addressing market niches that can’t support them all. In a tight market of investment capital, there may be more room for, and a need for, creative mergers of early stage companies. Maybe startup teams need to merge with other startups addressing the same markets. In effect, the two startup’s investment syndicates need to join forces to address a shared market interest with their collective teams. The danger of having too many spread-out competitors is that NOBODY survives because they are forced to resort to desperate competitive tactics. Merged together, they can more efficiently address their market niche and combine the best features of each one’s original offering. There is no doubt that this means redundancy will be trimmed and teams will be smaller. But that makes more sense than a war of attrition where no one survives.

What I’m thinking about here is something like a bottoms-up roll-up strategy. Earlier stage companies may need to look at their competitors as partners to join up with. The investor groups end up diluted but owning the best of both companies and with more syndicate partners and probably more money and staying power around the table. The resulting consolidated company benefits by having less mutually destructive competition in their niche. The market benefits by getting a more rounded product offering from a better-positioned company. There will obviously be some egos bruised as two entrepreneurial, aggressive start-up teams are merged and trimmed. But it’s a survival strategy in a down market, probably makes a company more fundable, and is a better outcome than getting shut down.

Obviously there are reasons why this strategy doesn’t work in all situations. Frequently neither company has enough money to survive much longer. The old aphorism that “tying two stones together won’t make them float” certainly applies here. But when an VC investor group is faced with doing an inside round or a bridge to one of their start-up companies because there isn’t enough capital in the company or there isn’t an attractive exit, but there IS the gist of a good company, maybe that is a good time to look at the competition and try to craft a creative merger. The result may be more fundable.

This posting has morphed into more of a discussion about exits in our current climate than about what makes a good VC. I do want to finish this series on what makes a good VC from an exit perspective. But given the above discussion, my bias in the coming paragraphs will be on deal-making skills rather than IPO/investment banking skills.

A good VC is helping their start-up team deal with operational challenges as they build their company. Since the majority of venture-backed companies will fail or exit at below their cash-in value, the majority of exits a VC must execute on may be under less than advantageous terms. A “dealmaker” mentality succeeds best in these situations, i.e. that individual who knows how to read the acquirer’s needs and get the most for their start-up by positioning it to meet those acquirer’s needs. It is salesmanship.

Other previously mentioned skills like a big rolodex are obviously valuable here. And VCs that have previously backed now very successful acquirers (think Google) can often have better luck selling their subsequent start-up companies to that earlier success. They know the management and key opinion leaders in the acquirer. Frequently those senior managers may even be limited partners in that fund.

I doubt there will be many IPOs in the coming couple of years. The skills that make a VC successful in a world of IPO exits aren’t likely to be useful now. They aren’t that different than what is valued in an M&A exit world. It may be important for a VC to understand some of the foreign exchanges that have been able to provide IPO exits in the past couple of years. Toronto and London exchanges were getting IPOs done a few years ago, so a VC with good international experience and even overseas partners might have been at an advantage then. But those days are over now.

My next posting will try to summarize this 5 episode rumination on what makes a good VC. I’m looking forward to talking more about how the VC world is evolving as it matures and adapts to changing economic times.

Thanks for waiting.

Who are those guys? What makes a good VC. Episode 4

2008-04-10T12:17:00.000-07:00

This is my fourth installment where I’m trying to define what makes a good VC. I have broken the task into 5 stages or episodes as follows, and I'm tackling each stage in turn.

1. Finding Deals

2. Evaluating and Picking Deals

3. Executing an Investment

4. Managing and Growing the Deal After Investment

5. Finding a Successful Exit

The previous three stages are earlier posts below. This is stage 4, where I am talking about the time after making a venture investment and building value in the startup, in preparation for an exit. This is the operational part of the job --- how do you help a startup succeed? I should disclose in advance that I am a believer in venture capitalists who are actively involved with their companies, who require board of director roles, and who keep in frequent touch with the startup team. There are VC funds that function as silent, hands-off players and follow other investors leads. The following really doesn't apply to them.

In my humble opinion, the best VCs are those that have an operating background. Starting a company presents the entrepreneur with a range of complex problems and decisions that have to be made. The best VCs are ones that have confronted these issues in their own careers. For example, a balance has to be struck between frugality and audacity. A thrifty startup fosters a healthy company culture and focuses the majority of spending on areas that increase the value of the enterprise and the likelihood of success. On the other hand, knowing when to hit the accelerator and spend the money for the greatest effect, that is a challenge that every entrepreneur faces. It really helps to have backers and VCs who’ve done that before.

And there are a host of seemingly minor administrative decisions a startup needs to address, e.g. payroll, benefits, facilities, accounting, legal, IP protection, capital equipment, hiring… Experienced entrepreneurs have encountered these issues in their past startups. They make the best VCs in my humble opinion during this stage.

One key challenge is transitioning a founding team into a management structure that can grow the business. Frequently, founding team members “get ahead of themselves” and get set on how they are the right people to lead this venture to the promised land. They see themselves as the next Scott McNealy or Steve Jobs, i.e. the founder that took the company all the way to billions in revenue. Or a cofounder has gotten comfortable with a lofty title and responsibility area and doesn’t want his role reduced or narrowed. Or the founders have brought along one of their fraternity buddies as a co-founder, mostly because he’s a long-time drinking buddy, but who has no qualifications for the job he envisions for himself.

A great stage 4, “operating” VC will be adept at building a sensible and scalable management structure from the founding team, without disrupting the operation or culture of the startup. Almost more importantly, a good operating VC will mentor the founding team members so that they see and buy into the wisdom of this management structure.

This is one of the most challenging aspects of investing in and helping manage a startup: managing individual egos and expectations to maximize the overall value of the enterprise. By definition, to have the courage to start a company from nothing but an idea requires a big ego and almost an irrational determination to succeed. But the VC is investing in the overall enterprise more than the individual egos of the founders. Sensitively managing those egos for the overall benefit of the organization (and everyone's investment or time or money) is a truly important skill for a VC at this stage.

Another key value that an operating VC can and should offer to a post-investment startup is introductions to key contributors, i.e. partners, customers, key hires, etc. That means it is important for the VC to have a full rolodex, which again favors VCs with long operating histories.

Perhaps the hardest to quantify but ultimately most important addition a good operating VC can offer to a startup team is rational and reasoned advice and criticism on strategy. An operating VC in this stage, typically also serving as a board member, is ideally suited to give the entrepreneur advice that is not biased by the day-to-day "drinking of their own Kool-aid" that an aggressive startup team may suffer from. A great operating VC can give the team perspective and balance, at least partly from an outsider’s perspective at those monthly or quarterly board meetings, and intervening contacts.

Finally, once a VC is invested in a startup, one of their key tasks is to bring in follow-on financing and new venture capital firms to lead those rounds. That means coaching a startup team to do a great venture presentation. It is ironic that now the VC is coaching the team on how to best sell their deal to other VCs. But it is further ironic that VCs are often particularly good at this coaching. They see lots of deals and they know a good pitch when they see it. They know what sells THEM on a deal. But a great VC can often help an entrepreneur position their deal relative to all the other competing deals out there that a follow-on VC might be seeing.

So to summarize, in this stage a good VC is bringing operating experience, mentoring, a good rolodex of contacts, team-building and human resource skills, strategic thinking, a balanced “semi-outsider’s” perspective, and coaching on how to best raise more money.

Who are those guys? What makes a good VC. Episode 3

2008-02-03T12:36:00.000-08:00

This is the very belated third installment of my running saga about what makes a good VC. I have previously laid out a framework for identifying the skills that make a good VC, in rough chronological order through the process. Each installment covers a stage:

1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit

So here’s stage 3, a discussion of the skills involved in executing an investment that make a good venture capitalist.

This is the stage where the rubber meets the road. The previous two stages were window shopping. Here the VC is buying. The VC’s goal is to buy a share of the startup at the best possible price in return for his investment capital. But it isn’t quite that simple. For that investment to actually pay off, the VC needs to incentivize the entrepreneur and help grow the business. It is a very rare business where a VC can add funding and any idiot can turn it into a large multiple. First, there are no certainties. Second, every startup needs motivated, intelligent people to grow the business and realize a big increase in value. Finally, pretty much every startup entrepreneur needs experienced advice and critical contacts to fully realize that big increase in value.

So a good funding deal is one that leaves everybody incentivized to grow the company. If that doesn’t happen then everyone will equally share the loss. A VC who drives too hard of a bargain, and leaves the entrepreneur with too little of the upside, risks undermining the founders’ determination to put everything into the business. On the other hand, a VC who puts too high a value on the premoney of the startup, and therefore takes too small a share of the ongoing profit, will not last long in the competitive VC world. Further, they may make it harder for the entrepreneur to attract further investment in a later round by unreasonably inflating the entrepreneur’s expectations on valuation.

The entrepreneur is at a disadvantage. They are lucky to have a buyer. In contrast the VC sees plenty of deals, dozens a week, and will only fund less than 1% of the deals he sees. And there is the “golden rule”, i.e. whoever has the gold makes the rules. Only very rarely does an entrepreneur have exclusive control of such a disruptive idea that they can dictate terms to a host of VCs. Usually, the VC sets the terms and the entrepreneur can only improve them by generating some competition for their deal. And VCs will usually work happily together in a syndicate, and tend to know each other in their focus areas, so even the competition strategy can be hard to execute.

I’m arguing here that a good VC is thinking about the long term success of the deal, and not so much about extracting the maximum amount of benefit for his fund. In most cases, a deal has a limited number of bidders who are focusing on that market area and could fund that deal. But I believe the VC who “sticks it” to the entrepreneur because he knows he can, because the entrepreneur needs his money more than he needs their deal --- that VC is really undermining his own chances for a long term success. The entrepreneurs need to have incentive to give the business EVERYTHING they’ve got. A good VC needs to strike that balance.

So a first key skill is balance and fairness, finding that right mix of founders’ incentive and investors return.

Another important aspect of getting a funding done is crafting the terms of the investment to fairly cover all of the eventualities. A termsheet is often filled with pages of clauses that attempt to cover every possible outcome. There is a lot of technician work here that is often based on hard experience by the VC or by their attorneys. VCs do carry an advantage in this phase, because they do a lot of termsheets and their attorneys are specialists in this phase. In contrast, many entrepreneurs are seeing a termsheet for the first time. True – they will hopefully also be represented by experienced attorneys, but the nature of the venture capital business is that only a minority of startups actually get financed, and even fewer have multiple financing options in front of them.

So another skill set (or maybe it is better described as hard won experience) is the ability to see all of the possible outcomes in a deal and anticipate them in the funding documents. When something happens downstream and it is completely unanticipated, that is usually a place where things will get ugly. It is better to try to anticipate even unlikely outcomes and try to agree in advance how they will be handled. Since most VCs have experience with failed companies, they are again more experienced here, compared to the entrepreneur. In fact, entrepreneurs are generally selected for funding because they DON’t have a lot of failure experience. But the nature of high-risk venture investing is that many (even most) VC deals will not turn out as planned. A competent VC knows the downsides.

My goal in this posting is to further explore what it takes to be a good VC. I’m not going to delve into the details of termsheet construction. But creating a fair, balanced and comprehensive termsheet is a key skill for a good venture capitalist.

There are also related skills in getting the deal done. Being able to reach out to syndicate partners where needed, and ironically to become the deal advocate, this is also an important skill. VCs often need to be able to “sell” as well as “buy” at this stage.

Also, a good VC needs to gain the confidence of the entrepreneur who is ultimately going to be his partner if the deal is consummated. It can be very challenging for a VC to gain the confidence and trust of an entrepreneur, while simultaneously pricing his deal and imposing all these arcane terms and worst-case scenario constructions on the deal. So I believe another key skill-set is to be a good communicator and negotiator.

So to sum up this episode 3, “Doing the Deal”, I think the key skills of a good VC are balance, fairness, experienced anticipation of downsides, communication, negotiation and openness that engenders trust in entrepreneurs. One must never lose sight of the fact that a VC is only successful when the startups he/she invests in are successful. Any behavior by a VC that hurts the chances that a deal will be successful is counterproductive and plain stupid. VCs must be ultra-confident to throw their money and reputations at completely unproven startups. Ironically, that ultra-confidence can easily lead them to be overly aggressive “cowboys”. Such behavior is ultimately not in their best interest if it disincentivizes their entrepreneur or scares off syndicate partners.

In the next Episode, the VC and the Entrepreneur are now ostensibly in the same boat, working toward the same end. We’ll see…

Who are those guys? What makes a good VC. Episode 2

2007-12-16T15:42:00.000-08:00

In my last posting, I laid out a framework for identifying the skills that make a good VC. I did it roughly chronologically, from finding deals to exiting them. I divided that process into 5 steps as follows:

1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit

I then analyzed the work a VC does in step 1 and the skills that make one VC better than another.

In this posting I’m going to tackle step 2, i.e. Evaluating and Picking Deals to invest in.

I must confess, as an aside, that I have in the past week received my preliminary full gene analysis from an unnamed company. It has been very distracting and kept me from getting to this next posting. Sorry for the delay. I’ll probably post something on my genetic explorations in the coming weeks.

Step 2: Evaluating and Picking Deals

The VC business is a sifting business, as I have commented before. It is like hunting for pennies in your coin jar. Step 1 was about getting as many pennies in the jar, ideally as many promising pennies, as you can. In this Step 2, the VC is going through the jar trying to find the most valuable ones.

What is involved here? An entrepreneur has submitted a plan summary to you and you are reading it. Or an entrepreneur is meeting with you and walking through a powerpoint deck and maybe giving a demo. The VC has to decide which deals to give more attention to. As I have commented on in an earlier posting, the VC business is like being at the end of a fire hose. There are so many deals, and so little time. So there is a premium placed on time management and a VC has to make quick, decisive calls to protect his/her time.

So the first skill I want to emphasize is decisiveness. Every deal wants to get financed --- every doll is wearing her best makeup. A good VC has to make an early decision as to whether this is a deal that is likely to lead to an investment. If it isn’t, or is very unlikely to, then a good VC will make that decision and move on. (Ideally, that will be conveyed to the entrepreneur in a constructive and polite fashion. Otherwise they will soon see less Step 1 deal flow.)

Now to make that early decision, a VC has to have some domain expertise in the market area being discussed and the technologies and incumbent competitors currently addressing it. Therefore, a second skill is domain knowledge in one or more market areas. Here there are arguably a range of approaches. Some VCs have a moderate domain expertise in a larger number of markets. Other VCs are deep domain specialists who generally only focus on a narrow spectrum of deals. I think it can work either way. I have commented in a past posting that I think it is possible to have too much domain expertise in an area, and therefore be blind to revolution, or biased against it, when it knocks. But if a VC can make their whole living investing in an area they know intimately, then why move out of that sweet spot.

But I do believe that it is important for a VC to have a fairly broad grounding in technology, at least in the high tech VC world I work in. Even if you have deep domain expertise in one area, often a revolutionary idea can come out of left field and it helps to have a broader technology foundation so you can perceive it when it comes.

A good VC is also a good judge of people and character. Do these entrepreneurs have the personality, ambition, expertise and experience to make this startup a success? You have to try to size this up quickly, often in one brief meeting. Given the fact that entrepreneurs have to be just a bit wacko to try to start a new business and knock off a bunch of better positioned incumbents in the process, judging whether they are investible, and just crazy enough, can be challenging.

If a deal meets the basic criteria, and has captured the VC’s interest, the next step is to investigate the deal further, validate the entrepreneur’s assertions, verify the market and its acceptance of this startup’s offering, and confirm the technology and its uniqueness and protectability. I would submit that another skill comes into play here --- a disciplined and analytical approach to problem solving. I think the best VCs try to identify the deal-breaker aspects of a deal and try to focus on them first. This is about time economy and responding to that fire hose problem. A poor strategy is to validate the easiest stuff first, i.e. get comfortable with the least risky parts of the deal and start to “fall in love” with the deal, before you have confronted the most critical issues. In the most extreme situations this can lead to an intellectual logjam, where the VC has been seduced by a number of easily validated aspects of a deal, has invested a fair amount of time in the deal, and then is less receptive to critical weaknesses that are identified later. I think they can get stuck at “maybe”, and then reluctant to say no.

So I believe the best VCs are skilled at zeroing in on the major risk factors that are deal breakers, and clearing them or calibrating them first. They don’t tackle the diligence process in order of ease, but in order of criticality. This requires clear analytical skills and discipline in execution.

Another advantage a good VC often has is a large “rolodex” of past associates and friends that he/she can call on to get an expert opinion from. The best VCs have huge rolodex’s, and they work to enlarge them. They add their investment portfolio management to their lists, especially the successful ones. A lot of the sifting process is one of networking with better informed minds on a deal.

And good VCs are a little cheeky --- they will be able to pick up the phone and cold-call a key source for info. It is never a good idea to let the entrepreneur sequence the investigation. The entrepreneur will always try to focus you on their good aspects. A good VC thinks independently, identifies critical risk factors, clears or values them upfront, and leaves the window dressing until later.

Finally, this deal evaluation and sifting process is going on in parallel for a large flow of raw deals, and a handful of deeper dive deals that have passed first muster. A key skill is the ability to keep a lot of balls in the air and be able to shift contexts on a moment’s notice. In my experience, a typical VC may have 20-30 deals in his head at any one time, may know a lot about 5-10 of them, and may be nearing a key final decision on 2-4 of them. And remember, that VC is also probably on a half dozen boards and providing key support to those companies as well.

The goal of the first step was to add as many good deals as possible to the top of the funnel. The goal of this second step is to manage the funnel process, whittling down a vast number of deals to the ones the VC wants to make a run at. It is about time management, efficiency in the use of attention, perceptive identification of risk factors, disciplined understanding or control of those risks, and judging whether the entrepreneurs can pull this off and make the fund a respectable return.

In summary, the skills needed in this second step are discipline, independence, confident cheekiness, analytical thinking, good domain and market knowledge, a broad technical foundation, decisiveness, good people instincts, a large backup network of people to call on for advice, and an ability to juggle many deals and contexts. (And let me add one more: a good bullshitometer --- every VC sometimes sees a deal where the spiel is just too good and you instinctively say something is wrong here. In my experience, it is often best to just walk right there, and save yourself the time.)

This sifting process is not perfect. Many good deals are sifted out, and every experienced VC has heard of or actually turned down deals that later were huge successes. But VCs are measured on how well they return to their LPs, i.e. how good the deals they chose did, and not on whether they turned down winners.

Next I will cover the key step of crafting and executing a deal.

Now back to my gene pool…

Who are those guys? What makes a good VC.

2007-12-09T10:52:00.000-08:00

I want to begin to tackle my original topic of interest, i.e. where is the VC business heading in the coming decades. I thought I'd start out be defining the tasks a VC performs, i.e. what skills make one VC better than another. The fact is there probably is only one ultimate measure of a VC that counts --- return on invested capital. I’m not trying to dispute that. But what are the characteristics of a VC that will lead to a good return in the end?

I’m going to organize this somewhat chronologically through the process. And I’m focusing on skills and tasks along the way. Here’s the outline:

1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit

One can assume that focus, intelligence, integrity, fairness, responsibility, and good communication skills --- these are all valuable and assumed across the board. Finally, I have no gender biases and will use the male gender for simplicity. A female VC can certainly be as good or better than any male VC.

In this first posting on this thread, I’m going to address just those Step 1 skills. Other steps will follow in succeeding postings.

Step 1: Finding Deals

For a venture fund to be successful, it must have a rich deal flow. Garbage in, garbage out… as the saying goes. And every deal presents a different mix of characteristics. The fund needs to see lots of possible deals, ideally all with the fundamentals in order: solid management, strong technology, addressing big markets and with barriers to entry. There is no such thing as a venture fund that invests in every deal presented to it. The venture business is a sifting business. The better the selection, the better the investments that will result.

Therefore a successful VC must either a) get a lot of deals referred to him by colleagues in the field or past associates, OR b) get out there, see a lot of deals and maintain a high profile.

In subcategory a) are those VCs who have a great deal flow coming to them naturally by referrals --- I believe these are rare birds. They are usually extremely successful VCs from the most prestigious funds. We all know a half dozen names of superstars in the field. The best deals frequently come directly to them. That is a result of their success up to now, not the cause of it. Sitting back and waiting for the deals to come to you isn’t something to emulate. I do acknowledge that some superstars are surrounded by a great support staff who often go out and do the legwork for them. But I’m talking here about how you become a superstar, not how you act after you are one.

The second subcategory b) “get-out-there” path favors a personality that is friendly, helpful and engaging. It definitely does not favor arrogance or reserve. Entrepreneurs are more likely to want to work with VCs who are approachable and mentoring. Unfortunately, the VC community often draws its players from the most successful leaders in business and these are frequently very egotistical people. In my opinion, this is counter-productive to getting a good deal flow.

Ironically, it takes a lot of self-confidence to invest millions of dollars in a deal where the team is young and imperfect, the technology is new and unproven, the market doesn't even know it's a market and the incumbents in the market are big and powerful. That favors aggression, competitiveness, and single-minded focus in a VC. In other words, it naturally pulls a VC's personality away from what I think are key skills to this stage in the investment process.

Nevertheless, I believe the key skills for a VC are to be visible, approachable, helpful and mentoring. It is possible to hold these skills and still be self-confident and focused. As an aside, I think this also favors former entrepreneur VCs over professional MBA VCs. A VC can be most helpful from a position of shared experience. Entrepreneurs will appreciate that experience.

So I would argue the best VCs are confident, polite guys, who relate to the entrepreneurs out there, who do lots of panels and presentations, are accessible, listen well, and contribute more than just occasional funding but also advice to entrepreneurs. A VC who does all these things, and does them well, will see more and better deals.

Summary Skills for Step 1: Accessible, open, helpful, visible, mentoring, confidence without arrogance

(To be continued)

Angel Deal Types

2007-12-01T17:09:00.000-08:00

I’m involved with three different angel groups, and often guest at the meetings or screenings of two others. I see a lot of deals in the screening process for these groups. It seems these deals fall into four general categories:

1. Low Capital Requirement Deals. Deals that don’t need a traditional, venture capital-sized investment to get to cash-flow breakeven. These are capital-efficient deals that can get to revenue early, and boot-strap themselves through the growth stage. In today’s web x.0 world, I think these deals are more common than ever (as I have blogged previously). And I think they benefit from a particular kind of angel investor, i.e. one who has a more active hands-on approach and plans to mentor the deal and team more. These deals are unlikely to raise or even need follow-on VC investment and get a more experienced and connected board later. The mentors they pick up in the angel round may end up being the guys they use as advisors throughout the history of the company. These are not “fire-and-forget” angel deals. And they may make more sense as simple priced, preferred stock deals, rather than convertible debt deals that I have advocated in previous postings.

2. Seed Deals. Deals that need seed capital to address some early risk factors prior to seeking their first formal venture capital round. The idea is to reduce those risks so they can get a better valuation from their first VC round and experience less net dilution. Frequently, a valuation inflection point is only an angel round of seed investment away. It may be to build a proof-of-concept model, or launch a beta test, or stabilize and add to a thin development team. I think deals in this category are more common in areas like the Bay Area where there is abundant VC funding. And this is the kind of deal where I think a convertible debt deal with a discount or warrant, and an escalator for delay in conversion makes the most sense.

3. Failed To Raise VC Money Deals. Deals that have tried and failed to raise their first funding round from conventional VCs and are “moving down the food chain” to Angel Groups. These deals normally have very tenacious founding teams who aren’t taking no for an answer. Often they revise their pitch to reduce their capital needs so as to appear more angel-friendly. In some cases this may make sense. If they were naïve at first and underestimated the impact of their risk factors on the VCs, they may have come up dry. They may benefit from converting to category 2 Seed Deals described above. The logic is “Raise less money, address your weak points, and then go back to the VCs.” Unfortunately, I see a lot of deals in the angel world that aren’t like this. They are simply failed venture deals. Frequently, they are failed VC deals because of team problems, or IP issues. They still have high capital requirements and are inappropriate for angel investment. There is an irrational aspect to starting a company, and slightly irrational entrepreneurs can assume that a lot of turn-downs simply means the VCs don’t get it. And angels may not look as deeply or be as experienced investors. A good story may snag an angel where it wouldn’t convince a VC.

4. “Bridge” Deals. Deals where a company has already successfully raised a previous round or rounds of money, has burned through that money and the existing investors are now disenchanted and no longer interested in follow-on financing. The entrepreneurs are trying to repackage the deal, spin it a different way, “put lipstick on the pig” and sell it to the angels. The entrepreneurs in this case may be reasoning that angel groups are less likely to come at the deal with knives, i.e. to force a down round. Angels may be more gullible. The entrepreneurs may position this as an opportunistic chance for the angels to bridge the company to its next “inevitable” venture round. As I have said in a recent posting, this is very dangerous ground for angels to be investing in. Failed startups that are back looking for new money from angels in a distressed condition, will very likely “experience the knives” eventually. The capital capacity of angels is unlikely to be able to fix what ails that kind of company. Angels who play in this category had better be experienced bottom-feeders. This is a special and dangerous world.

No doubt there are other more specialized categories, and admittedly, some deals won’t fit neatly into one of the above categories, and may have aspects of more than one.

An important question for angels to address when seeing a new deal is which category does this deal fits into. In my humble opinion, angels and angel groups are best advised to invest in the first two categories, i.e. deals that are clearly within the capital reach of angel money (category 1), or deals where the angels are effectively becoming cofounders and helping position the company for its highly likely first institutional round under fair economic terms (category 2). I believe angels should avoid deals that have been extensively and unsuccessfully shopped to VCs (category 3), unless they can see a way to turn the deal into a category 2 deal. And I believe angels should avoid deals (category 4) where VC’s have already played and are now absent. “There be tygers…”

Entrepreneurs are just a bit irrational --- they have to be to start a company from scratch. I know. I’ve been there multiple times. They will say what they need to to get funded. They will alter their story to make it seem angel-friendly.

Angels and angel groups are usually seen as the farthest out-there on the money tree. They will tend to naturally see the earliest and rawest deals, or the most desperate deals. It is best for angels to first try to separate the deals they see into early vs desperate piles. Highly motivated entrepreneurs are great; desperate, back-against-the-wall entrepreneurs can be a lot of trouble. Then focus on whether you want to back a deal with a few other angels, or as a precursor to bigger investment by VCs.

My two cents…

More on Convertible Notes

2007-11-15T13:55:00.000-08:00

I posted a couple of weeks ago on convertible notes and how I thought Angels were better off using them (Angel Valuations in Seed Rounds). I’ve realized that there were some inherent assumptions in that posting that I want to clarify. I’m prompted by a talk I saw yesterday where an experienced angel was discussing some bad outcomes he had had with bridge loans.

So I want to clarify. My posting was advocating the use of convertible notes in early stage deals, i.e. where the angel group (or individual angel) is providing seed funds or bridging to a first venture round. In those cases, I definitely think the convertible loan route is usually the way to go. There may be specialized exceptions, but that is a general rule.

The bad loans I was hearing about were much later stage loans. In one case, the loan was to a struggling company that already had taken in three rounds of money (i.e. had almost exhausted a Series C). They were running out of cash, and went to angels for a bridge. Presumably, their earlier investors were tapped out or disenchanted, but either way, the earlier investments were completely exposed. This is a “distressed company” bridge loan. Sometimes it is called a “pier” loan, i.e. a bridge to an uncertain destination.

I frankly believe this is an area where angels simply should not fly. Almost by definition, if the company can interest a Series D investor, there will be a major devaluation coming, and when that happens everybody is going to get a haircut. That kind of situation will even tend to select for a VC who is “bottom feeding”, and they are even more likely to not respect shallow-pocketed angels, even if the angel money is the most recent money in the deal.

It is a given that a seed-stage startup is distressed --- they have little beside an idea and sweat equity. But there is little to lose --- the valuation is hypothetical and somewhat arbitrary at first. The seed investors are in the same boat as the entrepreneurs, when facing the first institutional investors in a Series A. The Series A money doesn’t want to disincentivize the entrepreneurs, and the seed angels can shelter somewhat under that umbrella.

But later stage deals are cases where valuations have already been made, money invested, and positions have to be defended. These are circumstances where angels are ill-equipped to fight. This kind of defensive battle favors deep pockets and additional firepower. Most angels or angel groups are not good at deals that require repeated reinvestment. VCs know this and the knives will come out.

So I believe that in most seed and early stage deals, angels are well-advised to use a time-limited, escalating-return, convertible note instrument in their investing. And I further believe that angels should avoid getting involved in later stage bridge or “pier” loans in companies that have already been valued and are now likely to be revalued. In that case, I think angels should try to make any investment as a piggy-back on the new VC money, if they can get it, and not get out in front of that VC money. They will get run over.

An Alternate Investment Philosophy, Finding the Disruptive Deals

2007-11-02T14:38:00.000-07:00

As I have mentioned in an earlier posting, I believe the nature and scale of many startup deals is changing. While VC funds are generally getting larger and the amount they need to invest in every deal is also getting larger, startup deals are generally requiring less capital to get off the ground. There is a disconnect here. I’ve noted that this is opening a window for angels. And I’ve just blogged that it may not all be good for entrepreneurs.

The Holy Grail for VCs is the big, hairy, disruptive deal --- an idea that completely upsets the playing field in a market area and allows for huge scaling and a big win for the investor. Think Skype, or Google (the ad company). How do you find “disruptive” deals, i.e. ones that can create 100x returns?

I am inspired by comments made by Nassim Nicholas Taleb in his most recent book, The Black Swan, The Impact of the Highly Improbable. He describes an investment philosophy where 80% of your capital is in lower risk, more conventional investments, and 20% is in smaller high risk investments --- trying to expose yourself to lots of possible positive Black Swans.

Now admittedly, he is talking about an overall investment philosophy from the perspective of a fund manager in NYC. But there is the kernel of a good advice here, I believe.

I’m suggesting that a VC fund should consider such an investment philosophy. The VC fund should set aside a specific seed-fund that is used explicitly to look for positive Black Swans. This seed-fund should invest in earlier stage or riskier investments, or to simply play hunches. The partner group should loosen their normal criteria when evaluating these deals. They should focus more on how disruptive the idea is. There may even be an opportunity to allow an individual partner to play a personal hunch. The decision can be made by just that partner, subject only to the outright veto by one of the other partners. I am proposing that that partner does not necessarily have to convince everyone to agree with their vision. And critically, in all cases, such a seed investment would have to be made with the expressed provision, at the fund’s option, to subsequently invest more, up to some limit.

Some Justification and Comments:

It is increasingly apparent that IT deals often need less capital to get off the ground. Also entrepreneurs are growing wiser about delaying a traditionally-scaled venture round until they have more traction. And angels are increasingly filling that gap. Early stage VC funds are prone to being "jumped" by deals that go from an angel round to a larger VC round.

Setting aside an explicit subsidiary seed fund and committing to try to invest it in more, smaller, more speculative deals will focus a VC’s attention on playing some educated hunches. I believe that the rational consensus-oriented approach VC funds currently rely on almost exclusively, leads to a more mundane set of moderate return deals and misses on the individual investment hunches of each investment professional.

One can assume the fund will see a larger attrition in these smaller seed deals, but even if they all fail the total amount lost would collectively only be equal to one or two failed conventional deals. On the up side, the fund may get a large piece of a more disruptive deal by grabbing a piece earlier. The result would likely more than offset these speculative losses, and maybe even “make the fund”.

Such deals would require some time commitment to mentor. Such mentoring and early support will build the fund’s reputation in the entrepreneurial community. More early deals may also come the fund’s way. It can be synergistic to their investment goals. And they learn by immersing themselves in some leading (bleeding?) edge deals that they otherwise would miss. The selection criteria for these deals might include a requirement that the team is clearly identified as “coachable”.

To put it simply, making seed investments from an explicit seed fund allows the fund to bet on more horses than they otherwise would and increases the chance that they’ll get a big winner.

This does not necessarily represent a relaxation of the fund’s investment decision standards. I believe that some of the best returning, most disruptive deals a VC may see do not lend themselves to classical due diligence and risk minimization. Sometimes it is a matter of connecting the right idea to the right people that unlocks big value. Doing more seed deals will allow the fund to possibly unlock more of these big opportunities.

Some deals are execution deals while some deals are big idea deals. I believe the current VC process tends to favor the former, but the big, hairy, disruptive deals with >10x return potential are more likely in the later category. Big idea deals don’t lend themselves to classical diligence.

Finally I want to acknowledge that Charles River Ventures has prominently taken a position that is similar to this idea. I’ve seen it stated that they are addressing the smaller deal demand issue with this plan. My point here is there may also be a greater yield in big idea, disruptive deals by making more smaller investments.

“Worth What You Pay For It?” Musings on Entrepreneurism without a clear economic goal…

2007-10-30T15:22:00.000-07:00

A couple of postings back, I noted on how web startups could get going on much less invested capital, and how startup investing had to adapt. Well here’s another way of looking at it, that isn’t so sanguine.

I’m stimulated by a posting I read recently by Paul Graham of y-Combinator fame (http://www.paulgraham.com/webstartups.html). He is hitting on many of the same points, i.e. that startups can be launched much more efficiently now, that capital needs are lower and time to market is shorter. I couldn’t agree more. He also makes a number of sweeping generalizations that my 7th grade teacher would have nailed me for. I don’t buy the whole message.

But my point here is to say it isn’t all good. Along with a blossoming of inexpensive web startups, there are also a lot of cool apps with hopelessly non-existent business models … if we build it they will come. There seems to be a growing divide between things you can do that will have a big impact on the world, and things you can do that will have a large economic return on investment. I often find myself in a presentation on a new startup idea, where I could definitely use the product, but can’t figure out how they will make a business out of it. I can see clear value in it, but no way to extract that value.

It feels like we are in an Oklahoma Land Rush world. A couple of major paradigm-shifting changes have occurred (the Internet, the cellphone, ubiquitous computers, mapping the Human Genome…), and now we have this whole generation of bright people rushing across the newly opened landscape, seeking homesteading sites to stake a claim on. Some people are doing a good job finding economically valuable homestead sites. Others are just trying to sell wagons and provisions to the incoming flood of homesteaders. Yet others are trying to stake out beautiful view lots that won’t be economically valuable but give a great view (and someday may therefore become valuable). And others are simply enjoying the run in the countryside, and are admiring their beautiful running form.

Many startups I see today are simply not venture investible. That doesn’t make them bad, just not good vehicles for VCs to invest in and get a return from. VCs have to return money to their investors. Hence they can only invest in a subset of the new ideas brewing out there, i.e. the ones that have the potential for a steep increase in economic value over a short period of time. And not likely to help the entrepreneur put food on the table.

But what happens if you can start a company with practically no money and no hassle pitching angels. My fear is that entrepreneurs will expend an enormous amount of effort launching a startup that can never become self sustaining. They have become enamored with their own idea and it’s novelty, and haven’t tested it outside of their narrow circle. And because they haven’t had to go out there and convince others that it’s a good idea --- and pitch the idea over and over again to investors --- adapt the idea to what seems to stick to the wall --- they will ultimately be wasting their time. It may be very worthwhile meaningful work, which makes a difference and draws huge traffic and changes the flow of homesteaders across the prairie, but doesn’t end up making the entrepreneur or their investors any return. In the end, it’s possible the entrepreneur will look back on these years as wasted --- benefiting others but not themselves.

What’s happening on the web is frequently cultural, and not necessarily economic. Great revolutionary businesses are being created, and great cultural changes are happening, but they don’t always overlap. And the test of a good idea is not that it is neat, or that it can be implemented simply and elegantly, or that it can draw many other’s curiosity and interest. The test of a good idea is the value others will place on it, and a good proxy for that value is the money they will pay for it. A good predictor of that value is whether others find it investible, be they angels or VCs.

So I think it is a good thing for entrepreneurs to have to pitch their ideas and convince others to put a value on it. I found in my own entrepreneurial career that my business models and even my technical ideas benefited from being pitched and explained to others. They became more focused and distinct. I recall A-HA moments that happened in front of prospective investors.

I worry about a world where doing things, making a big impact, affecting our culture in a big way, has such a very low cost of implementation. And even pitching some small investors isn’t necessary. I think it is bad even for the entrepreneurs who might seemingly benefit from it.

Angel Valuations on Seed Rounds

2007-10-14T17:24:00.000-07:00

In a recent IBF Panel on the topic of Angel and VC cooperation, I made the observation that I believe Angels should avoid valuing startups in priced rounds, and rather should invest using a convertible note. I said that nothing could screw up a follow-on VC investment more than an unrealistic early angel valuation.

I want to elaborate on that observation. First, I want to divide the startup world into two general categories: 1) startups that can reach their goals with a small infusion of seed capital within the reach of angel financing (i.e. less than $1M), and 2) startups that will ultimately require VC scale financing and are raising angel capital to eliminate some risk factor and improve their ultimate VC valuation. Frankly, this is an easy way to divide startups coming to angels. Is this deal a nearly self-sufficient business, or is it seeking seed capital before later going to the venture capital community.

In the first category, angels setting valuations are probably taking a defendable position. But frequently it isn’t clear at the outset whether the angel raise will be all the money the startup raises. So I think the convertible debt approach is still a good way to go. The note should have an automatic conversion privilege after a reasonable period of time, at a clear valuation.

However, more often it is better to assume the seed angel round is a precursor to a later VC round. In this case I strongly suggest that a convertible debt approach is the right way to go. Let me explain why, by showing the pitfalls of angels valuing a deal. Again there are two possible cases: A) setting the valuation too low, or B) setting the valuation too high.

Suppose the angel (or angel group) succeeds in convincing the entrepreneur to accept a lower valuation than a VC would demand, i.e. case A. Frankly, in my experience over the past few decades, this is very rare. Valuations tend to be set by the golden rule --- whoever has the gold sets the rules. VCs have more money in play, with the potential for multiple subsequent rounds, and will therefore be most likely to get a lower valuation. But for the sake of argument, assume that a low initial valuation is successfully negotiated by the angels. In that case, a follow-on VC round will likely see this as an invitation to lower their valuation proposal below what they might have otherwise offered. This will hurt the entrepreneur and the angel prorata. Even if the follow-on VC chooses a more “fair market” valuation, the entrepreneur will still be getting a worse deal. Either way you end up with a less happy entrepreneur, and maybe the angel is unhappy as well.

Now suppose the opposite happens, i.e. the entrepreneur manages to convince the angels to give him a high valuation, higher than he might get from a VC. In my experience, this is actually a fairly common experience. Seed rounds are often made by Friends and Family, and they are emotionally involved with the entrepreneur. They will accept a valuation set by their friend or “son” because “he knows more about this”. But again, for the sake of this analysis, assume the entrepreneur gets a higher than “fair market” valuation. When the follow-on VC comes to see the deal, they will quickly come to understand the valuations previously set and the expectations of the entrepreneur to up that valuation. They know to get this outon the table early. I can say that my VC fund sees this case a lot and it often stops a deal cold. Frequently, the entrepreneur has taken the high seed valuation to heart, and is insulted by a VC opinion that it is excessive. For the VC to proceed, they will have to offer a down round deal. Remember that VCs often are investing to a formula promised to their LPs, that mandates their seeking a certain percentage of ownership. An overly optimistic valuation in the seed round directly hurts both the entrepreneur and the seed angels.

So in summary, if there is even a chance that follow-on VC money will need to be raised, in my opinion, an angel-priced seed round is a lose-lose situation. The best outcome is the angels set a valuation very close to what the VC expects --- and that is exactly what a properly constructed convertible debt deal will deliver automatically.

In essence, a convertible debt deal is saying that the angels want to be in the same boat as follow-on investors, rather than starting out in opposition to, or second guessing them. I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.

But a priced angel seed round is at best a breakeven exercise. Much of the time it will be to the disadvantage of the angel and it will almost always be to the disadvantage of the entrepreneur.

Convertible debt seed financing can be done with a timeout conversion at the angel’s option, with a time matched escalation of reward, and with interest and dividend privileges. In the end, the seed round is very exposed, and angels are investing monies they should never expect to get back. The lack of security for the loan is therefore relatively unimportant. And the conversion will be to a preferred round with all its carefully constructed advantages crafted by the VCs. In contrast, I often see priced seed rounds where the angels bought common stock. That opens the door to the VC constructing preferred terms that put the common stock class at a major disadvantage.

I will acknowledge that this advice is Bay Area centric, where there are many many venture capital funds. When the angel investment is coming in geographic areas with limited local VC financing, the value of this advice is lower.

As a general rule, ANY investment in a startup should be made so that follow-on financing is not inhibited. Valuation can be a big inhibitor to venture capitalists. And VCs will usually craft the best terms to protect their investment. It is better for angels to try to be under that same umbrella.

How close is Too Close?

2007-10-02T17:05:00.000-07:00

A common axiom is “Invest in what you know.” I want to amend it. “Invest in what you know enough about… but not too much about.”

I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.

You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.

In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.

So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.

The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.

Startups Then and Now

2007-09-24T09:34:00.000-07:00

A few years ago, I remarked to a friend that Microsoft Word took longer to start up on my 3GHz Pentium laptop than my DEC EDT word processor took in 1980 on a PDP-11/34 running RSX-11M. My modern laptop was hundreds of times more powerful, but I was still waiting 10 seconds. True, MS Word is much more powerful, but for the basic stuff, I was still waiting…

Nevertheless, when you read about productivity nowadays, it is apparent that in this decade we are reaping the benefits of the digital age --- all those computers and Internet linkages mean that the average information worker is much more productive today than he was just 20 years ago. In fact, according to the U.S. Department of Commerce Bureau of Labor Statistics, productivity in software publishing is up by a factor of 17x in the past 20 years. In Computer and Electronic Manufacturing, it is a factor of 9x.

So what does this mean to Venture Capital and startup financing? I submit that it simply takes less money to start a high tech company nowadays. Particularly in software development, the costs of developing a product are far lower compared to 20 years ago. And the reach of the Internet and the ease of leveraging viral marketing and messaging, means the costs of customer cultivation and product marketing and deployment are far lower as well.

I frequently see startup teams who have launched their company on less than $100K of total capital in, and only need $200-300K to get to breakeven. They can almost bootstrap it, if they use all the tools available to them, play the blogosphere right, leverage the buzz… Now it’s debatable whether trying to do it that cheap is always the best way to go, but it is certainly a viable option.

So one clear trend in my mind in seed venture capital is that deals are going to get smaller and VC funds are going to have to adjust to that. Six digit seed checks will become more common in the coming years, even with the effects of inflation. ($100K isn’t what it used to be…)

I actually believe that is healthy for the VC funds. As I’ve mentioned in my first post, I’m a big fan of Nassim Nicholas Taleb’s writings, particularly his most recent Black Swan book. He persuasively argues that a good way to invest in our inherently unpredictable world is, among other things, to expose yourself to as many positive Black Swan opportunities as possible, with a portion of your money. I think all VC funds would benefit from setting aside a portion of their funds, say 20%, and taking “fliers”, betting “hunches”, but most importantly making more, smaller bets. Yes, they can take up time, but I think it is manageable. And as Taleb says, your downside is limited to 1x, but your upside is largely unbounded.

The irony is most VC funds are going the opposite direction. They were so successful in the last decade that they have had little trouble raising gigantic new funds. When a partner group has to invest $1B, they are discouraged from making $250K investments. So they set a policy of investing no less than $5M in a first round investment, and reject deals that don’t “put that much money to work.” They say “your deal is very interesting, but it isn’t big enough for us”. In my humble opinion, this is a big mistake, and heading in the wrong direction.

VC funds, particularly those than do Early Stage investing, will necessarily have to evolve in the coming decade. This is a particular focus for me in this blog. More on this topic to come…

Dangers From Friends&Family Money

2007-09-09T15:27:00.000-07:00

There is one truism in the startup business. The more an entrepreneur can reduce the technical and market risk in their startup before seeking outside money, the better valuation they will get, and therefore the more ownership they will retain. VCs and angels will value a startup by the size of the opportunity and the inherent risks in that opportunity. An entrepreneur can only clearly describe the size of the opportunity --- it is what it is, but he/she can definitely reduce the technology risk by building a proof of concept demonstration, or reduce the market acceptance risk by signing up pilot customers.

These early risk reduction efforts typically require some seed capital. Entrepreneurs often self-finance this seed stage, or they turn to “Friends & Family” angel investment. In general, this is a good idea, and it helps a startup get later financing if the idea has been better validated, and if the entrepreneur seems to have some “skin in the game”. However, I want to discuss some aspects of F&F seed financing that may be under-recognized and hurtful to the entrepreneur’s efforts.

Here is a great saying that I have always respected for its wisdom:

“Reasonable people adapt themselves to the world. Unreasonable people attempt to adapt the world to themselves. All progress, therefore, depends on unreasonable people." -George Bernard Shaw

Entrepreneurs almost have to be unreasonable, even irrational, to try to start a business around a new idea. They have to visualize something that doesn’t exist, create it out of thin air, and sell it to others, particularly VCs and early adopter customers. If it was obvious, everybody would be doing it. Instead, it is usually obscure and often seemingly crazy. Who will invest in such a raw idea?

Mom and Dad, ... your best friend… that’s who. They trust you for reasons unrelated to the idea you are promoting. In fact, in the case of parents, biology drives them to support their offspring, even irrationally. In the case of friends, it can be payback for that time you bailed them out of a DUI in college, or any number of pre-existing debts, or irrational friendship.

I’m going to ignore the argument that parents investing in their kids is an unwise concentration of assets. I’m concerned with the hazier issue of irrational seed investors not giving the entrepreneur unbiased feedback. There is danger in F&F seed funding.

If for no other reason, subsequent investors will be looking to see who has invested before them. They will be looking for previous validation. Mom’s money is weak validation.

It’s a tough balance to strike --- you want some seed money to validate the idea, but you also want unbiased input on whether you are drinking too much of your own KoolAid. And believe me, after an unreasonable, irrational entrepreneur fixes on an idea and throws their weight behind it, it is hard to be convinced otherwise. The danger is that calling on the easy money, may delay getting a cool, rational dose of reality.

So I guess my advice is to validate that idea before seeking VC money, but test it both with F&F money and with unbiased, “tell you the honest to God truth” advice that a family member or close friend cannot give you. Don’t just labor away in stealth mode, eating up your parent’s money. Find “seed advisors” you can trust who know the space and the technology, and continually test your idea and fine-tune your pitch on them.

VCs have a phrase for Friends and Family money. Sometimes it’s just called Friends, Family and Fool’s money. Don’t trust the F's to validate your idea, and definitely don’t trust them to Value your idea. They love you and love is blind.

Shiny pennies

2007-08-31T10:24:00.000-07:00

So what is VC investing like today? The one thing that is hard to appreciate until you are doing it, is the magnitude of the deal flow. This is simply drinking from a fire hose. You see new deals every day, occasionally a dozen new deals a day at a pitch conference. But an active early stage fund may only close a financing on one deal a month and an active partner may only do one deal a quarter. So there must be an aggressive triage process to whittle down the hundreds of new deals down to the one you will devote significant time to. Being a VC means very aggressive time management --- you have to, or your life turns into an endless series of digressions. (It sort of looks like my desk, with stratigraphic layers of papers and ppts, but that is another story.)

In passing, this is one reason that VCs often seem to ignore entrepreneurs and aren’t polite enough to even say no. They live in a deluge, and can’t spend too much time responding to each submission. If they did, they would have no time for follow up study and pursuit of the best deals they see.

At the risk of trivializing what I do, in some ways, my VC life reminds me of the time back when I was a kid and an avid coin collector. My dad had this giant jar of coins and once every month or so, I would get access to it and avidly sort through the coins looking for the proverbial 1947 D Lincoln penny in “Fine” condition. I had a book of pages with little round slots numbered with all the preceding years and mints and variants, and I was always trying to fill every hole with a better example of that coin.

And my attention was inordinantly driven to penny-collecting because during the Second World War, in 1942, due to a shortage of copper, the U.S. Mint made pennies out of steel for one year. Some of these steel pennies were still in circulation when I was a kid, and to a coin-oriented kid such an obvious anomaly suddenly appearing in your hand made the whole idea of coin collecting just fascinating.

So there is my Dad's bottle, and initially every coin looks roughly the same. Some are a little shinier, but at first they blur together. You looked sequentially at each coin and roughly evaluated it: what was its year and its mint stamp, what condition was it in, was there anything special about that year… You put aside maybe 1% of the coins as possibly worthy of further study, while the rest went into rolls to be taken to the bank. Then you took the promising ones and did “due diligence” on them, comparing to your previous best coin in each category, and looking them up in the coin collectors handbook. Rarely, and with great pride, you would replace a coin in your collection with a newly found one. Some people looked at different coins, i.e. nickels, dimes, silver dollars (different investment focus areas). Some people went to shows and shops and traded for already discovered coins (later stage investors). I liked the adventure of searching for coins in general circulation, gleaning value from the worldly flow. I confess I would sometimes go to the bank and buy rolls of coins, scan through them, and then return the leavings. (I recall my local bank began to take a dim view of this after a while. Fortunately, a lot of my relatives had bottles of coins.)

I liked the penny business. The upfront cost was low, the deal flow was high, and yet if you found a 1909 VDB, it wasn’t worth 10% of what an equally rare dime was worth. Suddenly a coin’s value became detached from its face value. It wasn’t even proportional. It was all about uniqueness and rarity, and diligence, luck, perceptiveness and knowing when to flip them…

From Angels to Professionals

2007-08-15T17:12:00.000-07:00

In some ways, Venture Capital seems like a bank, accepting deposits and making loans, but this venture capital business is more focused both in what it tells its investors it will return to them, and how it will do it. And the goal is subtly different: the focus is on appreciation of equity value, not generating income. VC’s don’t want dividends or profits so much as they want to sell (or distribute) their stockholdings at a big profit over what they paid for them at the outset.

From the post war era and the early Venrock, the next jump is to raising a fund from a diversified group of investors, instead of a single individual or trust. In other words, we go from investing from one’s own money, to investing OPM (other people’s money). It isn’t clear to me who first made that transition (and I’m not trying to write the definitive history here, just outline some trends). I’ll mention the early firm of Davis & Rock, because they were very early, and because I had the pleasure of counting Arthur Rock as an investor in one of my startups in the early ‘90s (I wish I had returned more to him). He was a crusty and demanding investor but fair and focused.

Venture Capital is “bank-like” in the simplest terms --- you collect funds from depositors, use those funds to create profit, and return much of that profit to your depositors. What is important to me here is the types of skills needed in the early days to be a venture capitalist. You needed people who could raise money, and people who could invest it wisely in ventures that would grow enormously. I have the impression that in the early days, the technology was not that deep, and a well-educated individual, particularly one with an engineering background, could sufficiently fathom the core technology in most startups to make intelligent decisions. Maybe that is from the benefit of hindsight. To the earliest investors in Digital Equipment Corporation, the mini-computer may have seemed like quantum computing.

But one change from the early days to the late 20th century is the increasing specialization of the venture professionals and their frequently narrower technical focus. Most of the successful VCs in the 1980’s and 90’s have technical backgrounds and engineering or science degrees. Often they began their careers in those fields, graduated to management positions, and then transitioned into the venture capital field in mid-life.

As venture capital became an established and respected profession, generating sometimes huge success stories, the major business schools began churning out MBA’s that were educated expressly to become VCs. I remember encountering these young VCs starting in the late 90’s. Frankly I was not particularly impressed. As a seasoned entrepreneur, it was somewhat strange to be evaluated and judged by a young VC who had never hired (or fired) someone, made (or missed) a payroll, created a product (or category). The older style VC was much more credible if they had “done it” themselves. Particularly in the evolutionary 90’s, it wasn’t clear to me that you could educate someone to be a VC. There were exceptions, of course, but generally I was always more impressed by VC’s with operating backgrounds and technical depth.

Arguably, as we underwent the revolutions of the Internet and mobile communications and mapping the genome, young, freshly-minted MBAs had at least one advantage over older school VCs --- they often WERE the target demographic, and had grown up with these revolutions. But it is hard to underestimate the value of having BEEN an entrepreneur, and having started and run a company in your past.

So here we are today. Most funds are investing OPM, other people's money, under fairly standardized financial structures, in fairly well defined technical market areas that jive with their team expertises. VCs are frequently technical, often have operational backgrounds, but the younger VCs are more likely now to be educated as MBAs and to have jumped right into the field. More in my next post on speculating where the VC world is headed…

In the Beginning...

2007-08-10T15:21:00.000-07:00

If I’m going to address the evolution of venture capitalism, it will probably help to first establish a context and starting points for this ongoing evolution. Starting enterprises is arguably the “oldest profession”, since the first prostitute probably needed seed capital to dress up for marketing to her first “sale”. OK, a poor joke… But in the modern era (i.e. the last 100 years) entrepreneur seed capital begins as angel behavior. At first you probably had to have money to start something new. You self-funded your new ideas. A good example might have been Thomas Edison. He made enough early money that he could afford to personally incubate ideas from his fertile mind. And he could borrow ideas from outside, improve on them and spawn another business. It’s my relatively uninformed opinion that this is how it gets started. Wealthy industrialists fund new ideas --- think Andrew Carnegie, Henry Ford. The seed capital comes from insiders and largely from themselves.

Wikipedia has a nice article on Venture Capital. It seems to suggest a second source of seed capital that it doesn't call out explicitly, e.g. the government, especially during extraordinary times such as WWII. The military had to create industries and suppliers from scratch to meet its needs in major defense projects. Think about the creation of atomic weapons, and all of the various components and materials that had to be created from out of the blue. General Leslie Groves was effectively a venture capitalist with a bottomless Limited Partner in Washington.

Wikipedia credits General Georges Doriot as the father of modern venture capital. My guess is that he got the idea from his experience in the wartime years, where the audacity of the military meant starting things from scratch under duress. Doriot was clearly a well versed business professor, having taught at the Harvard Business School, but I’m guessing it took the audacity of war to break through to the idea that you could start a company entirely from scratch, and do this as a repeatable business.

So we begin with wealth, expansive thinking, audacity. This is an angel dominated world. Wealthy people spending their money to make them more money and expanding their legacy. But in my mind, modern venture capital begins when you have professionals investing other people’s money. This seems to first happen with Venrock Associates, which starts as a group of professionals investing the Rockefeller fortune. Laurance Rockefeller starts it off, but he quickly hires pros to manage it.

Frankly this is the beginning… a couple of senior management types helping their boss, Rockefeller, to be a better angel investor.

Stating Intentions

2007-07-27T13:42:00.000-07:00

As a serial entrepreneur for the past 3 decades, and now transitioning to an active VC, I'm in a good position to be looking at the VC community with fresh eyes. I'm forming some ideas on where I think the VC world is going, where it should go to remain relevant, and where it must go to adapt its return models to changing conditions. I hope to post some of these ideas here in the next few months, in my COPIOUS free time. Stay tuned.

In the meantime, I highly recommend the works of Nassim Nicholas Taleb, especially his most recent book, The Black Swan, The Impact of the Highly Improbable. VCs don't work in a predictable world, but they do work in a world where the improbable can be used to their benefit.

Easy