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January, 2007:

Hint: Nobody Has Any Idea How This Thing Works

In Venture Capital, we have lots of rules of thumb for assessing entrepreneurs. Some such rules are:

  • Invest in guys who are already rich, because they have fewer distortions in their motivations.
  • Invest in guys who aren’t already rich, because they’re hungry.
  • Invest in guys who have put their own wealth at risk, because they have “skin in the game.”
  • Invest in guys who have raised outside capital from credible investors.
  • You gotta outsource the tech stuff — it’s too expensive.
  • You never outsource the tech stuff — it’s too important.
  • Entrepreneurs should not come from a big company (because they have the wrong culture).
  • Entrepreneurs should come from a big company under a big-ego boss (because they want to make their own name out from the shadow of the big cheese).
  • Only young guys get this new (social networking, Web 2.0, whatever) stuff.
  • Only seasoned old guys will make any money.

When you’ve got guidelines like this, many of which are quoted with nary a trace of irony by the practitioners of our art, it’s fairly clear that you actually don’t have any useful guidelines.

Except one: invest in guys who’ve done it before.

The only person you know has a shot at creating a company with an exit value over $100 M (which is about the minimum exit value that most VCs would admit to wanting in any case, so I’ll use this as the threshold for my definition of a “star entrepreneur”) is the guy who’s already done it. Everybody else hasn’t yet proved it.

However, we have a major signal-to-noise problem here. When you look at an entrepreneur, even if he’s a star, you don’t know to which causes and in what proportions to attribute that stardom. Certainly, the quality E of star entrepreneurship could be the cause. But it could also be quality L (for luck). With only one exit, you just don’t know. But with no exits, you know even less.

If you were a statistician, you might try doing something with a Chernoff bound or a Z-test to figure this out. But a few things confound this approach. The main problem is that your number of trials is usually one. You can’t just keep tossing the coin to see if it comes up heads 51% of the time; you have to somehow guess the bias after only one flip (no pun intended!).

Another big source of error is that successful exit events are fairly rare. Most venture funded companies don’t have successful exits. (The old chestnut about VC is that a fund makes ten investments; five fail, 3 or 4 return 1x capital, and 1 or 2 make a 10x return. That’s hardly accurate, but it’s a good enough schematic for understanding the rarity of successful exits.) So if the probability of any given entrepreneur having a successful exit is 10%, then even a “rock star” who is five times better than the average is still only even money to exit big.

So, we have lots of both Type I and Type II errors. Finally, successive startups are not independent trials. That is, unlike rolling the dice, each startup you do is affected by the previous ones (both the experience of doing them and the ultimate outcome).

Even when an entrepreneur has been successful in the past, we don’t know if he’s likely to be successful again (though we can say, on average, he’s more likely to succeed than a newbie). But often, we fail to reject the guys who “hit the lottery” with their previous success. And even more often (almost by definition), we end up rejecting highly promising entrepreneurs who haven’t yet had a home run.

Yet, somehow, VCs continue to invest, and the returns (compressed due in large part to excess capital seeking a home in alternative assets / private equity) have continued to be good (if less princely than in the early years of VC). So VCs aren’t just monkeys throwing darts; we do have some discrimination ability.

Another chestnut in the VC industry is that “it takes $X million (e.g. $30 million) to make a general partner.” That is, to get a venture investor to the level of a seasoned senior investor, he needs to have led $X million in deals. This amount of deal flow (or, as it’s sometimes told, losses) is required to build up the black box of intuitions, gut feelings, sixth sense, etc. that a good general partner should have.

To me, this is a bunch of horse hooey. Yes, any good seasoned professional in any field will have some pre-rational judgment abilities that appear to be a “black box” — but these should only come into play at the margin. The core of any professional discipline must be reducible to a teachable, coherent syllabus. Take, for example, Malcom Gladwell’s example in Blink of the use of the Goldman algorithm for diagnosing acute myocardial infarction (heart attack). Essentially, the algorithm kicks the ass of expensive cardiologists and other “professionals” at doing one narrow thing, which is telling whether a heart attack is happening.

Now, the human body is a system, replicated and observed over billions of instances, with trillions of dollars cumulatively spent on measuring and exploring it. It provides feedback continuously on a second-by-second basis. And a heart attack is a fairly catastrophic and disruptive event — the death of part of the most important muscle. So the fact that a relatively simple algorithm can discriminate that event with great specificity is perhaps unremarkable.

But what is remarkable is that it took until the mid-eighties to promulgate the Goldman algorithm, and even today it’s not the gold standard. (Hey, at least medicine has the Goldman algorithm: in VC, nobody yet has validated such an approach.)

Doctors and VCs both have acute cases of what I call “special snowflake syndrome:” both groups tend to believe that they have special, irreducible talents and skills at doing whatever they do, and that they could never be replaced by a dumb machine. It is no coincidence that special snowflake syndrome tends to strike those in high-income jobs; folks who’ve seen automation or offshoring put downward pressure on their wages tend not to subscribe to this conceit. We also see special snowflake syndrome in industries where there are relatively high barriers to entry, such as regulatory (medicine) or timing / liquidity (10 year partnership agreements in VC).

In both cases, special snowflake syndrome will inevitably lead to heartbreak as people without the illusion of snowflakeness find and implement things like the Goldman algorithm (and the coming, immodestly named Lucas algorithm for VC). Unfortunately for the doctors, they won’t be capturing the economic surplus that results — it will be the middlemen in the hospitals and insurance behemoths that soak up the savings. (Doctors: save yourselves now, by demanding economic ownership of your patients’ well-being, the only humane and just way to allocate costs and risks in your profession!)

Fortunately for VCs, the implementation within a partnership of the Lucas algorithm will enhance that firm’s ability to identify and make successful investments with greater certainty and less manpower. And since VCs, through the carried interest portion, are compensated on financial performance, this will ultimately benefit the adopters. Yes, there will be some Schumpeterian woe for the old-school hangers-on as the snowflakes of their egos are melted in the sunshine of the new day that will be ushered in. And yes, a certain few of the old-school VCs — the ones with really great black boxes and/or Rolodexes — will continue to enjoy their maverick road gambler reputations. But by and by, rationality is coming to our market. Our black boxes will help us make decisions at the margin, but our algorithms will drive our core activities.

Does anybody want to work
on the algorithm with me? (I’m willing to hyphenate the name of the algorithm.) Drop me a line or give me a call at Voyager, +1 206-438-1822. (There will, of course, be several variations for different industries, geographies, stages, and firm preferences — so much so that each firm will likely need its own implementation — which is why I’m not too concerned about giving away competitive advantage by discussing with others in the industry.)

Your Old-ass Values Are Broken in this Shiny New World

I was slow to adopt a lot of new social networking technologies. I read blogs for several years (OK, like, three) before getting into “active” blogging (fairly frequent, first-person writing, unlike the mostly-error-message blog posts I put up at my Harvard Law blog.

I was super-fast, however, to adopt Linux, email, instant messaging, online banking, and even “traditional” Web-page-havin’. Why the delta? (Maybe I’m getting old.)

I think it’s got to do with values. My values were about:

  • the importance of one-on-one and small-group relationships,
  • the value of one’s words, and hence the advantage of controlling and using care with one’s communications,
  • measuring twice and cutting once,
  • privacy
  • etc.

There were also some values that I was aware of (but can’t claim personally to have really made much of):

  • modesty,
  • non-intrusiveness on others,
  • etc.

These values privileged one-to-one communications media (email and IM), and one-to-many, “broadcast” model, write-then-publish media (like print publications, papers, and old-school “resume-ware” personal Web sites). If you believed this stuff, you made a few friends but really good ones. You were loathe to publish things that might look stupid. You didn’t want folks to find out who you knew and who knew you, necessarily, as that could be strategic info. And (of course) you wanted to toot your own horn, but without seeming to be doing so yourself.

But social networking rejects all that. If you hold on to all those old values, you’ll get left behind. In social media, the values are:

  • promiscuity,
  • self-promotion,
  • frequency and speed of communications and replies,
  • saying some crap just to be the one talking (this was big at Harvard, come to think of it),
  • exhibitionism, or at least sharing one’s bad habits with the world, a la Hugh Foskett,
  • etc.

So, we have a generation being raised on social media for their IT experience. What little television they will be watching in 5 years will all be “reality” shows, mixed in with “mash-up” or “remix” TV a la VH1 (where celebrity becomes its own vehicle and its own end, perpetuating itself for the sake of itself, kind of like how degrees in certain subjects qualify the holder only to teach that subject). In this world, having old-ass values will pretty much be limited to accountants, lawyers, and maybe some fussy academics (but not the ones with glossy popularized books or lecture tours).

This is and should be somewhat disturbing. Every day, I ride in an 80-year-old elevator. While I’m sure most of its moving parts have been replaced at least a couple of times over its service life, the mechanism itself still functions as the original engineer created it. I’m frankly rather glad that he was raised with old, crusty values rather than the bright, shiny new values with which we’re going to be replacing them.

I wish this were a flash in the pan. But things like webcams, podcasts, blogs, tumblogs, Twitter, and Dodgeball, not to mention Myspace and the rest, all point to these new shiny values rising to ascendancy.

So, look: if you want to survive and thrive in the brave new world of social media, you gotta jettison those old values that got you into Stanford or through your MBA or into the partner track at Sequoia. You have to embrace the ADD and the confusion and the nakedness.

(Or, you have to figure out how to use your old-school values to operate at an abstraction level above that of the twittering throng…)

Playing Online Poker on non-Windows Platforms

I noticed today that I had a few people find my blog via Google with a search for, e.g. “ubuntu software install texas hold em.” This is because I have some writings about poker and about Ubuntu Linux.

Well, I don’t want to pass up the chance to give good, globally-utility-maximizing advice. The only place I’ve ever played real money online poker is PokerRoom.com, which has a cross-platform-friendly Java client. And while I haven’t played since 2004, in 2003/2004 I can vouch for their legitimacy.

Of course, the recent round of corrupt, hypocritical legislation that has created a War on (some) Gambling has really eff’ed up the entire online poker scene, so YMMV.

The Yen Carry Trade for Everyman, or, How You, Too, Can Unbalance Financial Markets

I was reminded by an Economist article recently about a conversation I overheard at an Asian noodle shop a few weeks back. Some guy was talking to his buddy. The conversation went, roughly:

“Yeah, I just got a great deal on a boat.”

“Where’d you get the money? Did you hit the lottery?”

“Naw, I got a loan, but with a really good interest rate.”

“What, like 6%?”

“No, 1.5%. See, in Japan they got really low interest rates. I was able to get the loan in yen, and then just convert it over to dollars to buy the boat. But the interest is the same!”

Wow. Amaranth and all other wackiness aside, you know financial markets are getting screwed up when average noodle-shop patrons are using the yen carry trade to finance trivialities.

Guy Kawasaki Hates Me

In a post entitled The Venture Capital Aptitude Test, quasi-famous blogger and sorta-VC Guy Kawasaki rags on junior venture investors in general and on young VC associates in particular. He prescribes “contempt” for “any young person who opt[s] for venture capital” and implies that such people are “full-of-shi[t]” (saying “shiitake” when you mean “shit” is just barely cute enough to countenance the first time, Guy, but let’s call a deuce a deuce).

In other words, Guy Kawasaki hates me.

Now, I am by no means the archetypal target of Guy’s scorn — his sharpest comments are reserved for MBA and I-banking types without operating experience, and he has a soft spot for those of us with engineering and sales backgrounds. I have, in fact, nothing but operating experience (two software startups, one profitable, one defunct) in my career to date, but being in my late twenties and working for Voyager Capital is inexcusable to Guy.

Guy sets up a straw-man argument, viz:

1. Working in VC is the best way for a young person to learn entrepreneurship.

2. Young seekers of VC positions are motivated by gigantic ($500k) salaries and massive carried interest portions.

3. Young VC associates are great candidates for shepherding along startups through their challenges.

Unsurprisingly, Guy knocks down that straw man, says “shiitake” a couple times, and then congratulates himself. Hurrah! He does so with the help of an interactive, Cosmo-style quiz that asks fairly shallow questions about who one is (“background”), what one has done (“first-hand experiences”), and what knowledge one has (“necessary knowledge”). Cognitive dissonance must set in for him around here, since his California-Bay-Area-influenced emphasis on “direct experience” was offset by an ancien regime-style weighting toward character and background (it’s Baba Ram Dass vs. the Greek chorus). Finally, Guy racks up the comments — mostly strokes for Guy with a bunch of self-reported high (or low!) scores and self-strokes — and takes the very odd approach of appending his replies, separated by a line of asterisks, to the three negative comments that dared to challenge his post.

Where should my criticism start?

A decent kickoff would be to work backwards through his straw-man points. Guy’s pointing out that VC associates aren’t necessarily the best mentors and board members for startups is not only obvious, but pointless. A VC associate isn’t supposed to be the wizened old sage who shepherds a company to success; indeed, I would suggest that in most VC firms, associates aren’t even allowed to take board seats.

Guy disingenuously ignores the idea of division of labor. A quick primer on investment team roles for those who aren’t familiar with finance (from which VC borrows a lot of titles):

  • General Partner / Managing Director: A “General” or “Admiral.” Not only a full investor, but an owner of the firm.
  • Venture Partner: A “Commodore” or “assistant undersecretary of defense.” Sometimes acts like a GP / MD, in other firms is more like a part time advisor.
  • Principal: A “Captain” or “Colonel.” Able to take board seats and have one’s “own” investments.
  • Associate: A “Lieutenant.” Might lead deals, but doesn’t “sign checks.” Not usually on boards.
  • Analyst: An “Ensign” (or maybe a sailor). Helps with deals and “bird-dogs” leads, but doesn’t do deals. Definitely not on boards.

Associates and analysts are generally MBA or pre-MBA types, and are expected to do much of the due diligence, financial modeling, and to follow up on the colder end of the lead spectrum (all the way down to cold calls, in some cases). In effect, they are doing exactly the work that their MBA, I-banking job, or consulting gig prepared them to do: spreadsheets, ginning up pitch books for LPs, reading of contracts and term sheets, talking to people and vetting their credibility, sanity-checking business models, etc.

It is at the GP / MD and Principal levels that advising of portfolio companies comes into play. (Now, will you in practice see overzealous associates running their mouths in situations they shouldn’t? Of course; in the mix of ambitious people you hire associates from, you’ll get some arrogant and / or impudent overachievers. But it’s the exception that Guy takes for a rule.)

And, if anybody is making the mythical $500k salaries, it’s folks in the GP / MD bracket. But don’t take my word for it; you can make a reasonable estimate of GP salaries for a given firm. Simply multiply the total assets under management of a VC firm by a reasonably high management fee (say, 2.5%) to find a credible upper bound for the firm’s non-carry revenues (ignoring for the moment “franchise” firms that essentially license their brands to others). Then, take a slice off the top (say 25% minimum) for rent, support staff, auditors, lawyers, insurance, and any “private jets” that Guy imagines, and you’ve got the total allocable to investment team compensation (salary, benefits, etc.).

Let’s take Guy’s firm, Garage Technology Ventures, for example. They’ve raised a first fund rumored to be $20M (with CalPERS as the “principle [sic] limited partner”), and possibly a second fund. Let’s assume that there’s a second Garage fund of $40M. That would bring total AUM to $60M; 2.5% fees would gross $1.5M annually for the firm. Let’s slice off 25% for rent, etc. — now we’ve got $1.125 M. Garage has three MDs and two VPs (venture partners); let’s assign the MDs 3x the salary of the VPs (who are probably part-time). That gives us 11 units of salary from the $1.125, or roughly $300k per MD and $100k per VP. Don’t forget that a chunk of that goes out the window to the employer costs of payroll taxes and benefits, so you’re probably looking at base salary to the MDs of more like $200k and to the VPs of perhaps $75k.

That took about three minutes (and I don’t even have a Wall Street I-banking background!). Admittedly, Guy’s firm is a remarkably small VC in terms of assets under management. Still: would any sane ex-banker think he has a shot at $500k base by going to work for Guy or any other VC?

Clearly, nobody is asserting these silly ideas (except Guy’s man of straw). This brings us full circle back to the straw man’s original plank: that VC is a great way to learn entrepreneurship. Well, precisely, this is false, and we must grant Guy that concession. There are a thousand things an entrepreneur must do that a VC associate, no matter how duly diligent he may be, will never observe him in.

But merely because the VC vantage point is insufficient to learn entrepreneurship does not mean that it cannot be helpful. Indeed, to the extent that raising investor capital (from someone other than your inner circle) is something you foresee doing, being on the VC side of the table is remarkably helpful. I speak from experience here: I roughly bootstrapped two startups using a combination of the five F’s: Friends, Families, Fools, Physicians, and Float (off of credit card convenience checks!). Yet my knowledge and ability concerning raising investor capital was nil. After my time so far at Voyager, I now have a relatively huge sample size to see what works and what doesn’t (and why!) in investor pitches.

Now: if I had spent the last two years pitching VCs, would I have more and different knowledge about entrepreneurship than that which I gained listening to such pitches? Certainly. And it’s almost undoubtedly better for the skill of raising capital to actually practice raising it than to observe others pitching you. But to the 25-year-old entrepreneur without a “base hit” or previous connection to the venture industry, practicing raising VC by just doing it isn’t ge
nerally a realistic option.

Guy also ignores the fact that a VC is supposed to be different from an entrepreneur. They operate on different logical levels; a VC must be at a meta-level to the entrepreneur’s. Meta-level occupations, such as consulting or I-banking, prepare individuals for this by having them view many businesses and compare among them for patterns, valuations, etc. It’s the difference between being an antiques appraiser and being Carl Faberge.

A better and more useful caveat to young VC position-seekers is simply to remark on the dearth of positions available. There are, to a first approximation, no jobs in VC. If VC wants you, it’ll find you; if not, you’re almost certainly better doing something besides quixotically questing for a junior venture job.

That said, I chose VC as a detour on my route to entrepreneurship. Although I wasn’t originally looking for VC as a next step, it was recommended to me by one career advisor around the same time as I learned of an open position looking for an analyst with operating experience. The money isn’t princely, but it’s steady. The learning isn’t everything I’ll need to succeed, but it’ll help. And frankly, it’s absolutely a blast and the next best thing to starting my own new company.

A final note: a subtext to Guy’s entry and its comments implied that junior VC personnel were all young whippersnappers who couldn’t hold a candle to the grizzled but worldly wise entrepreneurs they worked with (and that they ought to hold their tongues besides!). That thought is OK, I guess: I certainly am humbled when I have to communicate a pass to a repeat entrepreneur who’s sold more companies than I’ve founded. But seriously: if you’re a tough, worldly entrepreneur who gets offended by talking to some young VC associate, you need to suck it up and give less of a shiitake about what us whippersnappers say.

The Pauper Lords of Open Source

I spent some time this week with some friends from the Portland Perl Mongers (PDX.pm) at 2007’s first meeting, devoted to Web app frameworks, games, and Martinis, in no particular order. Just as Seattle is blessed with a vibrant Ruby community (the Ruby Brigade meets up on Capitol Hill), Portland has a truly exceptional Perl community. At any given PDX.pm meeting, you’re likely to see any number of O’Reilly authors, high level Perl monks, and authors of CPAN modules you use regularly.

(Whether or not you know that you use them, the Perl language and its Comprehensive Perl Archive Network, or CPAN, are the behind-the-scenes heavy lifters of a great deal of the dynamic Web. The “modules” on CPAN are rarely applications themselves, but are underlying code libraries or components that enable user applications.)

Many of these luminary or guru type attendees at the PDX.pm, therefore, are effectively vendors and colleagues to those of us who have written Perl software using CPAN modules — whether or not we’ve ever met. And yet, apart from the occasional pint of beer, or royalties on an O’Reilly book or two, most of us will never pay (at least not directly) these Perl gurus for their work. This got me thinking, and, as I get to below, also got me somewhat concerned.

Open Source Software (OSS), including Perl itself and the modules on CPAN, is much loved in the business world due, in part, to its compelling price tag. Some OSS, like the Linux kernel, is developed with a great deal of assistance from commercial entities, who are often motivated to increase compatibility with their product offerings (as in driver development) or to serve some internal functionality requirement. But a dirty secret — one whose propagation has been discouraged by the promoters of OSS as part of their mostly laudable efforts to gain for it the same credibility enjoyed by commercial software — is that a vast amount of OSS is in fact written and / or maintained by the “volunteer” developers of lore. These folks are, I must emphasize, not amateur or “unprofessional” — indeed, the reason that many OSS developers / maintainers undertake the task is for professional recognition or advancement — it is simply that they have no (or only intermittent) direct economic ties to the software they maintain. Therefore, in many cases, you might have a software module whose author maintains it “out of the goodness of his heart.” Without the financial lever, users of the module cannot compel him to resume development if it falls off of his list of priorities.

(Note that I do not condemn OSS on this account; from the user’s perspective, the benefit of having free and unfettered access to the source code, in combination with the gratis price, should more than make up for the incremental uncertainty added by the reduced extortibility of the author.)

What is gained for the author and maintainer of, for example, CPAN modules, is a measure of respect and credibility among his peers. The merry band of geeks at PDX.pm, for example, treats certain of its guru alumni like conquering heroes when they return to give a talk. And I have no doubt that such a status gains one an entree when seeking consulting contracts or employment. But it’s not guaranteed, and just as the user has no leverage over the author, the author has no leverage over his users by which to demand a quid pro quo.

A disturbing consequence of this economic model came up explicitly in the PDX.pm post-meeting chatter at the Lucky Lab, however. There exist major contributors to software projects relied upon and used by thousands (if not millions; and in the case of Perl and its indirect users, it would not be much hyperbole to say a billion) of people — which OSS contributors essentially live in poverty.

Why is this, more so than other forms of poverty, especially disturbing? Well, for starters, these people are clearly creating economic value, but are martyrs to a system that doesn’t pay them back.

That open source is economically valuable may not be obvious to an Econ 101 student or the less thoughtful MBA, but even a nontechnical executive can look at the market cap of e.g. Red Hat ($4.2 B as of January 2007) and consider their ability to get there with only 1,100 employees (that’s $3.8 M per employee, comparable to $4.3 M for e.g. Microsoft, who is nearly 70x larger and is of course the global market leader and therefore presumably can get away with less SG&A per developer, and much more than $1.6 M for Oracle). If that doesn’t convince you, consider the replacement cost of many open-source products with their proprietary counterparts, and even applying a devil’s advocate discount, we find that the OSS developers are creating something worth money — yet, they often capture little or none of that for themselves.

So, although a brilliant developer on his own (or in loose collaboration with a few like minds across the world) can produce some useful thing that we believe to be worth money, that same individual has quite a challenge before him to monetize that work. And in fact, the rewards he seeks — recognition and social credit among peers — are best gained in precisely the circumstances that (are conventionally believed to) preclude monetization. By that, I mean that being a great software guru these days is best achieved by having others read and admire your code — which is done by open-sourcing it — and which in turn (notionally) stops you from extracting a fee from consumers.

Therefore, an injustice is done here because the rewards of good work are distributed not merely inequitably but in fact not at all to those who perform the work.

Another, and more practical consequence, is that there are any number of important parts of any sophisticated open-source software stack that are cared for by persons in limited or sometimes precarious personal situations. I mean cases like developers without health insurance, developers who share rooms with dodgy roommates, developers who could be staring down tax liens. You may point out that there are many more and poorer folks than OSS developers to worry about; of course this is true. But OSS developers are providing the raw materials from which innumerable startups (and incumbents!) are driving the highest-growth parts of our economy and building substantial empires.

There are very real risks for users of OSS that a dependency for some major project could fall victim to the personal hardships of a developer, if, for example, he is made to seek other work to support himself or if he falls ill without insurance. In the biggest cases (say, Google), the firm running the dependent project could simply take over the code — but in the case of a startup building on an OSS stack, the danger looms rather larger.

I have no grand plan to remedy this. And I don’t think that the (terminally broken anyhow) music copyright regime gives us much guidance. While in music it is the peripheral producers who languish unpaid and the stars who get big dollars, in the case of OSS developers, often the marginal producers are comfortably paid corporate contributors while the true “rock stars” of OSS go broke.

And although a large part of this problem comes from the effective waiver of copyright inherent in OSS, closed source software is not the answer. Closed source software (at least that which is meant to be used by developers or geeks) sucks too much.

Probably the closest I have to a recommendation on this is that users of OSS find and reward the “stars” of projects they depend heavily upon. And, having said that, I am off to send money to Bram’s Ugandan orphan
s (for the incomparable vim) and beer and pizza to the GNU Screen guys.