Entrepreneurial Leadership and Management . . . and Other Stuff


Venture Capital Insights

Dharmesh Shah over on OnStartups has a terrific post titled 9 Pithy Insights on Venture Capital.  The post covers many of the key points that should be in the new entrepreneur’s handbook on getting venture capital.  I found myself nodding my head as I read each one. 

I’d add to the list (in a way that’s not nearly as pithy or concise as Dharmesh) that it is very important to realize that all VC firms are NOT created equal and the dynamics that those inequalities bring will, most likely, have a big impact on how your company gets it’s current round of capital as well as each subsequent round.  While I’m not a venture capitalist, my view from the outside, having been the beneficiary of more investment rounds than I can count, is that there are at least two tiers of venture capital firms.  There may be more than two, but for the sake of simplicity from the entrepreneur’s standpoint, tier 2 through tier n appear to be regarded similarly and, generally speaking, act similarly.  I’m not counting angels or angel funds here.  The former are almost always subordinated by venture capital firms and the latter act more like nth-tier VCs than they do like angels.

Top-tier funds are generally larger (in terms of money being managed and number of partners), more established, have more experienced partners on the whole and are better known in their areas of focus.  This is not to say that top-tier funds aren’t sometimes smaller or that second-tier funds don’t have uber-experienced partners, but the generalization does fit most often (as generalizations should).

Here are some actions that are indicative of a top-tier firm:

  • They do larger initial deals
  • More partners and more money means that they do more deals
  • A relatively high percentage of their investments are in later rounds
  • They frequently do M&A type investments along with pure venture deals
  • They don’t usually mention the 2nd-tier funds they have worked with
  • While they’ll jump quickly for certain investments, deals on the fringe of their expertise or that are otherwise not a slam dunk may take a while to close

Here are some actions that are indicative of 2nd-tier firms:

  • They look to do highly-leveraged, smaller initial deals
  • They’ll often move faster than larger firms to get a deal they find exciting
  • Since they are often squeezed out of popular deals, they tend to jump at the opportunity to get into or even lead a deal they think will be desirable by top-tier firms.
  • They almost always mention the top-tier funds they have worked with
  • They are often more likely to nurture a deal that they feel has promise, although resource limitations can make this difficult for them

None of this is shocking, of course, and if you’ve shopped a deal around before, you’ve probably already drawn similar conclusions.  In my experience, though, there is an added point that appears to be virtually unspoken: top-tier and 2nd-tier VCs often don’t play well together.  Why does this matter?  Because many venture deals involve investment from both types of firms and if an entrepreneur seeking funding isn’t aware of the potential pitfalls, they may find themselves wasting loads of extra time capitalizing the company instead of running it or potentially giving up more equity than is necessary.

As I see it, the problem manifests itself in two ways:

  • Startups that do their A-rounds with 2nd-tier VCs often have trouble bringing in top-tier VCs in subsequent rounds.  Top-tier VCs like being in control and, therefore, don’t like being subordinated to the smaller A-round investors.  This means that later rounds of funding may have to rely on 2nd-tier VCs that are generally not as deep-pocketed as their larger brethren.
  • Top-tier VCs often want to be the lead in a round that has both top-tier and 2nd-tier investors.  In my experience, this can result in a large amount of time and money spent on negotiating terms with the lawyers.  Because of the relationship, this can obviously happen when the 2nd-tier firm takes the lead as well.

This is not a science, of course, and your mileage may vary.  There are, I’m sure, many venture capital firms, both large and small that work together seamlessly.  However, having witnessed the problems of mixing oil and water many times and having heard about it from others plenty more, I believe that such problems are far from rare.  In the end, these factors only come into play when you have funding choices which many startups don’t have.  Most startups will end up taking money from the best (or only) available source.  This is absolutely the right thing to do, regardless of the factors mentioned here.  If you have a choice, though, these factors should be considered.  Even if you don’t, they’re good to know ahead of time.


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 November 6th, 2006  

The Changing World of Angel Investing

I read two interesting posts on angel investing this morning.  The first, by David Cohen over on Colorado Startups blog: Do you believe in Angel Investing?  And the second by Jeff Cornwall over on The Entrepreneurial Mind Blog:  Are Angels Changing Their Strategy?

As a recipient of angel funds earlier in my career and an investor of such funds now, I’m fascinated by the dynamics of Angel investing and the correlation between investment criteria and solid returns.  While I’d like to think of this as an academic interest, I think it’s more likely that I’m a greedy bastard and want to know how to make more money.

David Cohen posts about his discussion with Kimball Musk and Brad Feld concerning whether or not angel investing works at all – shouldn’t any company with a solid future be taking big money right away?  An interesting perspective, for sure, although one I have a difficult time with.  In the end, the three end up agreeing that there are more scenarios where angel investing doesn’t make sense than when it does, but there is a fairly clear situation where wise Angel investing seems to apply:

“Companies that don’t need to raise much money ($250k-$1m) before they can grow and accelerate, but are likely to later need an institutional round.”

This point makes a lot of sense to me and, in retrospect, is fairly highly correlated to the successful angel investments I have made and seen made by others.

Jeff Cornwall’s post questions data showing the decline in angel investing.  He makes some sound arguments why it’s difficult to determine just how many ventures are being angel-backed these days.  Among his points:

“Angels that do smaller deals are off the radar. They are hard to get data on in the first place because there is no formal reporting mechanism. Add to that their intense desire for privacy, and it is no surprise that we are seeing mostly the larger deal angels working in networks.”

This makes a lot of sense to me.  I’m seeing a lot of angel investing going on, but it’s much quieter than the deals being done by angel funds and, of course, well submerged below widely publicized VC deals.  FWIW, I discussed my views on startup funding strategies and the choices between angels and angel funds in my post, Show Me the Money.

Both David’s and Jeff’s posts are worth a read if you’re thinking about funding your startup with angel funds or you’re an angel investor.


 October 23rd, 2006  
 Investing, VC  
 1 Comment

2007 Camry – Tough Competition

I am not part of audience Toyota targets with the Camry.  In fact, I’m not in the demographic that Toyota targets with any product in their portfolio.  That has not kept me from admiring the slick engineering in Toyotas, though, nor the company’s ability to continually gain market share worldwide by creating vehicles that are well-built and offer a good value to the buyer (read: relatively inexpensive for what you get).  Toyota’s aesthetic design, however, has been uninspired, IMO.  The cars have almost never begged for a second glance from me.

Until I saw the 2007 Camry.  In the new Camry, Toyota has added a gorgeous skin to an already great vehicle (of course, loads under the skin of the 2007 is also new).  That’s the one-two punch.  The knockout comes from the fact that, like all of its previous Camry brethren, it can be had in its most basic form for a tad over $18K.

The pictures don’t do the car justice – not nearly.  You have to see it in person to appreciate how great it looks.

Seeing this car got me thinking about the competitiveness of American car companies (or lack thereof).  I’m rooting for them all the way, but it’s not like the bar isn’t always being raised by the competition.  It’s just going to plain difficult for the big three (can you consider a German-owned and run Chrysler as part of the big three any more?) to return to the dominant position they once had.  Especially with the perception of the American buyer having moved so far overseas.

I was compelled to look up some market data.  This is from Fortune Magazine.

Not surprisingly, Toyota’s kicking butt.  And, it’s not like Toyota’s the only one out there.  Nissan has come back to life after Renault took over (who’da thunk?) and the Koreans are making big headway too.  For American auto manufacturers to get any real momentum in their comeback, they’re going to have to do more radical stuff.  They don’t even have the luxury of time like the Japanese did when they slowly invaded the American market.  Being in Detroit right now is either the best place to be or the worst.  Is your glass half full or . . .


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 October 2nd, 2006  

Your 15 Minutes of Fame

I just ran across Jeff Bussgang’s post titled, VCs Blink.  Jeff’s post discusses how Malcolm Gladwell’s book, Blink, relates to the world of venture capital.  Specifically, Jeff talks about how VCs blink all the time – they frequently make intuitive and fast decisions about what investments to make and what teams to back.  From his post:

Simply put, VCs blink all the time.  Ask your VC friends how long it takes them to decide whether a deal will be a good one in a first meeting or call.  Typical answer:  15 minutes.  How long does it take them to decide whether an interview candidate is an “A” player worthy of an executive position in their portfolio companies?  15 minutes.  Everything else is just to fill the time.”

In my experience, this is a completely accurate observation.  As an entrepreneur presenting to a VC, Jeff’s wisdom and advice may be among the most important things to consider when preparing for and delivering your pitch for money.  Definitely required reading for anyone promoting an idea for investment.  Jeff’s post is almost a year old, but it’s content has no expiration date.  Check it out.

 August 16th, 2006  
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Show Me the Money

I’m not a venture capitalist, but because I do some investing and work with several VCs finding and evaluating deals, I get to see a lot of  plans and have the chance to meet many people working on new ventures. In the last year, the volume of plans that I’ve seen and entrepreneurs I’ve met has grown at an astounding rate. This could be because of changes in my little piece of the entrepreneurial universe or a trend resulting from good people and ideas coming out of hiding after the bubble burst earlier in the decade. I think the latter is more likely.

The problem is, that while the number of ventures seeking money has expanded rapidly, the money available to fund more deals has not. This leaves some great ideas and entrepreneurs out in the cold without funding or, for the luckier few, with crappy deals which require that the entrepreneur give up too much of the equity in his/her company for too little capital.

So here are my thoughts on this problem interspersed with some real data from Ernst & Young and Dow Jones VentureSource to make me sound like I know what I’m talking about. If you’re an experienced entrepreneur with a few successes under your belt, this stuff won’t apply to you.  If you’re a first-timer or you’re moving to a completely new market, though, here is the situation.

The number of venture capital firms today (~1,500) is roughly half the number that were doing business in 2000.  In 2000, a little over half of the then existing venture capital firms did four or more deals.  In 2005, the deal activity dropped to only about a third of the firms in business doing four or more during the year.  Keep in mind that this is also on a smaller base of venture capitalists, too.  At the same time, the percentage of funds with over $100M in investment grew from less than 30% in 2002 to over 60% in 2005.  That’s right; fewer funds but, on average, more money per fund. 

Additionally, most of the remaining venture capital firms are those that still have money available to invest from previous funds, although this money has a fairly short lifespan to it, it has to return a gain to the fund’s limited partners in a short period of time.  The only way for a VC to effectively use this money is by making follow-on investments into companies already in their portfolio or by making very late stage investments that could become liquid in short order.

The bottom line is that there are fewer, bigger funds doing a smaller number of deals, each deal requiring an investment of more money to best utilize the funds’ cash and maintain the dynamics of VC partnerships with a limited number of partners to watch over the investments. 

Of course, the problem isn’t only about fund size and number of deals; the path to liquidity for investments has gotten incredibly muddy.  Classically, venture-backed companies had two paths to exit – an IPO and a merger or acquisition.  The situation in the public markets has caused the first option to virtually disappear for most companies.  In 2005, there were less than 50 IPOs of venture backed companies.  During that year, 87% of all liquidity events of venture backed companies were through M&A activity.  Because of this, VCs are more cautious about their investments, having to limit the companies and markets they invest in to ones where M&A activity is likely.

This all creates a huge dilemma for the entrepreneur seeking any early round investment, especially seed money to get going.  What little money is available is substantially harder to get.  A considerably smaller number of venture capitalists want to make big investments into fewer companies and only into markets that have a lot of projected M&A activity.  The result of this is that in 2005, only about 2% of venture capital was invested in seed deals – a percentage that is not likely to increase.  This is down from a high in 2000 of 7%.  Of course, that was 7% of a substantially larger pie.   

Angel investors have always been a potential source of capital for startups.  The difficulty in taking angel investment is that, generally, the entrepreneur has to get many angel investors involved to have enough money to fund the company.  Often, this can take 6-10 separate investors.  Not only is it difficult to find that many qualified individual investors, but it is very difficult and time consuming to manage the group after the investment is made.

In order to fill this gap, Recognizing this problem and in an attempt to optimize deal flow and investment returns, angel investors have banded together to form angel funds.  Getting funding from an angel fund is quite a bit easier than getting money from many individual angel investors.  The entrepreneur can avoid the hassle of having to find and manage many individual investors by taking this route, the angel funds generally invest as a group. 

The rub here is that these groups have moved into a position where they are filling the void left by VCs who are no longer doing early-stage investing.  It used to be that an entrepreneur could get a good deal from angel investors.  That is, some reasonable working capital without having to turn over too much ownership in the company.  This is not true any longer as these angel funds think of themselves as similar to professional venture capital investors and are asking for, and getting, similar deal structures.  In my experience, these funds are making $500k-$1M investments with $500K to $1M pre-money valuations so they own up to 50% of the company with a relatively small investment.  Of course, some entrepreneurs take these deals because it’s their only way to fund their ideas.

Yup, the situation mostly sucks.  There is some good news, though.  Trends are getting better. 

The market for venture capital has caused startups to become much more efficient.  From 1998-2000, the median equity raised by a venture-backed company was $27M and the median value of an M&A transaction was $40M.  This represents a growth multiple of 1.3X.  From 2001-2004, the median amount raised was $10M with a median exit of $50M, resulting in a 4.3X growth multiple.  This increase in return on capital with a lower initial investment should work its way through the system to justify more early investment.

The M&A market is also improving.  In 2005, the median amount paid for the acquisition of a venture-backed company was about $60M, well above the $18M of 2002 and $23M of 2003.  Although still below the $100M median acquisition price of a company in 2000, the growth in this number should drive a trend toward more early investment. 

Finally, even the IPO market is doing better.  There were 13 IPOs of venture-backed companies in Q1, 2006, up from 8 in Q1, 2005.  These 13 IPOs also raised 61% more money than the 8 deals in the same quarter last year.

These positive trends will not likely create any immediate respite from the current problems for entrepreneurs looking to fund the startup of new companies.  There are some ways to optimize your chances for funding your baby, though.  Here are a few:

  • Don’t knock on doors before the idea is fully-cooked – for the most part, you get one shot at an investor.  There are plenty of good ideas to invest in.  If you present a half-baked idea and can’t answer rudimentary questions about your customer, product or market, you’ll have blown your chance.  The investor will just move on only remembering how you wasted his/her time.  Spend the time and energy to get it right before you start making calls and shaking hands.
  • In general, don’t think of potential investors as part of your team before they invest – I’m sure some VCs will say I’m wrong about this, but I have seen many deals die as entrepreneurs use an investor to help refine an idea.  See the first suggestion, above.  Post-investment, investors are obviously an integral part of your team.
  • Consider funding the development of the product (subsystems of the product for complex stuff) or refinement of the service prior to seeking funding – I see fewer and fewer people willing to do this these days.  Going to an investor with a beta product or completed service offering is huge.  It’s much easier to invest in something that feels real.  Less risk attracts more money.
  • Find a customer – Even better than creating the product; find someone who’s willing to pay for it.  Nothing like a customer to validate a need and the solution.
  • Recruit your team – More experience = greater chance of getting funding.  Period.
  • Don’t let the difficulty of getting money dampen your enthusiasm for your idea – The bar is pretty high these days.  Expect it and expect that you’re going to have to work harder and longer than you ever even considered.  If you truly believe in what you’re doing and it’s a good and unique idea in a strong market, it will get funded.  Follow some of the guidelines here and it may even get funded a bit faster or without having to hand over all the equity in the company to get the working capital you need.

We aren’t in the 90s anymore, Toto.  Finding money is a lot more difficult.  If you get too caught up in the stories of how venture capital flowed a decade ago, you’ll be ill-prepared for what it takes to get it today.  Over the next few years, access to money should get a bit easier.  In the mean time, money is definitely available today, you just have to be smarter about it and work harder for it.

 April 13th, 2006