Friday, December 26, 2008
I first came to the US in the late 80s and landed in search of the gold mountain, but found myself in the middle of a recession. It was a tough time to build business, and that first company we started almost went bankrupt several times. While it was hard to get customers, it was actually easy to get people, space and resources. It was actually a great time to build a startup but we couldn’t raise money because we simply had no idea how to go about it, and perhaps even if we did, no one would have funded two inexperienced entrepreneurs with funny accents--Dan Hogan taught me a huge amount about building business’s. It’s a long story, but that company created a successful Nasdaq IPO in Feb 1996.
In the last crash, here in the Valley we felt it first and worst, while the rest of the country really didn’t get hit all that badly. There was a big swing of assets from equities into real estate, and the rates were so low that it fueled a boom in real estate that ironically could be blamed for a significant part of the current financial meltdown. In 2002, I found this quote:
“America fell into an economic slump. The crisis capped a decade of frantic speculation in [space] securities and land stoked by heavy borrowing. The exuberant boosterism of the [space] was suddenly and dramatically quelled.”
Now if you put telecom or internet in the first space, and 1990s in the second, this quote applied perfectly to the tech nuclear winter of 2002. This quote was actually from Rockefeller, in the 1880s after speculation in railroad securities--you could also substitute mortgage securities for the 2008 recession--the two constants are land, and its all happened before. Telecom interestingly boosted railroad stocks again for the rights-of-way.
In my 2002 talk, the ghosts of Christmas future, predicted that telecom would come back in wireless, had no idea about cleantech, and had visions of optical processors. So the cleantech industry was born in the worst tech recession of all time, and ironically driven by the same people who had shifted from solar in the late 80s into telecom because solar was a dead space, then shifted back to solar when telecom crashed.
This recession's ghost of Christmas future, is simply this--innovation and creativity never die, recessions bring out the best in them, and great companies still get funded even through the decision paralysis of the biggest market meltdown we’ve ever seen (so far….).
To get funded in this market you have to be aspirin for the pain, not steroids for performance. Some VCs would even say you have to be antibiotics or an open heart surgery, rather than aspirin because the latter just covers the pain but doesn’t fix it … if we can't even agree on the right metaphors imagine how hard it is to agree on the right strategy ;-)
In this current recession the feeling in the Valley is somewhat opposite to that in 2002, back then we were badly hit here, and the rest of the country was lightly touched. This time the Valley is somewhat insulated while the rest of the country has been hard hit all year. Have no illusions, wherever you are, we will all be hit by this--the world’s economies are intimately connected as never before, there is no such thing as recession proof. China is hurting, India slowing, there is a wave coming so be ready for it. If you can get funded now, do it, always take the money when you can. At some point, greed will overcome fear again, but first there will be capitulation--my guess is real estate reaches bottom in Q3 next year, equities maybe six months later. You will know when it happens because, just like the taxi driver giving you stock tips signals the peak, when everybody stops caring about the price of a home in the Bay Area and are just sick of hearing about how bad things are we will have hit bottom. Companies that stick together during these times become great. That said, the next wave of great companies will emerge from this downturn, large corporations have more cash than ever there was in 2002, so M&A will be a rich area albeit at tough prices.
So to all a Merry Christmas and to all a goodnight ;-)
Tuesday, December 16, 2008
1. Why didn’t you do your homework on us before you came to pitch us? and
2. Do you think I’d be wasting my time listening to your pitch if I wasn’t actively investing?
Now #2 may not always be true because sometimes VCs hear a pitch out of courtesy to a trusted contact, or a favor to another firm, or just to get better educated. Generally the size of the fund isn’t hard to find, it's usually on the web site. The date it closed is also often mentioned--most funds have a 4-6 year investment period, so if it closed anytime in the past two years you are on safe ground.
More importantly, you should have done your homework on the partner in question, not just the fund. Does that fund do medical device, or lasers, if that’s your deal? What about the specific partner? Have they built a company or done several deals in your space? Are they likely to have deep contacts and domain expertise in it?
These are simple questions, and easy to answer just using basic web research. Leverage your service providers, especially in the Valley. Everyone from your landlord to your lawyer will know a firm or two, and most of them will know who’s investing. Your lawyers will have access to the venture databases, and can fill in the blanks on the questions above on fund size, and so forth.
There are also profiles to partners and funds. The classic profile is replace the CEO with a seasoned exec.--quite a few of the top tier firms have this systematic approach to investing. If you are particularly sensitive to this issue, you had better get over it, or don't pitch those firms.
You want to pick a VC partner who can really be a partner, someone you can build a trusted relationship with and ideally become lifelong friends with. There are a lot of entrepreneurs (and VCs) that are about as sincere as the IRS in trying to “help you.” I’ve said before that raising money is like getting married, so the insincere entrepreur or VC is to be avoided. It takes time to build a lasting relationship, and to build trust. The adversarial approach doesn’t help here, i.e. some VCs expect you to beg for money (and I admit I was always a bit cap in hand when raising capital--it always amazed me that someone would give you millions of dollars to fund just an idea). And on the entrepreneur side, we are looking at all offers and we’ll pick the best one. I don’t want to be part of a competitive bidding process to find a partner (investment or otherwise) I want to invest in things where I can add unique value, and with companies who can create unique value. If valuation is the only metric for fund selection then entrepreneurs should go first to a credit card, then friends and family, then a bank, then high net worths, then angels, but frankly never to VCs.
What’s harder is to guage the spirit of each firm--ideally, you want to talk to entrepreneurs who have taken $ from this fund, especially from the particular partner you are interested in. This is another reason why CEO forums/networks are so powerful, because it provides a great resource to qualify VCs in addition to giving a self help group for first-time CEOs. Fortunately, we have a great benefit from the carnage of the tech bust--because we have a four-year historical perspective on what the VC funds actually did to support their companies during this time vs. what they said they would do ;-)
Answers to questions:
Philip Crowley CEO Market Tech on your post "Picking the right VP Marketing":
Larry,I liked your comment “coming from a place that marketing was confused as marcom”. I think a lot of us in the photonics industry have seen this happen. There are many different and separate marketing functions that are required to have an effective marketing program. In larger organizations these roles, marcom, branding, product management, strategic marketing, can be filled by individuals. Of course in a start up situation this is not possible. What is really difficult is finding a single individual to fill all these roles as they are all important and in fact require different skill sets. I agree with what you pointed out that there really is no substitute for experience. My view is that marketing needs to start at the point of conception, the business plan. How large is the market? Who are the customers? What is the USP? If this information is vetted properly marketing is all about execution for a seasoned individual.
Yes, there is often a mistaken idea amoung investors that we should have a pure engineering team first, run it lean and defer bringing in the big guns in marketing and sales until the product is developed. Clearly this is partly right, but without a clear market vision even if the product gets invented it will likely be wrong….
Monday, December 1, 2008
All of us who grew up in the laser business are painfully familiar with the solution looking for a problem syndrome ... a great marketing person is deep enough in the space to have a vision for where the market is going, what it needs, and can therefore determine what product to create, and when it will be needed. Also what groups will want to buy it, and what value it will be to them in order to create a model for sales. This understanding is key to success--often the CEO has this vision already, so can get away with a weaker VP marketing, which is why this position is often filled with a great marcom person with little or no strategic vision.
The other critical element is the ability to point sales, to target the right verticals and user groups within those verticals, and to create the leads that sales can go try to close. The Internet has created many new tools to accomplish these goals and most capable marketing people should do well in this area. A finer filter is the quality of lead generation, and targeting--which again requires a pretty clear vision of the market. The next piece is analytic--how well can the marketing VP analyze the data coming back from the market, sales, engineering, etc ... and course correct accordingly?
The most arduous issue is that even a mediocre marketing person is great at marketing themselves, so it's really hard to tell how good they really are. Reference checks are absolutely critical here, and especially back channel i.e., not the references listed in the resume but ideally the boss they reported to and people around them in the companies they worked at.
Unfortunately it's not an area where you can afford to hire someone who does not have domain experience; you can’t afford to have them learn on the job--they have to already have a vision of your market. I have had a couple of cases where I was able to take a promising engineer, or sales person and combine them with an experienced marketing person to create a great marketing team, and put the inexperienced person on the right marketing track for their career, but it's rare.
Being an engineer I have a personal bias towards marketing people who have come from the technical track, but really, a well trained marketing graduate, with some business seasoning is pretty hard to beat.
One of my friends, Tony Surtees who ran a division of Yahoo, is one of the best consumer marketing people I know and caused some controversy when he first graduated by marketing himself a little too effectively and taking out a full page ad in a major newspaper--apparently no one from that prestigious marketing school had ever done something like that before; it's somewhat ironic that Tony quickly got out of print and into digital media ;-) Tony dazzles tech startups with his creative guerilla marketing plays. And this is another pet peeve of mine; marketing needs to spend money, often more than anyone else in the organization, but really good marketing people can do a lot with a little, and in the early stages of a startup it's better to build up a mystique and stay in stealth longer than to try to make a splash by brute force. It's more credible to be viral, less expensive, and keeps you out of the gun sights of large competitors.
However, as a lesson from the Telco era, and laser startups--you should never be in stealth from customers! Many, many, were ... ;-(
Friday, November 14, 2008
When the CEO leaves or is replaced, it’s a big deal and can really alter the company’s DNA. I’ve replaced myself several times as CEO, and have been replaced once by an acquirer (and a crazy founder). I think its always better to replace yourself. Most of us are good at only one thing--in this case either starting a company and nurturing it when its small, growing it until it becomes a real business.
Businesses change dramatically in their strengths and focus as they grow, and it’s a rare CEO who can change their characteristics to lead such a dynamically growing organism. Tech companies usually lead with technical excellence and unfair advantage. After a while they gain real traction with their customers and begin to create true customer focus and intimacy: some CEOs run out of horsepower at this transition. Generally, if they started the company because they had domain experience in an industry and realized that things were being done in the wrong way and they could fix it, then they usually fly through this transition (this is one of the reasons that VCs prefer these types of founders vs. the get rich or pure techie).
When a company really gets cranking its all about execution, and at this point a very different type of operational CEO or COO can really help. If they have this operational excellence and great market vision or instincts then they are likely to do much better than the startup CEO type. Usually you can't attract this type of CEO to the business until it is cranking, because such CEOs are in high demand in large well paying established companies. So anyway, you should always know when to replace yourself – its like “to thin oneself be true”.
The previous CEO really should get out and off the Board to let the new guy take charge completely--unfortunately, this rarely happens. I’ve seen the old guy hang around and undermine the new guy several times. I swore I would never do this, but in a recent experience I began to understand why this is so hard to avoid. I got completely out of the company, but I stayed on the board. Firstly, all the investors and employees trust you as the prior leader, so the authority of knowledge and trust tends to dominate all formal titles. The investors are always calling you to find out what's going on and what you think. This is worse when the new CEO wants you to stay, and you want to move on and do new things, so you end up saddled with twice the work and headaches. As a board member, even as prior leader, you have extremely limited day to day contact and little visibility into what actually goes on inside the company--especially if it's doing business internationally.
Like most other board members you know what you are told. Clearly, you know the history and strategy that you formulated intimately, but as the company grows new strategies are needed and markets change. If Eric Schmidt had held to the original Google strategy, they may never have gone public, but the foundation that he inherited was instrumental in facilitating that IPO. So you are also human, and you resist change, you don’t like it when the new guy wants to change strategy to adapt to a changing market climate, and you pretty quickly get at odds with him. This is bad--there can be only one leader. As a startup CEO I have always fostered a culture of questioning authority--this is critical in a startup, other people are always smarter than you, and the more brains you can get looking at a problem the less likely you are to screw up.
As a company grows and becomes public this startup approach doesn’t work anymore.
Now the worst of all scenarios is when the new strategy fails, and the investors all call you and say “you were right, come back and replace this guy.”
You have no right to do this, you are still the wrong guy to run this business which has grown beyond you--you need to bring in fresh blood, genetically engineered to deal with this situation. So this time, once I found the right CEO, I got completely out of the way but let the new CEO come to me whenever he wanted to get whatever he needed, but not at a board level--this was far more effective because I could focus on helping the new guy without affecting his authority.
The other scenario I am recalling now was with my US public company where the new guy made a wrong move, was undermined pretty badly by the old guy, and the board quickly brought the old guy back in, even though they had fired him after almost 10 years of pretty average growth. This was about 18 months ago, and that company is almost back where it was when the previous CEO was fired the first time--i.e., nowhere. Little wonder? You cant go back, there is only forward. Never be afraid to replace yourself, its your duty to get the best people running your company, its not about you its about success ;-)
Answers to Questions:
David has left a new comment on your post "Alignment":
Larry - I sometimes wonder if the standard VC approach to risk - comes predominantly from addressing risk as one dimensional - i.e. put in less money you reduce risk. Is in not true that sometimes putting in less money increases risk? For example - a start-up is looking to solve some problems occurring in a market that is in a cyclical change - if you miss this cycle your business dynamics will change. In such start-up's a very large risk may be missing a window of opportunity or not capturing sufficient market position to be the leader. There are many other examples. Perhaps it is more a risk/return bias shift - will VC's accept less return for lower risk in this type of environment. We also here often of VC's suggesting that returns are not reduced by reducing the capital invested - I expect there are many examples of where this is the case and many where this is not - where capital must be invested to capture an opportunity. There is also an issue of return on investment at various times - when is the time to be greedy? When is the time to be aggressive? Many famous investors would argue that the best time to be aggressive is when you can achieve much more with your invested dollar (valuations, market share obtained etc). This does not appear to be the attitude of many VC's.
David, you have hit right to the heart of the matter. I know many European VCs who take this approach, and quite a few here as well. Risk is clearly multi-dimensional--team, technology, market, financing, to name the main four (there are at least seven ofcourse). Most startups want to raise too little money, either to minimize dilution, or because they believe it will be easier to raise less than more. Good VCs want to ensure the company has enough cash to reach the next key milestone to trigger a step up in valuation. The fact is, the amount of money invested cannot fundamentally change the risk except to make it worse, i.e., to your point, not enough money means you miss the milestone and risk increases, but also too much money screws up the valuation structure for the next round and increases financing risk.
In the current market, there is a false perception that VCs can hibernate their tech companies-–technology has a shelf life--the market a definite cycle, again to your point, when you miss the market window there is very little you can do. I think the best thing is not to hibernate but rather to shift markets so you can continue to grow. Startups are a lot like the Roman Empire: they either grow or die. The growth stimulates the critical transition from technical leadership to customer intimacy that is essential to avoid the technology shelf-life problem. Of course, this continued growth allows you to survive long enough to be there when your original market comes back, but beware that in the interim, newer solutions will have been spawned and it will be a whole new ballgame.
Thanks for the comment, and ideas for at least two new BLOGs ;-)
Monday, October 27, 2008
Now few of these kids have ever worked before, but that’s not going to stop them become employers--I love this, it was so re-energizing for me to see this energy again. There was passion to spare, and that is part of the X-factor (the 7th thing VCs look for, if you recall the missing element from a previous Blog).
Some of them are driven by a desire to change the world, particularly in clean tech. There was a great little water company with a really elegant solution for disaster recovery, driven primarily by the passion of two founders who worked in third world countries and want to change things there.
There was a guy whose wife is suffering from a disease and he is going to cure it. This X-factor, just as in love, is often the catalyst for investment--passion gets you through the tough times when basic greed will not. Now people who believe can also be guilty of self deception so it's important to have reality checks--try not to spin yourself--but at the same time, this is the fire in your belly that will drive you to succeed.
Interestingly, I was told by an MBA that engineers and inventors are no impediment to starting a company--you just hire them. Funny, I always thought the reverse i.e., that the wellspring was the engineers and inventors, and you could hire MBAs. The point is that education can only do so much. Don’t get me wrong, I think MBAs add a lot of value to any business, but most people I know who are successful entrepreneurs who also have an MBA degree, wish they hadn’t wasted so much time on the degree and had started sooner on company building.
I don’t believe education can teach you how to be an entrepreneur. I think it can give you tools to use, but the entrepreneurial spirit comes from somewhere else. I wrote a blog some time back about the 7 things VCs look for in a company, but only listed 6--the X-factor is the 7th thing. Just like in dating there is a chemistry to teams that makes them work. If the VC feels that chemistry and it resonates with theirs, then the chances of investment success are higher.
Given that about 1 in 10 really make it big (VC by the numbers Blog), you can understand why I think entrepreneurs are heroes--the sheer force of will, determination, and drive to get out of bed every day to fight the startup battle is an amazing accomplishment--it's why I say you can’t fail when you take the risk to start a company. Once you make that leap into the void, you have made an amazing accomplishment--no matter what happens you grow, you become more than you were, and you change the world even if it's just for your friends and family--but sometimes its for everyone.
To those brave young entrepreneurs, one of whom won the $250k funding prize from DFJ, and especially to the rest who didn’t, I say this: There is no failure possible on your chosen path, forget funding, forget wealth, forget success (just for a moment), once you make the mental shift to try to become an employer rather than an employee, once you realize that you don’t actually need an MBA or a PhD in Physics to start a company, once you are willing to swallow your fear of failure and try to build something great, you cannot fail--you are forever changed (I think for the better) and no matter the outcome you will have a made a great contribution--I salute you!
Answers to Questions:
MelNet has left a new comment on your post "Alignment"
Larry - what are your predictions for the next couple of quarters on levels of VC backing for tech startups in the US? And would you expect to see the same or different trends in the US vs. Australia?
Well I can tell you that it slowed considerably in the last Quarter of last year, and has gotten more shaky since then – despite the VC investment cycle being out of phase with the macro cycle, there are a number of funds needing exits now, and getting them will be unlikely – this has made everyone nervous and caused an intentional slow down in the rate at which fresh powder is being deployed. There has been a bit of a bubble in Australia for a while, but macro issues have affected there as well – generally speaking, VCs should be funding early stage companies that are a couple of years from revenue so that they can take advantage of the downturn – instead what is happening is good established companies that are having trouble raising series B are getting down rounds because investors fear how long they will need to carry such companies before the greater market turns around. While many, many, fund managers & brokers in Sydney assured me back in January that Australia has decoupled from the US, I still don’t think it’s true ;-)
Mark Phillips has left a new comment on your post "Alignment"
Larry - any update on this now that there's been another month from hell go by?
So the market looks bad, but that doesn’t stop classic entrepreneurs--I gotta love this guy, he’s still sticking to his guns and pushing for more and more in the deal--so we still haven’t been able to craft the right deal structure. I am just writing another blog on what VCs should be doing in this market--will try to post by next time.
Wednesday, October 8, 2008
I have always believed that the value is in the execution, not the idea, so erred on the side of “giving away” a lot of information on the technology because ideas are cheap. Perhaps I’m wrong on that, but nothing puts me off more than trying to understand a pitch when the entrepreneur wont tell me what he’s actually doing. VCs are not in the business of stealing entrepreneurs’ ideas; they wouldn’t stay in business long if they were.
However, many VCs invite EIRs (entrepreneurs in residence) to work at their firms for 6-12 months--these are usually successful portfolio company CEOs who have exited the previous business and the VCs are tying to incubate the next business. The EIR will be a specialist in a particular field and often be invited into the meeting to hear your pitch. If you are a technical founder this can be great, because a seasoned, successful CEO may fall in love with your idea and bring the management expertise to the table and champion the deal to funding.
Conversely, you may just give the EIR the idea they were looking for to go start their own next business. EIRs are no less honorable people than VCs but they are not in the business of investing in your idea, they are looking for their next idea, and may inadvertently borrow pieces from a dozen pitches to create their next great opportunity. They also want to learn about the competition, potentially you.
Most VCs will explain that the other guy is an EIR, and ask if its OK for him to sit in. Don’t feel bad about saying No, I am not comfortable yet to do that. At a minimum, find out who this EIR is, what he’s looking for and ensure there is not potential for conflict. Also, don’t be afraid to ask the VC if they have any portfolio companies like yours--is there potential for conflict?
All too often, people assume without asking; again, most people will answer a direct question honestly, but may not feel obligated to speak up if you don’t ask. Don’t be paranoid, but don’t be reckless either.
Now a good EIR can be a real asset to your deal because they will give comfort to the VC and credibility to you if the idea resonates with them. Its worth arranging a follow-up meeting with the EIR to find out more about what their goal is, and if nothing else to augment your network. VCs don’t have a lot of time in pitches, but likely you can spend worthwhile time with the EIR to talk about the overall market, and get some good advice on where your deal needs to be fixed. The EIR is often in a position to share things with you that the VC may not be able to ...
Sunday, September 28, 2008
If I put my entrepreneur’s hat on, it seems to me that every entrepreneur wants the chance to raise as much money for as little dilution as possible. So why not structure deals that give the entrepreneur the chance to win by doing a lot for a little, but at the same time, give the VC a win if they don’t--i.e., underwrite the entire round, but put half the money in at the VC’s target pre-$ , and have a tranche and a milestone that if triggered pulls in the other half as a convertible into the next round (probably with a discount for risk); but if the milestone is missed the second half goes in at the same pre$. If the entrepreneur does a lot for a little, then more power to them! After floating this concept past several valley VCs, and wiping the vomit off my shoes, I think I am beginning to understand the problem ... so let’s see:
VCs worry a lot about alignment with the team. Often, especially in other places, you see deals where too little money is put in, and the team is basically set up to fail, but they got the deal done and are then at the mercy of the VCs when they run out of money. Clearly there's a fundamental misalignment here, and not a good working relationship.
A good investor will always want to fund the company with whatever it needs to reach the next valuation inflection, plus a buffer in case things go wrong. If the company does everything right but the market shifts, the VCs will still likely put more money in, and convert into the next round--if the company does not, they will likely put money in too, but at the same terms as the previous round--pretty simple, right?
The misalignment in the first structure is that the VCs will be hoping that the company misses the milestone so they can get to the valuation they need to make their fund economics work--when, instead, they should be cheering the company on to do as much as possible with as little as possible, to get the best valuation on the next round. They are also misaligned on the next round, because if they don’t get the percentage they need on the first round, they will want the new lead to set a lower valuation so they can buy up their percentage to reach their original target. The valuation sensitivity of the company and desire for funky structures also tells the VCs that in the next round, the company will be inclined to take the highest valuation regardless of where it comes from--letting finance dictate strategy, rather than making the best strategic decision to build long term value.
If the VCs don’t get their target percentage, then they will be spending a full partner on working with the company, but only getting a fraction of the reward for it--a good firm will simply not do the deal, a lesser firm might, but basically won’t give the company much time, so why do the deal anyway?
The other argument is, yes, but if you can put in less money you have less at risk, and if the company trips, you will still have an opportunity to buy more. The problem with this, is twofold--most early stage firms are in the business of putting 10M to work, putting 1M in a deal wont move the needle on the fund even if it is a 10x; second, if the company trips the VCs have to take a writedown which their limited partnerss hate ...
I would greatly welcome comment and debate around this issue, especially if someone has a great idea for a deal structure that resolves these issues so we could stop arguing about valuation, and get on with building great companies ;-)
If you prefer not to post, please email me at firstname.lastname@example.org and put BLOG in the subject.
Sunday, September 14, 2008
However, the economics and scale of the chip business keeps luring investors back. For example a GPS chip that might go into a cell phone, or a laser that might make a cell phone display ,get investors excited because of that wonderful "billion" prefix to the number of phones sold--even when multiplied by an ASP of only say $5 that turns into a very very large number.
Chips have large gross margins because they are hard to build and can have great IP barriers to entry. The downside is just about every design decision you make is fraught with risk and quickly followed by a $5M price tag on making your first serious chip run. The level of design team you need to get to tape out the chip means a million a month level burn rates, and pretty quickly your cash is gone.
If your market materializes and you are first in, then chances are you can be the Intel of that market and enjoy 80% share for a long time to come; but if you miss and your competitor gets in first, then you are fighting with the others for the scraps. The worst case is when the market does not take off when you thought--like femto cells, or RFID. Then you are stuck waiting for the market to happen and all your technological lead becomes worthless because your competitors have plenty of time to catch up while you are waiting. VCs get scared off by the lack of a market, and the company is in real trouble.
Volume is key to the chip-co; remember when DSP was first thrown at optical for dispersion compensation? It was like black magic for its ability to solve aberrations occurring in transit with DSP at the receiver. There was a massive wave of investment in that area because the technology offered such a compelling value proposition. Unfortunately, the volumes couldn’t support the chip economics, even in a high volume optical application like telcom (which for laser jocks is like consumer electronics is to PC people), you were still only selling say 50,000 transponders that needed EDC which simply couldn’t support the economics of a single chip-co let alone a flurry of them.
On the positive side, they are great because chips have the unique ability to integrate functionality on a scale never seen before. Remember how wireless started on a card or a USB plug-in and ended up as a feature on an Intel chip?
So once you are in, you can retain your gross margin and ASP simply by adding more and more functionality to your chip through integration of other hardware and software functions elsewhere in your customer’s product. From the customer perspective you are taking cost out of their product and driving up their gross margin, and at the same time you are supporting yours, albeit by eating someone else’s lunch ;-(.
There is a particularly interesting connection between CMOS and optical, at least for me, because the parallel processing potential of optics is so great, and the DSP capability of CMOS offers the ability to solve tough optical problems. The combination of the two often leads to great technologies, at least when there aren’t 20 companies funded at once to do it (circa 2000). Hey, maybe this is a good time to do a chip deal ;-)
Responses to Comments:
To Life Saving Beverage Maker:
It's true that at acquisition time many investors don’t seem to value the team, but I think it's all about Team--and a good investor should be part of that team, otherwise, sure, put the money in the bank instead. Man, we’ve met a few VCs who acted a lot more like bankers when it came to risk haven’t we?
Mate, I was actually thinking of Lightbit when I wrote this one; the CEO or Chairman should answer your question, but if you shoot me an email, I will forward to them. From the VC’s perspective it was a top quartile success, and 3x return in the year after IPO is great – but you’ve given me a great idea for a future blog, thanks.
Tuesday, August 26, 2008
Rewind 6 months to the painful realization that the company should not be funded again and needs to find a buyer. Should they engage a banker? (need another Blog on this). How many months did the investors & founders spend arguing over the liquidation preference and management carveout?
Typically, when the market is poor, management teams negotiate a carveout in the event of sale to overtake the liquidation preference of the investors and assure the team of some return. What’s interesting about this situation is how common it is and how it is reversing the urban myths of VCs reneging on deals. In this case management is reneging--they took the investor’s money and promised a return, agreed to preferences, probably participating preferred and liquidation, maybe anti-dilution to boot--so what’s going on here!?!
Do contracts mean nothing? Damn, sue them!!!
The only people I know who shout that are people who have never been involved in a lawsuit. Generally it's the battle cry of a fool. So the team gets a management carveout of typically 10%. I’ve seen many months wasted in this type of negotiation but it always seems to end up at 10%. I’ve also seen management argue that the investors shouldn’t get any of the earnout in the deal, unless the investors beat them to it with the argument that investors should get all their portion of the earnout up front since they have no control over the team’s ability to deliver the earnout ;-(
So let's look at what happens when the investors don’t negotiate an carveout--the acquirer has acquisition costs--the price he pays for the company, and the retention bonus for the team. If the acquirer can roll the latter into the deal price it’s a better position for them. Finisar did a number of acquisitions in the telecom downturn, and I can't think of one where they didn’t override the VC imposed carveout structure with something more suitable to the acquirer to reward the team. Earnouts rarely went to the investors, and new carveouts were imposed to reward the team and keep them in place. The counterpoint to this is obviously getting the deal done--in a competitive environment the buyer has much less chance to impose deal structures.
The upshot of all this is very simple--as an entrepreneur you can spend an inordinate amount of time negotiating complex deal structures and fretting valuation, and likewise the investors can impose all types of downside protections. But in the end value is generally rewarded. So despite liquidation preferences, anti-dilution, and a host of other issues that probably cost 6 months of painful negotiation, in the end the buyer decides who gets what.
The team is most of the value in a deal, and if they don’t get rewarded the deal doesn’t happen. So while all the power may seem to reside with the VCs because they have the money, in fact it resides with whomever delivers the value. At the time of initial funding the value is mostly the $, but once the company is established that power shifts ;-)
Tuesday, August 12, 2008
To give an example of the strength of marketing--Coherent, when they had a medical division, launched mixed gas lasers that made yellow light for ophthalmic applications. They could just as easily have made green lasers, but they realized that others could do that too. If you look at the absorption spectrum of hemoglobin there are two peaks in the visible, one in the yellow and a slightly smaller one in the green. From a theoretical perspective one would conclude that yellow is better--i.e., less power for more energy absorbed in same volume. So a great marketing campaign was launched to promote yellow as the magical wavelength for photocoagulation, and Coherent dominated the market.
Even more than 15 years later, most doctors, and surprisingly many engineers, still believe yellow is better and wont buy anything else--researchers still struggle with ways to create yellow, but in clinical applications the differences are barely distringuishable and from an economic perspective cost differences not justified. Just like Brand, it's an almost unbeatable argument based on belief. Whether nurtured from science or religion, the end result is additional value captured for years. To quote an oft misrepresented and misunderstood compay, dear to the hearts of all laser jocks--Novalux, making laser TV--what could be cooler than that!?!
As a quick aside to my “Is it a feature, product, or company?” Blog, Novalux could have been a company for sure, but they never managed to control the whole product solution. However, they did engineer the first ever TV solution with a hope of meeting the grinding wheels of consumer electronics (rather like CMOS, actually). They had the laser chip but they lacked the optical chip.
I am personalloy very proud of being able to acquire this company and merge it into the optical chip company to create the whole product solution. Novalux did a simply outstanding job of marketing, they convinced even the most cynical laser jocks (including me!) that laser TV was viable, they convinced the brands, and their OEMs, and darn it, they built the best looking TV I’ve ever seen. Classic marketing (not surprising for a group of ex Coherent guys ;-) ).
So at several Photonics Forum presentations I have predicted that laser TV will never happen. I am officially wrong as Mitsubishi is shipping these TVs. In fact, if Novalux could have gotten to market faster by say a year, I believe that several brands would be shipping these TVs now.
Novalux did a stellar job of marketing, which is why Arasor acquired them. The thing missing from Novalux was true partnership (see another Blog on this), which could have given them the missing piece to deliver a whole product solution to the market. The fundamental problem was they relied on third party OEMs who currently supplied the brands with product to manufacture the new laser TV product using a Novalux lisence. If Novalux could have gotten control of laser manufacture or a true partner to supply complete lasers, they could have driven the market.
Easy to say, much harder to do--one of the perks of being a VC ;-)
Monday, July 28, 2008
Remember when WiFi first came out, and we had those little PCMCIA cards that plugged into our laptops? Then we got USB plug ins. Then within about 28 months, WiFi was embedded on the Centrino chip. This is the way of the semiconductor--its why you never want to build a business in the way of CMOS, it will crush you--silicon always finds a way.
A corollary in lasers is, if there is any other way to solve a problem without using a laser ... then do it that way. Lasers generally only win in applications where there is no other option: ophthalmic lasers win because only they can get inside the eye non-invasively. Radio frequency (RF) or intense pulsed light (lamps) tend to beat lasers in most other applications because they are easier, lower tech, and less expensive.
Ironically, I’ve been run over by CMOS a couple of times. Worst case was EDC (electronic dispersion compensation) in telecom or optical silicon. By throwing DSP (digital signal processing) at dispersion compensation, a little Intel company called Intersymbol was able to negate the effects of dispersion and extend the reach of a variety of transponders, while the rest of us were selling optical solutions firmly convinced that this was the only and most elegant way to correct for dispersion. But take heart, the EDC company also turned out to be just another feature, and needed to use that to create a unique transponder to become a company ... but wait! That company needed to be acquired to be part of the larger ecosystem before the entire entourage of technologies could become a real company…..ugg…..
With optical silicon, Translucent created an optical gain medium trying to piggyback on CMOS and help solve the pin problem limiting speed of chip communications--again, the problem, even when you are trying to be part of the CMOS ecosystem, is it will always find a way to do it in silicon anyway. So as a startup, you may have a unique software algorithm that can accelerate chip communications, you may be able to do it faster than anyone else, and you’ve patented the hell out of it, but you are still at the mercy of a chip supplier to use your product and when they do it becomes a feature on their product and you have no company.
In contrast, you may be able to use this unique acceleration algorithm to create a new type of chip that you can supply to, for example, Cisco to make faster routers, and Apple to make a faster web interface on its I-phone. In this case you may just have a company (and some nice acquirers to boot ;-) ). The femtocell BLOG I wrote a while back is another good example. A large ecosystem has developed around femto, from carriers doing trials, to investors, femto vendors, and suppliers to those vendors. The femtocell makers are trying to sell to the carriers, the chip makers are trying to give the femto makers an unfair advantage, and everyone is trying to guess when the carriers will deploy, and the carriers are trying to drive down the ASP from $300 to $50 ... but promising massive volumes ... sound familiar?
Someone making a chip controls the heart of the femtocell, enabling the key characteristic valued by the carriers. That vendor is in a position of power while they can lead the adoption curve. Some cell maker recognized this early and leveraged that characteristic and is getting design wins--very likely, everyone else in the ecosystem is trying to tag along for the ride but will get crushed by the price erosion---sound like fun?
And by the way ... I’ve been getting quite a few emails with Q&As for the Blog, instead of postings here. So to make it fair for all feel free to send questions/comments to email@example.com BUT, please use the subject header BLOG so I can filter them ;-)
Friday, July 11, 2008
As a former professor (hard to believe I know), albeit for a short time, I know we tend to pontificate, but its silly to try and be something you are not--worse, per Abraham Lincoln’s theory, please don’t open your mouth and confirm the fact.
When novice marketers, or engineers try to sound knowledgeable they say really dumb things and lose their credibility. In contrast, when an engineer says, “I don’t know anything about marketing, but its seems to me that customers wont care much about technology…..” there is a great ring of truth to it. VCs want to know that they can work with entrepreneurs--if you try to sound like an expert in something you are not, you will first make them think you are not an expert in anything (including the field you probably are an expert in), and second, scare them off the idea of trying to mentor you if they make the investment.
Another secret that some VCs and most really good sales people use is the Enneagram--it’s a personality typing methodology developed by the Jesuits several hundred years back to help them convert people to Catholicism. It's like x-ray glasses to read people’s personality and thereby manage them more effectively. A good sales person can rapidly asses whether you are a big picture dreamer, or a detailed oriented slow decision maker--or whatever. If you are a dreamer, the sales person will simply drop by your company and let you paint a grand picture of life with his product; if detailed oriented, he’ll write a formal proposal outlining the detailed benefits of his product and probably throw in analytics to boot--just dropping in and waffling would irritate the detail oriented person. So, what’s the point? Well, while the Enneagram is hard to use, spotting someone who is trying to be something they are not is very, very easy--so don’t do it.
Another pet peeve of mine is the prelude--“well, to be completely honest …” or, “to tell you the truth ...” – so you’ve been lying to me up to this point, right?
Now, it seems a number of readers prefer email to posting--so here are answers to their questions:
Larry what are your startup CEO Tips?
Always take the money, when they pass the hors d'oeuvres take two
Forget about dilution, focus on value creation and leverage
Never lead with price, lead with quality and value and charge a premium
Choose your investors like your wife, with luck they’ll last as long, or longer ;-)
Until the company has more than 100 people, interview every hire yourself – for the first 20 interview them first: You are creating a DNA, you have to nurture it
Feed your sales people, starve your engineers--use cash to reward sales, equity for engineering--use both for marketing
CEO job #1 is never run out of money
There is no EGO in CEO--when the company wins, credit the team, when it loses take it on the chin yourself
Be honest and open with customers, investors, and employees--if you always tell them the bad news, I guarantee it will be better than what they were thinking and you’ll focus them
Spend your dollars on what matters--investors and good customers look at furniture the opposite way lawyers do
Invest in and understand marketing--most people confuse marketing with marcom, and sales with marketing. Understand the difference--the right marketing VP combined with the right sales VP can make your company; the wrong one WILL break it, and you can rarely tell until its almost too late
How do you decide which technology to use to reach a goal?
In the laser market there’s an old adage, mine actually, that says if you can do it any other way without using a laser, then that will be successful. Example: Iridex made lasers work in ophthalmic because it’s the ONLY way to get inside the eye non invasively, so it worked well, otherwise simpler technologies will always win. So my answer is pick the simplest, that you can get to market fastest that gives the best result in the application--i.e., use just enough technology to make it work well not more and ensure its well protected
Should you be an earlier adopter of new technology or wait until things are proven?
Early adopters take the most risk, therefore get the best reward when they win, and suffer badly when they lose. Customers have the benefit of being able to back two or three startups to hedge their bets. If you want to be average, you will lose. Early adopters usually win.
How do you determine the outcome of applying technology in a new way?
You don’t, the market does it for you ;-)
Are their secrets to financing a digital business that are different to other forms of business?
Its cheaper to fail than ever before, so VCs are funding many more deals with smaller raises. Competition is fierce, try to pick someone who really understands your specific vertical, not just digital, but preferably someone who has built a company in the exact space (or invested in a few) who can really help you win. Probability of success is lower in digital than traditional, and sticky funding is as hard to get as sticky customers ..
Monday, June 30, 2008
So, as an entrepreneur, you take great responsibility when you accept the first investor’s check. You get sleepless nights worrying about losing their money, and generally this means you don’t lose it. I remember the first check I ever got was from a retied DEC executive in Boston, and as he handed over the $100k check he looked me in the eye and said in all sincerity “I know you’ll make me money.” It’s a great feeling wining the check, but the sleepless nights aren’t far behind.
Fast forward to the successful exit, the major event that all your investors eagerly anticipated all those years ago when they invested in an idea. So you IPO the company and everyone gets liquid--it’s a Red Letter day! Now, problem, all the IPO investors have expectations of gaining great wealth, too, and you just accepted responsibility to them for this and you get more sleepless nights. Now the bankers should shoulder a lot of this responsibility too, since they diligence the company for the public investors, and underwrite the IPO, but too often they are onto the next deal.
As a founder, you leave the company to do the next startup, and the company goes on, grows and generates maybe a 3-4x return for the IPO investors--this is a stellar result, after all, the VCs expect to get a 10x return on 1 in 10 companies, and a base hit 3-4x on the rest that don’t fail. So imagine your shock when you start hearing the public shareholders talking about a 10x – after the company is public!?! Talk about sleepless nights …
So there I am, up at the podium facing a rabble of angry shareholders, actually I am one too, the difference is I spent years building the company, and making the shares valuable enough to IPO in the first place, and unlike the public shareholders, most of us have a two-year escrow and can’t realize any gain. Just to make it more interesting, the company secretary grabs me just before I go on, and redlines 50% of my speech because “you aren’t allowed to say that.”
So there I am, I was loaded for bear, but not I’m barely loaded for squirrels--and they are hungry ... looking into the eyes of retirees, stock brokers, institutional investors, and, ah yes …. that guy in the front is definitely a lawyer. Funny how there is always a lawyer around when the share price falls, wanting to take a piece, but when it rises, no one is giving you a piece ….
So what’s the point of this Blog? Well, there really is no exit. What you consider liquidity, someone else considers a great investment and unfortunately you carry the responsibility for all those investors going forward, and in some places, you will be blamed for many years after you exit, if things go south. Conversely when things go well, no one will remember your name--success has a hundred generals, failure only you. This is actually the hallmark of a great CEO. The oft misquoted lesson from the Godfather--it's not personal, it's strictly business--is of course opposite to the book’s intention, which was that the Godfather was great because he took everything personally and carried personal responsibility. Great CEOs stand up and take the hit when things go wrong, no matter who caused them--when Kevin Kalkhoven tried to buy Iridex and we were unable to convince the board that we should sell (I’ll cry if I tell you how much money this would have made), it was actually our fault for not being persuasive enough, not the board's for making what was in fact the wrong decision.
As a startup CEO, you are going to turn over a lot of rocks, and often you’ll find wriggly things underneath that you don’t like. Make sure you take the time to scrape them off before putting the rock back in place. Great CEOs shoulder blame personally, and as a result, they tend to fix problems before they result in blame. They also fix the problem, not the blame, in that they never blame their team. But when things go well, the team gets all the credit and this is exactly how it should be. Nothing engenders loyalty in a team as much as knowing they will be allowed to shine.
Monday, June 16, 2008
Its going really cheap, 100M pre-$, that’s right, this week only 5 will get you 10 ... well 5 actually, 5 million that is ... So my epiphany is this. How do you explain to a passionate entrepreneur that their idea is brilliant, and in fact if it does take off the way we all would like, it will be worth $100M? The problem is that they need the VC money and help to de-risk it and set it up for success in order to get that next valuation. Now most entrepreneurs, like me, are more old school and come a little more cap-in-hand looking for investment--but the new generation of Internet guys have a very different attitude--and lets face it, why wouldn’t they in the hindsight of the incredible price tags put on acquisitions by the Internet giants? Eyeballs, clicks, CPM ... and with so many clicks, probably, eventually, some revenue.
So we all understand Net Present Value, discounting for risk, etc ... but forget that business school argument. It's as simple as this. For an early stage VC to make money, they need to own about 20% of the company in their A-round. There is no magic to this, it's pretty much the benchmark across the valley, and across the world. Now a strategic investor who is getting a lock on a new technology or access, or preferential treatment, will pay a lot higher valuation but wont deliver much, if any, value beyond the money. The 20% number anticipates the VC contributing more capital to the subsequent B & C rounds in an attempt to maintain pro-rata, and reduce dilution. If things go as planned, the B round will be at a significantly higher (multiple of) the A, and the same cash that was invested in A, when invested in B, will buy a much smaller percentage. VCs love that because it means the company has become much more valuable through the A round, and they can attract new, later stage investors whose risk tolerance is lower but who will pay higher valuations for less risky investments.
Anyway, as an entrepreneur I tried to always worry about what milestones I could achieve with the A money, so that I could max out valuation on the B, rather than trying to optimize the A. Its hard enough to attract a quality VC to your business when he's seeing many comparables on a daily basis, without making the hurdle higher by slapping an outrageous price tag on it. Mind you, I am just a hardware guy so what do I know about what’s outrageous pricing for Internet deals.
So once I explained the VC model for funding and the 20% parameter, the sharp business guy said, OK but our valuation of $100M is minimum, so you’ll need to invest $20M to get your 20% ... and it went on. In an effort to make some kind of deal make sense, I proposed that we do the equivalent of investing $5M in an A for something close to 20%, and if they hit their proposed milestone in 6 months, we’d invest another 5-7 for a tiny % to hit 20% aggregate. After taking this to a few friendly VCs and getting a lot of laughs, I learned a new maxim for Internet deals – “its cheaper to fail than ever before” – meaning VCs are doing many more deals in this space by investing $250k to $500k, to test an idea. Most fail, but those that don’t move on to the more traditional $5M A round, still nowhere near a 100M pre-.
Putting it simply, pre-revenue companies (or concept plays) have trouble raising money from banks, it's not like real estate. Conversely VCs thrive on risk and leveraging their ability to reduce it and build great companies with great entrepreneurs ideas. The price for that is selling a greater percentage of your company to get the VC's mindshare beyond their money. I really like these two entrepreneurs and their idea, which reminds me a lot of Netscape, and would love to find a way to fund them (within the bounds of VC mandate and economics). I really like the way they made me rethink the VC model ... its important for us to reexamine our founding principles from time to time to ensure we really do understand them.
Tuesday, June 3, 2008
There are basically seven things VCs focus on in evaluating a business: Team, problem (customer’s pain), solution (product), opportunity (size of pie), unfair advantage (technology or biz model), and competition. I know that’s only six ...
You should be able to communicate all these in a first meeting, with 10 Powerpoint slides (and one of those 10 is the title slide). You know the Samuel Clemens comment “I had send a long letter because I didn’t have time to write a short one.” It's very hard to encapsulate a business into 10 slides, but even harder to do so in a single sentence, or on the back of a napkin.
This does not mean you replace the business plans of old (well I for one could do without the 25 page appendix of financials that never turn out anyway), but the objective of your first meeting, is to secure the second. I know a famous VC here who, when confronted with confusion from an entrepreneur, will say “stop, here’s my business card, I’m going to the bathroom, while I’m gone write your business plan on the back and we can review when I get back.”
If you can do this (or on an Il Fornaio napkin), then you really understand what’s important about your business – that crystalization is what makes it worthwhile, it's what shows them your ability to focus on the art of getting things done and subsequently gets you funded (or at least into the next meeting).
Now there are well prescribed formats for VC pitches – look at any VC website. And I agree that a common structure makes it easier to focus on what’s being presented, but I also think a pitch has to be tailored to the style of the person giving it – if you present someone elses idea of a pitch it will diffuse your passion and make you less credible. Last week I listened to the same pitch more than 10 times given by each of two founders; it was amazing how credible the technical founder sounded when talking about how he developed the product by spending 10 years in an industry creating the same solutions for customers who didn’t really understand what the underlying problem was – he described the epithany (the "ah-ha" moment), and it fell into place – he was not polished, not stylish, and he didn’t even use the carefully manicured slide deck, but these were actually getting in the way of what he wanted to say.
You must be customer-centric. If you can answer every question about your business from a customer’s point of view, you will not only show that you understand who is really funding your business, but also that you are already moving from the typical tech leadership of a startup to the customer intimacy phase of a rapidily evolving company.
Remember, given that most humans (who said VCs were human?) can only remember three things from any presentation, you are up against it trying for seven, so make it easier with a few focused slides and well chosen words ;-)
I saw your ANZA presentation last week in Brisbane... thank you you had some great comments. Having just come back from a scoping trip to the US and UK where we met VC's from Silicon Valley as well as a few clients... our international expansion plans look very positive indeed. One question though... given the exchange rates specifically pound to the dollar...given that the VC we are interested in has offices in London and the valley, what would be your thoughts around the best way to raise the funds? From the UK or Valley office... or how do you think the VC's would view it. I guess my logic is this.... raising $5mill from the valley office means that in the UK that's just been halved, however raising 5 million pound from the UK office is just that to them but its suddenly $10m in the US. I appreciate any comments.
Mate, this is the wrong question, you need to be focusing on which partner in which fund can add the most value to your business – ideally, someone who has built a company like yours theselves, or at least invested in a bunch of them, who can realy help you avoid the pitfalls of others. There is little to your arbitrage concern, since its where you will build your business that will determine $ leverage, and at best it’s a 2nd, possibly 3rd order effect anyway. Don’t get wrapped around eth axle on these things, focus on value not valuation; getting the deal done, not negotiation; and good luck with your deal.
Posted by Anonymous to Larry's VC View at March 25, 2008 3:53 AM
Great advice Dr Larry. So it's now almost 3 years since that 2005 VC tour to Australia. From your perspective, is the substantial need still unfulfilled, or did things change during/after that visit?
Dear Dr Anonymous – it was the “hole” in the ecosystem that made us want to form our fund, as entrepreneurs to try and serve that need better and fill that hole – so yes the need and “hole” still exist, but I am hoping we can make it better. Interestingly, our presence seems to have started to slightly change the behavior of other funds in that market……will write a Blog on this soon – thanks for the question!
Saturday, May 17, 2008
A typical A-deal (where there may be an idea of a product, little or no revenue, but some clear customer engagement and buy-in, and the elements of a team, or at least a strong technical founder and/or a domain business expert) has a pre-money close to the raise, and a pretty common structure is five on five, so $10M post and the VCs would own 50% of the company. Now “typically” their target ownership is 20%, so you might have a little back and forth and settle on VCs 40% (if you have two, and you should because that means more expertise, balance on the BoD, and around $20M in total reserve for your company--early stage VCs typically reserve $10-12M per deal over say three rounds of funding).
The variance around these numbers will be simply based on the detail, revenue or none, team, etc ... Your target post A-round will be to build out your team, launch the product, and validate the revenue/business model as quickly as possible. VCs are much more comfortable paying salaries out of revenue, and funding high risk new product growth out of investors’ money. To build sufficient value to secure B-round financing, you will want say $5M in revenue, a number of tier-1 customers who are evangelists of your product and team, and you will want a new VC who is willing to pay the higher price of B, this will be a later stage VC who is less comfortable with risk, and therefore happy to pay a higher price for lower risk.
In any investment, it’s critical for all parties to be aligned and share a common goal--your VCs want you to succeed, once they invest they are in the boat with you. Whatever they do, it will generally be to make the company as successful as possible. As a founder or BoD member, that’s your goal as well--and we all sometimes let our personal desires cloud that judgment. What the VCs will worry about on valuation is the post funds: i.e., they will want to ensure that the post doesn’t get too high for the planned performance of the company on this round of funding. Can the company realistically build revenue to a level that will justify a good multiple on that post-funding? If the market is uncertain or slow (like now), they will want to keep the post lower, to ensure that the company can perform and will be able to attract another good co-investor for the next round. In the end, the VCs are not buying a car here, they are trying to build a relationship and help build a company. If the relationship is good, and trusted, risk is decreased and everybody wins.
When you raise B, your A-round VCs will invest more money alongside the new VC, at least their pro-rata (i.e., sufficient to maintain their 20% target ownership). If the company does outstandingly well, your existing VCs will not be able to throw enough cash at the B deal to maintain their equity--are they upset? Hell no, they are ecstatic, they can now “carry” the company at a much higher valuation on their books and their limited partners like that a whole lot better than a down round. You are 110% aligned with your series A investors--the only place where there might be friction is if you have an offer to buy the company. Listen to your investors here, they have been through a lot of these offers, and series A is too early to sell most companies. You will usually do much better by building more value (unless its 2000, and you have a $100M offer and they want you to hold out for $1B … long story).
A “typical B might be $7-10M raise on $20-25M pre--the company needs to be on track to be cashflow positive, and either in the groove for an IPO by the end of B, or positioned to be sold for $300-400M. Either way, you will still take on a C-round, either as mez financing pre-IPO, or to seriously ramp revenue and infrastructure.
Finally, given the metrics of VCs funds, all valuations should be about the same--sure, you can get a mining millionaire to invest a million dollars in your medical device company at a great valuation (but what happens when you need $10-20M and larger economic concerns arise). As an entrepreneur, your deal decision should not be driven by valuation; it should be driven by value.
Tuesday, May 6, 2008
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 ;-) ).
Next Time – Typical deals (or the second part of valuation)
Monday, April 21, 2008
I’ve looked at a few of these companies, at various levels in the value chain. I am told by many local VCs that this is not a market yet, and that everyone who makes a part of a femtocell is expecting to win big, but only the femto makers or the carriers will really win. Other VCs have told me that the component makers will be the winners, which is hard for me to believe despite the JDSU analogy (remember when all they made was HeNe lasers).
A critical problem in femto is network timing and synchronization, and there are three quite different ways to solve this problem. I have seen three really good companies in the component end of this space, but I think two of them need to be put together. We really wanted to invest in this combination and build a killer femto play.
One of the companies has been around for a long time and tried several incarnations of its technology in various markets before femto came along. The VCs had some investment fatigue and we thought a deal could be struck to get the company better capitalized and fund either a put together or a strong standalone company. So history is a good thing, but if a deal has been around a long time, it can get difficult to deal with the history. Expectations get low with fatigue, but when there is a ray of hope the pendulum can swing heavily the other way and expectations get reset to much higher levels than perhaps they should. With history, and many rounds of financing to re-task a company, valuations become a little irrelevant; as a practical matter there is only so much of the company that the VCs can own--in non US deals these numbers get frighteningly high: 80-90%. And as an entrepreneur I wonder why the teams stay in those companies?
In practice what usually happens is the ESOP gets reset, so that new team members can be attracted and old ones retained, and the company is recapitalized for the new plan. With history, founders and original investors feel that much value has been built and valuations should be high, but new investors may look at the deal and feel that since the company has a new plan it’s a new A-round--consequently attracting a much lower valuation. Even in the case where there is revenue from previous attempts, new VCs may suggest that that revenue cease because its defocusing energy from the new “killer app.”
Companies that bootstrap often fall into this trap where they have revenue from several sources making enough to cashflow almost at breakeven, by serving several verticals. VCs tend to see this as scattergun approach, and worry about the team’s ability to focus.
So I really liked this femto deal, the team, even the history because it gave them a unique element of the femto unit, and I could see an ability to build it with some other key elements into not just a femto play but an infrastructure play as well. Unfortunately, I doubt we or any early stage VC will be able to invest in this deal because it can continue based on revenue from the legacy markets with only a little additional funding. The current team is faced with taking a dilutive round to bring in growth capital, or growing organically without dilution. If they land a really big order, they may be able to finance another way.
I don’t know who is right or wrong in this case (history will tell), but from a venture perspective, money is time, and experienced hands to help guide the team and de-risk the business. Looking at a deal when the VC has deep background in the market vertical, and can see a broader, larger opportunity perhaps through M&A, then he expects to get some value attributed to that contribution.
If the company is lucky enough to enter the tornado, a lot more capital will be required and the VCs, new and old, should be happy to dilute in order to bring in more capital to feed growth while the opportunity exists. There is no point for VCs to invest in organic growth and avoid dilution, it's reverse thinking. A strategic M&A can put together the two halves of the killer app (c.f. Light Solutions, my worst and best company … later) to build an opportunity that is perhaps ten times larger, or more critically to create a product that leapfrogs all competitors and secures leadership of a rapidly growing space. How much dilution is that worth?
Unfortunately many companies opt for less dilution and organic growth, but you can’t save yourself to success, you have to spend--so many, many companies find themselves in this limbo where their valuation has outstripped the VC’s ability to invest despite revenue, despite undisputed value--they are in the wrong markets or too diverse, or too much history. Many companies end up in purgatory with enough revenue to survive but not enough to grow and seize the opportunity when it finally presents itself.
I think femto will be a real and exciting market, but I suspect most of it will end up on a chip and whomever makes the capital investment necessary to do that will be the “Intel,” and there probably wont be enough market left for an AMD.
Larry, I saw your ANZA presentation last week in Brisbane... thank you you had some great comments. Having just come back from a scoping trip to the US and UK where we met VC's from Silicon Valley as well as a few clients... our international expansion plans look very positive indeed. One question though... given the exchange rates specifically pound to the dollar...given that the VC we are interested in has offices in London and the valley, what would be your thoughts around the best way to raise the funds? From the UK or Valley office... or how do you think the VC's would view it. I guess my logic is this.... raising $5mill from the valley office means that in the UK that's just been halved, however raising 5 million pound from the UK office is just that to them but its suddenly $10m in the US. I appreciate any comments.
Posted by Anonymous to Larry's VC View at March 19, 2008 6:49 PM
Mate, this is the wrong question, you need to be focusing on which partner in which fund can add the most value to your business – ideally, someone who has built a company like yours themselves, or at least invested in a bunch of them, who can realy help you avoid the pitfalls of others. There is little to your arbitrage concern, since its where you will build your business that will determine $ leverage, and at best it’s a 2nd, possibly 3rd order effect anyway. Don’t get wrapped around the axle on these things, focus on value not valuation; getting the deal done, not negotiation; and good luck with your deal.
Monday, April 7, 2008
I got a call from one of the entrepreneurs and was suddenly in the middle of a “he-said-she-said” scenario. Anyway, a group of us got together and tried to piece together what went wrong and whether or not it was fixable. And here’s the rub--VCs really want to invest their dollars (actually it's not even their dollars ... another topic). Their business is to help you build success, so when a deal blows up it means everyone is hurting because they invested a huge amount of time and emotion falling in love, and now both parties have been jilted at the altar.
There are a bunch of probable causes for this--another lover has come on the scene and stolen their hearts--either another VC has offered better terms, or the VCs have seen something scary in the potential partner and got cold feet. Enter the counselor. What killed the deal I am referring to was a syndrome that is very common in non-US startups, and to an extent in non-Silicon Valley startups.
What happened was that there was a CEO and a Chairman and it wasn’t clear who was really the CEO, because in non-US companies, the Chairman has far more control than he does in a US corporation where all he can do is call the board meeting to order--other than that he’s just another director. In non-US companies, he gets to use the Chairman’s lounge at the airport, and that’s not something that he’ll give up lightly, neither the control of the company. Often he became Chairman because he was the original investor, possibly even a founder. Sometimes he is a value-added Chairman, but usually he’s an experienced business guy but not experienced in the market that the company is targeting.
Now he will often bring in an advisor, read i-bank, who will really mess things up; these companies don’t often get through the door in Valley VC firms but are remarkably common outside the Valley and the US in general--this is a really bad combination because the banker is focused on a single transaction, while the VC is focused on building value from three or so rounds of investment and wants to reward only those people who will contribute to the business going forward. The banker is gone after this first transaction, the chairman will no longer have the power or prestige he has today, and so they are both at odds with the VCs.
VCs fall in love with the founders and their idea--young, driven entrepreneurs, particularly engineers, are the life blood of VCs. These young entrepreneurs often look for some grey hair to advise them, and this is a good thing, but the wrong kind of person in this role can be disastrous. Anyway, in the company in question, all the players were good, solid business people, but several of them wanted to be CEO, and as VCs we had trouble working out who was who. As things turned out, the counselor was able to save the situation, and get the deal back on track. To the company’s credit they listened to the VC's issues, understood them, and modified their approach accordingly. It was a stellar result to bring this deal back from over the precipice.
But it never happened. There is yet another problem that kills deals--time. Entrepreneurs frequently focus the negotiation on valuation, rather than on speed of getting the company funded so they can run with the business before someone else does. The negotiation had dragged on so long that everyone had deal fatigue, and in the end, the VCs looked at the other deals they had in the pipeline, and looked back at the original deal with different eyes. Now, six months later, the original deal was not as beautiful anymore, and they fell out of love as there eyes were drawn to other more alluring deals.
It's happened to me, too, all too frequently (with VCs ... and women). But don’t despair, a good team with a good idea will get funded, just don’t get wrapped around the axle on issues that will drag things out beyond the shelf life of a deal. A good friend who is one of the most successful M&A gurus in the US tells me that time kills all deals. Don’t waste time, get it funded, and run with it, show your VCs you are passionate to go, and they will go with you.
Next time: When to take a smaller piece of a larger pie; Femtocells a new wave?
Monday, March 24, 2008
I wanted to respond to some of the posts and questions, so I will do that in this BLOG and post “The deal that died” next time. Please keep the questions coming, or propose new BLOG topics, it really helps me focus on what’s important to you.
Joyce said … Hey Larry - what are your top tips for crossing the chasm? Also, how can I persuade engineers that one or two Evangelist Clients does not guarantee commercial success (without demotivating them)?
I always liked Geoffrey Moore’s chasm talk – he’s the only guy I know who can whip through 75 slides in 20 minutes ;-) we had a great breakfast a few years back (at Il Formation) … this is what I learned:
The early adopter is the heart and soul of your initial marketing process – without them there is likely no real business. They have to value your technology (unlikely you have a real product at this stage) way beyond the money. They need to see clearly the unfair advantage that they can gain with you and be willing to put up cash to validate it. Often they will pay NRE to craft the technology into the product that they critically require – particularly in hardware companies. They will pay a premium to get the unfair advantage to grow their market. They will tolerate all types of problems, provided you properly set their expectations because they share your vision of what could be. Beware the tire kickers who are price sensitive and skeptical who can trash your “product” and stifle your growth – pay them no mind at this phase because you are simply not ready for prime time yet. Now, Joyce is right, you will start to kid yourself that you have made it because these evangelists love your technology and you are making “sales” – but the fact is, what you are really doing is developing your product and crafting your marketing, and sales processes – these are just as critical (and just as much processes) as product development. It gets very scary when you run out of early adopters because suddenly sales evaporate, and you don’t know where to go next except down into
If the early adopters are properly mined, then you have the beginnings of marketing – these early customers can become evangelists who will be your best initial sales force – if you have chosen correctly these people will be respected and followed by the mass market and even the skeptical customers will start to pay attention to you. Beware, you don’t get second chances with the skeptics – so make sure your product is solid, and you understand the sales process. Your early adopter who should have helped you navigate thru the internal process of their company so you have the beginnings of a sales process, the touch points, the decision makers – can you close a skeptic? Your sales process will need to morph as you learn and you will iterate many, many times, but you will develop the process and ultimately use it to win more and more customers.
I want to use
Anonymous said … Can you write your next blog about great entrepreneurs going to the dark side?
So meet my buddy F who was a great product manager in telecom – he rolled out some of the most successful products in the early days (pre-bubble) of optical networking. A couple of years prior to the Internet and subsequent telecom boom, F saw what was coming and raised $45M to fund a revolutionary kind of optical transport company. Actually, initially he went to senior management and tried to convince them that this product would dramatically grow their business, but they were unable to see his vision. So F founded his first startup. He was funded by a dear friend of ours, who, during the telcom boom, was the most successful general partner at one the top three Sand Hill Rd venture firms.
In two years, his company had built a revolutionary new type of optical transport system and it was with great pride that he walked into his board meeting in early 2000 with an offer to acquire the company……for $1B…..!?! Now I still remember clearly his excitement at the offer, followed by astonishment at his board’s rejection of it – imagine $45M invested, $1B exit in just two years – it was unprecedented. What on earth was his board thinking? To quote one of the leading VCs at the time, “it’s not enough.”
Now many of us have been through this experience, very few at this price level, but many at far lower prices – and the shock of rejecting a perfectly good offer generally compounded into deep regret because the later offers (especially in 2001 and 2002) were far, far lower, or non-existent.
So F went back out into the market, continued to build his business, and later that year sold it … for over $3B!!! I guess this time, it was enough. With such a stellar return he was invited to become a partner at one of the leading firms, but decided, in a very entrepreneurial way, to control his own destiny, do his own investments and be a part time venture partner there. After a while, he took over a venture fund for a large corporation, and after making that fund good returns, he joined one of the rising stars in venture firms and continues to make great investments.
So what does F say about his journey? The hardest thing was realizing that he wasn’t an entrepreneur any more, i.e., he couldn’t do it all himself – he had to become a coach not a player, he had to learn to let the entrepreneurs do it themselves without jumping into every sales situation and deal and taking control. One of the characteristics I always notice when he hears a pitch, is that he stops the entrepreneur from diving into the story, and makes them talk about themselves – he has that uncanny entrepreneur’s instinct of judging character and will often get to know the entrepreneur for half of the initial meeting. It puts many entrepreneurs off (especially those who get embarrassed talking about themselves, i.e., mostly Aussies ;-)), because they want to talk about their products and companies.
F tells me he can make the general decision to invest simply from that first half-hour of getting a feel for the character and historical experience of the entrepreneur. He also is a great believer in first-time CEOs, not just because he was one, but because of their unique characteristics (discussed in an earlier BLOG). The other great characteristic that F has, is the ability to help the entrepreneur, in most cases strengthening their plan by seeing flaws in it that he himself has experienced. In a later Blog, I’ll try to get permission to tell
Mudmaps said … So Larry - tell us why you want to be a VC now? And why VCs want entrepreneurs in their ranks?
The other VC I wanted to mention in entrepreneur-to-VC transition was Dado Benato who founded Tallwood after building a very successful semiconductor company, and then doing a stint at Mayfield as a VC. Most VCs in
I think six startups is enough, and it’s time to help other startups get funded, and be successful. In 2005 I took a group of US VCs down to
Dado spends a day a week companies he is invested in and on the BoD of – his success metrics are exceptional. When asking for advice on how to be a better VC, one answer I got was this – “I don’t think the term VC is a meaningful term – your fund is a startup, like the companies you invest in. Focus on being a good entrepreneur for that startup and you’ll succeed; and if you do ever work out what a VC really is, please let me know” – I think that’s great advice for all of us ;-)