One thing entrepreneurs are always trying to figure out how VC’s think and go about their business. What is it that VC’s are looking for? Those trying to get into the business are trying to figure out the best practices of successful VC’s. Paul Kedrosky just led a panel of leading VC’s and asked them some of these basic questions and posted his findings on PE Week’s daily newsletter. He also publishes his own blog "Infectious Greed". His final conclusion is that the Wizard is schizophrenic…click above to get the full story.

"We are losing our battle with all that is personal and real about our
business."                                                                                                                          — Jerry Maguire

I think that all venture firms should have a Mission Statement a la Jerry Maguire. We don’t have one nor do any firms that I know, but it certainly is worth considering. It would help entrepreneurs better understand the firm while also creating a "northern star" for the firm. A number of you emailed me after my Entrepreneurial Entitlement post. You had questions about what the top VC Entitlements were. Underneath the various comments, I could infer the normal questions about why VC’s have a poor reputation when, in fact, they enable significant value creation. I think part of the issue is that over half of venture deals don’t work out (either partial or complete loss). A lot of finger pointing occurs during these wrecks and, rightly or wrongly, VC’s are implicated by association.

However, I think that there is something else going on. It reminds me of the scene in Jerry Maguire when Jerry finally snaps under the cynicism of his business and he writes the famous Mission Statement that gets him eventually fired. (By the way, I actually chased down the original statement in its entirety for anyone interested…while quite wordy, there are some interesting parallels to the venture business Jerry Maguire Mission Statement).

One of the most difficult things about being a VC is in walking the fine line between being in the creation business and being in the money business. Without providing constraints and structure, a VC guarantees that his/her fund will under-perform. Many times, a company or entrepreneur needs to be saved from him or herself, to have the straw taken out of the proverbial Cool-aid. However, VC’s can often fall on the other side of the line, whereby it becomes purely a money game. It is around this issue that Maguire had an interesting quote:

"We are losing our battle with all that is personal and real about our
business….We are
pushing numbers around, doing our best, but is there any real
satisfaction in success without pride? Is there any real satisfaction
in a success that exists only when we push the messiness of real human
contact from our lives and minds? When we learn not to care enough
about the very guy we promised the world to, just to get him to sign.
Or to let it bother us that a hockey player’s son is worried about his
dad getting that fifth concussion."

So, with that philosophical ranting done, here are my candidates for the top 5 VC Entitlements:

1) Nonconstructive Criticism VC’s often find their portfolio companies not performing as expected or promised. We all have a knee jerk reaction to state the obvious and to apply pressure to the management team to change things. However, it is one thing to point out an issue. It is another to a) frame it within what is realistically doable and b) help think through options and solutions. As my friend and former portfolio CEO, Juergen Stark, used to sarcastically say "Great. I got it. You want me to do more, with less and deliver it on time. Any more helpful suggestions?"

2) Micromanage Following up on #1, VC’s can often begin to micromanage portfolio companies when things are not going well. Maybe it helps us feel like we are managing a situation or maybe we just feel entitled to muck around in the business. In reality, unless a VC has specific domain or managerial expertise that helps the business, this usually results in a frustrated CEO and a lot of wasted time on both the VC and company sides. It also brings into question how much trust exists between the two parties.

3) Introductions I violate this one much too often. VC’s legitimately want to add value to their portfolio companies. One clear way is to make helpful introductions to customers, partners, recruits and such. However, we can also often push introductions that are not relevant but yet take up management time and attention to follow up on. Just because I know someone that seems important or useful doesn’t mean that he/she is an appropriate introduction. The key is thinking about the introduction from the entrepreneurs perspective while taking into consideration their priorities and objectives.

4) Opinion Heard  VC’s are obviously in a position of power because of the capital they can bring (or not bring) to a company. This gives us significant leverage. We also usually have an opinion or position on most areas of the company. These opinions are not always aligned with those of management (or relevant for that matter). Follow-up on #2 above, a VC needs to be careful not micromanage the business nor voice opinion frequently just to be heard. Entrepreneurs also need to realize that sometimes, a VC might actually have something useful or helpful to say!

5) Low Value Add Sometimes, what a company wants is just capital. However, more often, it needs help with strategic decisions, customer introductions, recruiting and such. Some VC’s are very good at rolling up their sleeves or in sharing their relevant contacts. There are other VC’s that see their roll predominantly as providing capital. This can be fine but the VC should at least make the effort to understand the business and industry.   

Should all go well, we hopefully can deliver to our portfolio companies the Maguire utopia:

"I will not rest until I have you holding a coke, wearing your own shoe,
playing a Sega game featuring you, while singing your own song in a new
commercial starring you, broadcast during the super bowl in a game that
you are winning."

Summary:
— pricing is driven off of multiples not IRR
— VC’s target 10x due to high failure rates
— start at the expected final valuation and work backwards.

What area of venture capital is more opaque and mysterious than how VC’s price deals? Professors have tried to quantify and analyze what we do. Ironically, it is quite simple, though subjective.

Many entrepreneurs try to approach valuation from a classical discounted cash flow model. They show what the next 5 years are going to look like and then discount it back to the present using various discount factors. If you are going to pitch a VC, please don’t use this methodology as you will start your relationship there with a mark against you (also, don’t claim a) your numbers are conservative…trust me, they are optimistic at best and b) you have no competitors…you need to do more homework).

The core issue is that the venture business is unpredictable. Numbers going out more than a quarter are unruly. Those going out 5 years are pure fantasy. Market adoption rates, pricing models, product mix and such are all up in the air. Therefore, the numbers are useless and the DCF from them are even more so. Furthermore, good luck trying to nail down what the right discount rate is…lot of beta in this business.

The venture business is driven off of multiples. Early stage VC’s target 10x return of capital and expansion/late stage investors target 3-5x. Why 10x…seems a bit usurious? The classic venture portfolio looks like this. Of ten deals done:
— 4 crater
— 2 are breakeven +/- a little
— 3 are 2-5x capital
— 1 is 8-10x

So, as a VC, you hope that all 10 deals will be the next Microsoft, but reality sets in at the first board meeting. You need to target 10x for your winners in order to pay for the losses elsewhere.

VC’s will then try to estimate a) what they think the company might be worth if successful in 3-5 years and b) how much more capital will be needed. In a simple case, let’s assume that the company is worth $100m in 4 years and will not take additional capital. Using the 10x rule, the VC will price the deal so that post-$ valuation of the deal is $10m. If the company is raising $2M and adds $1M worth of options to its pool, the VC will pay $7M pre-$.

Clearly, the Achilles heel here is how to estimate the terminal value. I have seen several reports indicating the average IPO (only about 10% of exits these days) has had an $180m valuation and the average M&A valuation is around $120m (about 90% of exits). This puts the average overall around $125-130m. Assuming no new capital (big assumption) and an average raise of $3-5m, this would put your average pre-$ around $7-9m. Seed deals will usually price between $2-4m pre-$.

There is lot of variance in these numbers, so use them more as examples to help you understand the black, Voodoo art of VC pricing.

There is much discussion in the venture business about whether you back the horse or the jockey. Some, like Don Valentine at Sequoia, state they look for large growing markets and find the team later. More frequently, you hear VC’s saying that the business is about people, people, people.  In the end, I would argue (conveniently) that it is both. Market readiness makes heroes and fools out of investors (right concept, wrong decade). If the market/customer base is not ready to adopt a technology or solution, for whatever reason, even the best management team will be unable to win. That said, management teams are critical to success in the race. Often, when the market is ready, the trophy normally goes to the team that out-executes the rest. Just look at Google versus Alta Vista, Ask Jeeves and Inktomi. Of these two, market (horse) has the greatest macro impact but management (jockey) has the greatest micro impact.

Warren Buffett, the largest cheerleader for backing good managers, once said however:
“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Along this line, Prof Steve Kaplan, from the University of Chicago, recently gave a great presentation at the IVCA annual lunch about Horse vs. Jockey, including some fascinating statistics and analysis. He clearly comes down on the Horse side of the arguement.  I highly recommend reading the attached PPT file of it. Download kaplan_horse_jockey_april_2006.pdf

Guys Kawasaki, Apple’s famed ex-evangelist, is well known for his top 10 lists. He published his Top Ten VC Lies earlier this year.  There is no such thing as "No" in the VC business, just indefinite "Maybe’s". While somewhat tongue and cheek, these should help shed some light on interpreting VC talk.

The Top Ten Lies of Venture Capitalists 

Venture capitalists are simple people: we’ve either decided to invest,
and we are convincing ourselves that our gut is right (aka, “due
diligence”) or there’s not a chance in hell. While we may be simple,
we’re not necessarily forthcoming, so if you think it’s hard to get a
“yes” out of venture capitalist, you should try to get a conclusive
“no.”

This is because there’s no upside to communicating a negative
decision. Entrepreneurs will simply hate us sooner–instead the game is
to string along entrepreneurs in case something miraculous happens to
make them look better. (An example of a miracle would be Boeing
approving a $5 million purchase order.)

Alas, entrepreneurs are also simple people: If they don’t hear
a conclusive “no,” they assume the answer is yes. This is an example of
the kind of breakdown of communication between venture capitalists and
entrepreneurs that causes much pain and frustration for entrepreneurs.

To foster greater understanding among the two groups, here is an exposé of the top ten lies of venture capitalists.

1. “I liked your company, but my partners didn’t.” In other words,
   “no.” What the sponsor is trying to get the entrepreneur to believe is
   that he’s the good guy, the smart guy, the guy who gets it; the
   “others” didn’t, so don’t blame him. This is a cop out; it’s not the
   other partners didn’t like the deal as much as the sponsor wasn’t a
   true believer. A true believer would get it done.
2. “If you get a lead, we will follow.” In other words, “no.” As the
   old Japanese say, “If your aunt had balls, she’d be your uncle.” Well,
   she doesn’t have balls, so it doesn’t matter. The venture capitalist is
   saying, “ We don’t really believe, but if you can get Sequoia to lead,
   we’ll jump on the pile.” In other words, once the entrepreneur doesn’t
   need the money, the venture capitalist would be happy to give him some
   more–this is like saying, “Once you’ve stopped Larry Csonka cold,
   we’ll help you tackle him.” What entrepreneurs want to hear is, “If you
   can’t get a lead, we will.” That’s a believer.
3. “Show us some traction, and we’ll invest.” In other words, “no.”
   This lie translates to “I don’t believe your story, but if you can
   prove it by achieving significant revenue, then you might convince me.
   However, I don’t want to tell you ‘no’ because I might be wrong and by
   golly you may sign up a Fortune 500 customer and then I’d look like a total orifice.”
4. “We love to co-invest with other venture capitalists.” Like the sun
   rising and Canadians playing hockey, you can depend on the greed of
   venture capitalists. Greed in this business translates to “If this is a
   good deal, I want it all.” What entrepreneurs want to hear is, “We want
   the whole round. We don’t want any other investors.” Then it’s the
   entrepreneur’s job to convince then why other investors can make the
   pie bigger as opposed to re-configuring the slices.
5. “We’re investing in your team.” This is an incomplete statement.
   While it’s true that they are investing in the team, entrepreneurs are
   hearing, “We won’t fire you–why would we fire you if we invested
   because of you?” That’s not what the venture capitalist is saying at
   all. What she is saying is, “We’re investing in your team as long as
   things are going well, but if they go bad we will fire your ass because
   no one is indispensable.”
6. “I have lots of bandwidth to dedicate to your company.” Maybe the
   venture capitalist is talking about the T3 line into his office, but
   he’s not talking about his personal calendar because he’s already on
   ten boards. Counting board meetings, an entrepreneur should assume that
   a venture capitalist will spend between five to ten hours a month on a
   company. That’s it. Deal with it. And make board meetings short!
7. “This is a vanilla term sheet.” There is no such thing as a vanilla
   term sheet. Do you think corporate finance attorneys are paid $400/hour
   to push out vanilla term sheets? If entrepreneurs insist on using a
   flavor of ice cream to describe term sheets, the only flavor that works
   is Rocky Road. This is why they need their own $400/hour attorney
   too–as opposed to Uncle Joe the divorce lawyer.
8. “We can open up doors for you at our client companies.” This is a
   double whammy of lie. First, a venture capitalist can’t always open up
   doors at client companies. Frankly, he might be hated by the client
   company. The worst thing in the world may be a referral from him.
   Second, even if the venture capitalist can open the door, entrepreneurs
   can’t seriously expect the company to commit to your product–that is,
   something that isn’t much more than a slick (10/20/30) PowerPoint
   presentation.
9. “We like early-stage investing.” Venture capitalists fantasize
   about putting $1 million into a $2 million pre-money company and end up
   owning 33% of the next Google. That’s early stage investing. Do you
   know why we all know about Google’s amazing return on investment? The
   same reason we all know about Michael Jordan: Googles and Michael
   Jordans hardly ever happen. If they were common, no one would write
   about them. If you scratch beneath the surface, venture capitalists
   want to invest in proven teams (eg., the founders of Cisco) with proven
   technology (eg., the basis of a Nobel Prize) in a proven market (eg.,
   ecommerce). We are remarkably risk averse considering it’s not even our
   money.
10. I’m at a Starbucks in Hawaii writing this blog. I’ve been at it for
    ninety minutes. I don’t have my charger with me. My PowerBook is out of
    gas. You’re going to have to be happy with the top nine lies of venture
    capitalists until “Dear God” ships the PowerBook Vaio.

Angelitis: I will write more on this topic in coming weeks, as it is a trap that entrepreneurs do not need to fall into. We recently had three different angel backed firms run into the same issue with us. We were forced to walk away from all three deals. They had priced their previous angel rounds too high, and did not want to go through a down round.

This situation is, unfortunately, increasing with frequency. I don’t know the exact reasons, but I have some suspicions. First, the cost of building out a platform has dropped significantly over the year. This enables entrepreneurs to get their offerings up and running and in customers hands for fairly small sums of capital (usually $500k-$1M). This is a good thing if structured appropriately. The second is that as the markets continue to flourish, angels are coming back into the market and are writing checks again.

However, the following pattern drives the issue. The company raises the first $500k at a $5M post-$. They grow and need more capital to ramp sales/marketing, so they raise the next $500k at a $10-15M post-$. At this point, the company is probably doing $1-3M in annual sales and growing linearly. The entrepreneur decides it is time to raise a venture round now, and goes to market with a $5M raise at $20M pre-$ valuation ($25M post-$). This is where the disconnect hits.

A company that is growing linearly (say $1-2m going to $3-5m this/next year in revenue) is going to be valued at a $3-7m pre-$ valuation. (I will write about different pricing approaches coming up.) The revenue often does not ramp as quickly as the entrepreneur expects (plans from two years ago had probably shown revenue of $10M vs. the actual $2M). Angels, being less price sensitive, had been willing to invest at the higher valuations. However, when the company needs more capital to scale (and is tired of living off of $500k rounds), it is forced to go to the professional venture community.

What should entrepreneurs do? The simplest answer is to use aconvertible debt structure. This avoids pricing the company too high or too low and also does not create unforeseen deal structure issues. The money converts into the professional round when raised.

Everyone loses when earlier rounds are mispriced. Venture capitalists lose the opportunity to invest in quality companies. Entrepreneurs end up running their business hand to mouth as they get trapped raising one $500k round after another.

I am involved in a deal with Elon Musk, the founder of Paypal, who is one of the quintessential serial entrepreneurs around. He is working on his latest company, SpaceX, to take on the aerospace industry in the satellite launch business. I once asked him how Paypal won the micro-payment race when so many other efforts failed. His response was straight forward: the Paypal solution worked simply and the others didn’t. Instead of creating a massive, proprietary payment network (like ABN and the other large players tried), Paypal focused on leveraging existing payment networks and found creative ways to link those networks together. In short, Paypal delivered simplicity and invisibility and leveraged other firms’ investments and developments.

Carl Ledbetter, a partner at Utah Ventures and formerly head of Novell’s R&D labs, recently made a great speech on this topic. In short, he said that technology is not useful until it is simple and invisible. He used the example of your car. How many people spend time popping up the hood on your car in order to use? Unfortunately, most solutions have a lot of trunk popping. Carl’s son (when he was a teenager) provided him with an axiom that stuck with him: if you need to read the directions to use technology, either you are an idiot or whoever made the product/service is. (the main caveat here is that this clearly does not apply to life science, material science and other highly technical fields!).

I would argue that it is this user experience, and the genius of a solution’s simplicity, that creates competitive advantage in technology. The old cliché says that new technology needs to provide 10x better performance to curve jump incumbent solutions.  While this is still true for many hardware/infrastructure plays, this is not the case with most technology. In fact, with the onset of open source, low cost hardware and outsourced resources, performance based competitive barriers are shrinking, as are technology cycles. The battle is increasingly being won around user experience, simplicity of architecture and responsiveness to market needs.

So what does this mean for entrepreneurs:
— focus on getting prototypes built quickly and into customers’ hands
— fail quickly the models/solutions that don’t work
— use blogs, chat rooms and websites to capture user feedback (and incorporate it)
— get prototypes up and running on as little capital as possible
— build “good enough” solutions and don’t over-design (think Microsoft versus Apple)
— get consumers using technology quickly.  Inertia is your best barrier to entry (especially with recurring revenue solutions)
— get to break even…you never know when the next nuclear winter will hit (and you’ll obviously own more of the company).

What is the right role for an investor with a portfolio company? When VC’s make an investment in a company, the founder/entrepreneur is often concerned about what impact his/her new partner will have on issues like control, degrees of freedom to operate, core decision making and future employment. There are many stories of VC’s swinging into companies, taking control of most core decision making and eventually forcing management out. However, there are many more (often untold) stories where this is not the case. In fact, I would argue that we would not have a venture industry if this were the norm.

At the two ends of the VC/Entrepreneur relational spectrum are a) the passive investor and b) the hyper-involved investor. Neither works well or benefits the entrepreneur. In the passive situation, the investor provides money and that is it…no advice, no networks, no assistance in recruiting, just money. In the hyper-involved case, the investor pushes to have a say in many day-to-day decisions, often second guessing the CEO and creating significant tension between investors and managers.

Experienced VC’s realize that there is a much more practical middle ground. It is based upon the simple tenant that it is the CEO’s company to run and it is the VC’s job to provide him/her with the extra resources, connections and advice needed to achieve his or her goals. My partner, Ed, has a great framework for this, which he describes as Principle-based management. The investor needs to be clear about expectations and key constraints (key milestones, certain end results, basic principles) up front. Once agreed to by all parties, it is the CEO’s show. By being clear in setting these up, it is easy to monitor progress without the need to be continually second guessing each other.

We have another saying: when the VC is making the core operational decisions, it is time to take a write-off. There is no way a VC will be more knowledgeable about the specifics of a given company, industry dynamics or customer interactions than the entrepreneur. Furthermore, we rarely make money when we end up usurping the CEO’s role. We do well when we pick the right partner to run an investment.

The other side of the coin is that the entrepreneur needs to have similar respect for the investor. While an investor might not be as experienced as the entrepreneur in that one business, he/she is much more experienced in the process of building businesses and in risk management. VC’s have seen a lot of successful and failed models. The entrepreneur can either learn from this experience or learn by making the mistakes themselves. Some feel a need to be self-reliant and this is big mistake. It is surprising how similar different situations are across industries and companies. It is, of course, most valuable if the VC is familiar with the company’s industry and has relevant experience in it as well as connections. 

Warren Buffett recently spoke to a class of students at Wharton. During the Q&A, he had the following to say about his approach to management. In short, it is his job to find those entrepreneurs that are capable managers and let them do their job. His job is to understand their business and to provide both support and encouragement. Here is his quote:

“So with respect to managers/entrepreneurs, I look them in the eye and ask, do they love the money or love the business?  If they love the business, then if they are NOT jumping out of bed (to go to work) it’s my fault.  So I have to give them two things, which are ability to paint their own painting, and applause.  The applause will come from me, and I think they see it as intelligent applause, because I know their business.  If that works for me, why won’t it work for other people.  Most people I buy businesses from are independently wealthy.  I need them to look me in the eye and say whether they love the money or the business.  I have zero contracts – the manager needs to have a better answer to say to his wife when he gets out of bed at 630am and she says “why do you get up just to send money to Omaha.”  I want a rational compensation scheme – not options on Berkshire stock [which is not driven by their performance].

I have caddied for Tiger Woods.  I try to find the Tiger Woodses of their industry. 

The most important things about work are to do something you love, and hire/work with people you like.  It just doesn’t work if you don’t admire or trust them.  I do not hire people I would not want as friends or as neighbors.  I work with people who make my life easier.  You can’t work with people who make your stomach grind.”

I believe, at its essence, the venture business is all about connections. Moreover, it is about good will or, at the risk of sounding very New Age, it is about Karma…the age old principle that what goes around, comes around. One of my favorite shows is My Name is Earl about a poor soul, Earl, who has realized that every time something positive happens to him, something bad takes it back and then some. He is determined to make good on a list of 260+ wrongs from his misguided life to kick start karma in his favor. I digress here, but well worth the watch.

Like Earl, I have found that good things seem to happen when you do good by others. There is no obvious cause and effect or quid pro quo. However, I firmly believe that when you help others, especially others that you do not expect can every repay the favor, favorable coincidences occur.

No one in the venture business has figured out how to systematize deal flow, customer introductions or other “network” effects beyond constant networking and spreading good karma.  Deal flow goes hot and cold very quickly and for no apparent reason. It also comes from the most unexpected directions and connections often.

Furthermore, venture capital and entrepreneurship is founded on the basis of mutual dependence. You see it in the need to form financing syndicates, sharing due diligence, helping each other recruit managers, getting introductions to potential tech customers and such. Your reputation is your core asset and it is built a meeting at a time and spreads through six degrees of separation. It is a surprisingly small community and world. Like a bad blog or video post (just ask Kryptonite locks), one or two bad acts can reverberate throughout the system.

So, what should we do? I don’t know what the right solution is, but my thoughts are:
— constantly reach out and meet new people and reconnect with old acquaintences
— help others whenever you are presented with an opportunity
— don’t approach relationships or interactions looking for what is in it for you (often it’s not there or obvious)
— commit random acts of kindness
— realize people are fair, helpful and good if given a chance
— do no evil (as Google, ironically, says)

Here is a story that came from a recent email chain forwarded to me.
"One Glass of Milk"

One day, a poor boy who was selling goods from door to door to pay his way through school, found he had only one thin dime left, and he was hungry. He decided he would ask for a meal at the next house. However, he lost his nerve when a lovely young woman opened the door.
Instead of a meal he asked for a drink of water. She thought he looked hungry so she brought him a large glass of milk. He drank it so slowly, and then asked, "How much do I owe you?"

"You don’t owe me anything," she replied. "Mother has taught us never to accept pay for a kindness."
He said, "Then I thank you from my heart."

As Howard Kelly left that house, he not only felt stronger physically, but his faith in people was strengthened also. He had been ready to give up and quit.

Many years later that same woman became critically ill. The local doctors were baffled. They finally sent her to the big city, where they called in specialists to study her rare disease.

Dr. Howard Kelly was called in for the consultation. When he heard the name of the town she came from, a strange light filled his eyes. Immediately he rose and went down the hall of the hospital to her room. Dressed in his doctor’s gown he went in to see her. He recognized her at once. He went back to the consultation room determined to do his best to save her life. From that day he gave special attention to her case.

After a long struggle, the battle was won.

Dr. Kelly requested the business office to pass the final bill to him for approval. He looked at it, then wrote something on the edge and the bill was sent to her room. She feared to open it, for she was sure it would take the rest of her life to pay for it all. Finally she looked, and something caught her attention on the side of the bill. She read these words…   

"Paid in full with one glass of milk"

(Signed) Dr. Howard Kelly