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Danielle Morrill is mostly right about VC deal sourcing – here’s how she’s wrong.

Danielle Morrill has put out a fascinating TechCrunch article about the art vs. science of how VC “source deals” (find investments). It’s a rare candid peek into a side of venture capital, and from a perspective, that is foreign to most writing from outside the industry. Danielle is spot on with most of her article, but there are a few glaring holes in the picture she paints.

First, what’s right:

1. Old guard vs. new guard. Danielle is absolutely correct that in VC, as in most professions, the older cohort is in conflict with the newer, rising cohort. And in general, the older cohort is the group that controls the power and the economics: by definition, they’re the survivors who’ve made it to late-career stage and have done pretty well, and so they will tend to bring a status quo bias. Change always threatens the status quo — even in an industry that outwardly worships “disruption.”

2. Cargo cult or “pigeon superstition.” Danielle nails it on the head that most VCs — firms and individuals — refer to “pattern matching” and rely on it to a degree that is often indistinguishable from superstition. Generals are often guilty of “fighting the last war” instead of seeing new situations for what they are, and the same is true with investors.

Now, Danielle is a promoter and a hustler (and I mean both terms in the good sense), and it’s natural for her to think about the world — and to critique the VC industry — in terms of an aggressive outbound sales process. But there’s a problem with this approach. VC is not sales, and seeing only through a sales lens will give you a distorted view.

Here’s what Danielle’s article missed by a mile:

1. Deal Types, and why sourcing doesn’t suffice. From the investor’s perspective, there are two types of VC deals.

  • Type 1: Deals that will get done whether you do them or not.
  • Type 2: Deals that won’t necessarily get done if you don’t do them.


Type 1 deals
are “obvious.” Given decent market conditions (e.g. not in a crash/panic), they are going to get funded by *somebody*. For example: I just heard a pitch from two Stanford grads, one of whom had already started and sold a company, and whose traffic was growing 10-12% a week in a reasonably hot sector. They want a reasonably sized and priced Series A round. That deal is going to happen, no matter what.

If you want to invest in a Type 1 deal, you have to *win* it. You probably have to “source” it to win it, but that alone won’t do. You either need to pay a higher price (valuation), and/or bring more value to the table (domain expertise, industry connections, personal competence / trust).

    • Pricing: To be able to profitably pay a higher valuation, you need to have a pricing knowledge edge (which is, in more traditional areas of finance, *the* edge — why do you think Wall Street pays all that money for high-performance computing?). To get that edge, you must know something that other investors don’t about the industry, technology, or people.
    • Value-add: To bring more value to the table, you need to have something rare and desirable, and which you can *apply* from the board / investor level. That typically means you’ve previously made deep “investment” of skill, connections, and knowledge in the relevant industry, technology, or people.

Winning Type 1 deals isn’t about sourcing. It’s about front-loaded work: work spent building up knowledge, connections, reputation, skill, etc., and then demonstrating and exploiting that front-loaded work to add value.

Type 2 deals aren’t obvious. Maybe the team is somehow incomplete; maybe the sector is out of favor. Maybe there’s “hair on the deal,” as we say when things are complicated. Maybe there’s no actual company yet, as happens with spin-outs or “incubated” ideas.

If you want to invest in a Type 2 deal, you have to *build* it. It’s true you need to “source” it, but often times “it” doesn’t even look like a deal when you first learn of it. Maybe that means building up a team or negotiating a technology license from a corporate parent. Maybe it means helping make crucial first customer intros (and watching the results). Maybe it means “yak shaving,” getting some of that wooly hair off of the deal and cleaning it up. (I like that metaphor better than polishing the diamond-in-the-rough, but same idea.)

Almost always, it means building a syndicate. That starts with building consensus and credibility with the entrepreneurs and within one’s own firm. Then, it usually means building the co-investor relationship and trust needed to get the round filled out. (For Type 1 deals, it’ll tend to be easy to win over partners and co-investors. Not so Type 2.)

Winning Type 2 deals isn’t about sourcing. It’s about back-loaded work: building up a fundable entity and a syndicate to support it.

2. Pattern matching and non-obvious rationality.

The way that VCs approach “pattern matching” seems irrational when Danielle describes it. Why do those behaviors persist? It’s because they’re rational, in a non-obvious way.

If you lose money on a deal, you’ll be asked “what happened.” If your answer is “X,” and you’ve never encountered X before, there’s a narrative tidiness to the loss, especially if you resolve not to let X happen again.

If you lose money on a subsequent deal, and you also say it’s due to “X,” then things start to get problematic. Losing money on X twice starts to sound like folly. What’s the George W. Bush line? “Fool me twice … um, … you can’t get fooled again.”

If you lose money three times due to “X,” well, then, you will have real problems explaining to your upstream investors why that was a good use of their money. (Even if, in a Platonic, rational sense, it was.)

In an early-stage tech world swirling with risks, so many you can’t possibly control them all, you grab a hold of a few risk factors that you *can* control, which risks — if they bite you again — will have outsized career / reputation / longevity risk for you. And that gets called “pattern matching.”

(The same applies on the upside. If you attribute making money to Y once, it’s nice. But if you make money twice in a row, and claim that it was due to Y, and your early identification and exploitation of Y, you look like a prescient investing genius.)

Now, I don’t believe that the “X factors” and “Y factors” are all meaningless, or that pattern matching is a worthless idea. But even if you did believe that (overly cynical) idea, given the reasoning above, you should still consider it rational for VCs to behave exactly the same regarding “pattern recognition.”

3. Teams do work.

Although Danielle is right that sourcing, winning, and, ultimately, exiting profitable deals is the formula for individual success in VC, that ignores the very real role that firm “franchise” and teamwork can and should play.

Throwing ambitious investor types into the same ring and letting them fight it out like wild dogs isn’t the route to VC firm success. Well, in certain markets it probably works very well — but it’s incredibly wasteful of time and talent to have unmitigated, head-on competition between a firm’s own investors.

No. In fact, teams can and do work. Danielle’s own article manages to quote both Warren Buffett and his longtime partner, the less well-known but still mind-bogglingly successful investor Charlie Munger. Do you think Berkshire Hathaway board meetings are dominated by infighting as to whether Charlie or Warren deserves credit for the latest M&A deal? Hell, no.

Teams work in investing when, between teammates, there’s enough similarity to ease the building of mutual trust and respect, but enough difference to bring something new and useful to the shared perspective. That can be a difference in geographic, sector, or stage focus, as is classically the case. Or, I would argue, it can even be a difference in the part of the lifecycle of a VC investment that best suits a particular investor.

Let’s do a thought experiment. Let’s assume we have two partners in our firm, GedankenVC: Danielle Morrill’s clone, Danielle2, and Charlie Munger’s clone, Charlie2.

Assume there’s a hot new startup out there, let’s call it Software-Defined Uber for Shoes (SDUfS), led by a young charismatic team, who’s intent on building out a social media presence, throwing parties and events to attract energetic new employees, handing out free custom shoes around San Francisco, and otherwise making the best of their recent oversubscribed $2.5 M seed round.

Who’s going to source that deal? Danielle2 or Charlie2? (Sorry, Charlie.)

Now, fast-forward 3.5 years, and everything is amazing, if complicated. They’re on three continents, Goldman Sachs has done a private placement from their private client group, bringing equity capital raised to $600 M, and they’ve floated the first ever tranche of $750 M in Software-Defined Shoe Bonds (SDSBs). Revenues are forecast for $3 B next year, but there’s trouble going public because of regulatory uncertainty around the Argentine government’s treatment of their main on-demand shoe 3-D printing factory in suburban Buenos Aires, and the complicated capital structure. Underwriters and investors are skittish about ponying up for the IPO.

Who should be on the board of directors of SDUfS? Danielle2 or Charlie2? (No offense, Danielle.)

GedankenVC will do best if the person who can source that deal sources it, and if the person who can manage that complex cap structure to exit manages it. Teams do work.

(Disclaimer: I help “source deals” for Seattle-based B2B VC firm, Voyager Capital, but on this blog I speak only for myself.)

Capital As A Service: A Manifesto

We have been misled.  We, the entrepreneurs, early employees, and investors who power the world of technology startups, are told that “everything has changed.”  Everything is now “agile,” “lightweight,” and “flexible,” and it’s all going to be available to us “as a service.”  We create user-friendly experiences, using elegant free open source frameworks, running just as many EC2 instances in the “cloud” as we need at any given moment.  We coordinate the world’s information by mashing-up APIs from across the Web, and we coordinate our dev teams with daily Scrum standups and free collaboration tools.  A book can tell you how to have an “epiphany” and learn all this for yourself, and a thriving startup culture on the coasts, in the Rockies and Chicago, and elsewhere will support you.

But everything has not changed.  Just try raising capital.

Software is now a service.  Hardware, indeed, infrastructure is now a service.  Need an office?  Use a Web service to pick a short-term coworking space.  Outsourcing?  Sure — there’s a service to manage those service providers.  Hell, the boys at OnCompare now have a service to help you select the services.  Everything you need is discoverable, trialable, and available 24/7, online, with a few clicks and a credit card, right?

But the moment you start to feel the rhythm, decide you want to dance to the music, and try to roll up funding to grow one of these agile new businesses, the record screeches to a stop.  Needle scratch, and silence: a disco full of folks staring at you.  Are you crazy?  You want what on demand? Capital as a service?

Yes.  You want just enough of it, just when you want it, conveniently and as automated as possible.  You want to try it out in 10 minutes, understand it, trust it, and, if you like it, use its APIs to integrate with your business processes.  This is how you advertise for clicks, how you get a new logo designed, and how you provision servers.

So what is money’s major malfunction?  When you can get 100,000 virtual server instances started for you in a minute, why does it take days and weeks (or worse) to get $100,000 in working capital?

Something’s wrong with this picture.  And it’s about to be fixed.

Find a money-man and ask him about “efficient markets.”  He will give you a sparkling smile and tell you the MBA answer, that markets tend to squeeze out transaction costs, and costly middlemen, and price gaps.  Then ask him about the cost of doing transactions with him.  Or ask if he’s a costly middleman.  Or ask what “price” he pays his investors to use the money.  Is he still smiling the MBA smile?

We like having coffee with our investors.  But you shouldn’t have to savor a fine latte from Cherry Street or Coupa to get funding.  Sand Hill Road is a lot more fun to travel on a bicycle carrying a picnic, than in a rental car carrying a pitch deck.  And banks are more fun once they’re turned into bars.

Money, especially the “buy side,” loathes change.  From where Money sits, everything is fine: by definition, wherever the Money is, folks are feeling pretty flush.  And so the Money will resist change, it will cling to its prerogatives.  Bankers would still be on the golf course by 3 PM if ATMs hadn’t revolutionized their customers’ expectations.  For heaven’s sake, it’s the year 2011, and the New York Stock Exchange still closes at 4 PM.  The barbarians are at the gates: it’s about time for the “buy side” to get a little less comfortable.

About to go public on the Big Board?  Toying with a half-billion M&A offer?  Trying to pioneer commercial space travel?  Building nuclear submarines?  OK, you want old-school money from old-school money-men, with old-school suits and rich mahogany, Corinthian leather, and white-shoe lawyers.  But rolling up the cash to take your SaaS company from $2 M to $4 M next year?  It it worth 12 weeks of pitching and partner meetings and Purell between uncounted firm handshakes, with no guarantee of success?

We think not.  For a specter is hanging over the Internet: the specter of capitalism.  And we believe that capitalism should and will deliver its promise as a service.  We at RevenueLoan are not the only ones who see this; we may not even be the ones who ultimately realize it.  But make no mistake: capital for growing technology companies is going to be available on-demand, as a service, and players in this market who ignore this trend do so at their peril.

The Secret Trick of Portfolio Effect Dominance

Smart-as-a-whip VC Sim Simeonov did some math and some simulations and came up with the conclusion that a large “portfolio effect” has a major, almost overwhelming, effect on the financial returns of e.g. angel and seed VC portfolios.

English translation: make a LOT of small bets in order to win. (Even if most of those bets are losers.)

Now, this sounds somewhat counter-intuitive to a lot of folks who have been trained to “think like investors:” after all, the more deals you do, the less of a special snowflake you must be, right? (And we all know, Private Equity Professionals are the Specialest Snowflakes of All.) Furthermore, doing more and more “losers” in order to scrape together more winners (rather than trying to avoid losers altogether) just grates the wrong way at the investor mindset.

Well, Sim Simeonov has rejected that mindset with his Simeonov sim. (Forgive me.) But the point of my post isn’t just an emulation of Sim’s simulation. It’s that he’s right despite his simulation math. Rational VCs should be doing as many deals as possible, true, but it’s not due to portfolio IRR; it’s in spite of IRR.

No, the real reason that rational VCs should be doing as many deals as possible is that, to a large extent, VC firm survival has been dependent more on appearance than on financial reality. Specifically, assume two similar firms on their 2nd or 3rd funds, and assume they both, 5 years in, go out to raise funds with a 20% IRR. However, Firm A has earned that IRR through a risk-averse, lower-beta type strategy, while Firm B earned that IRR with a much larger “shotgun” portfolio chock-full of duds, but with a tiny sliver of a Google or similar mega-hit. Which firm is going to be able to raise the next fund with more certainty?

How things have worked to date is that LPs fall in love with great stories, and so it’s more important (in general) that you have one great story in the portfolio (even if it’s for a small investment) than that you have a bunch of sleepy, boring stories that average out to the same return.

Now, I’d love to see what savvy upstream investors like the Super LP, for example, think of this theory: it’s certainly not very flattering to the LP community if you suggest that they make investments solely on “stories” and not on “math.” In the LPs’ defense, I don’t think they’re being lazy or stupid; on the contrary, for the first several decades of the VC industry’s life, the market was so inefficient, and the data were so very sparse, that “stories” were the only reasonable data to look at.

However, we now have a VC (and super-angel, and micro-VC, etc.) industry that is chock-full of history, overflowing with data, and crowded with participants in the marketplace who will (relatively) quickly compete for new niches (especially as the squeeze of a denominator effect and general anti-VC enantiodromia are felt). I no longer feel as strongly as I once did that we’d soon have algorithmic VC decisions, and I doubt that we’ll see a “robot uprising in venture capital.” But I do hope and believe that we will see a more disciplined industry, and one where VCs’ incentives get rearranged to align better with actual financial returns (rather than with “stories” that drive fundraising).

(I do happen to know that there are institutional investors who realize the “great story bias” and are seeking to exploit the inefficiency it creates… let’s just say that if you were going to exploit it, you might look quite hard at Revenue-Based Finance as the way to do so 😉

Can a VC sit on more than 10 boards without f***ing up?

[Update: the conversation referenced below was with Scott Austin of the Wall Street Journal; he has written an article about the subject. In it, he quotes some VCs that have well over ten board seats, including Forest Baskett of NEA. I know Forest only through his and his firm’s reputations (both stellar), and I emphatically do not mean to impugn his board service, commitment, or professionalism. That said, I can’t back down from the math below and I must suggest that overloaded VCs necessarily give some of their boards short shrift.]

I had an interesting conversation today about VCs and board seats. The essential question is: how many board seats is too many?

Happily, the math involved here is pretty low-key (algebra, the highest level of mathematical reasoning to which VCs are required to aspire).

One of the best VCs I know always aspires to be the lead investor. Being the lead investor means you’re the de facto coach, quarterback, and ringleader for that round’s investor syndicate (and likely the entire board). He also tries, both as lead investor and as board member in general, to be a coach, if not confidant and mentor, to the CEO. This is all in addition to the normal duties of a good board member: meetings themselves, prep for meetings, often board dinners the night before, regular if less frequent contact with non-CEO executives (diligence and prudence), recruiting etc., and of course, any audit/comp committee work.

What kind of time does this take, on a monthly basis (4.3 weeks/month)?

  • Weekly CEO calls: 4.3 * 30 min = 2.15 hrs
  • Board meetings q 6 weeks, plus prep: (3 hrs + 1 hr) * (4.3 / 6) = 2.87 hrs
  • Massaging the egos of other board members before/after: 30 min * (4.3 / 6) = 0.36 hrs
  • Monthly CFO or other exec calls: 1 * 30 min = 1 hr
  • Executive recruiting (2 major searches a year, taking 10 hours min. each): 2 * 10 hrs / 12 = 1.67 hrs
  • Committee work (2 meetings a year, taking 3 hours min. each): 2 * 3 hrs / 12 = 0.5 hrs
  • Go to one industry conference a year: 8 hrs / 12 = 0.67 hrs

This is the bare minimum theoretical lower bound that you can consider as the time requirement to be a good, lead investor VC board member: 9.1 hours per board, per month, or just about 2.1 hours a week.

That is for the perfect, steady-state, frictionless world: board meetings are in your town at your firm’s offices (no travel), you do not raise a round, and there are no crises. A more realistic assumption would be to add:

  • Meeting travel q 6 weeks (MINIMUM, even driving up the 280 from Menlo Park to the city takes some time): 1.5 hr * (4.3 / 6) = 1.1 hrs
  • One crisis OR new round per year: 20 hrs / 12 = 1.7 hrs
  • Actually “adding value” like you said you would (soliciting customers, buyers, investors, etc.): 2 hrs /month = 2 hrs

So the real-world minimum adds another 4.8 hrs / month, bringing us to 13.9 hrs /month or 3.2 hrs / week.

How much do VCs really work? I think it’s fair to suggest that VCs work at least as much as other ambitious but affluent, socially-encumbered, and non-hourly-billable professionals: probably on the order of 50-60 hours a week. Let’s call it 55, which would reflect the combination of 10 hour days, 5+ hours each weekend, and a long and/or exotic-enough vacation each year to brag about with the other nouveau-affluent in your social circle.

The real-world catch here is that VCs have to spend a minimum of 5 (and as high as 12) hours at weekly partnership meetings. Let’s call it 6 hours/week to be charitable.

55 hours total – 6 hour partner meeting overhead = 49 workable hours.

49 workable hours / 3.2 hours per board (real world minimum) = 15.3 boards.

So there we have it: 15 boards is the upper bound of what a VC can probably sit on. HOWEVER, this assumes 100% of his working capacity is devoted to board work — nothing here for new deals or fundraising (or for other exotic and occasional pursuits, like strategic planning, learning and research, or leadership and mentoring of junior personnel). That estimate of 15 boards also has what I call the “conceit of optimality,” or inverse-Murphy: it assumes that the crises, new rounds, etc. do not overlap and create impossible time-crunches.

Given that fundraising is THE existential requirement of VC firms, and given that new deal work does have to happen somehow (after all: how did those 15 investments get made??), you’ve got to make significant provision for the working time of a VC to those other, non-board priorities. I personally think that non-board work is at least HALF of the workable hours, but I could be convinced that a board-seat-heavy partner might spend 2/3 of his time on board work.

Therefore, I think that 10 is the maximum realistic board seat capacity of a VC partner who wants to do a reasonably diligent and good job on boards, while also doing the minimum to stay in business as a VC. In practice, I think many boards will take more-than-average time, and I think most VCs will need to spend more time on non-board work, so 7 or 8 is probably a better number to set as a prescriptive maximum.

One could exceed ten board seats without f***ing up in exceptional cases:

  • Independent angel investor (no “firm” overhead)
  • Exceptional geographic and/or industry concentration
  • Evergreen fund, wind-down of a fund, or other nontraditional partner role

Otherwise, you are going to be dropping packets on the floor like a Cogent router in a SQL Slammer epidemic.

One probably needs to hold significantly FEWER than ten (or even fewer than 7) if the following hold:

  • Geographic diversity (have to fly to board meetings)
  • Industry diversity (trying to stay up to date and mine contacts in diverse fields)
  • Series A/B/C rather than later stage weighting (hypergrowth, “chasm,” hiring, and fundraising challenges).

VCs passing for “soft” vs. “hard” reasons

I recently made the choice (mistake?) of telling an entrepreneur, whose business I actually liked and respected, the real reason why I was passing on investing at the time.

In this case, there was a new CEO recently signed up to work with a technical founder, there were some family relationships on the team and board, and there were some international complexities (overseas offices). I also believed that there were some cultural issues in the company that needed work (especially around customer service / customer experience issues).

Now, compare these things to the usual, “hard,” “objective” issues that VCs take: market size, defensibility / patents, growth rate, capital requirements — things that can generally be reduced to numbers. My concerns looked pretty “soft” in comparison: seasoning of the team working together, culture of customer satisfaction, family dynamics. I took a risk and laid it out there, adding that I would be happy to check in in a few months to see how things were shaping up on these “soft” issues (but I acknowledged the risk of losing the deal to a faster moving investor).

The entrepreneur’s reaction was mixed. At first he told me he appreciated the candor, but then, in a follow up email, objected pretty strongly and negatively contrasted our communication with other VC “passes” he’d received, each of which had a “hard” reason (like raising too much / too little, outside of geography, etc.). I thought about this for a bit.

If you were pitching, and the VC declined to proceed at that time, would you rather get a “hard” or “soft” reason for a pass?

I’d say “soft.”

If a VC tells you, “ah, you’re raising 10-12 million from two VCs, but my fund size will only let me put in 2-4,” or conversely, “you’re raising 2-3 but I have to put 4-6 to work in each investment,” what have you actually learned? With due respect, you’ve been told that your would-be date has to wash her hair on Friday. Perhaps, in fact, she is going to wash her hair, but if she was really attracted to you, she’d rearrange her shampoo schedule.

Likewise, total market size, IP, or the elusive “traction” are all “hard” reasons for a pass. They’re likewise convenient: they are impersonal / objective, deficient to some extent in all startups, and theoretically required for success. Each is a seed crystal around which a swirl of “soft” reasons can easily and apparently crystallize. And they all sound good, well-reasoned, prudent — things we can easily feel OK about mentioning to our partnerships or to you, the entrepreneur.

(Not that this is disingenuous or untruthful in any way on the VC’s part; since we must reject literally 99% of deals we look at, sometimes one reason is as good as another.)

BUT: if you can find someone willing to take a risk and share the “soft” reasons with you, have a close listen. Soft items include team dynamics, opinions about “direction” or “strategy,” or “pattern recognition” stuff. Sometimes it’s about a “smell factor” or something else that just makes a VC uncomfortable. Always, it’s a complex cocktail of different perceptions, judgments, and opinions (from the discounted cash flows to Lord Keynes’ “animal spirits”), and the true contents are much more varied and harder to describe than a single crystallized hard reason that’s dropped out of solution.

These things are risky for an investor to try and describe. They can be personal or interpersonal, and talking (or listening!) directly about one’s own self is hard. They often include a personal value or judgment call on the investor’s part, and those calls can prove wrong. However, in fundraising as in so much of startup work, perception is (or at the very least strongly feeds back into) reality. Getting an honest assessment of what one investor really, truly thinks at the “soft” and complex level is likely to be more helpful in shaping the business and the pitch than a pat “hard” answer.

Sometimes, things just don’t align and the real answer is: no fit, let’s both shake hands and move on quickly. And sometimes, there’s a complex swirl of doubt but the time and effort of dissecting and parsing it isn’t worth the likely yield: crystallizing on a “hard” rationale for a pass is fine. But if an investor takes the time to dig in, to do the “mass spectrometry” on the trace elements of his doubt, please listen. He’s taking a risk, and though the soft observations may be wrong, the mere fact of their existence and elicitation, as well as their details, should be valuable to the entrepreneur.

(The next step is getting VCs to solicit, appreciate, and iterate/improve based upon “soft” feedback from entrepreneurs. Which I am trying, the reader may have concluded in surmise, myself to do. The entrepreneur I describe is real and gave permission for me to mention him anonymously.)

Can you trust any VC OVER 40?

Steve Blank at Entrepreneur Corner writes with the inflammatory headline, “Can you trust any VCs under 40?”  He doesn’t actually talk about trust, but instead gives us a gloss on the history of the original Internet IPO bubble (1995-2000) and the subsequent mini-boom in M&As (2003-2008).  His thesis is that any VC under 40 has been negatively influenced by these cycles, and therefore eschews “helping entrepreneurs build companies” in favor of seeking “shortcuts to liquidity.”

Well, I call B.S.  The problem is that Steve starts with a bunch of unobjectionable and demonstrably true statements, then starts layering in misleading or irrelevant stuff, and concludes with what is essentially nonsense.  Observe:

“… Venture Capital firms have honed their skills and strategies to match Wall Streets needs …”

“VC’s make money by selling their share of your company to some other buyer – hopefully at a large multiple over what they originally paid for it.”

“[during the 1995-2000 IPO bubble,] old rules of building companies with sustainable revenue and consistent profitability went out the window.”

… the number of venture firms soared …”

True. VCs are businessmen.  We respond, like all businessmen, to price signals in the market, and when pricing indicated demand for new IPO issues during the bubble, VCs responded.  More people entered the VC market as a result of seeing these price signals.  That these price signals were amplified by bubble psychology is clear, but hardly novel: the Dutch did it with tulips back in the day, and half the country did it with houses in the last few years.

The boom in Internet startups would last 4.5 years – until it came crashing down to earth in March 2000.”

“For the next four or five years [2003-2008], technology M&A boomed, growing from 50 buyouts in 2003 to 450 in 2006.”

Misleading.  The boom in Internet company deals stopped in 2000, but those companies (except for the most egregious flameouts) by and large still existed in 2001.  And the M&A “boom” that Steve refers to is a chimera.  VC-backed M&A peaked for that period at $32 billion in 2007, yes — but this was still down from totals of $41 and $69 billion in 1999 and 2000, respectively (that’s M&A alone, independent of the IPO bubble; source: NVCA 2009 Yearbook).

Plus, it is entirely appropriate that a “boom” in tech M&A should follow, with a 5-8 year lag, a boom in VC investment.  All that Steve shows here is that the VC investments that were made during the first Internet bubble, on average, did in fact build companies that later were sold.  In fact, 2004-2006 is probably a pretty appropriate example: with our ~ $14 trillion economy, growing by ~ $420 billion a year (3%, though sadly not this year), it’s entirely reasonable to expect sustainably to generate $10-20 billion a year worth of M&A in the highest-growth sectors.

“… since the bubble, most VC firms haven’t made a profit.”

“… the message of building companies that have predictable revenue and profit models hasn’t percolated through the VC business model.”

“… [you should suspect that VCs are] trained and raised in the bubble and M&A hype and still looking for some shortcut to liquidity.”

Just plain false.  First, Steve confuses VC firms with VC funds.  Most all firms manage several funds.  The #1 correlate of a particular fund’s returns is its vintage year.  When you look at VC as an entire asset class, it’s like looking at performance numbers for mutual funds: most of them (with the same basic focus / strategy) perform pretty similarly based upon how the markets did in a given year.  A given fund having lackluster returns in a lackluster vintage year isn’t broken; it’s how the system works.  VCs’ upstream investors are asset allocators and make steady investments in an asset class year after year, and are richly rewarded for their patience.

With respect to the implication that profitability needs to “percolate” through VCs’ thick skulls, I urge you, dear reader, to talk to any VC-backed CEO.  I double-dog-dare you to come up with an example, outside of perhaps the top 3 or 4 highest profile growth cases (hint: think “tweets” and “pokes”) where his VCs are not harping on cutting burn, boosting margins, and getting to breakeven.  Heap all the abuse you want on VCs, but we’re not stupid — our “business model” is to respond to market demand.  If exit markets want Webvan and eToys, great; if they want six quarters of profit growth, great.  “Eat all you want, we’ll make more.”

I don’t know how Steve puts his pants on in the morning, but I don’t know of any shortcuts.  Until the magical pants elves start helping me with my trousers, I put them on one leg at a time.  And, as soon as the liquidity fairies start pointing to magical shortcuts, I’ll take them, but I sure as hell don’t know where they are.  “Companies are bought, not sold.”  Does a buyer want to buy an unprofitable company?  Great, if the deal is legit and satisfactory to the shareholders — but that’s called an exit, not a shortcut.

Finally, let me address Steve’s ultimate incongruity: the notion that under-40 VCs are “trained and raised in the bubble and M&A hype.”  I’ve already shown that there was little, if any, unsustainable M&A hype in the mid-2000s (though perhaps 2007 got a bit frothy).  So, disregarding that, we’re left with the “raised in the bubble” (1995-2000) argument.  Well, look: there are essentially no long-term jobs in VC for anybody under the age of 25; those few firms who hire IROCs (intellectuals right-out-of-college) generally treat them as “pre-MBA” positions with a guaranteed kick-in-the-ass after 2-3 years.  So what kind of current VC was “raised in the bubble?”  Let’s take a 27-year-old banker/MBA type who was hired in 1996, and so got a solid bubble indoctrination.  How old is he today, as 2009 draws to a close?  That’s right; the VC who was “raised in the bubble” is now 40 years old.

A modest proposal: maybe you can’t trust any VC over age 40.  Better stick to those of us who started our investment careers after 2000…

The Downturn, REAL vs. FAKE VCs, and REAL WEALTH

In early October 2008 I was asked by a local entrepreneurial booster group for a quote giving VCs’ take on the state of the financial world. Here’s what I wrote (but was too busy/lazy to blog) at the time:

  • REAL VCs have committed funds from stable, liquid, institutions who are not going away (state governments, universities, pension plans, countries).
  • REAL VCs have partnership agreements that last 8-10 years and aren’t tied to the current level of the NASDAQ or the price of anyone’s house.
  • FAKE VCs are everyone else who claims to be a VC but isn’t like the above.
  • FAKE VCs may be nice people but since they aren’t REAL VCs, you don’t know what you’re dealing with in working with them. So be cautious and “know your investor” if you are going to rely on them for your short- to mid-term capital needs.
  • Don’t sweat it; unlike the financial economy, early stage firms are inventing and creating and building things to sell in the real economy. Yes, you’d rather sell your company into a bubble. But great companies are often built in downturns and sold in upturns. Keep building and selling.
  • All the REAL WEALTH that humanity has ever created has been the result of new invention and teamwork. All of this CDO/MBS/hedge fund nonsense is just pushing around money. You, the entrepreneurs and inventors, are the real engines of true wealth creation and we VCs are honored to play a role in helping you do so.

All of this seems at least as true and relevant today as in the first days of October. So let’s all take a deep breath and keep this in mind: human ingenuity (Founders, CTOs, Visionaries) conceives new wealth; human effort and discipline (Engineers, Salesmen, Managers) bears it into the world; and the acceptance of it by markets (Customers, Sponsors) makes it viable and sustainable. VCs play our own humble role by advising the foregoing and making calculated risks of our (and our investors’) wealth and time. This is a GOOD THING, and furthermore, this is a cycle that despite its rough edges CREATES NEW WEALTH. That is not the case with all of the now-trashed asset classes (which were largely about flipping the same old bad ideas to one another) and the whining rent-seekers who (mis-)managed them.

If you’re reading this, you’re almost certainly a geek or a startup-world person. And that means you, like me, have a unique opportunity and burden to do the right thing in this crappy economic time.

So, please. (This goes for me too.) Turn off CNBC. Close the browser window for Yahoo! Finance. If at all you can, block out this volatility and pandemonium among the wealth-re-arrangers. And, please, focus and redouble your efforts on creating wealth and value that ultimately will be what allows our humble race of tool-wielding mammals to conquer ignorance, disease, malnutrition, isolation, Malthus, and generally the heat-death of the Universe.

VCs and the Naughty Bits

I spotted a piece by Paul Kedrosky today during a blog-feeds-catchup-session where Paul talks about a sort of “(minimum) two degree of separation” rule that VCs maintain between themselves and the sex industry. (Quotes above for my words, not his.) In other words: benefiting from infrastructure, transport, payment mechanisms — cool. Having fleshy bits linked to from the portfolio companies page — not cool.

This reminds me of an early experience I had at Voyager. We were looking at a company that was building an online search / social media app. They talked about people using it for various applications — consumer, enterprise, small business, blah blah blah. We were just about to the end of the pitch, when I asked pretty straightforwardly: “So, what’s the sex angle here? Is there an application in dating or porn?”

The room went silent.

I pushed on, oblivious to the mood that had just chilled like a shot of Jaeger down an ice luge. “You know, like VHS, or modems for BBSes, or early adoption of Web marketing tricks like affiliate programs and popups,” I articulated despite the intrusion of my foot now rapidly entering my oral cavity. “Is there a strategy for accelerating adoption around that content?”

The founders were visibly uncomfortable. Mercifully, my boss was not pissed, just bemused. “I … I guess people could use it for other things, too,” said one of the founders, finally. Handshakes all around, a quick note on our investment process, and we’ll get back to you after next week’s partner meeting, ciao for now.

Oops. Back at the office, this is addressed.

“Randall, in the venture business, we have certain things we don’t talk about, and certain things we don’t invest in, due to a number of reasons.”

At the time, I’m thinking: OK, VCs are pillars of the community, have to show up at the Opera, at the charity events, at the B-school reunions, and can’t be branded pornographer or such. I filed this away under the “shit not to talk about, Einstein” filter, along with ever admitting to listening to Journey, or denigrating tattoos while speaking to anyone whom you’ve never seen fully naked.

But now, Paul Kedrosky gives me a flashback and with a key piece of insight. It’s a follow the money moment: “… until the venture business is funded by groups other than pension funds, trusts, and endowments (ahem), the likelihood of mainstream VCs ever getting beyond flirtations [[with the sex business]] is vanishingly small.” Yep, follow the money. The paymasters here are the Prudent Men, the real stodgy guys, the Trustees and the Chairmen and the Stewards and the Overseers.

And frankly, this is probably a good thing. It’s a little like the Senate. You don’t want the country entirely run by a bunch of pasty old white dudes, most all millionaires, 60 years old and who won’t be fired for 12 years (on average), and who probably still think that Kudzu and the missile gap are our biggest national problems. But you don’t want a bunch of whippersnappers on the make driving all your big decisions without recourse to the accumulated wisdom of years past.

The real test will be if one of the trendsetter endowment funds like Harvard or Yale green lights a VC or PE investment that targets the sin sectors. If that ever happens, then the VC business will start to get a lot more (directly) involved in the naughty bits…

Liquidation Preferences: A Response to Leo Dirac

In a recent blog entry, Leo Parker Dirac poses the question of the fairness of liquidation preferences in VC financings of startups. He’s going to be delivering a lightning talk based on it tonight at Ignite Seattle.

(To those of you who don’t know, liquidation preferences, or prefs, are usually a multiple of invested dollars that a VC gets out first, before anyone else is paid. This is because if you take $10 M from a VC for half your company, then shut down the company one second after depositing the VC’s check, he would only have a claim on half of it, thereby snookering him out of $5 M. To avoid this outcome, and due to our general greed, we VCs like to ask for at least a 1.0x preference, meaning that you have no incentive to shut down the company until you’ve grown it to something more than our investment dollars.)

His conclusion seems to be that liq prefs can be fair if transparently communicated to all parties. Of course, this implies that sometimes, details of prefs are not communicated clearly.

How can this be? I’ve seen many tens of term sheets, and never once have I seen one that uses invisible ink. Neither have I ever seen a term sheet that has a clause invalidating it if you show it to your lawyer. In short, there is never a case where an entrepreneur isn’t reasonably informed about prefs.

Let me construct an example. Say that you’re a first-time entrepreneur, and that you don’t have anyone on your exec team, nor on your board of directors, nor among your existing investors, who’s ever seen a term sheet before. (I was in that spot starting my first company back in 2000, by the way.) And, let’s say, you get hold of a term sheet that casually throws out there something like “holders of Series A shall be entitled to an amount per-share equal to two times the per-share price…” and you don’t know what it means.

Well, one thing I can absolutely promise you is that no VC is trying to sneak one by you for a shot at 2x his money. A VC investment just takes way too much heartache and worry and effort — not to mention opportunity-cost of not investing in the billion-dollar blockbuster every VC’s looking for — for a VC to fuck around with taking a chance at cheating you out of a couple million (remember, he has to give all but 20% of that profit to his investors, and split that 20% through some formula of his partnership, so even if he cheats you out of $5 M he’s not going to deposit more than a few hundred $k in the bank, and that’s at risk of losing his several hundred $k per year sinecure for a GP of a decent-sized fund).

Another thing I can promise you is that no VC ever wants you to sign anything without reading it and having your lawyer read it twice. Think about this one for just a second: I’m about to wire you enough money to buy twenty or thirty Porsches, based on the notion that you’re a brilliant businessman who’s going to make us both rich. Do I want to give thirty Porsches worth of cold, hard cash to the kind of guy who signs deals without reading the contract??? Seriously: I want you to be the slickest of salesmen, the toughest of negotiators, and the most diligent of dealmakers (not to mention a prodigious engineer, a revered leader, and a master marketer). VCs do not want to give money to sloppy suckers who can’t be bothered to read and understand a term sheet — including seeking savvy legal counsel when appropriate!

Now, having said all this, there are at least two cases where Leo’s thinking really does apply to the question of liq prefs. (It shows of Leo that his thinking on the matter of prefs is mostly abstract, that he does not mention either of these two cases.)

The first case is where you are dealing with a fake VC. A real VC is someone who spends full time managing a fund of committed capital from one or more arm’s length investors, which capital amounts to at least, say, $10 M per general partner and is entirely meant to be invested in growth companies for the purpose of financial returns primarily via capital appreciation. A fake VC is anyone else who calls himself a VC without pointing out the major differences with the above. And a fake VC has God-knows-what sort of motivation and may well want to swindle you out of a preference multiple.

Your uncle who owns a chain of bagel shops is not a VC. A hedge fund is not a VC. A dude who claims to represent a group of “anonymous Asian industrial families” is not a VC. Anyone who is keeping his day job is not a VC. Real estate guys are not VCs. Note that this doesn’t mean they are bad people (unless they pretend to be VCs, in which case they are fake VCs). It just means that the ground rules that you can understand all VCs to play by don’t apply.

If you’re not dealing with a real VC, read everything three times and have your lawyer read it six.

The second case is in follow-on rounds where the company is in a distressed situation. Everything Leo talks about (and everything I assume in the first part of this post) is about the moment before you take your first VC investment: do I take this capital, with its strings attached, for a shot at building my dream? The alternative there is to simply walk away, and go back to working at Microsoft. But once you’re hot and heavy with a company, once you’ve raised money, promised the moon and the stars to your friends and family, bamboozled the VCs into funding you, alienated all your social contacts and exacerbated your RSI, hired fantastic people and worked them to exhaustion and made them love you enough to drink the Kool-aid, extended commitments based on your word and your honor to customers and suppliers — only to find that revenues aren’t ramping up fast enough and you need cash — OK, now you are officially up against a wall. And precisely now is when you will be addled from overwork, and adrenalin-high, and blinded with the urgency of your need — and when the sharks will smell blood.

That is when you will get the predatory term sheet.

If Leo wants to do entrepreneurs (and VCs) a favor, he should take a hard look at what happens then: when you’ve got a company that still holds promise, but is in a distressed situation and needs capital for its very survival. Exploring those moral complexities is a lot more interesting than the sort of clean-room, game-theoretical chatter about whether one accepts term X on a first round of capital.

VC Career Snippets: "The Wormhole"

This is the first of a series of “snippets” about getting a job in VC. I get asked about this approximately weekly, so I am going to try and do a highlights reel of things I tell people or thoughts I come up with on the topic.

In a nutshell, VC is this weird parallel universe into which there are very few wormholes. (To start a career in VC) It helps to distort the space-time continuum with an extremely concentrated mass of money that you already have.