Having been through two market cycles already, I have been waiting for the credit mess to filter down into the start-up world. To date, this effect has been minimal compared to that impacting Wall Street and the buyout world. I would expect this to change in the coming 8 months. The question is how it will happen, to what degree and what are the signs.

I will start off by saying that I am not a great prognosticator. The best I can do is explain how it has manifested itself in the past. So far, we have been buffered by the massive liquidity the Fed has poured into the market, pushing off the onset of a strong recession. When trouble hits, it will come in three areas. First, corporations cut back on capex. Second, corporations cut back on advertising and marketing. Third, corporate acquisition appetite wanes or grows more predatory in nature. The IPO also usually dries up, but that has tepid even during the recent upswing.

What usually triggers the pull back? While there are a wide variety of factors, the one consistent factor I’ve noticed is when corporate profits begin to decline, especially when they miss guidance on the Street. This causes stock prices to drop. Management looks to cut costs aggressively when revenue growth slows and they are watching their options go underwater. Marketing & advertising is one of the first to get cut back. This has been happening gradually over the past 12 months but has not hit with full force. When CPM rates plummet and key word buys shrink, you’ll know things have begun.

Additonally, Capex shrinks and decision cycles stretch out. Enterprise sales become painful. Software, hardware and large service deals all become more difficult.

Lastly, firms will increasingly find it hard to find suitors to buy their businesses. While the market is not as robust as last year, there has still been modest activity this year. Eventually, it will feel like there are no buyers for your firms or the terms that the buyers are throwing out are very predatory. We have not gotten there yet.

Now, it is possible that the Fed will continue to pump so much money into the system and the government will continue to bailout institutions that we never get to this ugly phase (until much later). However, credit card defaults haven’t hit, regional banks haven’t been going under so there are still several chapters to play out here.

While this may be helpful in understanding where we might be in the cycle and what signs to look for, the main question is “what to do”? This is fodder for an upcoming post…

Entrepreneurship is about attitude and perseverance.  Our CFO sent this over to me which I thought I would share for the weekend. It also helps to remind you what is important in life (family) and to keep things in perspective. Stick with the video as it is about a lot more than just another young sports prodigy. Enjoy.

"Pigs get fat, hogs get slaughtered" — old folk saying

What a two weeks it has been. Who knows what firm will be the next victim of Darwin.  I told you all to buckle up last June because things were going to be interesting. With the Fed letting Lehman go down, now everyone is starting to wonder about whether their bank, brokerage firm, etc be next. Confidence in the system has taken another hit. Lot has been written on this, so I will not jump in other than to say that this is what happens when the pigs become hogs (e.g. greed takes over).  While it is the investment banks and such getting taken out back to be shot, it could be any of us. Lose your moral compass and you will eventually hit the rocks.

What the heck does this have to do with VC and entrepreneurship (this time)? Well, it's a great reminder to be your own moral compass. What I mean by this is that when you create and sell something to someone else, look yourself in the mirror and do a reality check. Just because someone might be gullible enough or uninformed enough to buy something doesn't mean that you should sell it. I have seen way too many portfolio companies fail to live up to their potential, too many entrepreneurs fail to deliver what they promised to investors or customers and too many VC's not bring the value that they claim they will.  I understand everyone has to sell and that we are, to a great degree, in the dream business. But, if you know that your portfolio company is overvalued on the LP quarterly report or that your product doesn't really do what you claim with the customer, these will eventually come home to roost. Demand excellence from yourself and from your companies and if you come up short, find ways to continually improve to be what you want to be versus pushing harder sell the pig with lipstick.

Buffett's sidekick, Charlie Munger, said it best recently:

In my mind, money earned in this way (whether Ibanker, VC or entrepreneur) is Blood Money and relies on the Greater Fool theory. That is not how great companies are made gang. So, look in the mirror tomorrow and do a gut check…

"It was the best of times, it was the worst of times, it was the age of
wisdom, it was the age of foolishness, it was the epoch of belief, it
was the epoch of incredulity, it was the season of Light, it was the
season of Darkness…"
— Charles Dickens, Tale of Two Cities

While I wrote about my concerns on the coming part of the business cycle, I am actually quite positive about the flip side of this coin. These periods are not kind to existing portfolio companies, but create a very attractive environment for new venture investments. I believe that 2008, 2009 and possibly 2010 will be good VC vintage years. Some of the crazy pricing and activity we have seen over the past year or so disappear and more rational investing takes its place. These times are actually, I would argue, also positive developments for well managed companies.

1) fewer competitors are started
2) weaker competitors go out of business
3) Darwin forces efficiency and laser like focus in your business
4) this discipline continues on when markets open back up, making for more profitable exits
5) less capital consumed means more equity for the founders in the end

Sectors that do well are those with low average burn, those focused on performance (e.g. pay for performance models) versus "productivity" or intangible benefits, and those selling into less recession sensitive customer bases. Life is tough if you sell capital equipment, have asset intensive businesses, have high burn, have impression based ad models or sell into recession sensitive industries. You are going to see a lot of dead Web 2.0 companies that rely on advertising for their revenue.

Jerry Mitchell, who is a special guy here in Chicago for his decades of helping entrepreneurs, just had his 70th birthday. He recently told that Teddy Roosevelt said one of his favorite quotes about perserverence and effort which I really liked:

“It is not the critic who counts; not the man who points out how the strong
man stumbles, or where the doer of deeds could have done them better. The
credit belongs to the man who is actually in the arena, whose face is marred
by dust and sweat and blood; who strives valiantly; who errs, who comes
short again and again, because there is no effort without error and
shortcoming; but who does actually strive to do the deeds; who knows great
enthusiasms, the great devotions; who spends himself in a worthy cause; who
at the best knows in the end the triumph of high achievement, and who at the
worst, if he fails, at least fails while daring greatly, so that his place
shall never be with those cold and timid souls who neither know victory nor
defeat.”
— Teddy Roosevelt

Eric Olson and Frank Gruber are launching their first TechCocktail conference in Chicago this week on Thur, May 29th at Loyola University. You can register by clicking here. They have pulled together a great set of panelist including Dick Costolo from FeedBurner/Google, Jason Fried from 37Signal and a host of other luminaries. They have also thrown in a VC panel which I’ll be on with Brad Feld, Kirk Wolfe, Rob Schultz and Bruce Barron. If you can make it, it is definitely worth attending.

"…it’s more about people skills and the ability to assess whether there’s a market for something."
  — Dick Kramlich, co-founder NEA

I was cleaning out my files the other day and came across a 2005 NYT article by Gary Rivlin on the venture industry titled "So You Want to Be a Venture Capitalist". It is well worth a read for any of you inspiring investors. Couple of takeaways from it:
— "Below the surface, there’s a huge amount of turnover."  I did not realize the degree of turnover at some firms, including 70% partner turnover at NEA (1997-2005) and 70+% partner turnover at Kleiner (1997-2005). Some is due to poor performance and other is due to strong performance and retirement.
— Up or out. A large share of a fund’s profits are often driven by 25-30% of the partners. This is a true meritocracy and the results are clear to quantify. Over half the partners will fail in the bigger picture.
— Entrepreneurs have a hard transition to the investing side despite the large trend towards this.
— Success is driven by being a good judge of people and for understanding when markets are getting ready for inflection. "you’re a natural athlete or you’re not"
— It is a mentoring business with a long gestation period…"probably 6-8 years and you should be prepared for losses of about $20 million (per person)".

One last point that the article doesn’t mention is that the entry period can be grueling. It is not as rosy as most people on the outside assume. 60% of a good fund’s deal will lose money or breakeven. The losses come early and winners take time to compound. So, sometimes you have years of carnage while being out in the wilderness hoping for the hits to come through.

"By all rights Stewart Alsop should have been a terrific venture capitalist. So why did Mr. Alsop, long considered a cyber-prophet among technology leaders, wash out in a profession in which he seemed predestined to succeed?

In recent months, as venture capital firms have announced the formation of new investment funds, a hot topic among the Silicon Valley cognoscenti has been the exodus of "tourist V.C.’s," as people from nonfinancial backgrounds are known here. Some have left the field because they did not pick enough winners; others have gone on to pursue different projects. Whatever the reason, there are hundreds fewer venture capitalists around today than just two years ago…." (click here for rest)

The nice thing about doing angel investing on the side is that I can invest in fun, if not wacky, ideas from time to time. I put a little money into a friend’s (John Funk, wonderful serial entrepreneur) IP incubator called Evergreen IP. His partners come out of the CPG world and they have licensed an array of innovations/patents and are now bringing several to market. One of these is the Dog Pause Bowl (www.dogpausebowl.com) which is targeted at obese dogs or dogs that eat too quickly. Look out Weight Watchers… He describes this better than I in his post "We Have Liftoff!".

There seem to be two styles of bloggers. Those that drop shorter snippets into posts but do so once or twice a day and those that like to write longer posts but do so once a week/month. While I have always assumed that the former better fits people’s consumption behavior, there have been a variety of studies that confirm this. In "Not Quite the Average: An Empirical Study of Web Use", the researchers concluded that the average web page has around 600 words and the average reader only spends time on around 100 of them (about 20-30%). So, keep the posts to under 100 words…(note to self!). We’ll see if I can do it…whoops, I just hit 119 words.

I was looking at the global statistics page at the back of the most recent Economist Magazine and noticed that it had a chart laying out the % of households in each country that use IPTV (internet) as their primary means of getting their television services (vs. cable, satellite, etc). Below are the top 7 countries on the list:

Hong Kong 31%
Iceland 27%
Estonia 10%
France 10%
Cyprus 10%
Sweden 8%
S Korea 7%
(US <1%)

Much like cellular has leapfrogged land lines as the primary telecom pipe in developing countries, many countries are going with IPTV as a prominent source of distributing content. Homes can get both internet access and video/TV delivered through one pipe. We have seen this phenomenon up close through our Growth Fund’s investment in UUSee, the leading IPTV P2P provider in China with over 30 million users.

In addition to this IPTV trend, we are also seeing videos come at us from the hosted video sites like YouTube, Metacafe and specialized channels like Celebtv. My kids are watching entire episodes of their favorite shows on the show’s website. While people complain about having too diverse a choice through the hundreds of cable/satellite channels, imagine the complexity when thousands of IPTV channels emerge. With the low cost of production and low cost of distribution, people will be able to set up extremely niched “channels”.

This will create quite the challenge for advertisers, who are still trying to figure out how to use banner ads. Instead of a simple decision of what image to put in a banner that is broadcast out, they will have to figure out if they want to use pre/post roll advertising, sponsored advertising, contextual text links beside videos, overlays on top of videos or jump into the creative game and produce content itself. The permutations of types of content with types of channels is becoming mind boggling. However, for creative lead gen players, this will present a terrific opportunity to capitalize on the complexity and the glut of ad inventory arising.

Of course, this doesn’t begin to get into the challenges of integrating cross-media promotions (text/SMS, website, etc) or the rise of mobile advertising. It’s going to be a great couple of years here as the IPTV revolution swings through!