Category: Venture Capital

I just got back from a week in Israel having spent some time in Jerusalem for an Answers board meeting and then making my way to the Ohalo Resort on the Sea of Galilee for Kinnernet 2006.  Kinnernet is a techie geek camp organized and run by Yossi Vardi (cofounder of ICQ).  At Kinnernet, I had the privilege to spend time with some great people from Israel, Europe, and the US.  I suggest checking out Jeff Pulver’s blog and going to Flickr and searching for Kinnernet2006 for pictures and more thoughts on Kinnernet.  There were lots of robots, aerial shows with model planes and helicopters, great discussions on current technology trends, and of course, plenty of beer and laughs. 

One of the discussion groups that I led with Simon Levene (heads up Corp Dev in Europe for Yahoo and Yair Goldfinger (founder and CTO of ICQ and Dotomi) was titled "Are Internet VCs Dead."  You know the backdrop – it costs less to get a company started and to generate users and Google and Yahoo are agressively snapping up companies before VC rounds.  Google’s expertise seems to be buying engineers, many times before a product is even launched.  Yahoo, on the other hand, prefers to buy companies that have some nice user base, maybe no revenue model yet, but also before a VC round.  The last point is that companies are now more capital efficient (see an earlier blog post) where $10-15mm can get a company to cash flow breakeven vs. $30mm.  So what do VCs that invest in Internet companies do? Before I go there, I would flip the question and ask what do entrepreneurs do?  From my perspective, I wouldn’t take in more than $1-2mm to get my company started with a developed product and an idea of what usage will look like.  At that point, as Yair suggests, it is decision time.  Some of the questions to ask include:

1. Do I have a product or feature or can I build a real company (i.e., a growing cash flow sustaining business)? 
2. What is the risk I face in building a company for the long term vs. selling today. 
3. And finally, do the math – if I take in VC money I will clearly have to sell for alot more tomorrow than what I sell for today in order to generate the same or greater value.
4. Do I want to do it?

As a VC, I truly would not want to invest in a company that has not thought about all of the above with a founding team that is fully behind building out the company for a longer term play. All that being said, the numbers are still against the entrepreneur.  While there have been a number of acquisitions in the past year, it is still a fraction of the number of companies started.  Since it is so cheap to start a business, you can have anywhere from 5-10 companies out there in each category.  In addition, it is not clear that many of the acqusitions during the past year could have built real businesses rather than being a feature of a much larger entity.  While the math worked for a number of enterpreneurs that sold, one of the decisions you need to make is the likelihood and timing of being crushed by a larger player if you decide to go alone and raise VC funding.  Whatever you start, I would suggest thinking about what your potential revenue model is from day 1 and thinking through the economics.  Hell, it may change a couple of times, but building a company with the sole purpose of flipping is the wrong idea as your odds of success are very low.

Despite this, the opportunity for entrepeneurs and VCs could not be greater.  There are clearly more users globally, broadband is everywhere, users are more educated, companies can target more, capital efficiency has increased, and there are real business models out there generating tons of profits.  I do not think that Internet VCs are dead, but rather, need to reinvent themselves.   It is also clear that the VC model is broken and needs to change.  As you can see this is slowly starting to happen as smaller funds ($200mm vs $750mm) are being raised, VCs are doing less new deals per year and sitting on less boards, and many are trying to get in earlier.  Having a smaller, more focused fund allows a VC to make some investments during the Angel round ($500k-$1mm), watch the company closely, and give VCs the opportunity to lead the first real institutional round.  If the company has the chance to flip, then great, everyone wins.  If the company want to take the next step, then we can be there to lead or co-lead the next funding round.  It is imperative for VCs to get in early and structure their funds around this because in the Internet space companies can build momentum quite quickly which also means that valuations tend to move quickly as well.  That is also why the Googles and Yahoos of the world are trying to identify the emerging opportunities before the VCs get involved. 

All in all, it was a wonderful time, and I feel honored to have been one of Yossi’s guests and for having had the opportunity to network and participate with Israel’s tech elite.  Unfortunately, I had to head home on a redye Saturday night, but many of the attendees ventured to the Marker Tech Conference where 3500 people were expected to attend and hear panel discussions led by many of the participants at Yossi’s Kinnernet.  Kinnernet was great and I had a blast, made many new friends, and came away clearly impressed with Israel’s thriving and talented startup community.

There is an article in the Wall Street Journal (sorry-requires subscription) today on pre-emptive financings or financings that happen when a company is not actually looking for capital.  It is common wisdom amongst the investment community for entrepreneurs to "eat when dinner is being served."  In other words, companies should take cash even if they don’t really need it because you never know when the next meal will be served.  This can be great for a company because it can provide a nice cash cushion for the operations, allow a company to spend real time with a potential investor, and help them avoid spending too many cycles on financing down the road. The article also points out that this is a new trend not unlike one that happened during the bubble period.  To be honest with you, I don’t see this as a new trend and a negative thing for VCs to do.  It is a VC’s job to find the best investment opportunities which means being proactive about generating deal flow and not sitting back waiting for new deals to come to us.  Being proactive about new deals means spending time with entrepreneurs before they need money, staying in dialogue with them as they grow their business, and helping lead discussions on the next round of financing.

Being an early stage investor, I have played on both sides of the fence.  I have been on boards where we have been approached preemptively by other investors.  In those cases, it is helpful to think about two points:

1. Valuation isn’t everything – sure, you want to take cash at a good price but if you take too much cash at too high a price too early, it builds unrealistic expectations for you, your company, your existing investor, and your new investors.  You may end up chasing too many different opportunities, losing focus, and having a fractured board because of these lofty expectations.
2. Having too much cash can be a curse and not a blessing – speaks for itself (see my last post)

On the other side of the fence, it is important for us proactive VCs to maintain our discipline, value the opportunity fairly, and really understand and work with the company to determine how the money will be used.  In addition, we need to be careful about helping our companies use their bullets on the right opportunities and not every opportunity.  Let’s not forget the lessons learned during the bubble where companies with too much cash just crashed, burned, and died faster and more spectacularly than ones with less cash.  In general, pre-emptive financings can be a great thing for both VCs and entrepreneurs, but we must be careful about managing expectations and staying focused.

Trust me, I love having well capitalized companies.  However, having too much money can be a curse, not a blessing.  More often than not, I see management lose financial discipline and avoid making hard decisions when capital is abundant and not scarce.  To many executives, money does solve all problems.  And yes, having money allows an entrepreneur to do many things with his business like hire more talent, scale the back-end infrastructure, and ramp up sales and marketing.  On the other hand, when an entrepreneur has too much money, the tendency is to throw more money to fix a problem.  Sales are not ramping up quickly enough so let’s hire more sales people.  Marketing is not generating enough leads so let’s spend more money on lead generation.  Engineering keeps missing its product release date so let’s hire more engineers.  And what happens is that more money gets poured in and that only exacerbates the problem as management never really spends the time to dig deep to understand what the underlying issue is and to fix it at the source rather than layer on more resources.  In other words, an entrepreneur only hastens his downward spiral by spending more money on an inefficient business strategy. 

On the flip side, I have seen many an entrepreneur create successful businesses who some could argue were slightly cash-starved.  I am not arguing for entrepreneurs to starve their companies of the resources they need, but what I am suggesting is that having too much money can make one lose their creativity in terms of allocating scarce resources to grow a business.  This is especially quite important during the early stages of company development.  An entrepreneur needs to experiment with various ways to reach his target market, generate revenue, and develop product.  An entrepreneur also needs to stay focused, disciplined, and make hard decisions in terms of where to focus company resources.  Too much capital can kill this need.  Throwing too much money at the wrong strategy or too many different areas only adds fuel to the fire.  While money can really help an entrepreneur scale a business, having too much can be a curse.

I had a meeting last week where an entrepreneur insisted on showing me a demo first.  He was scrambling around asking for wireless keys and looking for ethernet jacks, while I sat there and tried to engage him in conversation.  He lost my interest right then and there.  As I started to think more about it, I thought it would be helpful to share some of my thoughts on how to make the first VC pitch a better experience for all participants.

1. Be flexible: Have an agenda but listen to and know your audience.  If the VC wants to run a meeting a certain way, be flexible, and go with the flow.  I have seen many a pitch where an entrepreneur comes in with an agenda and wants to go through each powerpoint slide in excruciating detail.  These meetings typically do not last very long as I wonder what it would be like working with that person or for that person.  Deal with questions as they come up, not later.  VCs can be impatient at times, and it really bothers me when an entrepreneur says, "Let’s wait until slide 15" especially when you are just on slide 3.  Meetings have a rhythm so be in sych with your audience.  Startups require entrepreneurs to be agile and adept to respond to quickly changing market needs.  If you are too engrossed with following every powerpoint slide, it makes me wonder how flexible you will be in responding to market conditions.

2. Have a well-honed elevator pitch: If you can’t explain to me succinctly what your product does, what problem it solves, and how you will make money then I wonder how you will explain it to your customers.  Don’t worry, I want to see your baby in action, but save the demo for later as I want to hear you articulate these points first.

3. The Slide Deck: make it short and sweet, 15-20 slides will do.  However, the best meetings happen when we never even touch the slide deck and end up in a free form conversation about the team, product, business, and market.  Many times, I have even found myself brainstorming with the entrepreneur about other revenue opportunities and go-to-market strategies – I just love those types of meetings.

4. Listen and ask questions: try to get feedback about your business and the opportunity.  The meeting is not a one-way street.  Make sure you figure out if you like me, my firm, and my style as much as I am looking for a similar fit.  Remember, it is a competitive market out there, and I need to sell my value add to you as well.  Asks lots of questions – be open to feedback but do not be afraid to respectfully disagree.  Not all of the feedback you receive will be right and many times it will be wrong, but take all the data you can so you can be better prepared for the next VC pitch.

4. The Demo: First, if you have any web-based business, I would hope that you have the wherewithal to have an alpha version running.  As we all know it is cheap to start a company, and if you have not taken the first steps to get a product/service up and running, I am going to wonder whether you have the technical know-how to make it happen or the passion and risk-seeking behavior to be an entrepreneur.  I love it when entrepreneurs have sunk some of their own money into their business or substantial amounts of time to turn their dream into reality.  This shows me a real level of commitment.  With respect to the demo, I like them live, but as Bob Rosenschein once told me, there are 20 things that can happen in a demo, 19 of which can go wrong.  So be prepared and have a cached version of your service to walk through.

5. Next steps: In any meeting, never forget to ask about the next steps.  What is the VC firm’s process, when will they expect to get back to you, is there any more information that you can provide, etc…

A couple of other points to add:

Pre-meeting: Research the VC, the firm and get to know the types of investments that he/she likes to make, that the firm likes to make, and what is currently in their portfolio.  Google is a great resource, look for VC blogs, and talk to others that may have pitched the VC and the firm recently.  We need to sell to you as much as you need to sell to us.

A couple of don’ts: don’t be late, don’t be arrogant, and don’t ask for an NDA before you start the pitch

Happy pitching!

A number of our portfolio companies have been fielding calls from strategic buyers expressing an interest in acquisition.  This is great news since many of the better acquisitions come when companies are bought and not sold.  For a startup, it can be quite flattering to have a large competitor or suitor express an interest in buying your company.  However, as an entrepreneur you have to be skeptical as many of these calls end up as just another fishing expedition from the strategic buyer. I have seen too many companies get overly excited about these acquisition feelers and waste time educating the potential acquirer only for the acquirer to either do nothing, build it themselves, or buy a competitor.  In fact, you have to recognize and assume that many of these initial calls are just fishing expeditions where a strategic buyer is just trying to get as much information as they can about a market and the competitive landscape.  You have to assume that they are talking to all of your competitors as well.  Before taking your first meeting, make sure you get as much information you can to gauge the real interest in your company.  Here are some questions you should be asking or thinking of during your initial conversation.

1. Who is calling you, what is their role, and what have they acquired in the past?  You need to determine whether it is just a junior person screening or if it is someone with real clout and decision making power.
2. Why do they want to enter this market and what is the decision making process by which they will make a build/buy decision?  If they are early in the process, you have to be concerned about wasting your time, educating a potential buyer about your market, and going nowhere with your conversations.
3. Have they talked to anyone else?  In many cases, an acquirer may already know who they want to buy, but will still talk to other players to fully understand the market and the competitive landscape and to use you as negotiating leverage.
4. What are they looking for in terms of an acquisition?  Revenue, product, management, both?
5. Who is responsible for making the acquisition work, and how does the acquirer intend to integrate your company into the existing infrastructure?  Will the acquisition be run as a separate, stand-alone unit or will it report to a certain group.  Knowing this will further help you understand the decision-making process of the acquirer, and who you may need to influence to get a deal done.

Before your first meeting, here are some questions you should have answered yourself:

1. What other acquisitions have they done, what multiples did they pay, and how recent were the deals?  If the buyer hasn’t done many acquisitions or if they paid low multiples do not start thinking about pie in the sky valuations for your company.
2. What is the company’s market cap and how much cash is on their balance sheet?  If your selling price is too high for the buyer based on the buyer’s market cap or cash on hand, don’t waste your time educating them about your product and the market.
3. Use your network to talk to some of the management or venture investors of companies that were recently acquired by the buyer to determine what their process was and to figure out if the opportunity is real or just a fishing expedition.
4. What is the corporate culture?  Does the acquirer have an NIH (not invented here) syndrome or is there a history of openly collaborating with partners and looking outside for new technology?

Once again, it is always nice to have a large company call you and express acquisition interest.  That being said, go into the conversations with a skeptical eye and make sure you do not waste your time as these strategic discussions can quickly lead to a dead end if not managed appropriately.  The tricky part of the dance is trying to establish early in the process a range that the acquirer will potentially pay for your company assuming everything you tell them is true.  The sooner you can get to this answer the sooner you will know if you should continue talking or just walk away.  If you manage this process appropriately you may find yourself in a great place as many of the best acquisitions happen when companies are bought and not sold.  The downside is that these discussions can suck up lots of your precious resources and be a tremendous distraction to your management team.

I had an enjoyable lunch with Jeff Jarvis today catching up on a number of things and brainstorming about value in the next generation web.  During the conversation I vented a little frustration at the use of buzz words and bubble-like mentality with terms like Web 2.0.  I am starting to get extremely tired and frustrated about every pitch that I see now where a company claims they are a Web 2.0 company and lists their principal reasons for being Web 2.0.  It reminds me of the mid-90s when everyone said they were an Internet company and sprinkled their pitch with wild growth expectations from Jupiter Communications.  Or when everyone said they were a Java company when Java was the cool buzzword.  Frankly I do not care if you are Web 2.0, Web 1.0, etc.  All I care about is what your service or product does, why it is valuable to the end user, why it is uniquely different from the competition, what the barriers to entry are, and how you plan on reaching your customers and how you will ultimately make money.  Don’t start your pitch with Web 2.0 ecochamber talk.  In fact as Jeff and I discussed several companies and ideas, we concluded that most of them were just features and not companies.  And as Jeff states, when small is the new big, then it poses problems for VCs as well.

Then Ed and I were talking about similar challenges for investors and entrepreneurs in the small-is-the-new-big age: Today, it’s much, much easier to start a new company on far, far less capital than it used to be. But this also means that it’s easier for someone else to start a competitor. So speed is more important than ever: You have to develop your business as quickly and nimbly as possible to build your product and then perfect it after it’s out so you quickly establish your value. This means that the VCs need to be able to act just as nimbly to invest as quickly as possible. The good news is that the investments are smaller and the risk is thus less. But the bad news, of course, is that it costs more effort and attention to manage many more smaller investments and it’s hard to act quickly at scale. Early bird, worm, and all that.

While getting in early and being nimble is a great way to make money, no matter how early you go, it is hard to build a sustainable VC portfolio investing in features.  As an entrepreneur, if you can get up and running for $20-30k, so can 10 other talented people.  Fred Wilson and a new VC blogger, Peter Rip, have written some thoughtful posts about a bubble mentality developing.  I have written about it before as well in an earlier post comparing and contrasting 1999 vs today.

In other words, these business models are quite capital efficient.  It is no wonder why VCs are quite excited about next generation web companies.  All that being said, I, like others, worry about believing all of our own hype, and moving ourselves to another bubble.  As you see from Tim’s map and my table above, if it costs less to build and launch a company, then the barriers to entry must be lower as well.

So if you are an entrepreneur, stop talking about Web 2.0 and start talking about how you are going to scale your business and make money.  Start talking about how you are going to create a defensible barrier to entry.  Better yet, since it is so cheap and easy to get started show me whay you are not just a feature, show me your user growth, and show me how you will maintain your competitive advantage.  Sure, as a startup, you will not have all of the answers and your business model may change, but show me that you care about these business concepts and that you have thought through these issues.  While I am a big believer in the promise of the web, I see this less as a revolution but more an evolution from where we started in the mid-90s.  We are talking about the same principles as the mid-90s, and we would not be here today were it not for the incredibly painful bursting of the last bubble.  But with every bubble bursting comes a rebirth and from the last bubble what we have is lots of cheap bandwidth, resilient entrepreneurs who scraped for crumbs to survive, and a mentality to do it cheaply (rise of open source and leveraging commodity inputs).  What we also have today versus yesterday are business models that can scale cheaply, be profitable, and throw off lots of cash.  Let’s focus more on these concepts versus being Web 2.0, as I do not want to think about what kind of rebirth will come from another bubble.