Why I don't sign NDAs. . .

by Alexander Muse

For those of you who have great ideas and want to share them with me I am happy to provide my advice, but please quit asking me to sign an NDA.  Its one thing if I contact you and ask that you share confidential information with me, it is another thing if you call me asking for free advice.  Literally, some people want me to enter into a contract with them without consideration, creating a potential liability for myself and my company.  So, no I won't sign an NDA, period.

Let me give you an example of the sort of crap I have to deal with.  Back in October a woman named Ellen Badinelli contacted me via email:

"We have licensed 3G Vision's Symbian client, and about to license a Windows mobile client from them but wanted to see if there was any comparable reader out there before purchasing.  Is the barcode reader IP your own, or do you license from 3G Vision or another entity?  If another, could you state which? Separately, our service fully complements yours and we are scheduled to debut on Nokia's web page/handsets by first quarter '09, A T & T wants us on "15-20" handsets, various platforms, by the same time, and we plan to begin development on the Andriod platform, and did I mention we are a solely-owned two and a half man [one part-timer] shop?  Any interest in exploring our compatibility?  A prompt reply to these questions is greatly appreciated; we are in the midst of Angel investor negotiations."

The next day Ellen Badinelli gave me a call asking if we would license our barcode reading technology so that she could launch her application.  She never revealed the nature of her application indicating that I would need to sign an NDA before she could explain what she was doing.  She expressed an interest in partnering/hiring us to develop her application.  I explained that we were too busy, but that the barcode technology had been released using an open source license - she could use it for free!  I suggested she work with another company I had talked to a few weeks earlier called CamClic, but she told me she had already been working with them.  The call ended cordially and I received an email from her shortly after the call:

"Thanks for your time this a.m.  I have been operating in this space way before the other entities you mentioned, and while I would like to explore what I think is a symbiotic relationship between our companies, I risk being an unpaid consultant to retailers and to developers, like Cam Click and a few others, who I have provided my materials and held discussions with.  As you are currently engaged with them, this would not be appropriate without an NDA.  I hope you can appreciate my position.  Should that be of interest to you, please do not hesitate to contact me.  Again, many thanks for the barcode reader referral and the advice on NeoMedia/Qode or whatever they call themselves these days, EB."

It was strange how Ellen Badinelli sent the email detailing her version of our call minutes after we hung up.  If I were a suspicious person I would have began to realize she was building a case (even if it is a lousy one).  I didn't hear from Ellen again until January 27th (a couple of days ago).  She reiterated her desire to work with us to develop her application.  She again asked me to sign an NDA and I repeated the fact that we were too busy to start something new.  She revealed that her idea revolved around health and safety information.  I explained we had another partner who already provides allergy, ingredient and heath information for our users.  She asked how we were able to afford the data and I explained that we received it for free.  I offered to refer her to our partner so that she could negotiate the same sort of agreement.  My appointment arrived and I cut our call short, but offered to speak with her later if she wished.

This evening I received a threatening letter from David Joyal an associate at Greenberg Taurig indicating that ShopSavvy is 'markedly similar' to Ellen Badinelli's technologies.  He suggests that Ellen Badinelli disclosed her technology to CamClic and that they must have revealed that information to our company.  He concludes that Ellen Badinelli is:

"willing to consider licensing the invention disclosed and currently claimed in Scanavert's above-referenced patent application; and remains interested in any of a variety of other partnership opportunties as between Scanavert and Big in Japan"

You get it?  She emailed me, called me and despite the fact that I refused on two occasions to enter into an NDA she had her lawyer threaten me with litigation over a technology she never disclosed.  Her goal was to have me sign the NDA, provide confidential information and then threaten me.  Imagine if I had taken the bait?  Instead of the court requiring that Ellen Badinelli prove that I have done something wrong, I would have had to prove that I didn't do something wrong.  The NDA would have shifted the burden to me.  Anyway, this will end up costing me at least $5,000 in legal fees and all I did was try to help someone excute on their idea.  People like Ellen Badinelli make it hard for all entrepreneurs.

Venture Capitalists Boycott Entrepreneurs?

by Rob Finn

Umair Haque should charge admission for his thoughts, but I disagree with a recentpost where he takes a solid left and sanctified right on venture capital. Charlie O'Donnell has a shorter response than mine. Umair implies that vcs are ignoring risky business plans. Either that or he is suggesting the impossible - for venture capitalists to wait for the plans that create new industries. Don't invest otherwise. Be even more selective and boycott today's entrepreneurs.

Why are venture investors failing to seed new industries and markets? … Where one pioneer invests, a slew of imitators follow, and so tremendous amounts of cash are poured into the same business design or market space - ad exchanges, social networks, and blogging/vlogging platforms to name just a few recent fads. Why does President-elect Obama have to invest a likely trillion dollars to renew, well, pretty much the entire industrial base of the economy - to seed new auto, energy healthcare, education, finance, and agricultural industries (to name just a few)? Because today's crop of apathetic, risk-averse venture investors didn't.

Umair's logic implies venture capitalists are choosing an investment over another because it has less market risk. Venture investors don't accumulate 20 or so deals and then at year's end choose the less risky ten. More business plans are rejected due to small addressable market and too much competition rather than big idea PowerPoint risks. Vcs have immense faith in the powers of sales and marketing.

Vcs are investing in incremental innovation for a reason; it's produced strong returns. It is tough to doubt incremental innovation when you see transistor per chip count move from 5k to 700M+. People thought vcs were doomed in the early 90s, but what followed was strong vintage returns. Some people are looking at the massive amount of commercial success that fed off the transistor and concluding there is nothing out there now which could fuel comparable change. The R&D of the internet started before we got the c in vc in '79. Note, most industry creation has come from military R&D which is considerably smaller these days. Solar cells could be the next wave and should not be discounted just because they are taking longer than the transistor to reach commercial viability.  Terahertz imaging, human-computer interaction/design and nanotechnology are other examples. I think Umair is remarkable-tizing recent return history. All innovation is incremental to some degree. You cannot generalize across this stuff on a two-times-two-equals-four basis.

Looking at vintage returns since '98, vcs are assuming significant risk and some taking their humble pie with it. IT and biotech took awhile to gain profitability momentum and still have room for significant improvement. Biotech is 30 years old and monoclonal antibodies only started recently delivering and 99/250 public biotech companies currently have less than six months cash on hand.  

Big idea bplans are scarce. Vcs are moving to later stage investing not for risk averse reasons, but because they have more assets under management. It's unreasonable to expect A rounds calling for $20M+. Most ideas cannot put this much capital to work that quickly, and the dilution would be unsuitable to management. However, many entrepreneurs believe they can do more with less and so don't forecast needing much extra financing past a first round.  Follow on rounds need to forecasted more effectively. This financing mentality is an expectations gap, otherwise being referred to as a funding gap. Refining this model would encourage entrepreneurs to think big.

Vcs need to put more dollars to work per investment to effectively manage portfolio companies, which has orientated some vcs to more capital intensive (riskier) business models. If there is capital intensity, better it be tied to first mover risk versus capital intensity relying on product substitution. The magnitude of product variance is directly proportional to consumer willingness to change habits. There could be new industries and markets that have been funded but are under Teflon. Pioneers are more apt to go stealth.

Vcs have a responsibility to put their investors' money to work real time. Vcs are not market experts and so build social capital in order to identify opportunities. Many vcs come from the biotech and IT which defines their trusted deal flow to those industries. There is proactive company building, take Book Byers at Kleiner talking about their new bi-defense and pandemic fund. "If large companies are working on part of the problem and doing it well, then we don't do that. We may do a couple of startups where we just can't find anyone working in one of these areas."

What is the systematic cause for shortage of radical bplans? Production became so expensive and complex that it muted optimism to try to build big new things. Large companies have become intimidating super powers. Companies' standard setting induced people to fall into formation. Culture has come from commerce.

Social networks and blogging tools will not get us out of the recession, but they are a platform to create a more informed consumer. Empowered, disciplined, balanced, and informed consumers could have saved us from the current mess. Reinventing news media from these new voices will go a long way to convincing the public that many Americans do care about issues.

The venture economy is failing investors, entrepreneurs, the economy, and society.

Umair is belittling the physics of other people's money. Vcs are responsible to create returns for their investors (limited partners). Limited partners' shareholders and customers are the public. All interconnected, all boiling down to personal responsibility. Creative destruction resulting in unprofitable companies is only valuable to consumers.

Yet, the trailblazers of making radical responsibility economically viable are non-profits and social businesses - not venture funds, who have been deeply reluctant to explore the economic possibilities of responsibly powered business models.

I agree. A lot of the world's problems are avoided by geography, involve commons such as water and lack demand due to poverty. We need to capitalize new asset classes and link foundations, private investors and nonprofits.

That striking homogeneity reflects an almost total lack of strategic imagination by venture players

Innovation is associated with overlooked or underestimated value / cost drivers that make proposed alternatives unattractive. Most really breakthrough stuff is not obvious. A lot of smart people got a free look at the Google deal at a price tag of $1M. Vcs cannot tell an entrepreneur what business to start. The great businesses are started from passion and imagination. Credit belongs to those who are in the arena.

Blake Ross of Firefox said, "The next big thing is whatever made the last big thing more usable". Innovation has been going at the same rate the last 50 years while we have entered an unimaginative era. The blog (a memoir)  is the leading art form. Problems are easier to identify these days. Entrepreneurs don't need to think long and hard to find something to be passionate about fixing. Look at most technology out there, it usually has to do with what a product can do versus what it should do. The product is more about having one more feature than the competition. Another factor that has tied us to incremental innovation is that the technology involved in processor, computer, software, and internet has all been layered in shared design, people and most importantly geography. PR's focus on Silicon Valley could be impairing Umair's assessment. The industrial revolution didn't happen overnight.

Homogeneity; you can argue that all the companies are eventually in the same bucket. There are scale and employee incentive economics that limit one company's ability to dominate more than a niche market. Granted, fortune 100 companies have 50 industry business lines on average, but that is a different equation than startup economics.

Venture investors have been free to take hidden action that maximizes their own near term returns - underinvesting in radical innovation.

The scapegoat is startup execution. It's not necessarily failure in big idea investing.Execution needs a stew of creativity to enable refinement of a business model and supports hiring needs. This comes from a local mix of media, design, film, international relations, fashion, health, etc. We need more diverse entrepreneurial friendly ecosystems like NYC. There are too many startup black holes across the country.

Most vcs accept the orthodoxy that sources of advantage are fixed - and that's the single biggest mistake they make… Brands are losing relevance; cost advantage is often an illusion; differentiation is too often simply skin-deep; and market dominance stifles innovation and creativity - to name just a few. Yet, tomorrow's sources of advantage remain largely unexplored - because vcs have been systematically underinvesting in discovering them.

Vcs and entrepreneur often start a business in an underperforming industry, because they think they can do better. Vcs are no different than industry actors who align to the rewards of their system and don't take countermeasures until the model breaks. This is easier mental calisthenics than recreating business advantages. Vcs have refined the model; gone vc gone are the tourist (investing abroad without local infrastructure) or drive by (investing without business model) vcs.

New sources of advantages such as creativity, continuous innovation, execution, collaboration and sustainability are needed. I also agree that some old sources of competitive advantage are less significant. Distribution channels are a less powerful source of advantages, forcing companies to seek other ways of reducing customer power, threat of substitutes and threat of new entrants. However, this does not mean that all tried and true advantages aren’t still rewarding such as cost (iTunes) and reputation, differentiation (iPod).

People argue choice paralysis and perfect information is killing branding.  Increased search costs and noise actually increase the value of branding. Branding is more accountable for the relation between message and product. The act of conveying expected value is still a representative, albeit less compressed, experience. It is increasing if you define brand as the level of engagement with consumer. It is getting better if you agree that advertisers have to convey unique value with less space (320 x 178 banner ad).

Commoditization of investment philosophies since the 1990s has generated technologies that can best be described as sexy-cool rather than disruptive and meaningful (with a few exceptions). It paved the way for get-rich-quick entrepreneurs that are skilled in feeding the dogs the dog-food, rather than support the real entrepreneurs that have a dissenting view of the world.

Sites like TheFunded are bringing transparency to the industry and encourage vcs to be less detached.  It would be great to see a vc do a Bob Swanson and collaborate with academia, government or corporate America to create new industry.

It's great that Umair makes spirited points for innovation. Hopefully my response reads as optimistic, constructive passion versus self serving, get too much from my job description. Pessimism is the new black; it seems can-do USA is gone and there is significant uncertainty. However, with recent events, participatory culture should only continue to grow. We need to improve education and generate more leaders.

To quote actor Wendell Pierce from "The Wire",

"I hope that people will look at 'The Wire' and look at the humanity in it, as harsh as the show can be, and understand that there is humanity and that there is shared experience. No matter how far your life may be from these characters' lives, it's a shared experience. There's hopes, there's dreams, there's inadequacies, there's strengths, just like with every human experience. To tap into that (is) to understand the wealth of knowledge we're denying ourselves and our community (by allowing) such an underclass to continue and thrive. I think about that every time I pass a cancer center. Man, we're sitting here struggling with cancer, and just think about the generations of great minds who'd probably have the cure for it (but) never got on that right track, were never given the right track. The cure for cancer may be on the corner of Rampart and Ursulines. Some character hanging out there, right there in the Lafitte project behind the cemetery."

"Indeeeeeeeeeed", to quote a character from "The Wire".

The hidden costs of raising venture capital

by Healy Jones

When I talk with an unfunded startup about their burn rate I am often quite impressed with their intelligent frugality and capital efficiency. These tech startup founders usually assume they will be continue to be extremely capital efficient post venture financing, and for the most part they are correct. However, these entrepreneurs sometimes do not take into account the additional costs of doing business with a venture capital firm. There is some legitimate additional overhead required to keep your venture capital partner happy, and some of it is not cheap. Keep these items in mind when you think about your cash flows post venture investment:

Audit/tax work

Most VCs will require some sort of audit from a known auditor. These can get quite pricey. Hopefully the VC has enough pull with the auditor to get you a reduced price in your first few years of working with them. Most real auditors will do this, and I've heard from some audit partners that they don't actually make money on auditing startups in the first few years. Regardless, this is still an expensive proposition. Tax wise, you will need to do what is called a 409 report if you are granting options to employees. The trick is that the commons stock options that you grant are probably worth less than the implied company valuation that you get from the VC. This is a good thing, as it lowers the tax burden for the employees who are getting the options. Unfortunately these things are not as cheap as you'd like. You can easily end up spending over $40k a year on these items. Most of these costs will spike around year end, April tax season and when you are raising additional capital.

CFO/Controller

Most of our really early stage companies have part time CFOs. You probably don't need a full time CFO or controller if you are a real startup, but you do need someone who knows what they are doing manning the finance wheel. Once you start sending out invoices you'll want a person who can call up and gently remind customers to pay you. It is also quite natural for a venture firm to want a trusted person managing the cash balances of the business, and these part time CFOs can greatly ease the work burden of the startup's CEO. They also help in the financial preparation work for your monthly board of directors meetings. I've been very impressed with the work ethic and output of the outsourced CFOs I've worked with at our portfolio companies. Their cost should be less than the cost of a controller. Once your business grows to the point where your part time CFO is costing you, on an hourly basis, as much as a full time controller would cost it is probably time to hire a controller. The cost for a part time CFO can really vary depending on the amount that you are using them, and will spike at the same times of year as your audit costs jump. You should expect to spend anywhere from $30k to $75+k on this service per year.

Legal

The transaction expenses associated with bringing on a venture investor are quite expensive - but I'm not going to talk about that here. Instead, little items that you might let slide when you don't have a venture firm as an investor actually need to get done when you have a professional investor on the board. In addition to your everyday legal costs, I'd add another $20k a year at least. Keep in mind this is legal work that you probably should have gotten done anyways, but is stuff that a lot of private, unfunded companies tend to ignore (such as getting all signatures on certain stockholders agreements actually signed, etc.)

Insurance

You'll have a couple of additional insurance items that you need to take care of once you've brought a professional investor into your company. These will include Directors and Officers (D&O) insurance and key man life insurance. I'm not actually sure how much these cost, but I think it is about $12k a year for decent coverage - consult a real insurance agent here, not me!

Board of Directors meetings

This goes beyond the tasty cookies that you should supply to keep your directors and investors high on sugar during your monthly board meetings - little things like perhaps paying for a director to travel to the meeting or rush delivering the first prototype in time for the board to see it. Of course, the real cost is the time required to prepare for the board meeting, which leads me to the final hidden cost of VC:

Time

There is also the additional investment that can be even more precious for a startup entrepreneur: time. Your VC will require attention! Calls, meetings, coffees, etc. Don't forget about this! Hopefully you've ended up with a VC that you like spending time with. When the venture capitalist is doing due diligence on you, you should be doing the same on them. Some of the questions you need to ask other CEOs in that partner's portfolio is how do you interact with the partner, how often to you speak with them, how much time does this take? Hopefully the venture capitalist is adding value in these discussions, either around strategy or introductions to customers, etc. Regardless, there will likely be some minor requests that don't add real value to you as a company. These include various metrics that the VC needs for internal purposes, such as the valuation work that auditors now require venture funds do annually or perhaps a clean copy of your logo so they can brag about you in their annual meeting. Make sure your VC doesn't overwhelm other portfolio companies with these silly little requests. They shouldn't be that onerous and should definitely not come that often - I'm more just letting you know that this is another hidden cost of taking on venture capital.

Valuation, Valuation, It's a rage across the nation......

by Dr. Larry Marshall

So I just finished a tour of another country, meeting about 700 entrepreneurs from medical devices to enterprise software, with a couple of chip companies thrown in for balance. During the Q&A session there was a lot of discussion around benchmarking deals there to Silicon Valley deals, and can a better valuation be won here? So at the risk of getting it wrong, let me make a stab at that--I think fund economics work in a way that requires an A-round investor to buy about 20% of your company--generally they will want another such investor in the deal, so expect to sell 40%. It doesn't really matter how much either side negotiates around the deal, at the end of the day they all end up looking something like this magical 20% rule because that's the only way that the economics of the venture fund will make sense.

Now outside the valley a lot of people think about VC more like the stock market--so the feeling is that once a VC invests, they disappear to go find other deals, and their equity is locked in, plus they get paid dividends over time. In reality what happens, is a B-round comes, and the A round VCs invest again to minimize their dilution. The lead B investor will likely insist that the ESOP is re-upped back to 20%, and that will come out of the A-round VCs.

I need to explain this much better in another posting because it's the source of enormous confusion, especially in other countries, and I think is at the crux of the adversarial approach to Valuation discussions. The point of this posting is to share an epiphany I had when taking a deal to the partners for approval to go to term sheet.

So what happens in these meetings? Generally there is a formal voting system that requires each partner to either love or hate the deal (on a 1-5 scale, there can be no 3s); but before that all the partners look for a fatal flaw in the company, i.e. something that would kill it in the market and make it too risky an investment [more on that later].

The prime topic of discussion is not valuation--actually its ESOP--if it's big enough, who else needs to be on this bus and how big a stock budget will we need to attract them. This has all been thrashed out already between the CEO and the partner leading the deal, but its important to second guess based on experience of the other partners with other companies in that space.

Another topic is, can we really add value to this deal--again, its been thrashed out a month or more before when the deal first came to the partnership, but it's good to review one last time. Do we really understand this space, can we add to the success of this deal?

A number of other issues come up, and then it's deal structure. How risky is the market looking forward--under the current economic uncertainty a number of areas could be tough. IT spending will decrease and it will get harder to build startup revenue, so a B-round deal will likely suffer in valuation because the investors know they need to carry the company longer to get through the coming rough patch.

If there was a previous round, it's likely that that VC isn't terribly affected by valuation of this one, provided he is investing pro-rata, because the new money dilutes the old. If valuation goes down, his pro-rata gets a greater percentage to compensate; if it goes up, the original investment is worth more to compensate. What he does care about is the dilution due to ESOP increase because that comes mostly out of him, but at the same time he knows the company needs to attract more talent.

So here's the rub, if the ESOP keeps getting topped up with each round, then the Team who build the company gets minimal dilution (or the company grows rapidly and the shares owned by each member become much more valuable) – so ironically, the VCs dilute themselves. Does this worry them? Of course not, because the pie is getting bigger. I am convinced that this is the only way to look at valuation, from either side. If we are obsessed with the percentage we end up owning a lot of nothing. If the company is really successful whether you own 20% or 30% you still make money and the fund succeeds, if it fails, owning 90% isn't going to help much.

My epiphany came when my partners voted the valuation up, and nuked the milestone tranching the deal – this was a deal with some history and potential performance issues. When VCs tranche a deal, i.e. fund part now and part later after the company hits a pre-determined millstone, it's highly unlikely they will ever use the milestone or withhold the second tranche--they are just trying to ensure the team is really 110% focused on the issue that defined the milestone.

The fact is that markets change and the team is the only element that can respond, so a milestone drafted today is probably meaningless in 18 months. So why have the milestone if it isn't really going to help, and is more likely to put investors at odds with the team? The VCs voted in favor of removing it because they wanted to align themselves with the Team--this alignment is critical for a successful partnership going forward to build the company together. Likewise, making the valuation a little higher can remove weeks of wasted time negotiating, and turn what would have been hard feelings from the Team, into feelings of support and aligned interests--what is that worth?

I've been through a really bad turnaround where I was brought in by Intel to triage one of its companies. The problem in that deal was misalignment between investors, and between investors and Team. It nearly killed the company. In contrast, when I ran Lightbit, we navigated through tech nuclear winter, and the VCs (Mayfield & Accel) with whom we had been brutally honest and built a strong trust helped us carry the company (of course, many of us stopped taking salary for a year as well ;-) ).

Top ten geek business myths

by Ron Garret

Since I've started my new career as a venture capitalist I have become keenly aware of some of the classic mistakes that geeks make when trying to raise money for a new business. Instead of writing the same comments over and over again I thought I'd try to summarize some of the mistakes that people -- especially smart people -- make when they decide to try to turn their bright ideas into money. Here then is my top-ten list of geek business myths:

Myth #1: A brilliant idea will make you rich.
Reality: A brilliant idea is neither necessary nor sufficient for a successful business, although all else being equal it can't hurt. Microsoft is probably the canonical example of a successful business, and it has never had a single brilliant idea in its entire history. (To the contrary, Microsoft has achieved success largely by seeking out and destroying other people's brilliant ideas.) Google was based on a couple of brilliant ideas (Page rank, text-only ads, massive parallel implementation on cheap hardware) but none of those ideas were original with Larry or Sergey. This is not to say that Larry, Sergey and Bill are not bright guys -- all three of them are sharper than I can ever hope to be. But the idea that any of them woke up one day with an inspiration and coasted the rest of the way to riches is a myth.

Myth #2: If you build it they will come.
There is a grain of truth to this myth. There have been examples of businesses that just built a product, cast it upon the ether(net), and achieved success. (Google is the canonical example.) But for every Google there are ten examples of companies that had killer products that didn't sell for one reason or another. My favorite example of this is the first company I tried to start back in 1993. It was called FlowNet, and it was a new design for a high speed local area network. It ran at 500Mb/s in a time when 10 Mb/s ethernet was the norm. For more than five years, FlowNet had the best price/performance ratio of any available network. On top of that, FlowNet had built-in quality-of-service guarantees for streaming video. If FlowNet had taken over the world your streaming video would be working a lot better today than it does.

But despite the fact that on a technical level FlowNet blew everything else out of the water it was an abysmal failure as a business. We never sold a single unit. The full story of why FlowNet failed would take me far afield, but if I had to sum it up in a nutshell the reason it didn't sell was very simple: it wasn't Ethernet. And if we'd done our homework and market research we could have known that this would be, if not a show-stopper at least a significant obstacle. And we would have known it before we spent tens of thousands of dollars of our own money on patent attorneys and prototypes.

Myth #3: Someone will steal your idea if you don't protect it.
Reality: No one gives a damn about your idea until you actually succeed and by then it's too late. Even on the off chance that you do manage to stumble across someone who is as excited about your idea as you are, if they have any brains they will join you rather than try to beat you. (And if they don't have any brains then it doesn't matter what they do.)

Patent protection does serve one useful purpose: it can make investors feel warm and fuzzy, especially naive investors. But I strongly recommend that you do your own patent filings. It's not hard to do once you learn how (get the Nolo Press book "Patent it Yourself"). You'll do a better job than most patent attorneys and save yourself a lot of money.

Myth #4: What you think matters.
Reality: It matters not one whit that you and all your buddies think that your idea is the greatest thing since sliced pizza (unless, of course, your buddies are rich enough to be the customer base for your business). What matters is what your customers think. It is natural to assume that if you and your buddies think your idea is cool that millions of other people out there will think it's cool too, and sometimes it works out that way, but usually not. The reason is that if you are smart enough to have a brilliant idea then you (and most likely your buddies) are different from everyone else. I don't mean to sound condescending here, but the sad fact of the matter is that compared to you, most people are pretty dumb (look at how many people vote Republican ;-) and they care about dumb things. (I just heard about a new clothing store in Pasadena that has lines around the block. A clothing store!) If you cater only to people who care about the things that you care about then your customer base will be pretty small.

Myth #5: Financial models are bogus.
As with myth #2 there is a grain of truth here. As Carl Sagan was fond of saying, prophecy is a lost art. There is no way to know for sure how much money your business is going to make, or how much it will cost to get to market. The reason for doing financial models is to do a reality check and convince yourself that making a return on investment is even a plausible possibility. If you run the numbers and find out that in order to reach break-even you need a customer base that is ten times larger than the currently known market for your product then you should probably rethink things. As Dwight Eisenhower said: plans are useless, but planning is indispensible.

This myth is the basis for one of the most classic mistakes that geeks make when pitching their ideas. They will say things like "Even if we only capture 1% of the market we'll make big bucks." Statements like that are a dead giveaway that you haven't done your homework to find out what your customers actually want. You may as well say: there's a good chance that only 1 customer in 100 will buy our product (and frankly, we're not even sure about that). Doesn't exactly inspire confidence.

Myth #6: What you know matters more than who you know.
Reality: You've been in denial about this your whole life. You were either brought up to believe that being smart mattered, or you just didn't believe your mother when she told you that getting along with the other kids was more important than getting straight A's.

The truth is, who you know matters more than what you know. This is not to say that being smart and knowledgable is useless. Knowing "what" is often an effective means of getting introduced to the right "whos". But ultimately, the people you know and trust (and more importantly who trust you) matter more than the factual knowledge you may have at your immediate disposal. And there is a sound reason for this: business decisions are horrifically complicated. No one person can possibly amass all the knowledge and experience required to make a broad range of such decisions on their own, so effective business people delegate much of their decision-making to other people. And when they choose who to delegate to, their first pick is always people they know and trust.

Ironically, C programmers understand this much better than Lisp programmers. One of the ironies of the programming world is that using Lisp is vastly more productive than using pretty much any other programming language, but successful businesses based on Lisp are quite rare. The reason for this, I think, is that Lisp allows you to be so productive that a single person can get things done without having to work together with anyone else, and so Lisp programmers never develop the social skills needed to work effectively as a member of a team. A C programmer, by contrast, can't do anything useful except as a member of a team. So although programming in C hobbles you in some ways, it forces you to form groups whose net effectiveness is greater than the sum of their parts, and who collectively can stomp on all the individual Lisp programmers out there, even though one-on-one a Lisper can run rings around a C programmer.

Myth #7: A Ph.D. means something.
Reality: The only thing a Ph.D. means is that you're not a moron, and you're willing to put up with the bullshit it takes to slog your way through a Ph.D. program somewhere. Empirically, having a Ph.D. is negatively correlated with business success. This is because the reward structure in academia is almost the exact opposite of what it is in business. In academia, what your peers think matters. In business, it's what your customers think that matters, and your customers are (almost certainly) not your peers.

[UPDATE: this is not to say that getting a Ph.D. is useless. You can learn a lot of useful stuff by getting a Ph.D. But it's the knowledge and experience that you gain by going through the process that is potentially valuable (for business endeavors), not the degree itself.]

Myth #8: I need $5 million to start my business
Reality: Unless you're building hardware (in which case you should definitely rethink what you're doing) you most likely don't need any startup capital at all. Paul Graham has written extensively about this so I won't belabor it too much, except to say this: you don't need much startup capital, but what you do need is a willingness to work your buns off. You have to bring your brilliant idea to fruition yourself; no one else will do it for you, and no one will give you the money to hire someone to do it for you. The reason is very simple: if you don't believe in the commercial potential of your idea enough to give up your evenings and weekends to own a bigger chunk of it, why should anyone else believe in it enough to put their hard-earned money at risk?

Myth #9: The idea is the most important part of my business plan.
Reality: The idea is very nearly irrelevant. What matters is 1) who are your customers? 2) Why will they buy what you're selling? (Note that the reason for this could very well be something like, "Because I'm famous and I have a huge fan base and they will buy sacks of stale dog shit if it has my name on it." But in your case it will more likely be, "Because we have a great product that blows the competition out of the water.") 3) Who is on your team? and 4) What are the risks?

Myth #10: Having no competition is a good thing.
Reality: If you have no competition the most likely reason for that is that there's no money to be made. There are six billion people on this planet, and it's very unlikely that every last of them will have left a lucrative market niche completely unexploited.

The good news is that it is very likely that your competition sucks. The vast majority of businesses are not run very well. They make shoddy products. They treat their customers and their employees like shit. It's not hard to find market opportunities where you can go in and kick the competition's ass. You don't want no competition, what you want is bad competition. And there's plenty of that out there.

Special bonus myth (free with your paid subscription): After the IPO I'll be happy.
If you don't enjoy the process of starting a business then you will probably not succeed. It's just too much work, and it will suck you dry if you're not having fun doing it. Even if you get filthy stinking rich you will just have more time to look back across the years you wasted being miserable and nursing your acid reflux. The charm of expensive cars and whatnot wears off quickly. There's only one kind of happiness that money can buy, and that is the opportunity to be on the other side of the table when some bright kid comes along with a brilliant idea for a business.
All these myths can be neatly summarized in a pithy slogan: it's the customer, stupid. Success in business is not about having a brilliant idea. Bright ideas are a dime a dozen. Business is about taking a bright idea and assembling a team that can turn that idea into a product and bring that product tocustomers who want to buy it. It's that simple. And that complicated.

Tough times for VCs means tough times for venture backed startups

by Healy Jones

Dow Jones’ Venturewire, a news service for VCs, today published an article titled “Darwinism Sets In At Claremont Creek.” This article described a venture capital firm dealing with the recent economic downturn, and how they are allocating their reserves to existing portfolio companies out of their older fund. The key take away from the article is that the fund will continue to fund their best investments but will stop backing their less-promising startups. In other words, some of their companies are not going to get additional funding from them.

That’s pretty bad news for some of their portfolio companies. The article talks a bit about how this is happening across the venture universe, and I believe that the journalist used the Claremont Creek fund as an example because they were very forthright on explaining their efforts/methods/thought process. Hats off to the investors at Claremont for being so honest about this. Startup CEOs can learn a lot from this example.

So that you understand a bit better what is going on here, we can go with the math presented in this article. Claremont Creek’s older fund was raised in 2005 and was $130 million in size. It has made $44 million in investments into 16 portfolio companies. (They are not making investments into new companies out of this fund; instead, new investments are made out of a new fund, a $175 million fund, that was recently raised.) The older fund should have reserved the remaining $86 million ($130 million - $44 million already invested) for these 16 companies. That’s about $5.4 million for each company. I’m willing to bet they did a robust job projecting the cash needs for these 16 portfolio companies, so let’s pretend that each portfolio company “needed” that $5.4 million to get to an exit/become profitable or whatever.

But now we have the evil economic downturn. Each portfolio company now needs 50% more cash from Claremont to get to exit (totally making this up, but it may be an OK projection). This could be for a variety of reasons, but the main ones might be that the companies are having issues finding new outside venture investors for their follow on financing rounds (this is happening to a lot of venture backed companies right now and is often only driven by the capital markets and NOT a function of how good the company is) and also, potentially, the portfolio companies are a bit more slow to get customers due to the downturn. So, each company now needs about $8 million to get to exit, not the $5.4.

That means that the venture fund in this example now needs $8 million times 16 portfolio companies, or $128 million - $42 million more than the firm thought it needed when it stopped making investments in new companies out of that fund. Yikes!

Regardless of how you cut the numbers from here, at least 4 companies are probably getting left out in the cold and will have to either dramatically cut their cash burn, find alternative sources of funding without a supportive VC or go out of business. And the major reason this is happening is not the portfolio company’s fault, it is the economy. Pretty depressing.

I know I sound like a broken record, but I’d like to suggest that your startup consider taking venture funding from more than one VC - syndicating - so that you have a better chance of avoiding this type of a situation. Two VCs are better than one in these types of situations.

How VCs Block Exits

by Basil Peters

Most entrepreneurs don't even know that a VC is likely to block an exit when they accept the VC's money. I didn't when I started out —and neither did my friend who I describe in "Why VCs Block Good Exits".

In my first company it wasn't until the final extraordinary general meeting, when the shareholders were voting to approve the exit transaction, that I actually realized how aggressively a VC will try to block an exit.

VCs design their investment agreements to give them the power to block exits. VCs worry that after they invest, the entrepreneurs will want to sell the company for something that might give the entrepreneurs a 100x return and the angels a 10x return but only a 3x return for the VCs. This concern was one of the reasons that VCs wouldn't invest in Brightside.

My previous post, at the link above, has more on why VCs block good exits.

The Legal Mechanisms

VCs usually build in more than one way to block exits:

1. The most effective way VCs block exits is with the terms in their preferred shares. Like my younger self, most first-time entrepreneurs have no idea how multiple share classes really work. For example, when I was starting out, I did not understand that different classes of shares each have to vote separately to approve important transactions. Usually, the VCs are the only ones with the pref shares, so they effectively have a built-in veto.
2. VCs can also effectively block exits by dominating the boards of the companies in which they invest. This is usually a contractual commitment of their investment.
3. They will also have terms and conditions in their investment agreements that allow them to make the decisions about when a company can exit.

Even the Y Combinator Docs Provide an Exit Veto

Paul Graham and Y Combinator are making enormous contributions to the evolution of entrepreneurship and early stage investing. Y Combinator invests very small amounts of money into early stage companies through an innovative, modern incubator model.

I admire Paul Graham for posting their term sheets and financing agreements. Even these simple agreements for very small, first financings contain absolute veto powers on exits:

"So long as any of the Preferred is outstanding, consent of the holders of at least 50% of the Preferred will be required for any action that: ... or (iii) approves any merger, sale of assets or other corporate reorganization or acquisition."

I am not saying this is wrong. In an earlier post on Preferred vs Common Shares I point out that in some situations preferred shares are necessary to be fair to the investors. Even where there is a board in place, there may still be situations where it makes sense for the investors to have veto power on exits. There is, however, no way to solve the fundamental conflict of interest when holders of preferred shares sit on boards. Nor is there a way to repair the fundamental lack of alignment between common and preferred shareholders.

My point is that every entrepreneur and board must fully understand how their exit options will be impacted before accepting any pref share investment.

A Chilling Perspective from a Law Professor

For a fascinating, and chilling, perspective on how venture capitalists view entrepreneurs and exits, read this paper "Control and Exit in Venture Capital Relationships" by Gordon Smith of the University of Wisconsin Law School.

Smith has obviously spent a lot of time working with VCs. Some of his language provides an invaluable perspective into how VCs control exits:

"In most venture capital contracts, veto rights are designated as "protective provisions". They are also referred to by lawyers as negative covenants. For present purposes, the most important veto rights are those that prevent the company from forcing an exit decision...

Even if entrepreneurs value control highly, they cannot demand its retention at the time that they are seeking venture financing.

...this paper describes a relationship in which a combination of staged financing, board control, and contractual protections ensures that venture capitalists are able to pursue the most desirable exit options.

In these early stages of the relationship, the outside directors would usually be selected by consensus, as conflicts between the venture capitalists and entrepreneurs have not yet (fully) surfaced.

First, they use negative contractual covenants (often called protective provisions) to limit the ability of the entrepreneur to act opportunistically. These covenants typically prohibit the portfolio company from engaging in fundamental transactions (e.g., mergers) without prior approval of the venture investors, thus cutting off the means by which common stockholders have traditionally taken advantage of preferred stock.

In the early stages of the investment, therefore, venture capitalists are less concerned about initiating exit than they are about protecting against forced exit. As the business matures, new conflicts begin to play a more prominent role.

The tricky part of venture capital contracting stems from the need to make mid-stream adjustments which position the company for one exit strategy or another. The potential for conflict between the venture capitalist and the entrepreneur is most visible at these moments, and the key feature of the relationship is control.

Preferred stock has fallen out of favor with most investors, but venture capitalists rely almost exclusively on convertible preferred stock. Bratton attempts to explain why. Like A&B, Bratton relies on the notion of control. Where venture capitalists have full control – holding a majority of the votes in a corporation and electing a majority of the board of directors – the venture capitalist may block any potential opportunistic actions by the entrepreneur. On the other hand, where venture capitalists do not control the voting shares or the board of directors and rely exclusively on contractual covenants and other provisions for protection, room for entrepreneurial opportunism exists."

This paper is not easy to read, but I highly recommend it for anyone considering a preferred share investment.

Can the VC model work with virtually no exits?

by Eze Vidra

The global economic crisis has brought IPO exits to a 30 year low and M&A activity is slower than previous year.  How do VCs cope with the new reality?

The National Venture Capital Association (NVCA) in the US has released the results of the Exit Poll report for Q4 of 2008.  The results are unsurprisingly disappointing. There were no venture-backed IPOs in the quarter, and the tally of M&A exits as of the last day of the quarter came to a modest 37 transactions for the period.

2008 only brought six IPO exits, the fewest annual VC-backed offering number since 1997. Overall, there were 260 M&A transactions in 2008, dipping below 300 for the first time since 2003.  28% of these M&A deals were "fire sales", well below the venture capital investment. The largest M&A deal this quarter was the $945 million  Bill Me Later acquisition by eBay, completed this November.

The 2009 outlook looks grim for the Venture Capital industry. In the words of Mark Heesen, president of the NVCA:

"The most significant impact of the US financial crisis on the venture capital industry has clearly taken place in the exit markets. The inability of our strongest companies to go public and the softening of acquisitions activity continue to have a major ripple effect that now reaches every stage of the venture investment lifecycle. As a result, new investments and fundraising will slow considerably in 2009 until the exit markets re-open and the pipeline is cleared. The venture community is poised and ready to bring the next generation of great companies to the capital markets and strategic buyers and, as we have done historically, contribute substantially to economic growth and innovation."

The venture capital model is based on exits north of $100 million and over 300% return. Now that the exit pool is dry, I see a real opportunity for VCs willing to take the risks and diversify. Remember all those entrepreneurs with great idea that you previously called a 'feature' or a gimmick? Now would be a good time to pick up the phone and call them over for a chat.

As can be seen in this Google Insights for Search query, global interest in venture capital online is hitting new lows. So how can the VCs make themselevs relevant again?

"The next big idea is being venture-backed, today"

1. Invest early

People say that in times like this, one has to switch the word 'crisis' with 'opportunity'. In my opinion, looking through the opportunity lense opens up a few options. Rather than sticking to the same old principles and assumptions, VCs should invest light, invest early, and look for small exits in the range of $20-$50 million.  Look at TechCrunch's web tablet, which received a lot of buzz yesterday. TechCrunch is by all means not an electronics manufacturer, but they had an idea, they executed on a prototype, and many large electronic manufacturers would be very happy to buy the technology early on.

2. Build the team

A friend of mine who runs a successful venture back software company, said that his favorite side effect of the recession is the ability to get talent for cheap.  VCs have a unique opportunity to act as headhunters. Rather than turning away a good idea with a poor/inexperienced team, VCs can invest in the idea and build the company themseleves. VCs have access to jobs accross their portfolio companies, and bringing in their own people to the company increases their control over the investment. I know this is being done by Sequoia, but other VCs should embrace the model as well. A first step could be the "Venture Backed Job Board" for those who lost their jobs in the recent layoffs wave.

3. Mashup Services

A strong synergy is one that produces better results than the sum of its individuals. VCs should not wait for their companies to do biz dev - they need to open their contact list and 'mary' companies together. For example, an analytics company can probably benefit from relationships with ISPs (similar to the Hitwise model). If they are not local, chances are that the process is going to be long and painful. VCs should learn from Angels like Yossi Vardi, who walks around conference floors with a trail of 20 entrepreneurs (you can watch this live next week  at DLD in Munich), who get introduced to executives in big companies. It's a win-win for Vardi, the start up and the big company looking for innovative ideas. That's a synergy. How many venture backed entrepreneurs can say the same thing about their VC?

It is projected that 30% of the hedge funds will not survive the current economic crisis. That is probably a good thing. What would happen is 30% of the VCs closed their doors?

Entrepreneurs are the problem, not VCs

by Charlie O'Donnell

People keep talking about the decrease in venture investing, and how the VC financing model is out of whack:

"Because venture funds invest not just in all the wrong places, ignoring clear supply and demand signals - but, worse, in all the wrong and same places. Where one pioneer invests, a slew of imitators follow, and so tremendous amounts of cash are poured into the same business design or market space - ad exchanges, social networks, and blogging/vlogging platforms to name just a few recent fads. That striking homogeneity reflects an almost total lack of strategic imagination by venture players."

- Umair Haque via Kortina.

Umair wrote about this twice--here and here.  Umair's a smart guy, but, like a lot of other people, he keeps blaming this on VCs.  Is it me, or aren't the entrepreneurs the ones who are supposed to be innovating and creating markets, not VCs?  VCs don't innovate.  They fund the innovation of entrepreneurs.  When I hear "lack of innovation", I'd guess there's a problem with the source, not the source of funding.

He piles on with the VC finger pointing:

"Why does President-elect Obama have to invest a likely trillion dollars to renew... auto, energy, healthcare, education, finance, and agricultural industries... Because today's crop of apathetic, risk-averse venture investors didn't."

"How many new industries or markets have venture funds created in the last decade?"

"...tomorrow's sources of advantage remain largely unexplored - because venture investors have been systematically underinvesting in discovering them"

When I hear people complaining about VC's and the venture capital model, my first thought is, "Are there amazing, innovative companies not getting funded because there's something wrong with the VC model?  Is there a viable entrepreneur with a groundbreaking idea who can't get cash for it?  Who??"

Honestly, most people's ideas just aren't that good... and then even if you have a good idea, the chances the you have the means to turn it into a real business is pretty slim.  Frankly, I'm amazed that any profitible new and innovative companies *ever* get build--its not easy.  The idea, though, that such businesses exist, but outside of the scope of what "lemming" VCs tend to invest in is pretty ridiculous.

He keeps bringing up the auto industry, but aren't there a bunch of VCs in Tesla?  Is there reason why that's the only auto startup I know of a function of unwilling VCs or is it a lack of capable entrepreneurs willing, able or interested in starting a car company from scratch?

Umair has never sat on the other side of venture capital deal flow.  Trust me, it isn't pretty.  It's not the VCs that are myopic--it's us entrepreneurs.  We're the problem.  We're the ones coming up with the "me, too!" businesses, and before you say, "Well, that's because that's what is getting funded", if you're an entrepreneur who creates businesses based on what you think a VC will fund versus things like value creation, potential for distruption, your own passion, then I'm not really sure how successful an entrepreneur you're likely to be.

Just look at entrepreneurship education in this country.  We spend more time teaching entrepreneurs how to write business plans than we teach them about passion (or teach them how to fuel it) or about the underlying technologies they're supposed to innovate with in the first place.

When I look at stats that say that VC investment is down, I think first about how deal flow is probably down, too.  When the economy turns, the liklihood that someone with a good idea is going to take a risk and jump from their cushy job somewhere goes down, too--understandably so.  I see lots of people complaining about the lack of financing out there, but honestly, I haven't seen one single deal that cannot get financed because VC doors are shut, VCs are risk averse, VCs are stupid, etc.  There are some deals that got financed on previously screwy terms and entrepreneurs might not want to take a round that reflects current market conditions.  That's a different story.  But seriously, where are the amazing ideas that can't get money?

I've hardly seen any innovation in the education space.  This is not a VC problem.  Most of the education ideas I've seen are marketplaces for learning and the most innovation I've seen in learning recently is on YouTube and Slideshare.

The tendency to blame the people with the money in this country is rampant.  We blame the Wall St. collapse on "greedy CEOs" and "predetory lenders".  Seriously?  I don't recall any lenders physically threatening me to try and get me to take their balloon payment/ARM combo loan back in '05 when I bought my condo.  Silly me.  You know what I did?  I made myself a financial model to figure out what my payments would be and made sure I could afford my payments.

Even this Madoff mess.  The fact that people threw the bulk of their savings to one money manager, even though they couldn't explain how he was making money, is ridiculous. 

If anything is going to change in this country, it needs to start with personal responsibility.  Don't invest in things you don't understand.  Don't eat more calories than you can reasonably burn off.  Don't blame VCs for not backing you when your idea isn't particularly innovative or doesn't have potential. 

Umair's posts get quite a fair bit of traffic...  You'd think that he'd be seeing the occasional groundbreakingly innovative entrepreneur with a great idea and he'd post a few times and say, "Like this company... here's my example... great idea, but VC's are too stupid or risk averse to invest in it."

I think it's very telling that the people who complain that VCs don't invest in the right stuff can't put to exactly what ideas they should be investing in.

Pitching 101: Say What You Do

by Eric Wiesen

I've been thinking about putting together a series of posts about pitching, not just to RRE, but in general. Some other bloggers, particularly my friend Mark Davis at DFJ Gotham Ventures, have done an admirable job of putting together well thought-out and structured guides that go through a lot of best practices around pitching, and I'm frankly not looking to recreate those efforts. Rather I occasionally see a poor practice repeated so frequently that I think it might be helpful to point out a few "hot spots" in pitching methodology that I think are important.

Today's topic is one of the absolute most important: SAY. WHAT. YOUR. COMPANY. DOES. I am continually amazed by the number of PowerPoint decks, executive summaries and in-person pitches that don't tell the investors being pitched what the company's product or service does until halfway through. This is not the right approach. If you're sending around a deck, the second slide should be a succinct description of what you want to do. In an executive summary it's the first paragraph. If you're pitching in person you should plan to tell investors what you're doing shortly after introductions have been made and you have all sat down to "get down to business". If you need a script, it's something like this:

"Thanks for meeting with us. We're [ScoobyDooCorp] and we're [the first ad network for pet-related websites]."

Instead, the first half of the pitch is often one of three things:

1. Long-form description/discussion of the management team's accomplishments.
2. Lengthy discourse on the problem or pain point being addressed.
3. Treatise on the technology, how it works and why it's superior.

Don't misunderstand me - every one of these is important and I want to hear them all. But if you tell me these things before you tell me what your company does, it makes it much harder for me to contextualize the value of these other parts of your presentation. This isn't a "VC ADD." issue. It's not that we're so impatient we can't listen to a well-structured pitch. But it's much more valuable to you as an entrepreneur if I'm hearing your accomplishments, the problem you're solving or the virtues of your technology in the context of what you're going to do after I fund you.

Why Do "Asshole VCs" Survive?

by Jeff Bussgang

One of our portfolio companies is raising money this year.  It's a great company, run by a great CEO, and it will get funded in a competitive process.  The CEO was briefing our partnership the other day and listed the firms he is talking to.  In another start-up a number of years ago, he had been backed by an unamed firm in Boston, led by an unamed partner, and made them money.  "Why aren't you going back to [insert name] at [insert firm]?" I asked innocently.  "Life's too short," he replies pointedly, "to work with assholes."

At a time when there is likely to be some shakeout in the VC industry, a question that perplexes me is:  Why do asshole VCs continue to survive?

Now don't get me wrong, I don't the VC business is unique in its profile or behavior.  According to the NVCA, there are 700 or so VC firms and 8,000 industry professionals (including associates, principals, etc).  The vast majority of these folks are decent people.  There are always a few bad apples in every barrell and an industry with type A, competitive people operating with very high stakes is likely to have its fair share.  Talk to any entrepreneur who has gone through an extensive fundraising process and they will eagerly share some their favorite, colorful horror stories.  So why do these VCs continue to succeed?  Why isn't there a stronger, self-correcting feedback loop?

Here's the logic thread:  the best entrepreneurs have choices, particularly those that have been successful before.  They tyipcally seek out the top VCs who are both smart/successful/value-add/relevant AND who are respectful/decent/good to work with (you can see my BCG roots coming through in the imaginary 2x2 matrix).  Even if a VC is charming during the courting process, with minimal effort, reputations can be investigated and references carefully checked as to how they behave when things don't go according to plan.  So why is it that Asshole VCs are able to persist?  Shouldn't the best entrepreneurs avoid working with them and therefore shouldn't they be less successful over time?

One of my VC friends from Silicon Valley suggested one explanation:  "Entrepreneurs get blinded by firm reputations and look past individual reputations.  They don't do their due diligence on partners and check references carefully on the individual board member."

"If I were an entrepreneur given the choice between banging my head against a cinderblock wall for a year or taking money from [unamed partner from unamed firm]," observes one VC friend, "I'd opt for the cinderblock wall."

Ouch.  With fewer financing choices for entrepreneurs likely in 2009, I hope they aren't faced with that sort of painful choice!

How to spot subprime VC

by Georges van Hoegaerden

Subprime VC is easily recognizable, here are some of my metrics. Run for the hills when the investor...:

1/ ...seems more interested in how it is built rather than what the disruptive business proposition is.
Innovation becomes successful when it marries macro-economic value with micro-economic (technology) execution. Technology risk is the least of our worries in Silicon Valley, yet fundamental disruption is crucial and should take up the majority of the discussion.

2/ ...seems more worried about cost of development than cost of greenfield customer acquisition.
Capital efficiency is a buzz-word investors love to throw around. In most cases they want you to be as cheap as possible. But capital efficiency is relative to the cost and value of customer acquisition. Not all venture capital deals start with a seed round below $250K, more disruptive innovation usually costs more to build well (think iPod, iPhone, iTunes, eBay, etc).

3/ ...talks about valuations before you've explained the value of becoming the market leader.
A favorite trick of investors is to value the company based on its present accomplishments and many entrepreneurs fall for it. Their companies become undervalued and underpriced which leads to early loss of control to investors. And when investors run a company, statistically the chances of success have diminished significantly. Early stage companies should be priced based on the value of the idea and accomplishments along the trajectory of market leadership. Your glass should be seen as half-full not half-empty.

4/ ...seems more occupied with categorizing the investment than understanding its unique business value.
When investors start categorizing investments in technology categories and subsequently base their investment decisions on them, that means they clearly missed the fact that you business proposition could have value regardless. Again, technologies are not the business, application of technology to a market segment is.

5/ ...talks about capital efficiency without probing market inefficiency.
Again, capital efficiency is a relative term. When a large market is extremely inefficient it probably means that the absolute cost to enter is high (otherwise someone else would have entered it before you). So, the cost to enter the market is a function of its current inefficiency. Many investors are less versed in inefficiencies than you and therefor misjudge the price it takes to enter. As the entrepreneur you will be faced with the inequitable consequences if you decide to bow down and take the investors' word for it.

6/ ...doesn't question market entry risk, but focuses on cost.
Investment risk is what should be top of mind to investors, but many of them think they have the operational experience to challenge the assumptions of the entrepreneurs. In many scenarios market entry risk can be mitigated by developing a better product, but a better product costs more money to build. At any time would I rather spend a dollar on R&D to make the product better, than spend a dollar on marketing expenses to try and make a "cheap" product land better. So, the right amount of money (not cost) is imperative to disrupt a market.

7/ ...doesn't ask about the runway to profitability, but the initial round to get in.
Most companies require multiple rounds of funding. Those rounds are not there for you as the entrepreneur, but for the investor to establish milestones to make him more comfortable. An investor that does not allocate sufficient runway, is effectively selling short on the promise of your company and will cost you months of fundraising efforts at every round.

8/ ...asks you which other investors you've spoken to.
Investors are lemmings, and so you should not disclose who you talk to until you have all their term-sheet on the table. Force them to make their assessment of your company independently. Usually each investor has a different risk analysis of your company and last thing you want to do is add up all the negatives before there is a buying signal on all sides. Herd the positives.

9/ ...asks you to talk with his associates first.
As discussed in this blog many times over, associates are graduates that should be used to perform due diligence, not to discover a black swan. Many investors will use associates as a way to offload the workload created by the noise inherent to our industry. The minute you get the associate, you have become noise.

10/ ...asks you more about your education than your work experience.
Building innovation that is truly unique requires an analytical mind and ignorance to anything else but bottom-line results. Education teaches you how to respond to prescribed scenarios, innovation requires the opposite; an ability to respond adequately to a myriad of circumstances that have never presented itself to you, in that composition before. Any investor that focuses on your (or his) business school accomplishments has a warped view of what innovation really is.

Never forget that a great entrepreneurial idea sponsored by the wrong investor yields nothing but failure. Keep searching for the right partner and don’t bow down to subprime investment tactics.

How do venture capital deals get done?

by John Gannon

Entrepreneurs should always understand how deals get done at the venture capital firms they're pitching.

Some firms operate on a consensus basis.  In this case, every partner in the firm needs to approve a deal before a termsheet is issued.  This is usually the case for firms with a small number (< 10) investment professionals.  If you're working with a firm that operates in this manner, an entrepreneur will need to find a champion for their deal.

This champion is someone who believes in your company, wants to invest, and then will work to convince the rest of the partnership that the firm should move forward with an investment.  The champion could be a senior person at the firm but it could also be someone at a lower level, like an associate.  If you are working with a lower level person it will likely take longer for your deal to get through the firm's process.

So, if you have the ability to get partner level attention for your deal, great.  However, if you're not able to get a partner's attention initially (and most startups are not), make sure you empower the junior VC staffer to make the case for your company within the partnership.  That includes accepting coaching from the junior VC, since they’ll be introducing you to the other members of the firm and will want you to customize your pitch to hit the key issues that appeal to the other members of the firm's investment committee.

Other firms (typically larger ones in both fund size and personnel size) tend to grant more autonomy to partners and allow them to invest without obtaining permission from the partnership.  Partners in these firms tend to have fairly focused investment themes and sectors that they pursue (for example, a partner who only covers enterprise software, or only does wireless deals, etc)  In this case, you only need to convince a couple of people (the partner and the junior person who is likely supporting them) that your company is a worthwhile investment.

The bottom line is that the deal process varies by firm and it is helpful to understand how the VC firms you're pitching operate.

Should a company allow early exercise of stock options?

by Yoichiro Taku

Some companies allow employees to exercise their unvested stock options, or “early exercise.”  Once purchased, the unvested stock is subject to a right of repurchase by the company upon termination of services.  The repurchase price is the exercise price of the option.  Please note that a stock option is typically not early exercisable unless the board of directors of the company approves an option grant as early exercisable and the company issues the stock option pursuant to an option agreement that permits early exercise.

Allowing early exercise of unvested shares can provide employees with a potential tax advantage by allowing the employee to start their long-term capital gains holding period with respect to all of their shares and minimize the potential for alternative minimum tax (AMT) liability.  If an employee knows that he/she will early exercise a stock option immediately upon the grant of an option (when there is no difference between the exercise price and the fair market value of the common stock), the employee typically should want an NSO as opposed to an ISO, because long-term capital gain treatment for stock issued upon exercise of an NSO occurs after one year.  In contrast, shares issued upon exercise of an ISO must be held for more than one year after the date of exercise and more than two years after the date of grant, in order to qualify for favorable tax treatment.

There are several disadvantages to allowing early exercise, however, including:

• Risk to employee.  By exercising a stock purchase right or immediately exercisable option the employee is taking the risk that the value of the stock may decrease. In other words, the exercising employee places his or her own capital (the money used to purchase the stock) at risk. Even if a promissory note is used to purchase the stock (future post to come), the note must be full recourse for the IRS to respect the purchase. In addition, if the employee purchases the shares with a promissory note, the note will continue to accrue interest until it is repaid, and a market rate of interest must be paid in order to satisfy accounting requirements. Depending on the number of shares purchased, the expected tax benefit from early exercise may not justify these increased risks to the stockholder.

• Tax upon spread. If there is a “spread” at the time of exercise, the employee will trigger ordinary income (in the case of an NSO exercise) and may trigger AMT liability (in the case of an ISO exercise). Any taxes paid will not be refunded if unvested shares are later repurchased at cost.

• “Back door” public company.  If the company ever reaches 500 stockholders, Section12(g) of the Securities Exchange Act of 1934 will require the company to register as a publicly reporting company.

• Securities law issues upon a sale.  If the company has more than 35 unaccredited stockholders at a time when it has agreed to be acquired in a stock for stock transaction, the acquisition will likely be more complex and take longer to complete.

• Administrative hassles.  A significant increase in the number of stockholders can place a tremendous administrative burden on the company. This is especially true when employees purchase shares subject to repurchase and when they purchase shares with promissory notes. The forms that the employee must complete and sign are much longer and more complicated. 83(b) elections must be filed with the IRS within 30 days of the purchase. Unvested shares must be kept by the company, which increases the risk that the stock certificates are lost or misplaced. Interest on promissory notes must be tracked. Furthermore, stockholders have more statutory rights than optionees, including inspection rights. Stockholder information requirements may also be triggered under Rule 701.

Always Treat Money Like It Is Your Own

by Fred Wilson

This should sound pretty obvious, but it isn't. And I think a lot of people have been violating this rule, particularly on wall street and in big corporations and the economic mess we are in is at least partly because of this problem.

One of my favorite investors on wall street is a guy I've known for almost ten years who has been in and around the hedge fund business for more than twenty-five years. Whenever he talks about his business or the funds he is invested in, he always cites how much of his own money in in his fund and how much of the fund managers he invests with have in their funds. The numbers are impressive. Often 25-50% of the funds he invests in are comprised of the manager's own money. His business was affected in 2008 like everyone else, but I have a lot of confidence that he'll come out of this mess way ahead of most others.

In our business, we have put a significant amount of our own net worth into our funds. It's often difficult to have a lot of your net worth tied up in illiquid assets like venture capital funds, but when you are writing a check every time you make an investment, it has a way of clarifying the mind.

This is particularly important when you are facing the decision to support or walk away from an old and  difficult/troubled investment. Most of the time, these kinds of financings are highly dilutive and very punitive if you don't participate. It's really tempting to put more money in because if you don't, you'll get wiped out. But if you do put money in, and the investment still fails, then you've lost even more of your own money and your partners money. The bigger personal check you have to write, the more likely you'll make the right decision. If you don't have to write any checks and all the money you are investing is other people's money, then it's incredibly tempting to "pour good money after bad."

If I think about all the issues we've had on wall street over the past year (see Michael Lewis and David Einhorn's two part column for a great description of them), I think most of these issues have been caused by investors playing with other people's money without enough of their own net worth at stake. Financial leverage is a good example of playing with other people's money. You put up a tiny amount of your own money and you borrow the rest. If things don't go your way, you write off the little you put up and the lender takes the bath. That's been going on in the financial markets and the housing markets for the better part of ten years and we are now seeing the cost of that approach.

Why is it that most of the best managed companies are operated by their owners? Think about Apple, Google, News Corp, etc. All of these companies are run by owners who have a huge amount of their net worth tied up in the business. The same is true of Microsoft until recently when Gates left the business for the most part. But even Gates still has a lot of money tied up in Microsoft. When these leaders make decisions, they are risking their own capital/net worth, not just the capital and net worth of shareholders who they supposedly work for, but really don't.

We don't like to overfund the companies we invest in for a lot of reasons, but there are two big ones. First, the less we invest, the more the founders and managers own and that makes them operate like the company is theirs, not ours. And I also like the discipline that managers have when they are operating with small balance sheets. It causes them to look at every expenditure carefully and act as if the money is their own. As I've said, that generally leads to better decisions.

It is true that entrepreneurs and managers often are too conservative when all the money they are working with is their own. And that's a good reason to bring in other capital, ideally sophisticated investors who understand the business and can add value. But even when you do that, you should treat the investors capital as if it was your own. It's a mindset, and an important one. We've seen all too frequently what can happen when people stop operating that way.

Is venture capital a lonely job?

by Bijan Sabet

The other day I was talking to a friend of mine that recently became a venture capitalist.

We discussed his take on venture capital. We talked about a wide range of issues like investing style, interesting startups, entrepreneurs etc.

The one thing that caught my attention in particular was his sense that life as a VC can be a lonely job. 

In his previous career he was an excutive running a good sized organization. It was a tightly knit unit. Everyone moved in the same direction and with a single purpose. Every waking, breathing moment is dedicated to moving the ball forward. Together.

His point was that as a vc, well, life isn't quite like that. A vc has a portfolio of companies to care about. A venture capitalist spends a significant amount of time meeting new people from a wide range of interests and thinking about new ideas & new markets. And inside a partnership, the team is a group of peers working together but also working on very different things at the same time. And at times, yes, partners divide and conquer inside a firm.

I can see his point but I think it varies on the individual, the firm and the stage of your career. I'll take those in reverse order.

1. Stage. A new venture capitalist isn't on any boards and hasn't made any investments. And most likely she/he won't make any investments for a year perhaps. I've heard of some new vc's that didn't make an investment until their 2nd year in the business. (I made my first investment within my first 6months but I don't think that is typical) You certainly don't want to rush in this business. So during that initial period of time, a new vc is helping out the partnership and thinking/finding new opportunities. All day. All night.

At some point that changes. The inbound calls, emails, SMS, meetings ramp. Big time. And most early stage venture capitalists tend to be active. So each board seat is a real commitment. (fwiw I'm on 7 boards right now)

2. Firm. Some firms are run in a structured fashion and maintain a hierarachy of sorts. Some are quite large. I've seen some firms with committees (e.g. software, datacom, etc). Other firms are smaller. At Spark we decided to have everyone based in one office in Boston. Even though our investments are all over the planet, we wanted to be together. We travel together and we goto each others board meetings. We make decisions together. We also dont’ make any significant decisions over email. We do it in person or worst case on the phone.

If I were to guess, I bet that VCs in larger firms may feel a more lonely at times vs vcs in smaller firms. Again, just a guess.

3. Individual. Ultimately this comes down to a very personal point of view. In my experience loneliness has little to do with physically being around others.

It's about a connection.

It's about connective tissue and a bond you form with your ideas, passion, your friends, your business associates, your lovers and your lovers.

So am I lonely? No. I'm not.

But I do understand why a new vc may feel that way. My guess with this particular person is that it's just part of the early stages of his new career.

And he’ll have to see if this particular shoe fits. My gut says it is.

Investors Strain to Sell Start-Up Companies

by CLAIRE CAIN MILLER

In 2008, entrepreneurs and venture capitalists had difficulty cashing out of start-ups, underscoring just how much the financial crisis has pummeled the technology sector.

Only six venture-backed start-ups went public last year, the fewest since 1977 and down from 86 in 2007, according to data released Monday by the National Venture Capital Association and Thomson Reuters. Venture capitalists sold 260 companies in 2008, down from 360 in 2007.

Stock market investors do not want to invest in initial public offerings, said Mark Heesen, president of the association. And "potential acquirers have just become much more conservative in buying — stock prices are so volatile that they don't know how much money they have."

Cisco Systems, the leading maker of computer networking equipment, is typically an active acquirer, buying 10 to 15 technology companies a year. In 2008, it bought only five.

The few companies that did go public have performed poorly. They raised $470 million in their public offerings, the lowest amount since 1979 and down from $10 billion in 2007. As of Dec. 31, only one company, CardioNet, which makes technology to monitor cardiac patients' hearts outside of hospitals, was trading above its offering price.

Acquisitions were more financially successful. Almost half of the companies acquired returned more than four times the amount of capital invested in them, according to the venture association. The largest sale of the year occurred when Dell bought EqualLogic, which makes storage systems for virtualization, for $1.4 billion in January 2008.

However, corporate acquirers may not continue to pay such attractive prices for venture-backed companies, Mr. Heesen said. He said that he feared Silicon Valley would return "to the postbubble period where we saw a lot of acquisitions, but most of them were fire sales."

If venture-backed companies cannot achieve public offerings or acquisitions, it could have a ripple effect. Some limited partners, like universities and pension funds, have sought to put off their commitments to invest, and venture capitalists said they are reluctant to back many early-stage companies without more certain gains.

"Right now, it's really hard for us to think about doing a start-up investment," said Annette Campbell-White, founder of MedVenture Associates, a venture firm in Emeryville, Calif., that invests in medical technology companies.

Instead of start-ups, she said, "we are looking for companies that are in revenue mode and don't have a whole lot of technology or regulatory risk, and those deals are few and far between."

Making the pie bigger

by John Gannon

Founders spend lots of time, money, blood, sweat, and tears in creating a new business, and they obviously want to maximize the financial return on their investment.  Thus it is important to understand how to value either a) new strategic hires or b) investment capital, as both will reduce the founders equity stake and controlling interest in their business.

I think the question to ask when valuing new hires and investors is "How does this new hire/investor make the pie bigger?"

For example, if you are a technical founder but don't have the key contacts within your target industry that will get you in the door with potential customers, how much is it worth (in equity terms) to get someone with those contacts on board?  This person will probably demand a significant chunk of equity but if you are confident that they can get you in the door with potential partners and get deals closed, maybe they are worth the dilution you'll experience as a founder.

Now let's turn to the investor case.  If you have bootstrapped your company and are able to become cash flow positive without raising outside funds, then you have a business that self-financed and quite possibly sustainable.  However, if your company is burning cash or has ambitious growth targets that can only be met by significant investment in product, sales, or marketing (beyond what you can finance through cash flows or your own wallet), then you will need to think about outside funding.  Taking on outside funding is going to dilute your ownership stake but may also allow you to make the pie (the size of your company in revenues, valuation, etc) bigger.

If taking in $X million in investment will allow you to hire 3 sales people to sell into target accounts and create a channel sales program but will reduce your ownership stake by Y%, is it worth it?  Do you believe that the $X million investment (and the hiring capability, etc that it affords you) will help you build a $50 million dollar company instead of a $5 million company?  Taking said investment may reduce your ownership stake to 50% from 100%, but my guess is that most entrepreneurs want to own 50% of a $50 million company versus 100% of a $5 million company.

Obviously you will never be able to accurately compute that adding $X of investment or giving up some % of equity to a key employee will grow the overall pie by a specific amount.  However, you should think about (in orders of magnitude) how these decisions will help you grow the overall pie (your company's value) as well as the absolute size of your piece of the pie (the value of your share of the company at exit).

Layoffs In Venture Capital

by Furqan Nazeeri

I just got off the phone with a friend who is founder/CEO of an early stage medical device company.  His company is doing well and recently received a couple of term sheets for his first institutional round.  As he was going through the process of negotiating with the potential investors, he said they were trying to set his expectations low.  He told me a story about how one investor recounted tales of startups making mass layoffs, cutting back everywhere and generally dire conditions (basically sending the message that he should be happy to be getting an offer).

So my friend responded, "Wow, that sounds terrible.  This must be really affecting you badly...how many people have you had to layoff here?"

The VC stared at him with a bewildered look.

But it's not so far fetched though that layoffs will soon be coming to venture capital.  We're already starting to see layoffs at the large private equity funds where Blackstone, Carlyle and American Capital announced staff cuts between 7% and 19% in December.  A survey of 400 venture capitalists found that 60% predicted a drop greater than 10% in 2009 venture funding (below I've embedded the full presentation).  The take away here is expect to see cuts of at least 10% in 2009.  Those first to be cut will be the associates and principals at the larger funds, but expect to see some partners leaving as well.

What does this mean for entrepreneurs and is there anything you should be doing to prepare?

The worst situation is if you have a partner on your board and that person leaves the fund and is replaced by an associate or principal.  That means your board member (i.e. your advocate within the fund) will have a hard time supporting you (heck, they won't even be invited to the partner's meeting where funding decisions are made).  In this scenario you want to fight hard to get an "upgrade" to a partner and talk to your other board members about whether you can downgrade the offender to an observer (or kick them off the board all together) if you're stuck with a junior person.  Your other remaining VC board members will have aligned interests with you on this and may even see it as an opportunity to cramdown the offending investor.

The other more proactive thing you can do is to develop relationships with other partners at the fund (other than the one who sits on your board).  My own experience was that I would meet with partners other than my own usually just once per year which is what will happen if you're not proactive.  Having relationships with more than one partner will help you have a "plan B" in case your current partner leaves but it'll also help you in other ways (like being more of a known quantity when discussions about funding come up).  People are always kinder to someone they know than just names on paper.