BeyondVC

Robert Scoble has asked the VCs to respond to an eWeek article titled Is .Net Failing to Draw Venture Capital Loyalty?.  There is not much for me to add to this article as we all know that the only loyalty VCs have is to their Limited Partners to generate long-term capital gains.  This means we do not fund a company because of what technology platform it chooses to develop on but rather what problem the company and product is solving and how big that opportunity is.  It reminds me of a panel that I spoke on in 1997 at the Red Herring Java Technology Conference.  The moderator asked me what types of Java companies we were interested in and my reply was that we do not look for Java companies, but rather solid management teams that are solving large problems in innovative ways.  If Java happens to be the right technology platform to use, then so be it.  Nothing has changed since then.  As Brad Silverberg from Ignition rightly says in the eWeek article, "We’re technology agnostic here at Ignition."

To that end, let me talk about .Net.  I have spent time over the last few years with .Net evangelists and they have been helpful in certain situations.  That being said, most of the fund’s portfolio companies (90%+) are not using a .Net platform.  When I dig deeper into technology and platform decisions, I like to think in 2 separate buckets, the consumer market and the enterprise market.  On the consumer side, one big value for Microsoft has been its hold on the desktop as Tim Oren strongly points out, but as we move more and more into a web-based world its strength is diminishing.  Look at Google, Firefox and new scripting services like Greasemonkey and Yubnub which are increasingly offering users more and more functionality through a web-based interface.  I am sure Microsoft will get it right with Longhorn but it has taken way too long and many a more nimble, startup has out-innovated Microsoft and decreased its competitive advantage.  While the OS is important, Microsoft has lost its complete and utter dominance as we move to a service-oriented world where broadband is everywhere, apps are in the cloud, and the browser becomes king.  All that being said, I will not make my decision to fund a startup based on whether or not it uses .Net.  For example, if you want to see a great app built on .Net go to a friend’s web service, Phanfare, and try using the application.

On the enterprise side, the only reason I would support having a company move off an existing platform to .Net is if there was significant customer demand for it and if Microsoft would really provide the company with access to its channel.  Microsoft has been putting a huge effort in promoting their go-to-market support for startups but the irony is that Microsoft really wants companies to develop vertical, industry-specific applications on the .Net architecture.  In other words, many of these companies are nice businesses but not venture-backable opportunities where VCs can make big returns.  If Microsoft can change this attitude and show me where and how to make money leveraging its Ecosystem and partners, I am all ears.  In the end VCs have be loyal to its Limited Partners, not a technology platform, so the eWeek article itself is overblown.

I am not sure how many entrepreneurs understand the structure of venture capital funds but the bottom line is that while VCs manage funds, we ultimately report to our investors or Limited Partners (LPs).  It is not our money, and we have a fiduciary responsibility to manage it properly and generate the returns our LPs expect of us.  And like you, we have to go out and raise capital every 3-5 years for a new fund and similar to entrepreneurs we need to network with the right people, have the right meetings, and go through extensive due diligence.  Every year the Dow Jones Private Equity Analyst puts together a show where fund managers can listen to what the LP community is interested in and where they plan on allocating their dollars.  This year’s show was billed as an opportunity to meet "more LPs per square foot" but truth be told, it was a place where I could meet more VCs or private equity managers per square foot.  In the early morning, a show of hands revealed about a 20% LP audience and 80% fund manager group. It reminded me of a typical VC/entrepreneur conference where you have panels of VCs talking about where they want to allocate capital and entrepreneurs trying to flag them down to hear a pitch.  In these conference you typically have a similar ratio, 20% VCs or those with the money and 80% entrepreneurs or those seeking funds. 

Anyway, as I had time to think about it, it might be helpful for entrepreneurs to understand how VC funds operate to better understand our motivations and to better align interests.  At the end of the day, VCs are in the capital gains business.  We make money when our LPs make money which means that the companies we fund and entrepreneurs that we back need to be successful.  Clearly when VCs and their LPs negotiate their agreement, economics are the most important topic at stake.  While VCs get management fees to pay the bills, it is the carried interest portion or % of profits that VCs receive that really drives our thinking and aligns our economics with performance.  In any typical fund, we except 1 to 2 deals to be homeruns with 10x or greater returns, 3-4 to be pretty good returns, and the rest to either get our money back or lose money.  What that means is that every one of our deals needs to have significant return potential and market size for us to think about investing in a deal.  In addition, companies should be capital efficient (see an earlier post on capital efficient business models) meaning that no more than $25-30mm should go in, especially if a home run deal acquisition is $200-300mm (not $1b).  If only 1 to 2 deals have home run potential, the chances of us getting any one of them to really work is slim to none.  If the majority have this potential, we get more at bats at the plate and more opportunity to create real value for the fund.  As a fund matures, VCs need to demonstrate real cash-on-cash returns to go out and raise the next fund.

This is the point at which conflict could exist.  First, there could be situations where the VC says no to a great opportunity to sell the company but for whatever reason wants to hold out for a greater return.  On the other hand, there could be situations where a VC wants to exit too early with a decent return but not optimizing the overall value of the company in order to return capital to investors.  At the end of the day, what this means is that entrepreneurs and VCs need to get on the same page pre-investment in terms of everyone’s expectations for performance and goals.  In addition, there needs to be constant communication as the markets and company evolves to ensure this alignment.  The good news is that given a VCs economics, we only do well when the entrepreneur and company does well so what better alignment could there be.  A point of diligence for entrepreneurs could be understanding where in the fund lifecycle a VC is and what some of their returns to date have been.

There is a supply and demand equation for every startup’s product or service.  In early stage companies, I sometimes see too much from the supply side and not enough from the demand part of the equation.  In other words, inventing great products that no one wants to buy is a waste of time, money and effort.  While there are not nearly the amount of startups on the East Coast as in Silicon Valley, being in New York I do have tremendous access to Fortune 500 companies.  One of the ways we like to invest is by talking with the buyers in the market, the CIOs and CSOs, and understanding what their pain points are, what solutions they are evaluating, and how open they are to working with early stage companies.  We have gotten many a referral using this methodology and it has helped us develop our own investment thesis on certain markets where we can look ahead far enough into the future but not so far ahead that we invest in just another technology looking for a problem to solve.  We also like to speak with strategic partners and understand gaps in their product portfolio (to the extent they will share that with us) to further triangulate our thoughts on the market.  Bill Burnham has a great post on thesis-driven investing and why it matters in today’s competitive venture world.

Tying together a demand-driven approach to investing means that you have to have access to the IT decision makers with the budgets.  This is typically not easy as every tech vendor in the world is pounding on their door to give them a pitch.  That being said, if there are more IT buyers like James McGovern that understands the value that VCs can bring to IT buyers then we will all be in great shape funding companies that solve real problems. James, an enterprise architect at a major Fortune 100 company, recently wrote a post  on ITtoolbox explaining how his brethren can continue to innovate and stay ahead of the curve.  He goes on to say:

The methodology used today within corporate America is fundamentally busted. Sitting around waiting for a vendor to show up on your doorstep with the right solution at the right time is simply gambling (I really wanted to say irresponsible). Enterprise architects need to not sit on their butts waiting for the "right" solution to magically appear. Instead they need to make sure the venture capital community understands what problems we face so that they fund the right portfolio companies.

Competitive advantage within corporate America via the use of technology isn’t gained by implementing service-oriented architectures or any of the other hype in published in industry magazines. SOA is a reality of today’s marketplace and everyone will be doing it (hopefully doing it the right way by purchasing my upcoming book).

Competitive advantage can be gained though by being first to implement new waves of technologies before your competitors even learn about it or it appears in a matrix by your friendly neighborhood industry analyst. It is in the best interest of enterprise architects to start setting aside time to learn about technologies that are not yet released within the marketplace and are seeds within the minds of CTOs of Internet startups.

With this thought in mind, I have decided to take deliberate action in making this situation better for both parties. I am reserving Friday’s at 5pm on my calendar to talk with venture capital firms who want to bounce ideas off me related to funding or to listen to the pitches of early stage Internet startups that simply need a sounding board for someone who sits in the walls of corporate America on a daily basis…

The same principles go with VCs as well – sitting around waiting for deal flow in this competitive VC market will not get you very far.  Be proactive, develop an investment thesis, and reach out to the end users like James – I wish more IT buyers thought like him.  Of course, as VCs we must remember not to solely rely on the buyer’s advice and use as many data points as we can to further validate or kill our investment thesis.  The danger of solely relying on IT buyers is that the solution may only be necessary for a handful of buyers and that the problem is so near term that by the time your product is ready another vendor has already stepped in to fill the void.