Eat when dinner is served

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.

Having too much money can be a curse, not a blessing

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.

Why we invested in Sipphone, developers of Gizmo Project

Dawntreader Ventures has just led a $6mm round of financing in Sipphone, its first outside round of capital.  We look forward to working with Michael Robertson and Jason Droege to fuel continued growth in the Sipphone and Gizmo Project service and to roll out new features and functionality.  As you can see from Michael Robertson’s blog, the basic premise of the company is to provide SIP-based dial tone to any software or hardware device.  For those of you who don’t know, SIP is a standard protocol for voice and video. 

Gizmo Project voice calling and IM is booming on Macintosh, Microsoft Windows, and Linux computers because Gizmo Project works well and connects with every type of device like WiFi phones, other VOIP and IM directories like GoogleTalk and even the popular open source Asterisk PBX software. I think people are beginning to understand the difference between Skype who walls their customers in and won’t play nicely with anyone and SIPphone who connects to everyone making it possible to have just one address. Next week SIPphone will announce closing of a major venture capital deal which will help the company grow even faster.

As you can read in an earlier post, I, like Michael, am a believer in the growth of open standards. We want to provide consumers with the ability to have one address and connect to anyone on any network.  We want to expose our APIs to allow anyone or any company to easily integrate our VOIP/IM service into any application or device.  In addition, we want to make it extremely easy for consumers to bridge the Internet and traditional PSTN by extending the SIP functionality to non-PC devices such as routers, wifi devices, adapters, and dual mode cell phones.

While there are a number of factors that go into an investment decision, these are the key highlights for us.  Sipphone has a strong team led by Michael Robertson (founder of and Jason Droege (founder of, first video search engine).  They know how to develop and market great consumer products and services on the web.  The market is huge as only a tiny fraction of overall global voice traffic is VOIP-based on the end-consumer side.  This is not a zero sum game between other VOIP/IM players but between the incumbents driving analog telephony and the new players driving digital subscriber growth.  Sipphone has demonstrated it has a winning product that can grow its user base and upgrade free users into paying customers for value added services and features.  The cost of sales and marketing is zero as Sipphone is a frictionless sale, especially when compared to a Vonage.  Finally, I believe that consumers are smart and demand interoperability and that open standards will win.

Tips for the first VC Meeting

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!

Beware of fishing expeditions

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.

VC Blogs – the old and new

I was in California 3 weeks ago when Jeff Nolan told me he was leaving SAP Ventures and moving to a new group within SAP desgined to "Kill Oracle."  We talked about all of the great innovation happening on the web, much of which is consumer-focused, and why it was a good time to make a switch.  Yes, SAP is the dominant player in the enterprise market and even after you account for Oracle’s acquisition binge Oracle still remains the distant number 2 player in enterprise software.  That being said, there are new technologies and new ways of doing business which SAP must keep close tabs on as it maintains its dominance – think service oriented architectures, SaaS, and new markets to enter and conquer.  So I am sad to see one of my VC buddies go back to the operational side, but I look forward to working with him closely as he helps SAP evolve its stategy and maintain its leadership.

Another VC friend, Scott Maxwell of Insight Venture Partners, has launched a new blog with encouragement from myself and Brad Feld.  Many of the VC bloggers on the web are early stage focused so Scott will bring a unique twist to the VC blogging world by focusing on expansion stage companies that have a product and some decent quarterly revenue.  As Scott mentions in his post:

The issues faced by technology companies at this stage of development are very different that early stage companies. The major issues are around distribution strategy and execution, but as companies scale they tend to need more formal development approaches and have many other process, organization, skill, and staffing gaps as well. Every CEO is also looking for more leads, customer introductions, and ongoing advice in every category, personal and professional.

I tend to agree with Scott so if you want a different perspective, a perspective of what your later round VC is looking for, I suggest putting Scott’s blog on your must read list.

Web 2.0 Bubble

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.

Venture Capital and Hedge Funds

Well, there is clearly lots of money sloshing around in alternative assets like hedge funds, private equity, and venture capital.  That being said, I still believe there are plenty of great investment opportunities.  In an earlier post titled, "Go Early, Go Late, or Go Home," I shared some of my thoughts on what company stages of development looked attractive for investing.  In addition, I highlighted the blurring of hedge funds and private equity.  As hedge funds receive more dollars and the markets, therefore, become more efficient, hedge funds need to find new ways to generate returns.  Increasingly, hedge funds are moving just from private equity and now more aggressively into venture capital.  Barron’s highlights this trend in an article from this past week’s edition.

Investors had better take notice. As hedge funds search for new strategies to produce the holy grail of "alpha," or outsized returns relative to risk, private-equity investments of all stripes are suddenly turning up in the industry’s portfolios.

The holdings — ranging from modest positions in startup companies to multibillion dollar corporate buyouts to a variety of more esoteric instruments, like subordinated debt — already amount to $65 billion, or 7% of hedge-fund investments, according to estimates by Freeman & Co., a New York-based financial boutique. That tally, the firm believes, could swell to $100 billion by next year.

Today’s Wall Street Journal has an article (can’t find online source but in Marketplace B3C) on hedge funds entering the venture capital market.  It is no secret that hedge funds took flyers on early stage tech companies during the bubble.  However, what’s different this time is that hedge funds are looking to create separate vehicles to make venture capital investments with a longer time frame to withdraw capital.  As the article states, the big concern is if hedge funds can be patient enough to generate the needed returns.  Instead of worrying about the tick, hedge funds need to understand that VC is a 5 year game plan.  The other area of concern for me is the idea of even more money plowing into early stage deals.  I can vividly remember during the boom being priced out of a few deals from some hedge funds who were willing to give money at a higher valuation with less oversight to eager entrepreneurs.  All this being said, this trend is just starting but one to which we should pay close attention.  I just do not want all of this capital to end up badly in the next bubble.

.Net and VC Loyalty

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.

LP Conference

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.