Monday, June 30, 2008

When to let go

This is a cynical one--be warned. I just completed a really tough shareholder meeting for a company I took public where the CEO recently had to be replaced and the chairman didn’t show up for the meeting, so I had to stand in for them.

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

Nosebleed Valuations

So I never thought I would ever have this conversation with any entrepreneur, but here it is. There’s this exciting new Internet company with a brilliant founder, and a sharp business guy and their business is going to eclipse Facebook, Yahoo, and probably even Google ... want in?

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

Business plan on a napkin?

So I’m sitting around the corner from our office, having breakfast at Il Fornaio, listening to the conversations around me and watching the entrepreneurs pitch the VCs on a Tuesday morning--The entrepreneurs are the ones carrying laptops and waiting impatiently – the Aussie entrepreneurs are the ones in suits ;-). Dado is here on time and talking animatedly about a new chip idea, sketching a business model on a napkin as the entrepreneur looks on and then starts to argue back ... its an interesting lesson in valley culture – VCs adding value? If you sit here every day for a month, I swear you would get a completely different view of how to pitch, plan, and execute a business.

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 ;-)

* * *
Posted by Anonymous to Larry's VC View at March 19, 2008 6:49 PM
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!