

# Take the Money and Run!

# An Insider's Guide to Venture Capital

### by

### Gerry Langeler

### SMASHWORDS EDITION

### ~~~~

### PUBLISHED BY:

### Gerry Langeler at Smashwords

### Copyright 2011 Gerry Langeler

Smashwords Edition License Notes

This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this book with another person, please purchase an additional copy for each person you share it with. If you're reading this book and did not purchase it, or it was not purchased for your use only, then you should return to Smashwords.com and purchase your own copy. Thank you for respecting the author's work.

### ~~~~

### About the Author

For over 20 years, Gerry served as a Managing Director with OVP Venture Partners (OVP), the most experienced venture capital firm in the Pacific Northwest. OVP was formed in 1983, and raised seven venture capital funds, the most recent at $250 million. The firm focuses on early-stage companies in clean tech, digital biology, and information technology. Since its founding, OVP has backed over 125 startups – and seen over 50 liquidity events including 25 IPOs and more than 30 others being acquired by public companies.

From 1981 to 1992, Gerry was co-founder of Mentor Graphics Corporation (NASDAQ: MENT) where he served as President and Board member. He helped lead Mentor to over $400 million in sales and $1 billion in market capitalization. The company remains the fastest growing public software company to $200 million (in constant dollars) in US history.

His service as a board member covers the range from communications, digital media, energy, enterprise software, and network security to biotechnology.

He is the author of _The Success Matrix – Winning in Business and in Life_ (Logos Press, 2014), and _The Vision Trap_ (Harvard Business Review, March 1992), which continues to be widely used in business schools and corporate training sessions. He also authored a chapter in _Venture Capital Best Practices_ , Aspatore Books, 2005 and a chapter in _Great Patents_ , Logos Books, 2011. More about Gerry's latest book at www.thesuccessmatrix.com.

In 2011, Gerry was awarded the Oregon Entrepreneurs Network Lifetime Achievement Award. In 2012, he was selected by Oregon's Governor to be a founding member of the Oregon Growth Board, where he serves as co-chair. More about Gerry at www.langeler.com as well as on his Linked-In profile: www.linkedin.com/in/gerrylangeler/

He holds an AB in Chemistry from Cornell University and a MBA from Harvard University.

### ~~~~

### Acknowledgements

This book is a compilation of the most relevant articles I wrote over thirteen years, initially for the OVP Venture Partners newsletter and later for various blogs. Resurrecting all that source material from both electronic and printed media, putting it in some sort of logical sequence, and then serving as editor-in-chief of the text has been masterfully done by my long-time assistant and friend, Linda Hoban. There would be no book without her fine efforts.

My partners in the venture capital business, especially Bill Funcannon and Chad Waite all have contributed their wisdom directly and indirectly via their counsel and at times tough-minded questions as we have looked at new potential investments and worked to help existing ones. Professor Rob Wiltbank of Willamette University has provided important encouragement and guidance in my literary efforts.

The book is dedicated to all the entrepreneurs I have known. Without your bravery in stepping out past the comfort of your secure corporate jobs, out over the abyss of start-up land, usually without a net, there would be no need for venture capitalists. Your drive and dedication is what makes technology advance and the world a better place.

Finally to my family: Kim, Chris and Michael, thank you. I treasure your support in letting me do what I love, putting up with the travel, the breakfast and dinner meetings, the late-night emails, and for still always being there at the end of the day.

### ~~~~

### Foreword

This book is for entrepreneurs who want to realize their vision, want to build a major enterprise, and want to change the world. To do that, you'll need two things: cash and speed. You'll need to get the money, and then run like mad before a big existing competitor slows you down, or another fast-moving start-up runs up your tailpipe.

To get the money, you may want to consider raising money from institutional investors, the venture capital firms. The good news is that venture-backed companies rank among the most successful enterprises ever created. The bad news is far fewer than 1 in 100 companies approaching venture capitalists ever get to "take the money."

So, the first section of this book gives you a behind-the-scenes look at how venture capital firms work, and much more importantly how they think. You'll get first-hand insight into what things you can do to improve your chances and the things to avoid that can doom your hopes.

The second section of the book will help you "run." It is a series of short pieces of advice covering almost every segment of start-up operations, from product development to financing to staffing to sales and marketing. The chapters catalog some of the best start-up practices seen over the last 20 years, and also some of the biggest errors made.

Best of luck on your journey!

### ~~~~

### Contents

Take the Money...

Chapter 1: Avoiding the Quick "No"

Where Does VC Money Come From; Why Do VC's Say No Most of the Time; How to Avoid a No – People; Product; Market; Financing; Potpourri; Business Model Muddle

Chapter 2: Making Your VC Pitch Count

What's Hot In VC – Don't Ask, Don't Tell; After You Leave - What Do VCs Say Behind Closed Doors; Vitamin, Aspirin or Vaccine; How to Wow a VC in Seven Slides

Chapter 3: Questioning Our Way to "Yes"

20 Open-ended Questions; Your Business Plan, For Better and Worse; Numbers, Numbers; Five Percent of a Huge Market Stinks; Is it You or Your Location; Incoming Term Sheet; Dilution & Ownership

Chapter 4: To Know Us Is To Love Us

How to Buy a Venture Capitalist; Why Syndicates Matter; What Do VC's Do All Day; What is a CEO-a-thon; How to Manage Your VC

### ...Run!

Chapter 5: In the Right Direction

Managing in Uncertain Times; Make a Plan You Can Make; The Myth of No Surprises Management, Hocus Focus; Two Frogs with One Hand; Goldilocks Financial Projections

Chapter 6: Don't Look Over Your Shoulder (We Are There)

The Back Channel & Triangle of Trust; The Good, The Bad & The Ugly; Seven Reasons to Remove a CEO

Chapter 7: Get the Product Right

The Beauty of Asymmetric Warfare, Know Your Competition, Know Your Customer, Your IP Is Patently Ridiculous

Chapter 8: The Sale's the Thing

Sales DNA, It's in the Genes; Time Kills All Deals; Pricing for Fun & Profit; Navigating Channels; Branding, What's in a Name; Three Universal Truths

Chapter 9: To Your Reward

The Price-Progress Paradox; A Pull Through Financing; When is a Strategic Investor Like Baseball; Exit, Stage Right

### ****

# Chapter 1

# Take the Money: Avoiding the Quick "No"

#

Where does VC money come from?

Let's start at the beginning, a very good place to start, as Julie Andrews in _The Sound of Music_ would say. For those start-ups interested in raising venture capital (VC) dollars, it pays to understand your customer. In this case, the customer is for your stock not your products and the buyer is a venture capitalist - but the same principles apply. The better you know your customer and their "care-abouts," the more likely you are to match your offering to their needs.

Most dollars managed by venture capital firms come from institutional sources such as pension funds, charitable trusts, university endowments and the like. And just as you need to understand your customer, it never hurts to understand your customer's customer. Those major institutional sources of money have a couple of things in common.

They put a rather small percentage of their total capital into private equity overall (which includes buyouts, etc.), and usually less than half of that into venture capital. As an asset class, we are a very small piece of what they do every day. So, while they invest in venture capital funds to try to get better returns than they can in public markets, and are ready to accept some added risk and illiquidity to do so, if we don't deliver they get more grief than the dollars involved probably justify.

They are judged internally on internal rate of return (IRR) in most cases. A select few get judged also on multiples on capital. But by being on the IRR clock, they care about not just how much we make, but how fast we get that cash back to them. If you ever wonder why VCs say they are patient money but seem to be impatient sometimes, here's a place to start.

In the venture capital asset class, those institutional investors have literally hundreds of funds to choose from. And while we have all heard the mantra that "past performance is no guarantee of future results" we also know that most decisions by these folks are driven very strongly by what your last fund or two did, not how convincing your presentation is.

About every four to five years, we have to go back to raise a new fund. That is because each fund we raise has both a total expected "life" of about 10 years, and a contractually limited investing in new companies period of about five years. So, it is at times like those that we very literally find out if we get to stay in business. If our investors, called Limited Partners, don't find the performance and prospects of our recent prior funds compelling, their easy option is to say "no" to the new fund. Remember, they have hundreds of other choices, and we are small potatoes in their eyes.

So, when you wonder why VCs are both VERY selective about where we place our funds, and VERY involved in how well those investments perform, you now have a picture of our world.

We have to raise money just the way you do. We have competitors just as you do. In fact, we have many more. And we all recognize that no matter how successful we may have been in the past, "What have you done for me lately?" applies to us as much as any other industry.

** **

**It's not a pile of cash in the corner.**

VC funds receive cash from our investors in tranches. We don't want the money all up front, because that would start the IRR clock ticking on all that cash, most of which would be sitting in the bank earning meager interest. However, we get to call the tranches as we need them, called a "capital call" in our parlance. So, we wait until either we have an investment coming up, or need money for our day-to-day operations, and then call an amount that matches our need.

The money isn't exactly allocated over time, but we do plan on a spread of need in the following way. We get a "management fee" on the total amount of committed cash - usually in the 2% area, and that covers our salaries, office rent, travel, etc. We plan on that being available year after year over the 10 year life of the fund, although it usually tails off in later years.

Then we make our investments to build the portfolio of companies. We plan to average about one new investment per partner per year. So for my firm, with 5 partners and a 5 year investing life, we target about 25 total investments per fund. Every time we make a new investment, we allocate follow-on funds to that company; notwithstanding the fact that all of you claim you'll only need one check! In fact, for every dollar we put in initially, we usually put two dollars in "reserve." Often, even that is not enough.

When our companies are sold or go public we return those funds to the Limited Partners. Initially, they get their money back in proportion to the amount invested by them and from our private contributions to the fund. However, once we have paid back all their capital in (the total size of the fund), including the management fees we've taken as essentially a loan, then we get what is called "carried interest" on the gain. For most funds, that amounts to about 20% of the profits.

If there is no profit on any individual deal, such is life. This is a high risk business we are in, and most individual projects fail. But, if we don't generate a profit on the whole portfolio, then our Limited Partners get very cranky with us \- as they should. But, beyond not investing in any future funds of ours, that is the extent of what can happen at that point.

If a start-up doesn't perform in the expected time, but is still promising, we call it, "Normal." Not a widely known fact, but of the 125 some-odd companies we've backed over 30 years, not one (that's right NONE) has made their original business plan. Yet, we've had the pleasure to grow some very successful enterprises that made our investors a lot of money. This is why we reserve those extra dollars you don't think you'll need!

VC firms and partners profit in essentially only one way. It's what I call the Vidal Sassoon model, "If you don't look good, we don't look good." If our portfolio companies (in aggregate) return considerably more than what we paid in, then we look good. You'll hear about how we like to make 10 times our money or better (this is true!). But, the reason we have to shoot for those numbers in each project is that usually we're wrong, and the company either loses money (often all of it) or doesn't make much. So, to cover our losers and our day-to-day expenses, we need our winners to be big winners.

A respectable venture fund will return somewhere above 2x what its investors committed. At 3x or more, everybody gets very excited. Another way to think about this is a spread over the S&P 500 Index. Most investors will tell you that if they can net 500 basis points (5%) or better over the S&P, compounded over the ten year life of the fund, they are happy.

Why do most VCs say "No" - most of the time?

We know it can be very frustrating to entrepreneurs to put their best foot forward, make what they consider a compelling presentation, and yet get turned away, again and again. So, why are we so "mean?"

Hopefully we are not that, even if we don't choose to invest. In fact, our internal goals are for those we turn down to go away at least with some valuable free consulting for their time and effort.

But we do say "No" the vast majority of the time, and owe it to you to explain ourselves better, in general and in specific. Here, I'll focus on the general and on our internal dynamics. Later, I'll address things that begin to reach more directly across to your side of the table, and to those specifics.

We say "No" most often because, frankly, the vast majority of start-ups simply aren't right for institutional venture capital. The companies involved are never going to scale to a size that makes our investment worthwhile.

To explain, here's some simple math, using our OVP VII fund as an example. That fund is a $250M pool of capital. Our management fees and expenses will eat up about 15%-16% of that over 10 years. Let's call it $40M. We'll make about 24 investments in that fund, and assume we average just under $9M invested in each company over their life. We'll usually own ~20% of each of these companies at the end of the day.

Finally, assume typical venture fund dynamics: that 33% fail - where we lose some or all of our investment, 33% are only OK - we get our money back, or maybe a little bit of a profit, and the final 33% are the winners we feel good about.

For the eight that failed, say we lost ~50% or $35M out of the ~$70M put in. That's probably a best case scenario. So, we're now "down" at least $75M from where we started: $35M plus the $40M for OVP management fees.

On the next eight, let's say we got mediocre returns of ~1.5x our capital paid in, or a $35M profit on top of our $70M invested for $105M returned. Again, history says that may be optimistic. So, we're back to $40M under water.

Internalize that! We've just accounted for 2/3 of our investments, and we're not even close to break-even yet!

To be a respectable total fund (at least 2x paid in) those last eight have to get us at least $360M on the $70M we invested in them or about 5x our money. That means each deal has to return, on average, ~$45M. At 20% ownership, that means each firm has to average a market capitalization value of >$200M. But for those eight to average that, probably two have to be north of $500M, with one probably close to $1B. Those are "big ideas" indeed.

**Sample Economics for a 2x Return on a $250M Fund**

Now, how many start-ups can legitimately claim that if all goes according to plan, they will reach a market capitalization of $200M-$1B? Yet, if we invest in a company knowing it never can - even if it executes well - then we are stacking the odds against us ever having a good fund for our investors.

To be fair, we actually do this periodically, because we know that a higher hit rate of companies in the lower $100Ms can balance us out. And we talk ourselves into believing that THIS deal is not going to be one of those losers, hence the higher hit rate. I'll leave it to you to decide whether this is folly. But, at numbers below $100M as an optimistic exit value, the math just doesn't ever work for a fund our size. Yet, there are many, many fine companies that can be built that end up in this value range. They can be very rewarding to their founders and employees, serving their customers and society well.

This is why there is a real place for investors such as friends and family, angels, small venture funds, customer financing, the whole panoply of financial backers to assist the whole range of companies for whatever scale they should strive to be. For example, if you were to divide all the numbers above by 5, and then approach a $50M venture fund or angel group, you might see something that fits your world and theirs. The important thing is to match your realistic company scale to the proper financing source. If more entrepreneurs did this before approaching potential investors, there would be fewer disappointments on both sides.

Of course, if you do have one of those "big ideas," we VCs most definitely want to check it (and you) out!

Now that you know a bit more about how we look at our business from the inside, let's turn to how we look at you. More importantly, how do you avoid the default answer that over 99 out of 100 applicants for venture capital hear, the dreaded, "No!"

It seems a useful way to organize this series is around the four major risks all VCs think about when looking at a new potential investment: People, Product, Market, & Financing.

How to Avoid a "No" from a VC: People

The old saying in the VC business is investors invest in three things: people, people and people. There's more than a little truth to that. We've seen great teams dig themselves out of some deep holes, and weak teams dig themselves into the ground.

But how do you know you have a great team, at least in the eye of the beholder (us)?

First, ask yourself this question: "What is the probability that there is a team with more domain expertise, more horsepower, and more high-level industry connections located somewhere along the Silicon Valley, Seattle, Austin, Boston, London, Zurich, Haifa, Mumbai, Shenzhen, Tokyo, Seoul corridor?" Really - ask yourself that! Because we are asking ourselves that as you speak.

We know all too well that in this global, internet-savvy world, unique ideas are fleeting. But, unique teams are precious.

If you can't answer the question above with a solid "yes," then ask yourself if you CAN gather such a team. We understand that early-stage startups often start with less than fleshed-out teams. So, know where you are weak or missing talent. Know what you don't know, but know you need to know. And know that if you share that level of introspection with us, we will be much more impressed than if you try to blow by us with a patched together personnel story - or worse a bunch of B or C players plugged in to fill holes on an organization chart. We VCs are very used to building teams and used to working through team transitions as companies grow. But we'd like to fully understand where that help will be needed before we begin, not after the first key milestones are missed. And we'll be evaluating how much heavy lifting is reasonable and still expect you to succeed.

Next, beat me to the punch. I have a set of questions I love to spring on unsuspecting entrepreneurs (I guess this ends that opportunity). I go around the room and ask each member of the founding team to describe who they are, their background, and their role.

• Now, I'm looking at you, "Bob, what's your role?"  
• and you say... "I'm the CEO!"  
• and I say... "Why?" (this is usually the first time anyone has asked you that question)  
• and you pause for a moment and then say... "Because I'm the founder."  
• and I say... "So?" (long pause...) "What do you think a start-up CEO has to be good at? Are you good at those things?"

You'd be amazed how many times I've done this and how many deer in the headlights moments it has engendered. Let me be clear, I'm not doing this to be mean. I'm doing this both to make a point, and to get at some very important information. You wouldn't hire a VP of R&D unless they had proven they had the right skills and experience to do that job, nor a VP of Sales, nor a CFO.

**But founder after founder thinks that being a founder is all it takes to be a good CEO.** We have ample evidence to the contrary.

Actually, being a founder shows you do have one key attribute of successful startup CEO's - the ability to craft a compelling vision of the future direction of the enterprise and then get people to follow that vision. But, vision buys you the first couple of months. After that, only steely-eyed execution matters. And the fact that I put entrepreneurs on the spot doesn't mean they can't be CEO. It means they need to understand that from the day they take our money it's no longer about them, or about us. It's about the enterprise and what's good for it. If that means you are a one-in-a-million like a Bill Gates, Michael Dell or Steve Jobs and can take the company from day one to billions in sales - terrific! If it means you need to step into another role in six months - terrific! What we all need to be working on is building a powerful, lasting, valuable enterprise - with whomever we need in whatever roles need filling.

My final ploy on this topic is to ask a simple question, "Do you want to be the boss, or do you want to be rich?" There is only one right answer. Again, it doesn't mean you can't be both. But it means if it becomes clear someone else is needed to help the company reach its potential, you are not confused about our shared need for economic success. By the way, there is absolutely nothing wrong with answering that question, "the boss." It just means you are not right for institutional venture capital - and as I said earlier, there's nothing wrong with that, either.

In the end, we look at the team and say to ourselves. "Are these guys and gals likely to go toe to toe with those phantom start-ups around the world that are somewhere between six months behind and six months ahead - and win?" If we think you are, then we start thinking seriously about the next three risk areas.

How to avoid a "No" from a VC: Product

So, on to the second of the four great risks VCs evaluate when looking at a new deal: the Product.

Because we are technology investors, at OVP this actually means Product + Technology since in many of our investments it is not a certainty that the product envisioned by the founding team can actually be delivered, or will work as advertised.

In any event, as you are presenting your business plan to us, we are asking the following questions about your product and when appropriate, your technology:

If this is an area of deep technology barriers, do you have clear rights to the intellectual property (IP) you need to have freedom to operate? How much work has been done to validate that assumption? Who are the competitors most likely to feel threatened by your arrival – especially those who employ more lawyers than you will have total employees? If this is not a patent issue but one of know-how and trade secrets, as in most software companies, what is the evidence that you possess proprietary advantage?

How hard is it to do what you are setting out to do? This actually cuts both ways: If what you are doing is not hard, that means it is very likely you will deliver, but it will be much easier for someone to come up your tailpipe. If what you are doing is very hard, then you may not succeed in getting it done, but if you do, you'll be in the clear for a while.

Frankly, if we have to choose, we'll go with the latter. We like tough technology barriers erected for others to have to hurdle. Not all VCs do – another reason to match yourself to your potential funding source.

**Is your planned offering a "feature", a "product", or a "company platform?"** Most great companies are not built around a single product, but a set of products covering a range of needs across some adjacent market segments.

So, we ask ourselves: Is this a capability that we might see subsumed in the next release from some existing major industry player (a feature)? Or, is this a capability that might be stand-alone for a while, but really needs to be part of a larger more complete offering to succeed (a product)? Or, is this a platform, with a specific product as its first deliverable, but with a broad foundation that can support multiple products and/or services over time (a company)? Companies built around a single product can be successful, but they are inherently more risky because a competitor can hurt you much more easily than if you are a platform. On the flip side, platforms can be harder to get launched, because they may not address enough of a pain point immediately to get budget dollars.

We don't ever knowingly invest in a "just a feature" deal. We will sometimes do a "product deal" if we think its space is large enough. Platforms are our favorite, as long as the first product from that potential platform can penetrate the market on its own merits.

However, for those who lean towards a platform play, there is a trap. Somewhere at the outer reaches of a platform you become a "boil the ocean" project. Those companies are simply biting off more than any rational start-up can chew – often more than any large company can chew. (Mixed metaphors are us). Ask yourself if any reasonable team of people can do all the things you are setting out to do in the time allotted.

On the other hand, the company I helped found (Mentor Graphics) was told by knowledgeable observers that we couldn't possibly do what we said we were going to do with the small team we had at the start. When we did, we became the fastest growing public software company ever to $200M in sales (to this day, in constant dollars). So, if you can boil maybe not the whole ocean but a good sized bay, the rewards can be terrific!

Do you have adequate control of your destiny? One of the very first VC deals I was involved in as an outside board member was planning to build its future success on top of Windows 1.0 (yes, I am that old). You can guess how that one ended. This is not to say there aren't big rewards available for those who build onto existing eco-systems. But, betting on a new external eco-system to arrive on your schedule is multiplying your risk. And betting on an eco-system to spring up around your little piece of the world, as a requirement for your success, is multiplying your arrogance.

Do you require success to be successful? Huh? You'd be amazed at the number of Internet deals we've seen that essentially posit, "We're going to do X, and then once we get to 10 million visitors a month to our web site, we can monetize that with advertising." Well, of course you can! The problem is getting to the 10 million unique visitors. That is damn hard. Assuming you can make that happen by just showing up is naïve.

Do you have multiple revenue streams? That's not good. What? Doesn't that lower risk? Not in our experience. There's a proverb on my wall that says, "Do not try to catch two frogs with one hand." As a start-up, you barely have one hand. Some of us can remember back to the early days of Sun Microsystems when Scott McNealy was hedging his bets using microprocessors with both the Sparc architecture and Intel architecture....and Sun was struggling. His famous, "Let's put all the wood behind one arrowhead," was a key turning point in their ultimate success, until many years later.

Again to be fair, many angel investors love multiple revenue streams. In their world, it does reduce risk. But, they usually don't have the diversification we have, and usually aren't as ready to be totally wrong and lose all their money in an investment in return for a chance to be screamingly right. So, a project that has multiple revenue streams may be better for angels than for VCs.

Final thought, if you do present multiple streams look at your numbers. Are there some streams that you could just drop and not materially change the top and bottom line? If so, do that! For more on this topic, see "The Business Model Muddle" later in this chapter.

Let me leave you with a case study of a deal OVP did that turned out to be a big winner.

**Complete Genomics** (NASDAQ: GNOM) came to us with a revolutionary product concept that was essentially one to two orders of magnitude better than the competition. They were going to fully sequence human genomes for 10 to 100 times lower price than had been done before, but at very high quality. In fact, it was so much better it would open up potentially huge new demand. But, to succeed they had to deliver on three separate technology areas, pushing or breaking the state-of-the-art in all three. This was VERY close to a boil the ocean project, so much so that one of our more risk-averse partners at the time voted "no" on the deal. But, the rest of us thought the risk was balanced by such a large potential reward that it was worth the chance. In addition, this was a killer team, so the People risk part helped mitigate the Product risk.

The company had all its IP nailed down and it would be completely self-reliant. Although it might ultimately engender a new eco-system around it, that wasn't necessary for it to succeed. A very large company could be built around the initial product concept, but the technology (if all three legs worked) had applicability into adjacent areas. It had a single major revenue stream, albeit a very different model than its industry was used to, services rather than equipment sales.

Complete Genomics indeed took longer and more capital to succeed than they planned. But in the end, GNOM went public in late 2010.

How to avoid a "No" from a VC: Market

Now, on to risk number three: Market.

In many ways, this can be the toughest to figure out, since so often start-ups are targeting markets that don't exist yet, or are introducing products that could potentially change the dynamics in existing markets. The question is: "What evidence do you have that your prospective consumer really needs and will buy what you're offering?" This is essentially a test of customer readiness.

Frankly, we put about zero weight on market research reports from the big consulting and pundit firms. They are remarkably self-serving, are usually overly optimistic as to timing, and can't foretell the future any better than the rest of us. So, when it comes to market analysis we go about this in the most basic, bottom's-up way we can. We ask the customer!

One of the most surprising things I've found over the years is how willing complete strangers are to take our diligence calls, and share in-depth insights into their businesses, their "care-abouts" and their priorities. This goes all the way back to my days as an entrepreneur, when we emulated vaudeville and traveled the country asking these questions face-to face of potential customers. We started with those not quite in the mainstream and worked our way to our version of "Las Vegas," which in our case was Motorola. By the time we got there, we'd gotten feedback to our initial concept and adjusted accordingly, our "act" was polished and so when we presented our product concept to Motorola they said, essentially, "If you build it, we will come." Then we went back and asked our engineering team if they could build it. Fortunately, they said they could, and then did.

As potential investors, we maintain a cadre of contacts in the industries we serve, and so when an entrepreneur gets our attention, we get on the phone and ask those key industry players to evaluate the idea. If we don't feel confident explaining the product ourselves, we'll put the start-up team on the phone and play fly-on-the-wall while we listen to the pitch, and the questions that are asked. The amazing thing is it doesn't take too many of these calls to pick out a pattern. Years ago, some academics found that at about 20 data points you've hit diminishing returns. We often seem to get there at about 10-15.

**The most important thing you can do as the start-up leader is make these calls before we do.** What you never want to have happen is for us to have more customer insight than you do. So, before you darken our door, darken the doors of your prospects and be prepared to share that anecdotal insight with us. We'll still do our own, but you'll have started out on the right foot.

Of course, sometimes if you are at the leading edge of technology, you are explaining a product the customer can't even fathom. These are the really tough ones. On our end, we do hobnob with some "futurist" type folks and we'll certainly bring them into the mix. Our key issue on these "change the world" deals: is the product a nice-to-have or a have-to-have? The difference can be subtle or time driven. The initial cell phones were nice-to-haves, because they were big, bulky and expensive, and not too many people had them. But once they hit the right form factor, cost and penetration, they became have-to-have's. The problem for VCs is we usually can't wait long enough for a nice-to-have to become a have-to-have. And when we are wrong (which is often) it is because we didn't evaluate properly the universal truth that technology moves faster than people do.

Another major concern besides customer readiness is market scale. The key issue is, if you are successful can your company grow to a scale whereby our economics work? There are many fine companies that create products customers are ready to buy, that are have-to-haves, but there just aren't enough of those customers, or they aren't willing to pay enough, to grow a major enterprise.

One additional thought about markets: I've seen thousands of product feature comparison matrices in start-up presentations. But, not once have I ever seen a company comparison matrix. Yes, your new product may be better in certain ways, but what about your distribution channel? What are the switching costs for customers who have solved your problem in some other way to date? What is the average evaluation cycle for new products in this market? How important to your customer is eco-system integration? Do those big, established competitors have relationships with your prospects that transcend a simple product feature decision? When they FUD (fear, uncertainty & doubt) you for being a small struggling start-up, how will you counter that (a strategic partnership, perhaps)? When they cut price to keep you at bay, how will you respond?

Market entry against entrenched competitors is very, very hard. Relying on product features alone to carry the day is very shortsighted.

How to avoid a "No" from a VC: Financing

When is a lemming not a "lemming?" When it's bath time!

I'm not even sure where I was going with that, but there is a point to be made. Many folks criticize VCs for acting like lemmings, all blindly jumping off the same cliff into the sea, investing in the same sectors, while ignoring interesting projects outside those currently hot spaces. There is a lot of truth to that complaint. But there is a rationale for it, too.

Often the hardest check to get is not the first one but the second (or third!).When reality interjects itself into the financing process, the sparkle and promise of a Series A investment gives way to hard questions once initial targets have been missed and a Series B or C check is needed. It is in times like this that financing risk can become the most important risk facing a start-up. And this is when being in a "hot space" can help overcome an otherwise cold start.

Most entrepreneurs believe in at least one of two fallacies:

1. Their business plan is correct, or better yet, conservative.  
2. If they need more cash, investors will automatically pony up, regardless of how they've performed on the initial tranche.

The reality is that those business plans are not correct, much less conservative. And we've seen many, many examples of companies that, having missed their initial plan, struggled or failed to raise follow-on capital. Not only do the entrepreneurs pay in that circumstance, we do too.

So, when we look at a new start-up opportunity, we are asking ourselves about the financing risk in that deal. That risk comes in at least three forms:

**What is the capital intensity of the business?** The more money needed to take the company to the Promised Land, the more chances there are for a stumble to turn into a problem financing, which turns into a down round, or a fire sale. In addition, the more money needed, the more VCs will be needed to share the load. And the more VCs you have, the greater the chance of one or more turning negative on the deal and upsetting the syndicate dynamics. Bad syndicate dynamics kill more deals than ever gets reported.

**What is the investment popularity of the business?** Here, lemmings rule. I'd much rather be looking for the Series B round for a company in a hot space than a cold one. The same holds true for the Series A. We've gone "off popularity" enough to know how hard it can be to get another VC firm to co-invest with us when we are "out-of-step" with current market psychology. That said, we often like to be temporarily out-of-step, as that is where the big rewards can be found. But, there is nothing quite as frustrating than to have an investment in a company that is succeeding where others have failed, yet be told by our friends in VC-land that they won't look at our firm for the Series B because they lost money in a similar deal years ago.

**What is the time predictability of the business?** This is actually a part of capital intensity, but in a less-than-obvious way. You may have a business that is not capital intense on its face. But, if it is one where no one can tell exactly when the market will engage or, if appropriate, when regulatory hurdles can be jumped, then it may be more capital intensive than it appears. We saw this many years ago in wireless location-based services. We got in early (too early in retrospect) and so those start-ups that really were not very capital intensive by nature became more so as we had to wait around for the market to develop.

So, what can you do about these issues? First, recognize they exist and they are just as important as the previous three risks in this series (People, Product, Market). Be ready to discuss the financing risks with us. Next, find ways to mitigate them. For example, while most software companies don't have to worry about capital intensity, even they can find creative ways to use fewer dollars (cloud computing, etc.).

If your start-up is in a currently unpopular sector, find a strategic partner who would benefit greatly from your success and get them into the first round. Or find a customer who is desperate for your product and get paid 50% up front as a deposit. If you are in a "cold space" either find a way to morph the plan to get closer to warmer climes, or belly up to the fact that you are looking at a long, tough slog to raise capital.

Next, value your investment syndicate the same way you value your most critical employees. When it comes time for the next check, you absolutely need all your VCs to be telling their partners, "Yes, the company is a bit behind plan, but our investment thesis still holds. This group deserves another check," rather than, "There is still an opportunity here, but I'm less confident in this team than I was initially." You'd be amazed how many start-ups take their VCs for granted once that first check is in the bank.

**Never say, "I can't wait to be done fund raising so I can get back to running the business."** As CEO, fund raising IS part of running the business! In fact, you are always, or should always be fund raising. So, be looking for opportunities to expose your firm to investors beyond your initial set. Those are the ones who might lead your Series B or C round. Jump on any chance to present in the private company portions of the investment banker beauty shows in your sector.

If you treat Financing risk with the same attention that you treat the other three, you'll positively stand out from 90% of the entrepreneurs who go looking for venture capital.

How to avoid a "No" from a VC: Potpourri

So far, we've covered the "big four" risks in a start-up that are front of mind for every VC when you walk through the door (People, Product, Market, Financing). But there are some other issues, irritants and obstacles you can inadvertently toss in your path that don't fit nicely into those categories. While not as important as the big four, they can still direct an otherwise positive impression in the wrong direction. So, beware of:

**The ill-advised adviser:** This is a tough one, because once I describe the issue people immediately ask for specifics that we VCs are not comfortable giving out. Here's the situation: you come to visit and either bring along with you, or mention that you have a key relationship with someone who we know is either a pain to deal with, or worse a charlatan who doesn't know what they are doing. The former adds a level of friction to a process where we already have many more interesting new companies to look at than we can invest in - risking us taking a path of lesser resistance. The latter reflects badly on your process of selection of key people and puts up a big red flag on the People risk domain.

But, you say, "How do I know these advisers are going to be a negative? I'm new to the start-up scene and have no way of knowing who to trust." Well, this is one of your first tests. We VCs are not comfortable revealing the names of these folks who raise the hair on the back of our necks (and there are only a few), because you never know when they'll hook up with the next killer deal and we do not want to be black-balled by those advisers. But, you can look around, ask around and see who we and others prefer to deal with.

Start with the law firms who guide most start-ups around your town. There are usually just a handful of those, and they tend to be very professional. Use them as your introduction source to VCs, if you feel you need one. This is not to say those firms can't be appropriately tough with us when they represent you. But it says they know the rules of the game, and we know they know. So everyone tends to operate in good faith, while representing their respective positions. A secondary message here, you don't need to pay anyone to introduce you to VCs. A quality service provider (lawyer, bank, or accountant) will do so at no charge. Better yet, they tend to know what we have funded and have not, and can point you towards the most likely VC match.

Another thing you can do is ask us, "We're looking for someone to advise us in area X. Can you recommend anyone?" What may be most interesting to you are not the folks we mention, but those we don't mention. Sometimes, that can just be a momentary oversight. But if you ask a couple of VC firms that same question, and there is a consistent name or two missing of someone you were considering using, then you have your answer.

**Control and dilution, not optimizing for success:** One of the obvious questions we'll ask you is how much money you need. There are many possible right answers, but a couple of wrong answers, too.

If you respond with, "It depends on valuation," you just told us you are optimizing for dilution rather than for success. The company needs a certain amount of money. In fact, it probably needs more than you think to allow for likely slippage somewhere in product development or customer traction. But if you skinny down the raise to optimize for dilution, you have dramatically raised the risk of running out of money at an inconvenient time. BTW - there is no convenient time.

If you respond with, "I don't want to give up control," you've just hit two negative points. First, as I said earlier, when you take institutional money it is no longer about you, or about us. It's about optimizing the value of the enterprise for all stakeholders. So "you" and "in control" are off the table as primary issues.

Second, someone once gave me a very cogent piece of advice. He said, "When you are running a company, there is only one way you are in control. That is by executing. If you own 100% of the stock, but don't execute, someone else is in control (the bank, your customers, your suppliers...). On the other hand, if you own 20% but execute, you have all the control you'll ever want. No one will do anything other than sit in the back of the bus and cheer for you." It's true.

**With too many angels, you're in hell:** Angel investors can be enormously helpful. Sometimes, they may invest prior to VCs being willing to. But, DO NOT accept the notion that this is always true. We have backed MANY companies that came to us with a business plan, and nothing else. Angels love to try to position VCs downstream from them, to make sure they get their bite at the apple. As with all things, the truth is fuzzier than that. However angels, if selected carefully, can provide business and industry guidance and connections along with their cash. We often invest in rounds where angels provided the initial seed money, and have positive, long standing relations with them afterward.

However, there are two potential problems with angels. First, they often are good for the first check, but have trouble with follow-on financing rounds. And, if the terms include a "pay to play," which means an investor who does not participate in later rounds gets crushed, those glowing halos can turn dark in a hurry.

In addition, unless you really fancy yourself as a cat-herder, the more angels you add to your cap table, the more cats will need to be herded. And some of these cats will keep you up at night with yowling if you aren't right on plan, or right on the phone when they have a question.

I have a good friend who over time raised an enormous sum from angels for his company (>$40M). While he must now be ranked as an expert cat-herder, he also was on the cusp of becoming a public company by default. That threshold is at 500 shareholders, and he came very, very close. When he started, you can be sure he never dreamed it would take so much money, so many investors, and so much of his time. He eschewed VCs early on, but suddenly found religion as he approached the 500 investor mark. One $10 million check is a whole lot easier than two hundred $50,000 checks!

**"We're selling stock at $0.50 a share."** Your price per share is meaningless to us. What matters is the implied company valuation (price per share multiplied by number of shares). In addition, I hate to be this blunt, but the price paid will be what we offer, not what you ask. Now, that's not to say there won't be some back and forth negotiations. But the surest way to scare off a VC is to put a valuation on the table that we know is crazy. Rather than try to educate you to how the world works in private equity, we're likely just to move on. When someone asks you what valuation you are expecting, answer simply, "The market will determine that." Your job is to get an offer. With an offer in hand, the games can begin.

" **We can't tell you what we're doing until you sign a NDA."** (Non-Disclosure Agreement) We can make this very short. We aren't going to sign it, so you can decide before you visit whether that is really a criterion or not. Practically, we see thousands of new start-ups every year. There is no way for us to be in absolute control of, or even remember, everything we've seen and heard about.

Now, that said, those of us who do this for a living do operate with enlightened self-interest. We know that if we EVER violated the confidence entrepreneurs place in us, the word would get out and we would no longer see the best deals. And that is a prescription for death in our industry. So, deal with an established VC firm, and your ideas should be safe. Of course, if the issue is one of disclosure for a potential patent, we'll find a way to make sure your IP is protected. And you should do your homework on the VC before you visit to make sure they don't have a competing company already in their portfolio.

Let me close with one of my favorite stories that trumps the NDA example. Years ago, I was approached by an entrepreneur who said he had a technology that was going to revolutionize the world. In fact, it was so powerful that the company he was starting would reach over one billion dollars in revenue in just five years. There was only one catch: he couldn't tell me what it was until AFTER we'd invested $10 million. Now that's a powerful position! I guess he never found that investor/sucker, because I've never heard of him again.

The Business Model Muddle

One of the surest signs that a startup doesn't have its act together, and as such is not yet ready to ask for serious venture capital – is a muddled business model. It is usually a symptom of a larger focus problem.

The refrain often goes something like this:

"We are going to start a business to business portal on the Net. We'll get lots of people to come to the site based on our unique content and information aggregation. Then we'll capture their dollars through these five or six different revenue streams." Here is the problem: As venture capitalists, we are forced to be not only students of startups, but students of the history of startups – the good, the bad and the ugly.

Looking backward, we are hard pressed to identify any businesses, but certainly none in their early years, that can really develop five or six meaningful revenue streams at once. Those streams do not flow together to make a river, they make a muddle. What they say to us is the company does not yet know where the real value capture points are in the business, and as such is forced to throw a bunch up against the wall and hope some stick.

Remember when the Internet was young? Many startups said they would make their money with advertising. A few years later, people realized that only solidly established web sites such as Yahoo and Google would be able to attract ads at significant dollar volume. Along the way, other companies tried subscription models where you paid for the right to access the information. Most died, while a few thrived. Then we saw transaction-oriented models, where a site helped bring together buyers and sellers, and in making those markets, extracted a fee. There are many more business models to come.

However, where we as venture capital investors get nervous is when startups come to us pitching their enterprise as combining ALL these approaches. They plan to: attract visitors with their unique content; charge for more detailed content; sell placement position in their information aggregation and supplier list sections; attract advertising because of their large unique visitor counts; transact business in their 'marketplace' and get paid a fee; sell some products directly and take those margins; sign affiliate deals with other sites and get a commission on pass-through sales. This is way too much for mere mortals to handle.

**Our advice is simple – make it simple!** Go figure out where the real value capture pressure points are in your business. Where are customers really in need versus only slightly in want? If the message is: in this industry there are tremendous inefficiencies in information flows that cause buyers and sellers to have trouble getting together – then go set up a forum to make that happen. You may enable many of the portions of that multiple revenue stream site described above, but make no mistake about where you will live or die – as a market maker taking a transaction fee, not as an advertising venue.

This is not to say that having more than one revenue stream is a bad thing. For some businesses it is a requirement. If you are starting an enterprise software company – you need to plan not only to get paid both for your software (probably via software as a service – SaaS) but also perhaps for the services and training your customers will need to deploy the system. Planning for the revenue forces the critical planning for the resources to deliver the revenue – such as staffing for the customer support function in this case. Healthy software companies often see 70% of their revenue from software licenses and 30% from services. What they do not see, and in fact we never see, are five revenue streams with none greater than 40%, nor any less than 10%, driving the business.

The question to ask is this: If you are forecasting multiple revenue streams for the enterprise, are there any you can or should forego, in order to maximize the others? If you have a revenue stream that will never amount to more than 10% of your business, it isn't clear it will ever get the management attention necessary to thrive. If you cut off that 10%, with no recourse, would anyone really care? However, what if you took that value and packaged it with another part of your business value position? Could you win more business? What if you gave away that 10% entirely, could you raise the 40% in another category to 50%? If so, you just broke even on the trade-off!

When it comes to business models, simpler is better. Even when breaking new ground in new markets, with no established business rules, focusing on a few points of customer contact and value delivery yields dividends. Avoid the muddle – narrow your model!

### ****

# Chapter 2

# Take the Money: Making Your VC Pitch Count

What's "Hot" In Venture Capital? Don't Ask, Don't Tell!

No matter where I go, people usually ask the same question, "What are VC's interested in these days? What's hot?" The query often comes from entrepreneurs who mistakenly believe that if they only can mouth the proper buzz words in the proper sequence, VC dollars will fall from heaven. Or sometimes it comes from folks who think that if they can tap our brains for what is hot, then they can go start a company in a space that we will fund.

Both notions bother me.

The former assumes that the guaranteed path to funding is a well-crafted well-presented PowerPoint pitch. People who believe this miss the most basic part of getting a business funded by professional venture capitalists. Sure, we all like a crisp professional presentation, because it shows us that the entrepreneurs can "sell" – which they will need to do to customers, and they can "simplify" which they will need to do to focus their energies. But, after the entrepreneurs have left the conference room with the VCs interested, what do you think happens? We start calling and emailing people we know to get broad perspective of the idea, the market, the team and the strategy. It's called due diligence.

Just as in war, where no battle plan survives contact with the enemy, in venture, no business plan survives contact with the market. As we do our due diligence, we learn a lot – even if it is an area we already know well. If anyone thinks they can overcome that in-depth process with buzz words and slides, they are sorely mistaken.

The way you win our trust and our money is to really know your technology, your market and your competition, be tackling an area where customers have real pain, and then arrive on the scene with a team that screams to us "these are the guys and gals who can beat anyone in the world in this space." That has nothing to do with what is hot. It has everything to do with what you understand and where your passion lies.

Ask yourself: **How many of the best startups were created by entrepreneurs who first asked what was hot and then tried to get their juices flowing to chase that space?**

None!

But we all know the names of the successful startups that came into being with an individual or a team passionate about a big opportunity, who executed like crazy, and along the way rapidly adapted to what the market feedback told them.

Besides bothering me, the "What are you interested in?" question also puzzles me.

It assumes that venture capitalists are somehow fickle soldiers of fortune. Worse, it implies we are like crows, attracted to the latest bright shiny object. So OK, sometimes we plead guilty on both counts. But in general, what we are interested in really doesn't ever change. We are looking for companies that will cause major disruptions in established industries, so as to displace established competitors, or create new industries of significant scale. We don't need to tell entrepreneurs what those are. We need entrepreneurs to tell us where they are!

Now certainly, there can be areas at a given time positioned to offer that disruptive displacement or major new movement. But rarely are those a big secret. There are infinitely more great opportunities than there are great teams with great ideas to serve them.

So, don't ask what's hot. Show us you're hot! We'll pay attention.

How to Win a VC "Beauty Contest"

Sometimes, you have a chance to pitch a bunch of VCs all at once. To "Take the Money" there, you'll need to know how to win a VC beauty contest, or at least make it to the swimsuit competition!

I'm often asked to serve as a judge for the applications to these venture capital beauty shows. Given the high rate of success in actually raising money by those selected to present, it strikes me that getting picked to go on-stage (the swimsuit competition) is a huge step for many start-ups. So, it is useful to review how judges like us choose between many attractive contestants.

First, let's review the criteria from a recent one where I was involved. The score sheets all the judges received listed the following categories and weighting factors:

• Management Team (35%)  
• Product (15%)  
• Served Market (10%)  
• Sales/Marketing Strategy (15%)  
• Core Competency / Competitive Position (15%)  
• Scalability/Liquidity Opportunity (10%)

Here's a key first issue: The entrepreneurs all had access to the criteria and weightings the judges were going to use. Yet, did the business plans or PowerPoint pitches submitted reflect not just the list, but the weighting factors? Sadly, most did not. Those entrepreneurs simply could not break out of their "product is king" mentality. Now, some might argue with these weightings. But, they were developed over a period of years by people very close to the start-up community, with an eye towards getting companies on stage that would then get funded.

Most pitches we see are very heavy on Product Technology and Product Competitive Position, and very light everywhere else. But the weightings above tell a different story as to what matters to VCs.

Do you place over a third of your emphasis on your Team? Can you score a perfect 10 in that category against the stated reference point for these judges of: "full complement of expertise, very knowledgeable about product and market, have start-up experience?" Or are you closer to a 4: "primarily founder, very knowledgeable about product, but limited mgt./start-up experience." Notice how far the score falls for lack of a complete, experienced team.

How about Sales / Marketing Strategy and Scalability / Liquidity Opportunity? Together, they are worth almost as much as Product and Competitive Position combined. Are they worth that much to you? Can you rate anywhere near a perfect 10 against these judges' Sales/Mktg. Strategy criteria of: "Market is clearly defined, demand is assured, customers are easy to find and will rapidly see benefits, i.e. customers are accessible and reachable?"

Without going through every category, and every scoring level description to help rank the contestants consistently, it is clear what entrepreneurs often see as the key parts of their pitch, whether to beauty pageant judges or directly to VC's, is often a subset of what is really needed to make it to that swimsuit competition.

Speaking of swimsuits, whatever your opinion of actual beauty pageants, there is a reason that part of the competition comes late in the contest. A swimsuit hides no flaws. Having to walk on stage, alone and that "exposed," is a test not just of physical dimensions, but of cool and poise under pressure. It often helps judges see beneath the surface beauty.

The same is true for entrepreneurs at their beauty shows. When you walk on stage, "clad" only in your PowerPoint and your most convincing song & dance, you show much more than the words you use. Your tone and confidence in that pressure-packed room come across far more forcefully than the content of your pitch.

So, if you want to not only make it to the swimsuit competition, but leave the audience of investors clamoring for more - follow the outline and emphasis in the bullets above - and go knock 'em dead.

After You Leave, What Do VCs Say Behind Closed Doors?

So, now you've made it to a VC firm partners meeting. Do you ever wonder what REALLY happens around the venture capital partners table once you, the entrepreneur, leave the room? Well, it's time someone told you. Hopefully, out of this you'll become more skilled at getting to "Yes," or maybe getting to "No" - but faster, and getting some value out of the experience. The most dreaded words you can hear, if you had an ear pressed to the conference room door are:

**"What do they do?"**

But how can it be that after an hour of your best PowerPoint magic, VC's can ask that question? Because the entrepreneur did not think about that question before they put together said PowerPoint!

Candidly, this happens fairly regularly. Recently, the CEO of a startup came in and presented to our entire partnership. He talked about his company, and the issues of his markets, and his competitors, and his financial plan. But nowhere, and certainly not at the outset, did he stop to explain the simple issues of:

• this is the problem we are solving  
• this is the value to the customer of having this problem solved  
• this is what we make that solves their problem

This entrepreneur was simply too close to the forest to see his trees anymore. All he saw was bark and moss and the occasional ground squirrel.

Now, lest you think this was some neophyte or someone not otherwise ready for prime time - here's the dirty little secret. The presenter was the CEO of an existing portfolio company of ours! We KNEW the answer! They already had millions of dollars from us. So, while the question raised by one of our partners was facetious - that made it even more powerful. From the presentation you couldn't tell what they did.

If this is a trap even experienced VC-funded CEO's fall into, you can be sure that those less seasoned fall in far more often.

OK - so you've passed the test of "What do they do?" Now we come to the next set of words you don't want to hear with your ear pressed to the OVP conference room door:

**"Who cares?"**

So, you think we're just being rude? (Well, maybe.) But, in reality those words level a verdict on the startup as falling into one of two traps.

Either the company is serving a market that is just too small to scale, or is offering a product that is in the "nice to have" category rather than "have to have."

Recognize that institutional venture capitalists fund a remarkably small percentage of startups (again, fewer than 1 in 100). The reason is that the overwhelming majority of new companies will never be able to grow at the explosive rates to the major scale that VCs need to make their economics work. That's not a slam on those other 99% of startups! It just means they should look for funding someplace else.

This reminds me of an entrepreneur who came to see us some years ago. He had bootstrapped his company over five or six years to about $10 million in annual sales. It wasn't growing all that fast any more, but he was taking home over $1 million a year personally from the enterprise. My first question to him was, "Why in the world are you here? Go, home. You don't need us!"

The flip side can also be true, as in "we don't need you."

Before you visit with VCs, ask yourself or a trusted service provider who caters to startups, "Is this really a VC deal?" If so, we'd love to see you. But if not, that's perfectly OK. Just spend your valuable time with potential investors more likely to find your idea compelling.

**"Right idea, wrong team."**

This is a tough one. If you were listening in to our partner meeting after presenting your startup, what would you do? Well, the first thing might be to think hard about why we were feeling that way. Does your team have deep domain expertise in the business you are starting? If not, then we worry a great deal about what you don't know you don't know. Or perhaps to paraphrase Will Rogers, "It ain't what you don't know that hurts you. It's what you 'know' that just ain't so."

If you don't have domain expertise, it is still possible you've come up with a killer business idea. But, you'll need to go land some senior people from that industry to team up with you to help you avoid the obvious (to them) pitfalls. Please come back when you do - or at a minimum when you realize you need to.

Now, what if you do have deep domain expertise in the space, but we still give you the "right idea, wrong team" brush-off? Then the real message is, you have an A quality idea but are chasing it with a B quality team. Did you round up just your buddies, or the best and brightest in the field? Did you make everyone a VP, or did you recognize that you'll need to hire people above some of the founders to grow the business? If you are a founder coming out of the sales ranks, do you know what makes a stunning VP of Development? If you are a killer engineering or scientific founder, do you know how to select and hire a VP of Sales?

One of the best things you can do if you have a great business idea is to leave the VP titles at the door and even leave holes in your team. If you don't have world-class talent in all areas, or aren't sure how to evaluate talent in certain functional areas, let us help you. It is part of what we do every day.

Now for one of the really tragic whispers emanating from an OVP partners meeting...

**"Right team, wrong idea."**

We really agonize over this one. It doesn't happen all that often, but every once in a while we get this absolutely killer team in to present, with deep domain expertise in an exciting market. And then, after they explain their business concept we say:

"Is that the best they can come up with? What a shame!" (and then we shed a collective tear)

It is so hard to get really high performance teams put together that it pains us to see one going after a target that is just too small to be interesting, or too far ahead of the market to be financeable, or too crowded to be sustainable. I have to admit, there have been times we've come close to backing these all-stars in the hopes that they'd figure out some other business to conquer nearby the original target without blowing a wad of cash first.

In fact, it turns out that some of the best startups we've seen, whether we backed them or not, fall into the category of "missed on the original plan, but adjusted." Great teams can do that. The problem is, great teams can also simply fail if pointed in the wrong direction - or burn so much cash bumping into trees in the forest that it is the same as failure to us.

So, if you have pulled together that once-in-a-lifetime team, please work hard to make sure the business you are chasing is worthy of the talent. You don't want to see a VC cry, do you?

Wait...let me rephrase that.

Vitamin, Aspirin or Vaccine?

One way to start the conversation is to tell us what you are: a vitamin, an aspirin or a vaccine?

I was doing due diligence on a start-up that did a very nice, crisp job when they presented to my partnership in describing their value proposition. With their permission, I thought I'd pass along a framework they used in case it is helpful to you.

They laid out the possible reasons customers might buy a product such as theirs as "vitamin, aspirin, or vaccine." Is it something to help you do better (a vitamin), something to take away current pain (an aspirin), or something to avoid serious pain later (a vaccine)? In many ways, this mirrors the way we think about how compelling a start-up may be on the "nice to have - have to have" continuum, but with more specific descriptions.

While they didn't make the point explicitly, it is clear that most of the time people will pay more for aspirin than for vitamins, and that if the risk of future pain is high enough, may pay the most for vaccines. I must admit, our bias has always been to invest in companies more on the aspirin dimension, since corporate budgets seem to flow better to current pain, than potential pain or potential gain. However, in business segments where regulatory risk rears its head, a vaccine may be just as powerful to dislodge budget dollars.

Now, given how clever this team was, they managed to make the case that they were essentially all three, depending on the customer's need set. Nice work if you can get it! To co-opt an old beer commercial: "Less Filling! Tastes Great! Gives a Great Buzz!"

For most start-ups, your products probably hit just one of the dimensions. But, as long as you understand which one is your primary value, you can focus on how that flavor of budget dollars gets released, and how you get to stand at the head of the line when they do. Then, if you can articulate that to your friendly local VC, you'll have a much better chance of convincing us you are in the "have to have" category - regardless of vitamin, aspirin or vaccine.

How to Wow a Venture Capitalist in Seven Slides

We've seen all sorts of presentations from startups over the years. But none were as succinct, yet as effective as the one described below.

The company in question was one that had pitched us a few years prior. At the time, we loved the team, but thought they seemed to be remarkably unfocused. So, rather than have our money burned in a "bumping into trees" exercise, we passed. Now, they were back with laser focus, and it showed.

Before the presentation started, the CEO told us he only brought seven slides. And oh, by the way, they were all in 30 point type! My immediate reaction was, "This guy must have his stuff together!" Rather than subject us to death by PowerPoint, he was planning to engage us in a real discussion, where the knowledge of the management team was the foundation, not the slides. And the goal was interaction with potential investors, not to baffle us with BS.

They did not disappoint. Picture this:

• Slide 1: Company name, their thesis in three words, the opportunity in nine words  
• Slide 2: Their secret sauce - in about five bullet points and a total of 15 words  
• Slide 3: Why their customers see their value - in three bullet points and a total of 30 words  
• Slide 4: Their customer traction - in four bullet points and about 40 words  
• Slide 5: Customer traction graph (essentially proof points for slide 4)  
• Slide 6: Revenue forecast for last 2, next 8 quarters - with justification in less than 10 words  
• Slide 7: Profit model - in three bullet points and about 20 words

That was it. We talked for an hour, and had to end the session with all of us still fully engaged.

How different that is than the standard pitch where we see slide after wordy slide while the CEO or other members drone on, and by the end of the hour half the room has mentally checked out or is secretly trying to check their email.

Now, to be fair, besides a crisp presentation, this team also had a powerful one. Having bumped into trees as we expected them to, they had their eyes open. So, when a customer started pulling them in a direction they hadn't initially targeted, they were ready to engage, understand and generalize that opportunity to a broad market.

We still had work to do to find out more before we chose to invest, which we did. But as an initial meeting, it didn't get much better than this. In fact, right afterward I dropped a quick email to our lead partner on the deal that simply said, "Nike (company name)" - or in other words "Just Do It!"

Next time you think about pitching a potential investor, see if you can condense your pitch down to something under 10 slides, using something north of 24 point type. If you can, you'll stand out. If you can't - maybe you need more focus.

### ****

# Chapter 3

# Take the Money: Questioning Our Way to "Yes"

The next big thing we do after you make that compelling 7 slide presentation, but before you get to take our money, is "due diligence" on your deal. If we get to this point with you, you've already passed a huge hurdle. Your odds now have probably gone from 1 in 100 to 1 in 10.

The Power of 20 Open-ended Questions

Many of us of a certain age can remember the game "20 Questions" - used largely by our parents to pass the time on long car rides. One person thought of an object, and the others could ask up to 20 "yes or no" questions to guess what it was. You may recall the first question, not counted in the 20 - was "animal, vegetable or mineral?"

In figuring out what companies to invest in, venture capitalists are caught in their own game of 20 questions - usually built around the fundamental issue of, "If you build it, will they come?" It turns out a key to playing this game successfully is not the number of questions you ask but how many potential customers you ask, and the nature of the questions themselves. As mentioned in Chapter 1, for some reason known to marketing gurus and/or statisticians, 20 is a magic number. Once we've called and spoken with about 10-20 potential customers, especially if that list includes at least half not given to us by the prospective portfolio company, we've reached the point of diminishing returns. Whatever we are going to learn from that process, we now know.

I'm always amazed when we make these calls both how open people will be on the phone with a complete stranger, and how after all the calls are completed we often know more about the startup's prospective customers than they do. (Again - hint, make sure this does not happen to you. Make those 20 calls yourself BEFORE you go out to raise venture capital).

But making the calls is not enough. The way you ask the questions determines the value of the answers - and therefore your conclusions. Too often, we see people asking questions with the goal of getting a specific positive answer, rather than really getting inside their customer's head. They remind me of a local TV sports reporter who asks questions such as these of our NBA basketball players after a win. "You seemed to come out aggressive tonight. Was that your plan?" Just once, I'd like to see the player answer, "Yes, you moron, that's ALWAYS the plan. We never PLAN to come out passive, for heaven's sake!"

Yet, I've seen start-up executives make a similar error." Is this a product you think you might buy?" The answer is almost always, "Sure." But if you ask something like, "How would this product fit in your priorities for budget next year?" you might just learn whether it's a nice to have or have to have. And that can be the difference between a successful product launch and an unsuccessful one.

" **It's a Cluster #$%!"**

How's that for a direct quote (modified for family viewing) from a recent due diligence call I made?

This is one of the joys of doing due diligence on a new deal. It's very much in the Forrest Gump "box of chocolates" model - you never know what you're going to get. But sometimes, just sometimes, you get far more than you expect in just a few words. In this case, I was probing around with an executive on our Technology Advisory Group who was getting his first exposure to the company in question. It turns out his firm had created an in-house tool to handle some of the functionality the start-up was offering. And while they were getting by with their proprietary solution, his "candid" assessment of how he felt about the internal product that his team had to create, support and enhance told me all I needed to know about whether this was indeed a pain point - and a major account opportunity for the startup, whether we invested or not.

Granted, he and I knew each other before the call, so his propensity for direct talk was higher than it might be with a stranger. But that's why venture capitalists keep a broad stable of very connected, very savvy industry professionals on whatever they call their Advisory Group. That direct talk has both saved and made us millions over the years.

Not every call goes like that, of course. Usually, we start with potential or actual customers of the start-up, who have all been pre-screened to tell us exactly what the start-up wants us to hear. And they usually do. But even then, some carefully worded questions can lead to remarkable insight. On a different diligence quest recently, I called one of those pre-selected end users, and after some initial questions to understand her business and how she was using the product from the start-up, I started down a different path. It was clear she was an enthusiast. So, I asked her how many other people in her organization used or were planning to use the system. "No one," was the response. Probing some more uncovered a couple of real concerns that a core piece of the functionality, while attractive to this individual, was just not comfortable for most people to embrace. So, a key piece of the startup's differentiation just got vaporized as a value point.

Of course, one data point does not make a curve (unless you are the CEO!), so I made some other calls and discovered this issue was indeed a universal one. As such, this really cool company with the really slick product isn't going to get our money. Maybe down the road this "uncomfortable" part of the functionality will become comfortable to people. But, if there is one thing we've learned the hard way: **do not ever expect to drive, much less time, change in human behavior as a venture capital investor.**

This brings me to an interesting point about the startup in the first paragraph of this section: How do we as venture investors react to a negative due diligence call? While the Advisory Committee executive above was very positive about the need for the product, later that week I had a diligence call with a former CEO of ours, who essentially dismissed the entire premise for the startup. He didn't see the need, didn't see the company's connections to major industry players as important (and in one case a negative), and certainly would never spend his company's money on a product like that!

Again, here it's good to remember some basics. With very few exceptions, most startups plan their success around market share percentage numbers in the low double digits. So, it's absolutely OK to find prospective customers who either don't see the need, or have had that need met elsewhere. The overarching question is, "Why do they feel that way?" This gets to the core of good market segmentation and good sales account targeting.

If you can figure out, in advance, who is likely to buy, and who isn't, on some dimension that falls into customer business dynamics rather than the simplistic segmentations that keep consulting firms in business, you are onto something. Ideally, it's far better for the startup to have figured this out before we do. But in any event, it is crucial we jointly figure it out before throwing money at marketing and sales campaigns. So, even before we invest, we poke around with customers trying to ascertain what separates a hot one from a cold one. In this case, my call right after the recalcitrant CEO was to a former VP of his, now with a different company. He lit up like the proverbial Christmas tree. Since then, the startup has had a demo with him, and is planning a price/value conversation. Now, I also have a picture of why he's hot, and his former boss is not.

My comment to the CEO of the startup went something like this, "We are always uncomfortable until we get a negative diligence call. No product is perfect for everyone. Once I get some negatives to go with the positives, we can start to figure out exactly where you fit and where you don't. That's better for us to understand before you start spending our cash."

The absence of that is what we call "bumping into trees." And we again know from painful experience that bumping into trees burns cash at rates that bring tears to our eyes.

Here's an off-the-wall suggestion: The next time you approach a venture capitalist, have teed up not only a list of prospects or customers you think will say wonderful things about you and your products, but a couple you know are not likely to buy. If you can use that approach to demonstrate to us how well you understand your market, and show that the segment that is accessible is still very large and attractive, you'll be miles ahead of your competitors vying for our cash.

Your Business Plan: For Better and Worse

Extending the old maxim I raised earlier in the venture capital business: VC's invest in five things - the people, the people, the people, the product and the market. While perhaps a bit overstated, the point is still valid. Nothing is more attractive to a potential investor than a team of high-powered individuals, all experienced in both the disciplines they plan to lead and the market space they plan to attack.

As mentioned in the "Beauty Contest" section in Chapter 2, it is remarkable how little attention entrepreneurs pay to this issue when thinking about starting a company and going out to raise money. More often than not, the product concept is the driver while the team and the market are just necessary passengers. For example, we see far too many business plans that go something like this: a few pages on the market, more pages on the product and/or technology, and as little as a page on the team members. Sometimes, the team is listed only by name and title - with no backgrounds given! Does anyone expect VC's to get excited about a set of names on a page? Would you hire a new employee that way?

**Meet Our President**

Not quite as bad, but close, is the startup plan whose founders come from fields far from the space they intend to address. "Our company CEO, R. P. Featherweight, has successfully grown his family cardboard recycling business to over 50 employees in 10 years. He leads a star-studded team of former plumbing rack jobbers ready to command a leadership position in worldwide Internet commerce, growing to $100 million in sales in three years."

Don't laugh; we see business plans far closer to this than you might believe. Now this is not to say that people cannot get brilliant product ideas outside their area of direct work experience. However, if they do, they had better be teaming up with folks directly in that marketplace to make sure they really understand the issues. Just as important, the speed of business today virtually demands a top rated contact database to be successful. If you have to build all of your key industry contacts, relationships and partnerships from scratch, you will probably be caught and passed by a later market entrant with a better set of connections. Hooking up with the right venture capitalists (and their contact lists) can help, but VC's help those best who can also help themselves.

**Great Job, No Pay**

So, how do you go about getting the team before you have the money? How do you get great, experienced people to leave their comfortable jobs and step out on a limb with you with no visible means of support? Hmmmm... what an interesting test of leadership! No one said this was easy. As a founder, one of your key jobs is to have a vision so compelling that intelligent people will make what appears to be an irrational decision to follow you. Clearly, not all individuals are in a personal situation where they can expose themselves to that much financial risk, but some are. Others may be willing to commit on the condition of financing and be willing (under confidentiality) to let you use their names with prospective investors.

Even then, you may end up short a key executive or two at the start. That's OK! It is far better to have a hole on the organization chart, with a clear description of the experience and skills you are looking for to fill that position, than to fill the hole with a warm body with weak credentials. The wrong person in a key position sends out more negative messages about the CEO's ability than any other red flag. Again, VC's are more than happy to help find and recruit folks to flesh out the team. We are far less excited about having to first convince you it was a mistake hiring "good old Charlie" to fill the VP Marketing role, deal with removing Charlie from that position, and then start a search for a replacement.

**Start With the Team - The Money Will Come**

Examples tell the story: Two of the most successful startups in the Portland, Oregon area were Mentor Graphics and Sequent Computer. While the companies, their cultures, their products and markets were very different, they shared one common factor. Both came into being with complete teams of high-powered executives and individual contributors, all experienced in their areas. Both raised venture capital easily. Both became successful public companies - though not always via the path laid out in their initial business plans. Both teams were capable enough to take what they knew, learn what they didn't, and adjust accordingly. In the end, their venture investors were well rewarded, as were the founders. Not every startup can be a Mentor or a Sequent. But if you want venture capital, they provide good case studies. Build your team with as much care and as much attention to quality as you plan to build your products. It will make raising venture capital much easier, and give you a far better shot at creating a substantial enterprise.

Maybe after all this time talking with potential customers and assessing your team, we'll get around to looking more seriously at your financial projections. It seems to surprise many entrepreneurs that the financial analysis is a laggard in our process, and often not all that important in the final decision.

Numbers, Numbers, who's got the numbers?

A fundamental part of any startup's business plan is the financial section, which details the economics of the enterprise. We often see plans where at least half the pages are taken up by spread sheets showing everything from top line revenue growth to how much will be spent on office supplies in the year five. It is remarkable how much more emphasis entrepreneurs place on those numbers than venture capitalists do. The reason for that is simple. Venture capitalists know from years of experience that there are a couple of universal truths in business plan financials.

**U R Wrong**

First and foremost, your numbers are wrong. All we do not know is how wrong they are, and in which direction (although we can guess!). We also know they are not conservative. Most new businesses, even those backed by sophisticated venture capitalists, fail. Even those that succeed usually take twice as much capital and twice as long as their founders and financial backers ever imagined. Therefore, to say a business can go from zero revenues to over $50 million in five years or less, and still be projecting itself conservatively is folly. It is also an insult to the intelligence of the investor audience.

**Action 1:** do a search and replace in your business plan for the word conservative! Replace it with the word "realistic." You are still wrong, just not as much.

**Bottoms Up**

Secondly, we know that most smart entrepreneurs are getting counsel from experienced accountants who give the following advice. They tell the startup that to get venture money, they need to show $50 million in sales by year five, and need to demonstrate a good handle on the financial needs of the business. While both are largely true, the way they get played out can backfire. Many business plans seem to work backwards from the $50 million number rather than building up to it.

We see lots of examples of CEOs who can talk about that top line dollar number. Too many do not have any clue on how many product units have to be sold to reach that level, or how many customer accounts that translates into. They do not know what kind of sales resources will be needed and what the average sales per salesperson will be required. There is usually no thinking on what the actual sales cycle is and why. In fact, the entire plan is "top down" rather than "bottoms up." No business is ever built top down. It is built out in the marketplace belly to belly to customers while hacking away at competitors.

**Action 2:** Go back over your numbers and build them from the bottom up, so they make sense. More importantly, look at that exercise as a way for you to learn more about what areas are key to your business success. If the numbers do not add up to a firm attractive to venture capital backers, better to find out before you even bother with VCs. Go pursue more likely sources such as corporate partners, angels, etc.

**Step Back**

There are a couple of real dangers with spreadsheets. First, they let you crunch out detail where detail makes little sense. Let's face it, you really have no idea what your budget for office supplies should be five years from now, nor does it matter. But a nice formula will provide you a number. Second, spreadsheets have this look of authority to them that makes people believe what is in them must be true. We see many startup CEOs who get passionate about defending their financials rather than defending the underlying tenets of the business. Finally, as the formulas you put in place in the early years play out in later years, they often become silly. You would be amazed how many startups think they will really have 40% net profit margins in year five. Unless the product they are selling is an illegal substance, those numbers are very unlikely.

**Action 3:** Your financials should be monthly for year one, quarterly for year two, and annually thereafter. Your income statement should pass this simple test: The key ratios a few years out should be no better than those of other companies in the public market in your industry.

**Discounted Cash Flaw**

The final indignity in business plans is when the entrepreneur takes the projected earnings over the life of the plan, calculates a discounted cash flow (at some arbitrary discount rate), and then proudly proclaims that result as the valuation of the company. This methodology has a number of flaws. First, since we already know the numbers are wrong, and almost certainly aggressive, there is little basis to use them. Second, at what discount rate should we evaluate a business with a better than 50% chance of going bankrupt? Try discounting the numbers at 100% or more. Those valuation numbers will shrink rather quickly! Finally, the ultimate value of the company has nothing to do with manufactured financial projections, and everything to do with supply and demand in the venture markets. Your company's valuation will be determined by what VCs are willing to pay - and whether more than one wants to play!

**Action 4:** Put off valuation discussions until the fish is at least partially hooked. VCs spook easily, and have lots of other bait they can nibble. Keep the financial portion of your business plan in perspective. Your chances of getting funding will improve.

Five Percent of a Huge Market Stinks!

One of the most common mistakes we see in business plans run something like this:

"Our startup, Hi-tech Corp., has developed a concept for a new product that will revolutionize the Internet market. You may know that over 500 million people are already connected to the Internet market, according to DataGrind Research. We only need to get 5% market share to reach $100 million in annual revenues."

There is no faster way to turn off a professional venture capital firm than with a lead-in such as this. But wait, didn't I say earlier that venture firms are only looking for companies which serve large growing markets that will allow the company to scale to just this size? What's the problem? Actually there are at least three problems.

First, there is often no such thing as the Internet market. It is not a market, but a technology infrastructure in which many markets exist. The same can be said of the wireless market or the medical device market or the biotech market. All of these "markets" are far too large and amorphous to have any meaning to a technology startup. If you do not understand your potential market, customers and competitors better than this, no venture capitalist will want to let you take their money and fritter it away finding out.

This is analogous to the old line, "All we need is to have 1% of the people in China buy our product." China is not a market, it is a country. A market is a collection of people or companies with a specific set of wants and needs that may be met by a specific set of products and/or services. Now, if you have a product which fills a set of needs that everyone in China has, that everyone in China knows they have, and everyone in China has the money to buy - then China is a market.

Second, venture capitalists hate secondary market research. Most of these reports are far too sweeping to identify real markets, are far too optimistic in their growth projections (at least in the short term) and are far too expensive for anyone to actually buy! If a startup is relying on those numbers to prove its point, then we have to ask, "Do they really understand the business they are going after?" In addition, although there may be times you have evidence to the contrary; venture capitalists are not stupid (just misguided!).You should assume that at a minimum we do read most business journals and keep up on fundamental technology trends. The fact that the Internet is a major change agent is well known. Do not insult us with touting those huge but meaningless numbers. A much more persuasive argument might go something like this:

"Our startup, Hi-tech Corp., has developed innovative new software which solves a critical problem facing 2 million of the 500 million people who use the web on a daily basis."

You have already told us a few very important things with this statement. First, you have clearly identified a market within the Internet space that has a common set of needs (described in more detail in your plan). In addition, that market is a "heavy user" market and is therefore likely to feel more pain and be more ready to buy than casual users might be. It sounds as if you actually do have clear perspective on what you are setting out to do. If it is really 2 million users, it is still plenty large enough to get us to keep reading!

Now, we come to the third and most basic problem. Rarely, if ever, is five percent share of any market a good sustainable profitable position. Give me 20%-30% of a smaller market any day. You may have read that former CEO of General Electric, Jack Welch, had a fundamental rule for that company. If they could not be number 1 or number 2 in a market, they would get out. Jack was no dumb bunny! You can look at market after market and industry after industry, with the same results. The number one player in a market usually makes about one-half to two-thirds of the total profits in that market. The number two player often sees about half that. Numbers three on down are either marginally profitable or unprofitable. Unless a market is very fragmented, it usually takes 20% share or greater to be number one. Venture capitalists want to invest in firms that have the power to be the leader in their space, knowing that they can fall to number two and still be OK.

The real issue here is simple. Understand your product and how it maps to customer needs and competitors well enough to articulate how you are going to carve out a leading position in a rapidly growing market. Then show how you plan to sustain that position. You will almost certainly find that the "market" you define is smaller than the pundits describe, but is far more real and reachable. In addition, you will have laid a foundation to growing a profitable, focused enterprise.

What does "Audi partem alteram" mean to startups?

Yes, I did take two years of Latin. But no, I had no idea what this phrase meant until I ran into it in an in-flight magazine article. It means "Hear the other side" and is attributed to St. Augustine.

Where it struck home to me is how often entrepreneurs are tone deaf to hearing about the holes in their strategy or plans, and yet how as venture capitalists we are paid to poke those holes not only before we invest, but afterward as Board members. Therein lies all the makings of a communications gap, when it should be opportunity for both sides to hear each other and learn.

By definition, entrepreneurs have to be driven to believe in their vision, beyond the point of logic. Because logic says that by far the most probable outcome is you will fail, and fail badly. That's just a reflection of how hard it is to start and grow a successful enterprise. Every start-up has to essentially say to itself (or ignoring reality not even think about) that while "thousands of other equally bright, equally driven and passionate people have traveled this road before and died along the way, that won't happen to me." So it is with all explorers, and start-up founders are the explorers of the business world.

For venture capitalists, the reverse is true. We know that after sorting through literally hundreds of business plans and smart teams, and doing countless hours of diligence on a new deal, the default answer on yours is we should pass - because history says that if we invest at least two out of three times we are either somewhat wrong, or completely, totally, embarrassingly wrong. So, as part of our diligence, we are looking for all the reasons the new enterprise might fail, and then trying to see if the risk of failure is maybe just a little less than normal and the rewards if successful are maybe more than just a little better than normal. This, in the face of data that tells us no matter what we think the most likely outcome is to die along the road, too. We are the explorers of the investing world.

So, what can we learn from each other? How do we audi partem alteram?

First, start-ups need to recognize that we VCs have the advantage of pattern recognition. We have seen many thousands of potential deals, have done (at least in our case) well over a hundred, and so have our pattern recognition engines loaded with case studies that form our collective judgment. We are far from always right (see the 2 out of 3 misses above), but we are way better than average versus about 1-2% success rate for all start-ups. Therefore, when we hit you with questions and concerns, accept them as perhaps the best free consulting you'll ever get. We are asking you questions you need to be asking yourself. If you can hear our side, go back and then return with good answers to most of our "objections," you will head down the perilous road with a far higher chance to survive - whether you take our money or not.

But VCs need to hear the other side, too. It is very easy in our line of work to end up jaundiced. We see failure so often we get numb to it. Sometimes, we forget the power of a high-performance team, operating with intensity, and how much a small set of people can accomplish when driven by a shared goal where they must succeed to survive. Sometimes, we can temporarily forget that our investors have paid us to suck it up and take those leaps of faith along with the entrepreneur. It's more than OK for you to not just tell the story, but share your passion for it. In fact, one of the best ways to get a polite "no" from a VC is to show up with a polished PowerPoint, but an uninspired delivery. Make sure we hear not only what you plan to do, but why and why it matters to you, personally.

Hearing the other side comes from a fundamental belief that none of us has all the answers. And that hearing the other side, as annoying as it may be at times, is the best vaccine against preventable mistakes. It is why smart executives know to reward those who come to them with bad news, rather than shooting the messenger. It is why smart entrepreneurs and VCs know that often the best gift they can get from each other is a well-reasoned argument.

Finally, I'll leave you with my favorite "Latin" expression. After all the deep analysis is said and done, it describes the keys to success in start-up business.

"Veritas per intestinem intuitionem." (Truth through gut feel) For entrepreneurs, gut feel is often all you have to guide you early on.

Is it You or Your Location?

What if after all our due diligence, we come back with a "No?" Do you look around, blame the "lack of venture capital" in your particular geography, or do you look in the mirror?

Recently, I participated in a panel discussion that covered topics around the current state of the venture capital industry and startups in general. At the end of the session, the moderator asked the quintessential question of the audience, "How many of you think there isn't enough startup capital in this town?" He followed with, "How many of you think there aren't enough quality startups in this town?"

Not surprisingly, the overwhelming majority of hands went up on the first question. Just a few brave souls, including mine, raised their hands on the second. As you might expect, there was general muttering about the latter, "Well, of course the VC would say that!"

So, where is the truth in all this? Certainly, conventional wisdom in almost any entrepreneurial setting is there isn't enough capital, or willing capital, or risk capital, or whatever. This is presumed true because "MY startup, which certainly deserves venture capital, didn't get any." On the flip side, the VCs in the room are saying to themselves, "Hey, I live here and I'd much rather drive than fly to board meetings, and we have lots of dry powder for new deals. If only these guys and gals understood how high the bar is to get VC dollars."

There is a more data-driven take on the answer. We know that the explosion of dollars into the venture capital asset class in the late 1990s led to very poor returns for most venture funds for more than a decade thereafter. So, at a minimum we can state that the capital added into the system did not find good places to go forth and multiply. Perhaps VCs are stupid or lazy (how's that for an opening) but more likely there just were not enough high-quality, differentiable startups to take those dollars and make them grow.

"But," you say, "that might be true for the general economy, but in MY town it's different - we just don't get enough venture capital to meet the demand."

To counter this, I was made aware of some fascinating research led by Professor Rob Wiltbank of Willamette University that sheds light on that assertion. With respect to his intellectual property, all I will do is summarize the findings. His team looked at the results of venture investing by geography all across the USA. They found that returns were not impacted by where the money was put to work. Let me repeat that a different way. A startup funded in Silicon Valley, or Seattle, or Montana, or Boston, or Texas, or East Boondocks was equally likely to provide attractive returns. Sure, there may be 100 times more deals done on Silicon Valley, but the odds of a home run are the same!

**What this says is that money will find the really good deals, regardless of geography.** In addition, it says that no geographical area is underfunded, because if it was, those areas would see better than average returns since there would be a supply/demand imbalance versus other parts of the country.

Now, there are absolutely other reasons why certain regions might want to get more venture dollars flowing (job creation, etc.). But, for those of us running funds, operating as fiduciaries, the message is clear: from a supply and demand perspective by geography the system is in balance. So, if you get multiple "No's" from VC's, look in the mirror.

Go back and read the beginning of this chapter and try to figure out where you came up short in our eyes, fix it, and come back at us again.

Incoming Term Sheet!

On the other hand, what if you've had the success you hoped for and we come at you with our most prized possession, other than cash – an official term sheet? Ah, the games have begun, but they are far from over. Only rarely do we see a term sheet that does not ultimately result in an investment. But it does happen, so be prepared.

This is probably a good place to introduce some important terms of art, as we are about to start discussing thorny issues like valuation.

**Pre-money value:** The value of your company BEFORE new cash is invested. For example, if you have two million shares of stock outstanding, and I am ready to offer to invest in you at $1 per share, you have a $2 million pre-money value. (2 million shares times $1 per share)

**Post-money value:** The value of your company AFTER the new cash has been invested. In the example above, if I now invest $1 million at $1/share, it buys 1 million new shares. You now have three million shares outstanding, at a value of $1/share, for a post money value of $3 million.

Simply put: **post-money = pre-money plus new cash.**

**Preferred stock:** What VCs normally buy, not Common stock. In most cases the "preference" means the VCs will get their money out in some fashion before the Common gets to play. There may be other types of preferences, too (dividends, etc.). But they are usually less important.

**Preference stack:** The amount of the preference. For example a "2x" preference means the investors get 2 times their money before the Common gets any. But often this preference is capped or vaporizes. So, for example if this was a good deal and the investors were going to make more than 3x their money, then the preference is waived and everyone gets their share based on an implied conversion to Common stock. In the 2x scenario, the preference stack in the Pre-money example above would be $2 million (2 times the $1 million invested).

**Participating preferred:** A special form of preference where the VCs first get their preference no matter what (no cap or vaporizing), and then additional proceeds are split on the basis of an implied conversion to Common and the resulting ownership percentages for all shareholders.

If this is not perfectly clear, "take a number"....and call the number of your local startup attorney to have them explain it in gory detail.

Dilution and Ownership

Did you hear about the guy who died from dilution?

One of the toughest issues we deal with in early stage investing is overcoming the founding team's fear of dilution. That fear is perfectly natural, normal, and completely misguided. It turns out most of the pushing and shoving on this issue, particularly at the first round Series A stage, gets lost in reality as the company grows and requires additional rounds of capital. Let's consider the following case:

Most substantial early-stage venture capital firms require 20%-30% of a company to make their economics work. Most also invest in syndicates with at least one other firm. So, no matter what other valuation and discussions go on, after the Series A, the VCs will own 40%-60% of the company. Of course, the business plan usually says this is all the money that will ever be needed. But, reality says that is nonsense. The overwhelming majority of firms need two or more likely three rounds to reach cash flow positive.

So, if the VCs pony up the money for round 2, regardless of the progress made, one should expect that financing may consume half the previous one, or about 20%-30% of the company. Round 3, again even with nice progress will require half of that or 10%-15%. So, do the math. At the low end: 40% + 20% +10% = 70% of the company to the investors. The management team owns 30% in the best case. At the other extreme, the investors own 105% (60+30+15), which is clearly not possible.

That brings in the reality of a reasonable floor. We tell all young management teams that the good news is we may be greedy, but we are not crazy. If they don't have enough incentive to put in the 100 hour weeks, we don't get paid. In our judgment, that floor is around 20% of the company. If financing events take them below that, we dilute ourselves to refresh management's incentive. So, in the end, all the fuss and bother about valuation and dilution is about a maximum possible spread between a 20% floor and a 30% ceiling on management ownership at the end of the fund raising process.

The same can hold true on preference stacks. If after a number of rounds of financing those grow too large to leave management any hope of a payday, investors will usually either reset them to a lower level, or put a "carve out" in place to ensure management is properly motivated.

This is why we say, over and over again, **"No company ever died from dilution. The ONLY thing companies die from is lack of cash. Optimize for cash – not dilution."** Sometimes the entrepreneurs hear us, sometimes they do not.

**How Much Is Too Much?**

When was the last time you met an entrepreneur who looked back on his or her business efforts and said, "I wish I'd raised less money?" Better yet, have you ever heard of a company dying from being overcapitalized? But we still see start-up management teams proposing to skinny their way to greatness, raising just enough cash to make it if everything goes according to plan - in order to minimize dilution. This is patently unwise. In any business, but particularly a fragile startup, cash is like altitude in an airplane. If the engines start to sputter, you can never have too much. In a startup, you can be sure the engines will sputter, and sometimes they might even quit running for a while as you struggle with product, market, personnel, or other problems.

**Double Your Money**

One of the best pieces of advice we have seen for CEOs is this: Do all the spreadsheets you want until you think you have a rational model for the business. Look at the amount of capital those calculations call for, and then double it! From personal experience, I can say that this is a minimum approach.

Years ago, I was involved in a very successful start-up at Mentor Graphics. We put lots of attention on our financials that showed we needed only $600,000 to grow the company to $50 million in sales. To be "safe," we raised $1 million in the first and only (planned) venture round. Two more venture rounds and $9 million later, we went public. We were off by more than ten times in our projected need for cash! If the VC money had not been there in a timely way, we would have gone bankrupt - even as we grew like topsy.

Today, we still see business plan after business plan with the same fundamental flaws. Planners assume that one initial financing will be all that is needed. They assume that all product shipment dates, pricing and margin assumptions, and inventory issues are certain. They assume that the business, in fact, can be planned.

Here's a key news flash: **No start-up can plan its business.**

There are just way too many unknowns to have any degree of certainty as to what will happen next month, much less next year. What you can plan on is that things will almost certainly not go as you expected. A few will go better, most will go worse - or at least slower. There will probably be a few things you didn't think about at all that will rise up and surprise you. The only way to buffer yourself and your enterprise against those unknowns is to have enough altitude under your wings to coast for a while until you figure out where you are and what you can do about it. Again, that altitude means more cash, not less.

**Dilutions of Grandeur**

However, the issue of dilution still rears its head. You don't want to give up more of the company than necessary in obtaining funding. First, remember that 100 percent of nothing is always nothing. If you fail because you were undercapitalized, that ownership percentage is meaningless. Second, remember that a key risk to your business is financing risk. Even if you get initial funding, there is no guaranty that a second round will be available, or available under reasonable terms, or available from acceptable investors, even if you are making nice progress with your business. In our experience, the second round of venture capital is often the toughest to land. But, you still don't want to give up the whole company by raising too much in round one.

So here's an approach - look for "value inflection points" in the growth of your company. For example: business plan written, team in place, product prototype available, beta sites installed, first revenue shipments, customers ready to serve as references, strategic partnerships in place, profitability, etc.

**Raise enough money in every financing to get you not just to the next valuation up-tick, but comfortably six months past it** \- allowing for inevitable slippage. Maximize your chances for success by raising far more money than you think you need at each step. Minimize dilution by handling your financing needs in a couple of rounds, each hopefully at a higher price with the value inflection points well proven.

**Beware of VCs Bearing Gifts**

The only counter to this argument is driven by the fact that today there are many venture capital firms with so much money in their pockets that they are out pushing more money at start-ups than those companies might actually need. Some early stage VCs are now saying their minimum investment is $10 million! Not many start-ups need that much in the initial going. Aim yourself at firms that can push your thinking on how much money you should raise, but not on those that will push their need to invest onto your capital structure. A balance between your real needs for cash and your desire for minimum dilution is often the best outcome.

****

# Chapter 4

# Take the Money: To Know Us is to Love Us

How to Buy a Venture Capitalist

All along, perhaps you have mouthed the words "We are looking for more than just money." Now you have the chance to prove it! Here is a guideline and checklist on how to buy a top-notch venture capitalist. Up until now, maybe we were asking all the questions. Now, it's your turn. There are three areas you should probe in depth.

**Connections:**

Most entrepreneurs relate to this one very quickly. They are eager to know what potential customers and strategic partners venture firms have lurking in their databases of contacts that can help launch the business. What is often glossed over is that there are many other areas where connections can be equally important as the business grows. Your investor's connections need to be helpful beyond the first Board meeting.

**Experience:**

A venture capitalist should bring experience in both starting and growing companies from your size to well past the IPO point. This encompasses a host of issues, from follow-on financing to strategic thinking, from changing key management to hunkering down when things do not go as well as planned, from corporate partnering to liquidity paths such as public offering or acquisition. Do not settle for anyone who is going to run into some of these issues for the first time. New folks to the venture business are great. Just let them learn on someone else's deal!

**Staying Power:**

Your venture investors need to be there when you need them, both with dollars and support. Therefore, staying power measures both the ability of a venture fund to handle follow-on financing (how deep are their pockets?) and their willingness to hang in there if times get tough (how long are their arms?). Beware of anyone who has not been through lots of bumps in the road with a number of startups. You do not want to learn how they will react to bad times when it is your company's future on the line.

For each section below, ask the venture capitalist to go beyond their response and provide a list of people to call to get a direct perspective.

**The Connections Checklist:**

1. Name the potential customers and/or strategic partners you can put us in touch with, and how you know them. How will you go about expanding that list? Do you have an Advisory Group and/or a side fund of key industry people or other means of expanding your direct knowledge in our marketplace? How does it work?

2. Who are some of the other venture capital firms or corporate partners you have invested with over the years that might be good later-stage investors in our firm? In what companies did you co-invest with them?

3. Who are some of the investment bankers you have used for initial public offerings or for mergers and acquisitions? On which deals did they work? Which analysts in our industry do you think are the best and why?

4. Give us examples of how you have used your contacts to locate and attract key employees for your startups.

**The Experience Checklist:**

5. How many Boards have you served on as a venture investor? Of those, which ones have gone public or been acquired at attractive prices to both you and the founders?

6. Tell us about some deals in which the follow-on rounds were difficult. (Usually, this is not a short list!) What did you do to help?

7. Tell us about some projects in which you decided not to follow-on earlier rounds of funding. Why did you reach that conclusion? What happened to the company?

8. Tell us about some projects that had serious management problems. How did you handle it? What about serious strategic problems? How did you help?

9. Tell us about some portfolio companies you helped get acquired. How did you help?

**The Staying Power Checklist:**

10. How much money do you have in your current fund? How much is left for follow-on investments? What is the maximum you would commit to any one project?

11. Tell us about your history in syndicating deals to other VC firms. How do you go about this? How much money do the others put in? Who are your favorite co-investors? Why?

12. Tell us about some times when you had to bridge finance a startup between its first and second equity rounds. Why did it happen? What did you do? How long did you bridge and how much money did you commit before the next round happened?

13. What is the longest time you have been invested in one company? What are the most rounds and dollars you have ever had to invest in one company?

14. What is your personal time horizon in the venture capital business? Do you expect to be doing this in five years? In ten years? Why? How many deals are you responsible for today? Is this the amount you like or is it high or low versus your norm?

Your choice of a venture capital investor may be the most important, least reversible decision you will make in the early days of your startup. Never let it be said that your investors knew more about you than you did about them. Venture capital is very expensive money. However, if you are a savvy shopper, you can get great value for your money.

Why Syndicates Matter

Periodically, our partnership takes a few days off by ourselves to contemplate what we are doing well and, more importantly, what we need to improve. We recently returned from such a gathering with profound new respect for some rather ancient wisdom: syndicates matter.

Looking back over almost 30 years of successes and failures of our venture-capital backed startups, we noticed a recurring pattern. While a strong syndicate of like-minded, like-sized venture investors did not ensure success, the absence of such a group was a leading indicator of failure. We were hard pressed to remember more than one or two occasions when going it alone, or pressing ahead with a syndicate of weaker players, yielded major positive results.

Sadly, this pattern is not news. When I joined the venture business, it was already conventional wisdom. My partners, with over a decade in harness by then, had learned those lessons through the boom and bust of the prior ten years. But with the VC funding boom, and the rush to get into increasingly hot deals, that wisdom was lost—not just by OVP, but by the industry as a whole. Many deals were done based on how much cash a single venture firm wanted to put to work, rather than how much the startup needed or what kind of help other than money would have benefited the new company.

So ours is a cautionary tale, not only for those of us acting as fiduciaries for other people's money, but also for those who would take that money and build a company. As an entrepreneur, you and only you get to decide whose money you take. Raising venture capital is hard. It can be tempting, after running the gauntlet and emerging at the other end with a term sheet, to keep trying to negotiate some of the terms, yet simply accept the set of players as a given. If you have done your homework on the VCs, as they will have on you, you will already know who you want on your board when things go bump in the night. (Trust me, they will!)

So instead of taking the first term sheet you get, with a pre-programmed syndicate, you might consider the Chinese menu approach. If you have a number of quality venture firms at your door, consider taking one from column A and one from column B. Chemistry matters, so those firms may or may not agree to team up, but it does not hurt to ask.

Of course, an alternative approach is the standard ploy of trying to play one firm or syndicate against another to get the best terms. This overlooks an important point: the best terms are not merely found in valuation and preferences; rather they are offered by the investing group that gives you the best chance of success. An old saying goes, "If you make the pie big enough, you can afford to leave a little on the knife." Many successful ventures survived near-death experiences because of great syndicates. The investors offered their company real added value, and had the courage and the capital to hang in there through a period of difficulty.

An OVP Venture Partners example was a firm in Seattle, which we backed along with a top VC from Silicon Valley. It came within weeks of going under, but with a little more cash and a lot of hard work, it recovered to deliver 20 times our investment. In contrast, many failed ventures never got the chance to find out if another few weeks or months might have enabled them to survive and ultimately prosper. Their investors ran out of good advice and dry powder at an inconvenient time, or got a sudden case of "deep pockets but short arms disease."

As venture capitalists, we've seen this movie from the other side of the screen. We've been left holding far too many bags after others have hit their investing limit or have simply cut and run. So, there are VC firms we trust and others that we shy away from. There are partners at fine firms whom we know well and whose behavior we can forecast, and there are a few we know to avoid. And we've discovered that even among firms we like and partners we greatly respect, an added risk arises if there is any significant difference in the amount of money that two VC partners want to invest. It doesn't hurt to be slightly smaller than your syndicate partner, but it can get very lonely if your investment is much larger.

Whether you are an entrepreneur, a service provider to such a firm, or a venture investor yourself, syndicates matter. In good times, strong syndicates offer respect, trust, and a positive collaboration of styles and resources. In tough times, you know how they will react and you know that your objectives are aligned. Don't settle for less than a strong syndicate. Otherwise you'll be selling your company, and your chances for success, short.

Yes Is Best!

You got an official "Yes!" And now we've agreed on terms, too. A strong syndicate is in place. Congratulations! You have just beaten the odds. But before you actually take our money, you should know a little bit more about how we work beyond the VC checklist above, and what you can expect day to day and year to year. That way, you'll have a better idea where we might be able to help you, and perhaps similar ideas about where we cannot.

What Do VCs Do All Day?

Recently, I was a guest lecturer at an entrepreneurship class at one of our major universities. I covered the usual topics (the four risks of a startup and how VCs evaluate against those criteria as in Chapter 1), etc.

But at the end of class, a student came up to me and asked an unusual question. He said, "So, now I know more about how you decide on which startups to back. But, more generally, what do you do? What does a typical day or week look like?"

It struck me that he probably isn't the only person with that question, as VC-land is a foggy land to many folks. In addition, I think those that love to bash VCs (OK, sometimes we deserve it) or minimize the value of taking VC money might curb their enthusiasm if they knew what we actually did all day. Or maybe not, but I'll let you make the call. Here is a running log of the first couple days of a recent week for me:

**Monday:**

We start every Monday with a partners meeting. Over the course of three to five hours we go through our existing portfolio of companies, review new potential deals, and take care of other internal business. What might be interesting to you is exactly what we discuss during that period.

We review the existing portfolio in reverse order of "time to cash hitting zero," starting with those in the red zone (weeks left to six months), then the yellow zone (6-12 months) and then the green zone (more than a year). For each one, but particularly those approaching the cash-out wall at high speed, the lead partner/board member talks about what the issues are at the company where we might have an impact. Help with finding new outside investors? Introduction to potential key partners and/or customers? Key personnel hires? If no new investor shows up, are we ready to write a check by ourselves? Given the level of the discussion, and the fact that we have about 30 companies to discuss, this usually takes a few hours.

This particular week, our partners meeting happened to fall directly after our annual Technology Summit, the gathering of our OVP Technology Advisory Group (OTAG), so a number of times we agreed that an introduction to one of those folks would be useful to some portfolio company. In addition, we reviewed the folks who comprise our OTAG and decided we were delighted with the IT and Biotech folks, but needed to beef up the Clean Tech representation a bit. As the clean tech lead for the partnership, I came away with the action item to go make that happen.

Then, we spent an hour or so looking over the list of startups on our "potential deal" log, with discussions about which ones we could dispense with easily, which ones we wanted to follow closely, and which few we wanted to invite in to present in the near term.

After lunch, we had a presentation from a potential new investment where I would be the lead partner. So I was listening to them, but as importantly listening to the questions my partners raised, as a guide to where I should focus my attention assuming I got the green light to proceed with due diligence. (I did, so the work began....). Here endeth the partners meeting.

Now it's 2PM, and it was onto a call for one portfolio company where I am the Board member shepherding the process of hiring a CEO (with the founder's full support) - and we spent some time with the executive search firm trying to figure out how to land the big fish we think we've hooked.

Now about 3PM, I've moved into a temporary unofficial role as "VP of Dialing for Dollars" for one of my companies as they are about to look for an outside VC for their Series B round. I spent about an hour roughing out my suggestions for the pitch deck, and sent them off to the CEO of the company.

The rest of the day was mostly catching up on calls and emails - with one notable one where a portfolio company (I am the backup to my partner Mark Ashida) has just landed a new VP of Sales after a long search. I sent off a sassy email to the CEO congratulating her, but also asking if this meant the forecast for the year was going up. She responded in kind, with words not appropriate for this book. Those who think we don't have some fun amongst the serious tasks at hand are misguided.

**Tuesday:**

The day started with an email from another portfolio CEO with a draft business update for a potential strategic investor that I recently introduced to the company. Said CEO wanted my input on the draft, particularly because I know the potential new investor and have at least some clues about that investor's "care-abouts." The goal is to get a relatively non-dilutive chunk of cash to fund R&D on some exciting areas we just can't support out of operating cash flow right now. The draft got some editing from me, and was on its way back to the CEO. We set up a meeting for early on Thursday to review it, and also deal with some major people issues on his plate.

It wasn't the first time I've had a CEO say as he did very directly, "It's lonely at the top, and I appreciate you being willing to be a sounding board on this."

At 10AM, I was visited by someone representing a large university. They are trying to figure out how to align their curriculum to better serve the community by preparing graduates to create or join start-up companies. We had an active discussion about what we think they can do better, and what models there are for doing this well. I mentioned that the University of Washington does a very nice job, in our estimation, and encouraged them to tap that group.

Then it was off to lunch with an entrepreneur whom we had turned down six months ago. He had reached back out to us to indicate he had made significant progress along some dimensions that troubled us back then - and wanted to see if we would be open a fresh look. Our answer was, "Of course!" He indeed has made good progress, and so he's back on the deal log list. So, all you entrepreneurs who hear "No" from a VC, do not despair. We do react to new data. In addition, it became clear that this startup, and the one I'm just starting diligence on, have some good reasons to work together. So, I engineered a mutual introduction and got out of the way.

Then, back to the office to meet with two investment bankers from one of the largest financial services firms in the US. They wanted to learn more about our portfolio, with this particular team focused on software and digital media. While they were pumping me for info, I returned the favor and probed on their quarterly session at which they expose relevant startups to their IT department, with a budget that ends in $B. We're now on that list to tee up the companies we have, when they are ready. In addition, this firm has an annual beauty show with a private company track that could be ideal for late venture/mezzanine rounds for our firms. We'll now get the chance to propose a select company or two.

During a quick review of the email that had piled up I found one portfolio company who had been trying to work out a deal with another one, but had gotten at loggerheads with that other firm. I tried an ego-diffusing "let's all play nicely" request to the CEO where I'm on the Board.

Finally, I was part of an ad hoc portfolio company Board call late in the day where the CEO asked us to wrestle with the issue of a customer who was very late in payment. We had to decide how hard to push, and whether to actually cut off that customer from product delivery and maybe lose them forever. Trying to do this firmly but carefully, and maybe retain the relationship, demanded all our collective experience. With the passage of time I can say we got it at least half right, as in the portfolio company has now collected over 50% of what was owed, and the relationship is on-going.

So - that's two days in the life of a VC. They are typical in the degree of variability and the number of events that are ad hoc, time sensitive, and yet fairly business critical. Some deal with the immediate term, some long term. Some are portfolio specific, some are community service, and some are OVP internal. You can see all the business risks and challenges on display.

For those who aspire (if that is the right term) to be a VC someday, decide if this kind of life sounds fun. It can be certainly stressful. For those who think all VCs bring to the table is money, I'd offer this up as counter evidence. Whether my counsel across these various scenarios was useful is another topic, of course. But there is no question that as an active VC, we are called early and often to be supportive and to contribute well beyond the dollars invested.

Even after the due diligence is done, the deal is struck and you've taken our money and started to run, it's not over! The fun and fund raising never really stops. So, before the next section where we describe some of the best and worst practices of those who have run with our money, here are a few more thoughts.

What is a CEO-a-thon?

Portfolio companies of OVP know, and perhaps dread, this annual event. However, we look forward to it eagerly. It comprises three days in the first quarter every year where we have every CEO of ours stand up and deliver a one hour summary of where they've been, where they are going, and why we should still feel great about our decision to invest. Every hour, on the hour, another one steps up to the podium. On one hand, there is nothing quite as exhilarating as seeing all these bright, motivated leaders wax passionately about their companies. On the other, there may be no more high stakes event for these folks, post our initial investment.

Because while we are hearing each one individually, by putting them all in such close proximity, we have the opportunity to compare and contrast. Who really has a handle on their business? Who seemed to not quite know where they were headed? Who exuded the leadership qualities needed to attract and retain a killer team? Who gave us pause to think, "Is that the best we can do?" Who took responsibility and was clearly ready to be held accountable for their firm's performance? Who tried to pass the buck?

We've been doing this many years now, and some consistent patterns have emerged:

• We always feel better about our portfolio after the session than we did before.  
• We always seem to have one CEO (out of about 30 each year) who commits seppuku by clearly demonstrating that he or she doesn't get it.  
• Our "red shift" report (remember how as stars go away from you, light shifts to the red end of the spectrum) shows that many missed their plan for last year. But, by golly, they are all sure they will make the new plan for this year!  
• Somewhere between two and five companies jump out as, "Let's back them to the hilt! How can we help them grow even faster?"  
• Somewhere between two and five companies jump out as, "Ouch, that one's not going anywhere. How do we find the dog a home before its fleas bite us?"

Of course, whether you are an OVP portfolio company or not, there are some generic lessons to offer here:  
• As a startup leader, you are always on the bubble and need to always be on your game - even among your most ardent supporters.  
• If you can't articulate your company's value, your competitive position and your operating plan clearly, and back it up with real data and substance - you are in trouble.  
• Those leaders who own their performance, and own up to what hasn't gone right as well, have credibility that gives them more latitude than those who duck and cover.  
• Those leaders who make an annual plan that they then make, rather than getting way out ahead of themselves, have credibility that can translate into real dollars of support.

Some specific reflections from a recent CEO-a-thon

We scored each firm and each CEO on a scale of 1-5, with 5 being the best.

The CEO's in our more mature fund scored slightly higher than their companies, while the most recent fund CEO's scored slightly below their respective firms on average. This makes sense, as in the older fund we've had more time to either let the CEO's grow, or find CEO's who fit the growth opportunity.

One (and only one) CEO scored a perfect 5, while no company scored a perfect 5. We don't think there was much, if any, grade inflation in play.

As we looked at the 'by partner' data, the OVP representative Board member was often among the lower scores for both the company and the CEO, even if both were high. Familiarity doesn't breed contempt, but perhaps it does add to realism.

Value added is a group thing

Being a "value-added" VC is a whole lot easier when the entire firm has seen the company recently! The venture industry is a strange area in that our job is to make smart investments and then guide them along their path to hopefully a great liquidity event. We are organized in groups, usually 5-10 partners depending on the VC firm, specifically so we can add value as a team to our portfolio. However, as a practical matter, the lead partner Board member is the one who sees the company all the time, while the other partners hear from that Board member in summary on Monday mornings.

The challenge we have is: how do the other partners consistently add value to the thinking, strategy, pipeline, hiring or even brainstorming, if you only hear the story in a condensed form once a week? Too often, those mornings are limited to reporting high level performance, any bad news, and/or any fantastic news that happened the prior week. Very rarely is there time to go through company by company and circle the room of partners to see how each might add value. Who might know the head of Investing at Nielsen? Who most recently met with the clean tech partner at a specific VC firm? Who knows of a top shelf VP R&D for a wireless equipment deal? And those are the easy ones that email can cover!

What about: This company is being requested by their biggest customer to launch a new product line that could potentially lead to a broader and big opportunity for the start up \- but it is somewhat off current strategy. How do you put gates around the customer requests, plus demands on their payments, so we don't get in too deep? At what point do you invest in the market analysis to see if it's worth spending any time on this as a broader opportunity. When do you say 'no' to one-offs? While this sounds simple, and will surely be discussed by the start up's very smart Board, getting the benefit of five other partners' pattern recognition on the topic is a challenge. Yet it is exactly that challenge the start-up CEOs and our Limited Partner investors expect us to solve.

The three days were very helpful to us for thinking through future decisions on these firms. Now the goal is to maintain that broad engagement with the partnership in the months ahead.

CESIT – The Fuzz! How to Manage Your Venture Capitalists

For those too young to know the origin on the title of this section, it refers to an expression from the mid-1900s, "Cheese it, the fuzz!" - meaning "Let's get out of here, the police are coming." To some people, the arrival of venture capitalists onto a company's board of directors carries with it the same urge to flee! However, if you understand how we VC's see the world, and what indicators we watch in the companies in our portfolios, you might just get a leg up in managing your investors. At the same time, it might give you some clues on how to manage your company, too!

CESIT is actually an acronym we use at OVP Venture Partners to monitor our portfolio companies. It stands for: Cash, Execution, Space, Investors, and Team. For each category, we assign a ranking for every company, every two weeks. Those rankings are simply "green" as in "all systems go", "yellow" for "warning, something is not quite right", and "red" for "stop and pay attention – trouble."

**No Cash? You Crash!**

For **"Cash"** we say that more than a year's worth in the bank is green, six to twelve months is yellow, and less than six months is red. Since it takes many months to raise new capital, we want everyone focused on not running out of this most vital of business commodities.

For **"Execution"** we look at performance versus plan. Green means at or very close to plan, while yellow means a modest miss/delay, with red meaning "it's not happening!" The metrics we watch vary by stage of company. Since we usually invest before first revenues, product development and staffing may be the initial focus. Later on, we might switch our attention to beta customer feedback, and then ultimately orders, sales, gross margins and earnings versus plan.

**"Space"** refers to how large/attractive the product-market segment is that the company is chasing. It is a leading indicator to how valuable it is likely to be in the public market or as an acquisition. As we have seen, "spaces" can blow hot and cold. So, we do not necessarily feel badly if a company we've backed finds itself in an out-of-favor sector. We are long-term investors, after all, and sectors can heat up as fast as they cool off. On the other hand, if we discover that a market is considerably smaller or slower to develop than we had expected, that may be impossible to work around.

**"Investors"** measures the strength and cohesiveness of the investor base – that syndicate described earlier. Do we have high quality, deep-pocketed venture capitalists sitting right alongside us, or is it a weaker syndicate, or are we in solo? Are our fellow investors ready to put more money in, or are they tapped out? Is the investor dynamic positive and supportive with a value added mind set, or is it dysfunctional in some way? This category forecasts how likely the company is to attract follow on financing.

**"Team"** looks into both the completeness and competence of the management team and key individual contributors. Are all the vital slots filled with "A" players, or are there holes? Are there people in top jobs who do not seem to be measuring up, or do not appear to have the ability to take the company to the next level? Is the team working well together, or are there areas of friction and conflict? If we are going through a CEO transition, however well-planned, that makes this a "red" in our parlance.

We use these category rankings to help guide our discussion as to where each company may need our help, and then try to collectively determine how we might add the most value to turn those yellow or red indicators into green ones. They also helps us in our discussions with our portfolio CEOs, as they force the discipline of talking about fixing what is wrong rather than reveling in what is right.

**What Color is your Bucket?**

Finally, we take one more cut at the data. We lump companies into three buckets. The predominantly "greens" are the ones where, if they stay that way, we will make most of our returns. They are our potential home runs as IPOs or major acquisitions. The firms with many "reds" are the ones that either must be fixed fast, or get acquired fast or be given up for lost. The "yellow" crowd comprises the toss-ups. We've gotten some of our best results from yellows that turned themselves into greens. But some of our biggest losers were yellows that gobbled cash on their way to becoming red – then dead!

If this sounds very Darwinian, it is. Startups are not for the faint of heart – for entrepreneurs nor for investors. There is a constant winnowing out of winners and losers. However, if you measure your own company the way venture capitalists do, you might just find your way into the winner's circle more easily!

So, now you have "taken the money." Get ready to "run."

****

# Chapter 5

# Run: In the Right Direction

First off, you need to make sure you are pointed in the right direction, properly focused, with a culture within your team that will make execution paramount, and a full understanding of what hurdles you need to jump, and potholes you need to steer around.

One of the best pieces of advice I got when starting my company was, "The culture of the firm will be set in the first six months, and barring a complete change in management will be almost impossible to modify thereafter. So, be very explicit about what you want it to be and then drive it there. Otherwise it will drive itself somewhere else."

Managing in Uncertain Times

First recognize that you are always managing in uncertain times. Frankly, these kinds of lines, "xxxx-ing in uncertain times" drive me to distraction. Can anybody tell me when the times were certain? The only difference between sometimes, when people are hand-wringing, and times when they are not, is that in tough times we admit to ourselves they are uncertain. In "good" times, we think we know what comes next, even though we don't.

One of the reasons most major, sustainable enterprises were started not in "certain" times but in "uncertain" ones, is the different mind-set and culture that is forged in the crucible of worry. Companies that come to life in an industry boom never develop the fear of abject failure, the palpitations of wondering if we can make payroll, the perspective that comes from knowing at a gut level that your customer is your life-line.

It goes without saying that a culture of frugality, born of necessity, stands firms well in all times. When the "good-time Charlie" firms hit a tough economic patch it is amazing how long some can go on little capital, once they finally understand at a basic level that no more capital is available.

One of the best practices we see from top-flight CEOs in our portfolio is where they are, from day one, constantly challenging their teams to do more with less. They are regularly prodding their sales organizations to deliver the orders, but also pushing back very hard on what appear to be overly optimistic assessments of the speed at which accounts will close. Engineering teams are being asked very hard questions about their schedule assumptions, and exactly "why" they believe the current development forecasts are likely to be achieved.

One CEO we know recently hit the nail on the head. He asked his sales VP how confident he was in his forecast for the quarter. Of course, the response was positive, as most sales professionals are. Then the CEO asked a second question, "If you had to literally bet your job on the number, what would your number be?"

Needless to say it was not as bullish an outlook. The CEO then turned to his CFO and said, "Tell me how we don't run out of cash at that lower number, because in these times, I'll go with the 'bet your job' test. We're all betting our jobs here today."

All times are uncertain. Those startups that manage as if their life depended on surviving tough times are the ones likely to still be around when good times return.

** **

**Make a Plan You Can Make**

No company can ever say that its plan to jump from zero to many tens of millions of dollars in sales in a few years is conservative, or even realistic. That kind of explosive growth requires many things to go right, with many of them not under the direct control of company management. Every entrepreneur needs to go to sleep at night (or perhaps in the early morning) with the clear understanding that his or her business plan is at best a guess and at worst a dream, based on multiple miracles occurring on a predetermined schedule.

**Caveat emptor**

So what happens when you put together a business plan that you really believe in, raise money, and then don't make your plan? Nothing good! First, you send a message to your new investors that your judgment is not to be trusted. There is no worse feeling for a venture capitalist than to go to the first board meeting after the check goes in and have the company immediately announce that it is falling short of or "missing plan." It happens all too often. All of us in VC-land dread those first Board meetings for exactly that reason.

One of the most undervalued yet precious commodities in the start-up world is a constructive, functional board. The fastest way to make a board of directors dysfunctional and destructive is to get the people on it suspicious because they think they've been had. You'll quickly see behavior best reserved for the local preschool. In addition, one of the reasons that VCs are tending toward staged financings these days (a policy that we do not happen to like) is that they are sick and tired of getting burned by paying for optimistic, unrealistic projections. Now they are putting the heat on entrepreneurs to put up (execute) or shut up (and take a lower valuation).

**A culture of failure?**

The second bad thing that happens when you miss plan is that you send a message to your employees. You tell them one of two things, or perhaps both. On the one hand, they all feel as though they are failing at exactly the time when you need their maximum contribution and positive motivation. It is perfectly OK for the team to feel stressed to achieve and feel the hot breath of potential failure on their necks. It is quite something else for them to feel impending failure staring them in the face.

You also send a contrary message: It's OK to fail. We had a plan, we're missing plan, and we're all still here! Talk about a cultural problem. One of the worst things you can ever do to members of a startup team is to let them believe that failure is acceptable. What happens to next year's plan? Do people take it seriously? Do they take corporate performance personally, or is it "something that the board worries about?" If failure is acceptable, do I step up to nonperformers in my organization or hold their hands and muddle through? If the CEO can miss plan and keep his or her job, "What, me worry?"

**Three's company**

So what do you do? You need a plan that shows how good it could be in order to demonstrate that you have a business that can scale to attractive size. Investors do want to buy the dream even if it is a stretch. Then you need a plan that encourages the organization to achieve, but doesn't expect "everything to go exactly right," because it certainly won't. Finally, you need a plan that tests the boundaries of "what if" on the downside, to make sure that if sales are seriously delayed, for whatever reason, you still can survive to fight another day. As VCs, we'll ask for this even if you don't have it, so you might as well get it ready in advance.

You really need three plans! The "aggressive" plan assumes that almost everything goes right. The "internal" plan is what employees and management sign up for. The "conservative" plan, and even here I hesitate to use that word, factors in product slippage, longer sales cycles, and tough competitive response. Our history says that no one hits the "aggressive" plan (which is the plan we always see), less than 25 percent of start-ups hit what would have been their "internal" plan, perhaps 50 percent are in the neighborhood of their "conservative" plan, and a full 25 percent or more would fall short of even that.

When you put together a business plan to raise money, you have many audiences for those numbers and many consequences from their accuracy. To maximize the chances of getting all those constituencies in sync, lower your sights, expand your field of view, put out a plan you can make—and then make the plan!

**Plan for Success – Prepare for Failure**

All startups plan for success. It is the very nature of entrepreneurship to see the glass as not only half-full, but filling. However, startup teams need to recognize that the most likely outcome is failure, simply because creating and growing a major enterprise is one of the hardest things to do on the planet.

So, as CEO, how do you balance these diametrically opposed perspectives and keep your sanity? Start by managing the downside things structurally from the moment your company begins its journey. Doing so will give you the latitude to have more degrees of freedom if failure becomes more than a theoretical issue.

For example, one of our institutional lessons is to discourage any, or nearly any, employee vacation time carry-over from year to year. First, as much work as there is to do, and as much as you need everyone putting in the crazy hours that make startups the stuff of legend, your people need a break. Better to see them take some vacation than have dumb mistakes made by brilliant but exhausted engineers and scientists.

However, there is also an important economic reason to keep accrued vacation time to a minimum. If things don't go well, and you and your venture investors have to think about shut-down costs, vacation overhang will shorten the window you have to recover. One of our struggling portfolio firms was carrying on their books over $500K worth of accrued vacation. That was $500K we had to choose to allocate to shut-down cash rather than buying a couple of extra months for the ever-promised miracle to occur.

As with all employee benefits, start small and then expand as the company grows and as you leave the grim reaper in the rear-view mirror. Start with zero vacation carry over and improve the benefits as your sustainability becomes assured.

The Myth of "No Surprises" Management

I was recently involved in a CEO search for one of our portfolio companies. During the process of interviewing a number of very successful, seasoned business leaders, I was struck by the number of times I was told in resonating tones, "I believe in no surprises management." Of course, this was designed to impress me as a Board member and major investor.

However, it had quite the opposite effect. I usually responded with something like, "I guess you've never been in a start-up before." In fact, I could just as easily have responded with either, "I guess you've never been in business before," or better yet, "I guess you've never been alive before."

As far as I can tell, life, business, and especially start-up business is a series of surprises. Do you really know what is going to happen tomorrow? Really?

• Yesterday, I didn't know a branch would fall out of one of our trees and cut off power to the whole neighborhood (we are SO popular today! - or should I say poplar?)  
• Yesterday, I didn't know that VC seed financing for start-ups was going to come in well above previous quarters. (Yea!)  
• Yesterday, I didn't know one of our portfolio companies was going to get a major order from a customer we thought had gone to sleep on us. (Yea, again!)

One bad surprise, two good surprises, but surprises nonetheless. Anyone who really thinks they can avoid being surprised by the ebbs, flows and uncertainties of business is just not paying attention.

So, why do we see all the chest-beating about "no surprises" management? I think what these CEOs really wanted to say, but didn't quite have the right language for was "completely transparent and alert" management. This means not that they don't get surprised, but that when they think they see a surprise coming, much less get one, they let their Board know essentially immediately. And, when they think there is a probability of a surprise (does that make it not a surprise?) they plan for that eventuality so there is an action plan ready to deal with it. It even means going hunting for potential surprises to find them earlier, when they may be less disruptive.

To give you an example: Early on in my VC days, I was asked to step in as back-up for one of my partners on a deal. We do this to get a second set of eyes on the prize, and also try to provide more value-added to the company. At the first Board meeting I attended as an observer, I listened to the sales VP present her outlook for the quarter, this meeting coming about mid-way through the last month of that quarter. All the PowerPoint slides indicated that her team was going to make their number. I'm sure she was trained to present like this in previous jobs, and frankly most good sales executives can't fathom the notion of reporting in advance they are going to miss their quota.

But, having had a number of sales VPs report to me when I was an operating executive, the first thing I did when the meeting was over was to turn to my partner, the Board member, as well as the CEO and say something like, "Guys, I'm new here. However, I'll bet you the price of a good dinner that you are going to miss your plan." They both pushed back hard. But indeed, a few weeks later that was what happened. And to them, it was a surprise. But it wasn't to me simply because I had enough scar tissue from missing quarters in my previous life, that I knew when a Sales VP was giving me the body-swerve clues, preparing the ground for the excuses to come. That doesn't happen when a Sales VP is really confident.

So, here's a case where the CEO could have questioned my judgment (always a wise move) but still accepted my experience and gone hunting for more indicators on his own. If he had, and kept us informed along the way, we probably still would have had the quarterly sales miss. There wasn't enough time then to adjust. But, the Board and the company would have been much better prepared for the corrective actions that needed to happen afterward.

Claiming you ascribe to "no surprises" is false bravado. I'd much rather have a CEO who I knew in my heart had the intestinal fortitude to come to the Board not only with real bad news, but with his or her gut feel of possible bad news coming, even if there was no concrete data to support that yet. We've always said that in start-ups, "the distance from euphoria to panic is one phone call." And we've all gotten that call.

Likewise, I don't mind if potential good news is shared (everyone likes to do that) but along with the clear expectation from management that the Board won't take it to the bank, and won't bang on the team if the news doesn't prove out. In the third bullet point above, the CEO - who is a master of completely transparent management - had shared with us both the bad news that this big customer had appeared to go to sleep, but also that there was no obvious reason for that. So, when we first got a glimmer of the giant waking up, and then concrete evidence in the form of orders and delivery requests moving in, we were happy, but not overly surprised.

Transparent and alert - that's what we like to see from the CEO, and from the entire management team.

Hocus Focus

One of the most fundamental issues facing most startups, whether they are out looking for money, or out spending the money they have already raised, is focus. It is remarkable how just a small deviation from a laser-like focus on the critical issues for the business can mean the difference between success and failure. We often say, "More startups die from indigestion than starvation." Lack of focus manifests itself in a number of ways, during fund raising and then in operating the business.

**The Bootstrap Trap**

Many entrepreneurs come to us with a "bootstrap" model of growing the enterprise that looks something like this: "We will utilize this initial product/market to get the company started, while we do the R&D necessary to build the "real" product for the "real" market we find really attractive." This model may appeal to commercial bankers who care about how you are going to service their debt and other lenders who exist in a world where cash flow is king, but it strikes terror into the hearts of venture capitalists.

The single most precious resource any startup has is its people. The bootstrap model requires those people to serve two masters, today's business and tomorrow's. While we have all heard the story that today's business will take very little management time and attention, allowing most of the energy to be focused on the big future opportunity, we have seen compelling evidence this is a myth. In fact, what usually happens is that the pressure of today's products, customers, competitors, etc. is actually a full time job for management, leaving little time or attention to the true, venture-fundable part of the business. Most ventures fail even when one hundred percent of everyone's attention is focused on one and only one goal. What do you think the chances are when you split that attention?

To those who say the bootstrap model lowers the risk, we say "nonsense!" The goal is not to avoid the downside. The challenge is to achieve the upside. That requires everyone in the organization to get up in the morning with no uncertainty as to which master they are serving. Come to a venture capital firm with one of these two headed monsters, or even a three headed one as we saw recently, and be prepared to go home with your empty hat (or your head!) in your hands. Instead, chop off the extraneous business before showing up for funding.

All of us who play this game are more than prepared to take great risk for great reward. If that means you have no revenues for twelve months while developing your product, so be it. You can kid yourself into thinking the bootstrap model raises your valuation, since there is some provable revenue stream up front. The reverse is true. We don't want to pay for a business we don't want!

**The Red Zone**

American football teams know that a key to their success is whenever they get the ball inside the 20 yard line (the "red" zone), they need to come away with at least some points on the board. Startup companies often do not understand this issue. It is remarkable how many times we see firms out blowing through their venture financing, with burn rates that give new meaning to the term, trying to do far too many things at once. They keep trying to advance multiple balls down the field from multiple distances from the goal line, rather than taking the obvious early leaders and driving them into the end zone.

Not only does this drive the finances of the company crazy, it also drives the employees crazy. Many get confused as multiple conflicting priorities, all for "critical" projects, hit their desks. For many people, it gets hard to know how they are going to be measured. The natural response is either to chase the priority of the moment, or to shut down all together. A far better approach is for the company to decide what things absolutely need doing to reach the next few milestones that matter most (revenues, financing, etc.) and then focus just on those.

We recently went through just such an exercise with one of our portfolio companies. They were in disarray after missing the sales forecast for the quarter, and were burning through cash at an alarming rate. Rather than sack the CEO or the Sales VP, we all sat down and tried to peel back the onion to find the core reason for the problem. It quickly became clear everyone had too many irons in the fire. In addition, there were some terrific strategic opportunities that were languishing while the sales force focused on meeting the short-term revenue plan. Development was running in at least three directions. "Operation Red Zone" was put in place, with dramatic results in less than ninety days. If you want to raise money, focus! If you want to use it wisely, focus! Anything else is hocus-pocus.

Two Frogs with One Hand

Once upon a time, the standard approach for a startup was to do its product development locally, then test early versions of its product regionally, then start selling its product nationally, and only expand internationally once domestic sales ramped up. Not anymore! What was once a very simple and linear process of company formation and development has become a complex and parallel approach.

In today's global economy, many new firms come to life with international components operating not just at the same time as their domestic colleagues but before. If you are working in the wireless arena, does it make more sense to do your product definition in Seattle or in Scandinavia? If you are an enterprise software company, do you want to develop your product in Beaverton or Bangalore? If you are a company in the medical field, will you do your first clinical trials and sales in the US, or get an earlier start in Europe? Will you set up manufacturing in the Silicon Forest or in Singapore?

**Let Your Reach Exceed Your Grasp**

To start a company with global reach, you need to reach out. To grasp the complexities of business that has dimensions far beyond the shores of North America requires a mind set, not just an operating plan. It means that everyone on the founding team needs to appreciate how hard it is to start a company with far-flung activities, but at the same time how necessary it might be. All this puts a premium on experienced management from day one. We are delighted to back first time entrepreneurs and young management teams - but if you are trying to keep a development team in India in synch with a business development person in Helsinki, a product marketing group in Redmond with manufacturing in China - you'd better not be trying that for the first time. In fact, you'd be better off not trying that at all.

**But Don't Try To Grasp Everything All At Once**

As the proverb on the wall of my office says, "Do not try to catch two frogs with one hand." There are just too many moving parts to that scenario. Just because there are compelling reasons to start a business with the goal of global reach doesn't mean you have to reach everywhere at once. It means you have to reach where you need to reach, when you need to reach there. A smart approach is to focus on doing the things you have to do well first, and do them in the place they are best done, before moving to the next pad in the grand global lily pond. If that means you send a team to Europe to spec the product while the developers slave away at their keyboards in Seattle, so be it. But if you think you can do that and manage a software team in India, and a fledgling domestic sales force, while trying to raise a round of funding from VCs cross the USA - you are probably going to fall prey to the fate of the proverbial frog catcher, and wind up empty handed.

**Domino to Dominate!**

Trying to find the right balance between global reach and keeping things under control is a tough task, and a problem for which there are no simplistic solutions. Perhaps the best way to think about it would be to imagine you are setting up a huge set of dominos. As you build the design, you are wise to leave some holes in it so that an accidental bump doesn't have the whole thing trigger before you are ready. In the world of startups the same technique can apply. While building your initial core activities you can extend your reach with small efforts by small teams who are not just physically remote but also kept organizationally remote. You might hire a very experienced person to handle what needs doing in Europe or Asia. But you must have the discipline to not let them drag the whole organization towards them, until it is time to put the dominos in place to connect them with the main enterprise. By then, they should have built their own set of dominos that can be made to fall in sequence. That will make your company effective in the new domain and your enterprise ready to take its place on the global stage.

When done with the proper balance, starting your company with an international dimension makes perfect sense. Two of our OVP portfolio companies recently recorded their first revenues, from customers in Korea and the UK, respectively. However, in both cases, they were careful to focus their energies and their enterprises to make sure the first domino to fall was the one they chose to fall and for the right reasons. Now they have the opportunity to extend back to the US at a time and circumstance of their choosing. That's a good initial model for a long-term global success story.

Goldilocks financial projections...how do you get them "just right?"

So, you are putting together your investor slide deck for your upcoming Series B financing, and you are about to drop in your 3-5 year projections. Should you goose them up, knowing we lovely VC's give them a 50% haircut anyway, or should you be conservative, nail them, and have a higher chance of keeping your job post financing? Yes, you are Goldilocks - looking for that perfect temperature porridge, and we are the bears who can get very grumpy if it's not "just right."

Everyone wants to see the hockey stick (investors, employees, YOU) so you feel like it's worth the trip and sweat in building a start-up. But there are a few booby traps to be aware of along the way. We've lived through experiences on both ends of the spectrum -- as a new investor who "bought in" to an aggressive set of numbers pre-financing, only to have the team cut the current year by 50% at our first board meeting. Ugh! We were not happy, and neither were the angel investors when we insisted they go back and cut the pre-money valuation of the round just closed in half. They did, but it was no fun for anyone and serious credibility was lost.

On the other side, we had a portfolio company that was about to raise their B round, growing from $1M to $3.5M of revenue year over year. That's a great percentage increase. But we told them, "This just doesn't feel like enough growth to capture the imagination of the VC community!" The team pushed back and said while the second year looked light, in their business, they would be planting seeds (smaller deals) with all the right customers, setting themselves up for a $13M third year. "You have to be patient," they said. We loved it! We went out to the investor market with their numbers, not goosed by us.

A third example, and one that we think hits the "perfect temperature porridge" middle ground nicely, is a deal that where the CEO gave us two sets of projections. The first was the sales or "stretch" projections. If they hit it, everyone would get 200% bonus. Then there was the base plan where bonus would get paid but at a much more normal level. They wanted us to set our investment valuation on the first plan, while we wanted to set it on the second plan. They did a fantastic job with a bottoms-up analysis defending the more aggressive plan. As a result, we still pegged it on the second plan, but on the aggressive end of the range. While the company has tremendous potential and we are very happy with the investment, they ended tracking much closer to the "conservative" but still very attractive plan. So our valuation, in retrospect, was on the entrepreneur side of "just right." Both of us feel good about how we came together - and there is terrific trust both ways.

****

# Chapter 6

# Run: Don't Look Over Your Shoulder (We Are There)

We're on your side, but we're on our side, too. We want you to be successful. But even more we need you, or someone else much like you, to succeed. So, here are some of the things we think about when it comes to managing the enterprise from the Board level. You should, too.

The Back Channel and Triangle of Trust

Official communications channels are wonderful, but back channels are precious. This is true whether you are a VC investing in a company, a company manager with a department to run, or a sales professional trying to land a major account.

What is interesting is that the sales professional probably has received formal training in the care and feeding of back channels, while VCs, CEOs and VPs probably have not. For sales people, Strategic Selling Skills classes share a common vocabulary: "coach", "champion", "technical buyer", "economic buyer," "gate keeper." The coach and the champion are key contributors to any complex sale getting closed.

Those of us who invest in or manage enterprises need to develop a similar cast of characters to help us "sell" the organization on our chosen direction, and to not be "blocked" from understanding exactly what is going on.

As an investor, our primary communication channel into portfolio companies is the CEO, with perhaps a formalized "side channel" to the CFO. Most of the time, those channels are sufficient for us to know what's going on. But, more often than we'd care to admit, we need to triangulate into the company through a different set of eyes. This is especially true if something goes wrong at the CEO level. Having an open, trusted back channel into the rank and file can save the company from serious problems, and save us millions of dollars.

The challenge is to have the back channel work exactly the right way. From where I sit the concern is: you don't want to cut the legs out from under the CEO, and you don't want a culture to develop of "if we don't like where the CEO is taking us, we can whine to the VCs." On the other hand, you don't want the company to be driven over the cliff while the rank and file can see it coming, but never speak up.

The key is to develop personal connections below the CEO where people feel comfortable talking with you, understand that they can periodically share things in confidence if needed, but know that you are not going to run off and act on every little comment. In many ways, I find I have to project the image of "write-only memory." You can feel free to tell me anything, and I won't violate the confidence, but don't expect me to do something in real time about it.

My experience is the only way this works is via an approach I call "the triangle of trust." The three vertexes on the triangle are: history, self-disclosure and time together. First start with time together - you need to spend face time with the rank and file. It may be through company social events, or wandering the halls after Board meetings, or some connection outside of work. That provides the opportunity for self-disclosure. After rank and file employees hear you express your appreciation for them and their ideas, and that you certainly don't have all the answers to their business, they begin to see you as a person rather than a scary Board member. Then you'll have the opportunity to receive little tidbits of insight. Once they have history with you that they took that risk, and you didn't go running to the CEO and get them in trouble, you will have set the stage for the big revelation down the road, should one ever be needed.

One interesting thing to watch for is how the CEOs of the companies react once they understand that you are developing these back channels. Some welcome it, essentially saying they value that openness and they trust you to handle the information appropriately. Some CEOs are threatened by it, and will go the extreme of getting the word out that employees should not talk to those wandering Board members. Needless to say, the former self-confident CEOs are the ones where the back channel is rarely ever needed, while the latter are signaling that it may be needed sooner than you realize.

So, use the triangle of trust to develop rank and file relationships, and use those relationships to maintain a good watchful eye on the organization. It will pay off - trust me.

The Good, the Bad and the Ugly

We've all heard the horrific tales of venture capitalists behaving badly. And while those of us who practice the profession would like to brush them off as sour grapes, we have to admit that sometimes they do hit close to home. However, so far, I haven't seen any venture capitalists brave enough to point out that there is a corollary issue that only gets aired behind closed doors.

There are plenty of entrepreneurs who behave badly, too. Some VCs fear that going public (no – not IPO) about these characters will turn off potential startups from visiting them. I'm betting on the opposite. I think that since the vast majority of entrepreneurs behave well, you'll get some useful insight out of our challenges in dealing with the minority who peg the needle in the other direction. In addition, by pointing out our hot buttons, you'll know what actions tend to set us off, in advance.

So, here goes – with the circumstances obscured to protect the guilty. However, take heart – since the title says "Good" as well as "Bad & Ugly" we'll get to two stellar stories of entrepreneurs, too.

**The Bad**

I was attending a Board meeting of one of our startups when the CEO excused himself because he was feeling ill. The VPs continued on presenting their functional areas, but there was a notable tension in the room that could not be explained simply by the circumstances. Then, the most experienced member of the team took the floor to tell the Board that the VPs had been talking and felt the CEO was not able to lead them anymore. In fact, it was so bad that the ultimatum was, "Either he goes, or we go!" Needless to say, this was a shock to the system. While we knew the company was having problems, we certainly did not have a clue it had risen to that level.

We did some additional discovery, and came to understand that what had happened was as the company had grown, and things became challenging, the CEO had essentially frozen at the controls. He wouldn't make any key decisions, for fear of being wrong. But he wouldn't let the VPs make decisions either. So, when it came down to the choice of fire the CEO, fire the VPs, or try to get everyone to play nicely – we went with the former.

To his credit, the CEO took his dismissal as a real pro. Frankly, I think he was relieved because he must have been terribly stressed being in that far over his head. And once we turned the VPs loose to make decisions, the company started performing again, while we searched for a new leader.

The lesson: If you are a CEO of a startup and are over your head, don't freeze up – put your hand up and ask for help. We might have been able to save that CEO's job if we'd known earlier and could have gotten him some coaching. Most importantly, realize that if you think you are over your head, you are - and your direct reports already know it!

On the GBU scale – this only qualifies as a marginal B. Everyone was behaving honorably and trying to do their best for the company. Next up, we'll talk about a "U".

**The Ugly**

Ever wonder where those strange or seemingly onerous terms in a venture financing come from? You are about to find out.

As with most lessons in life, the ones we learn the hard way stick with us the best. And you would think that after almost 30 years in the venture business, we must have seen it all and learned it all. Not so! What follows is an example of what we consider a "U" on the G-B-U scale - and one that actually caused a change in the agreements we strike with entrepreneurs going forward.

In most startup financings, employment contracts are drafted with the founders. This gives us some assurance they won't just walk out with all their stock the first time the Board doesn't agree with them. In turn, those contracts protect the entrepreneur from an out-of-control Board. At least 95% of the time, the agreements prove to not have been necessary, as everyone behaves well. But every once in a while...

In this case, part of the entrepreneur's employment agreement included a six month salary grant if he was terminated for other than legal cause. It was a protection against an arbitrary dismissal and one we decided to accept as part of the total package at the Series A closing. However, this was one of those startups where things didn't work out. For all the good efforts by the team, the product did not end up matching market needs, and we had to shut the doors after millions of dollars were invested.

We were going about the wind-down process as gracefully as one can and the issue of the termination provision was raised by the CEO. Since we were closing the doors, the employees were technically being "terminated." And since it wasn't for what is legally defined as "cause" (essentially wrong doing) the case could be made that we owed severance payments.

Now, in our entire history, we'd never seen an entrepreneur CEO who had received millions from people like us take the last dollars the company had and put them in his or her pocket as the lights were being switched off. Even if the dollars were not material compared to the millions invested, every prior example was of a founder who saw to it that the investors at least recovered that minuscule part of their total bet. But, not this time. Since the contract language allowed for the founder to take our money, we obviously agreed to abide by the letter of the law. We also made it clear that we could not imagine any CEO actually enforcing that provision in this circumstance. Silly us.

So, we now have a term in our founder employment agreements to void the severance payment provision if a company is terminating employment because it is ceasing to be a going concern. Sad, yes, but that's how an entrepreneur on the "Ugly" scale made our documents seem even more finicky than they already were.

Oh, and to add insult to injury, a VP of the same firm came forward in the final days with out-of-pocket expenses from one to two years prior that had never been turned in for reimbursement. The company did not have a stated statute of limitations on how long such expenses could be in arrears, even if that violates all the common sense notions of what year-end audited financials include. So, there's one where you, the entrepreneur, can add some extra language to your documents (i.e. employee handbook), too!

**The Good**

This is actually two stories rolled into one. Most of the time, the entrepreneurs we back act responsibly, ethically and professionally. So, it can be hard to decide where to pick and choose, since there are many "Good" stories to tell.

But, recently we saw two CEOs do something very similar that strikes us as exceptionally "Good." In both cases, she and he (one of each gender) came off a very successful quarter. Both came to their respective Board meetings with the happy news that the company had grown nicely and had finally achieved that wonder of wonders: cash flow break-even!

So, what did they ask the Board for at that moment? More stock options? Bigger bonuses? Perhaps, relax the expense plan so they could hire more employees? No! They both asked permission to cut expenses below the currently approved plan.

"What?" you say! "Cut spending as things are looking good?"

Both these CEOs were alert enough, and knew their businesses well enough, to be looking past the immediate good news to see their sales funnels contracting, their sales cycles extending, with the knowledge that new equity would be very expensive, if even available. They both got a taste of what it means to control their own destiny, which you do at cash-flow break-even, and they weren't about to give that up without a fight.

Just as importantly, they got out ahead of events, ahead of their respective Boards, and ahead of the power curve. That's what seasoned executives do. Oh, and on that note, they are both first-time CEOs. Their lack of "CEO experience" didn't stop them from demonstrating superb executive instincts. Good on both!

From good CEOs, we'll move to the other side of the ledger. What gets CEOs fired?

Seven Reasons to Remove a CEO

Here is a surefire bet: Gather together a bunch of entrepreneurs to talk about venture capitalists, and before long the conversation will turn to the issue of control. Here's the common refrain: "If we take VC money, the next thing you know, they'll be in control, and we'll be out on our ear."

Now, try the reverse. Gather a bunch of VCs, and before long you'll hear something like this: "If we invest in them and we don't have the ability to take control, these young hotshots may run right over the edge of the cliff and take all our money with them."

The problem, of course, stems from the following: Entrepreneurs often have mixed goals in starting a business. They want to deliver on a product vision, want to grow a major enterprise and make money, and also want to be the boss. Venture capitalists have only one goal: To make money for their investors and themselves. Sometimes, if the company gets off track and management doesn't seem able to fix it quickly, VCs want to bring in people who they believe can.

So, if you are the entrepreneur/CEO, how do you avoid this potential conflict point? First and foremost -- perform. The last thing a VC wants to do is change senior management. It is messy and risky and often leads to a washout of the previous round of investment. And no VC in their right mind wants to take the reins themselves. We know how hard you work!

In that spirit, here is a checklist I've found useful over the years in serving as a board member in a number of firms, both public and private. It doesn't cover every situation and covers some that tend to appear only as companies get beyond the start-up stage, but you may still find it useful. If you as the CEO can put this list up on your bathroom mirror and every morning tell yourself you aren't running afoul of any of its tenets, then you have a long, successful career ahead of you!

With all due respect to Stephen Covey, here are: The Seven Reasons to Remove a CEO.

**1. Poor Leadership**

• Lacks the confidence of key personnel  
• Hires/retains weak people in key positions or fails to fill key roles in a timely way  
• Fails to grow/retain successor(s) and/or create management depth

**2. Poor Vision**

• Lacks clear understanding of where business is going  
• Lacks focus on organization and priorities or tries to keep too many balls in the air  
• Is unable to strike key industry strategic partnership relationships

**3. Poor Results**

• Has major and sustained poor financial performance or missed targets  
• Shows major loss of competitive position or market share  
• Is unable to forecast timing/nature of recovery events or of revenue achievement

**4. Poor Understanding of Business**

• Misses key industry trends and changes  
• Lacks understanding of fundamental profitability factors  
• Cannot crisply define what it takes to win

**5. Poor Work Habits**

• Does not put heart and soul into business  
• Sets bad example/role model for others  
• Is not viewed in industry as a key player

**6. Poor Management Style**

• Allows top management infighting, not working as a team  
• Demonstrates unpredictable decision processes or will not make tough decisions  
• Starves key programs but spares sacred cows

**7. Poor Board Candor/Communication**

• Controls flow of information/agenda, preventing focus on or sufficient time for critical issues  
• Does not allow ready access to VPs and other key individuals  
• Keeps favorite nonstrategic programs or perquisites out of board review and approval process

Significant evidence across any one of these categories should be enough to awaken a board to the potential for trouble. Two or more should cause a responsible board to act. Venture capital boards are like normal boards, only more so! They have little time to spend developing management in the face of fierce competition and dynamically moving markets. They are much more ready to fix something that is broken or keep a rocket ship from coming off the rails.

So, avoid The Seven Deadly Sins for CEOs. You'll find your venture capitalists supporting you every step of the way!

### ****

# Chapter 7

# Run: Get the Product Right

So, you've got your team in place, the culture of high expectations set, and you have plans that are aggressive but achievable. It's time to face the realities of completing your product or service and protecting (if you can) its intellectual property.

The Beauty of Asymmetric Warfare

I read a book a while ago that was both fascinating and troubling. It is _One Second After_ by William Forstchen. The plot centers on an attack on the United States using just three EMP (Electromagnetic Pulse) nuclear weapons exploded in space over the country. There was no blast. There was no fallout. But the EMP essentially fried all the electronics in the country and took society back to pre-industrial revolution times in a matter of seconds. Speaking as someone who once sold electronic design automation (EDA) systems to the military for "rad-hard" applications, this is not science fiction.

An underlying theme of the novel is the power of asymmetric warfare. Not only do you want to hit an enemy where they are weak (of course), but hit them in a way where their ability to respond is circumvented. In many ways, start-ups by their nature are asymmetric competitors. They are more nimble, more innovative, and have essentially nothing to lose. The big, slow moving companies they attack have everything to lose. However, if those small start-ups attack on a set of terms that are well understood by the big firms, then the big firms have the advantage.

You might introduce a product that is better, faster, or cheaper than your competition. But if that's all it is, they can respond by cutting price (temporarily - until you die), promising futures of better or faster (temporarily - until you die), or hiding their price using some bundling technique. (Don't try this if you have 80% market share - ahem - Microsoft). But, if you truly hit your competitors with asymmetric attacks, there is very little they can do. What were the big box specialty stores going to do about Amazon? Ultimately, they all opened their own web sites, but those sites were still just for their specialty, and didn't have the sophisticated analytic elements Amazon built in as a fundamental advantage. Most of those stores and companies are gone now.

Earlier I mentioned an OVP portfolio company \- Complete Genomics. Their business model, selling the complete sequencing of human genomes as a service for just thousands of dollars each, was an asymmetric attack on the large firms selling machines for upwards of a million dollars each to do a similar function. Those firms had no straightforward way to defend against this small, nimble player who was playing by different rules. The leading big equipment firm tried its best. They even countered by introducing a service business of their own. And they immediately tried to take the oxygen out of the room by offering their services at prices below what Complete Genomics was charging, perhaps even below their cost. But, we'll leave that to the lawyers.

Regardless of the potential legal points or counter-points, the interesting thing is that Complete Genomics kept winning customers. Those in the industry recognized that what to the industry heavyweight was a tactic, to GNOM was a strategy. And so they understood that at relatively equal prices, Complete Genomics was far more likely to be committed to not just an order today, but their long-term satisfaction as a customer. Even a wide-awake competitor can have trouble with asymmetric warfare.

In _One Second After_ , the author quotes Sun Tzu (who wrote _The Art of War_ ) saying, "Your enemy will never attack your strength, only your weakness. So, know your weakness." Asymmetric warfare is simply a way to exaggerate your competitor's weaknesses.

It's a lesson start-ups need to exploit.

** **

**Know Your Competition**

One of the most fundamental elements of any successful enterprise is its ability to serve a segment of customers better than its competitors. Therefore, any startup hoping to receive venture capital funding needs to be able to articulate how it is going to do just that. However, when we read business plans or meet with entrepreneurs, it is remarkable how weak their understanding of the competition is, and how narrowly the word competition is usually defined.

Your Product Is Not Better In Every Dimension

Most business plans have a competitive analysis section that highlights how that firm's products will be superior to all competitors. Some allege they have no competition. They are wrong! As mentioned in Chapter 1, others include a nice matrix showing feature comparisons where, amazingly, only the startup has a check in all the boxes - while other players are lucky to have half the boxes filled.

There are a number of problems with this approach. First it smacks of a naïve view of the world. Certainly you will need to have a substantial product advantage to break into a market, but are your competitors really that stupid and lazy? Many have probably been selling to your target market for years. Perhaps some elements of their products that you do not include in your matrix, or even in your product, are more important to customers than you know. Perhaps a more detailed analysis will show that there are multiple segments in your market. Some will clearly value the product attributes you offer. Others may favor your competition. That's O.K.! The better you know your customers, the better you know your competition. We are much more comfortable with a competitive matrix that shows where you have advantage, where you will be at a disadvantage, and why the segment(s) you are targeting make sense.

**Your Product Is Not All That Matters**

Even those business plans that do a good job on the product competition section rarely look at the more telling competitive issues of marketing, price, distribution and sales coverage, services, strategic partnerships and other absolutely critical elements of what a company needs to win. If you came out with a superior word processing software package - that beat Microsoft Word in every product dimension - do you think it would have much of a chance? Not likely! Companies that understand all the real world issues of competition are the ones that have the best chance of success.

As we look back on the companies we have backed that have gone public or been acquired at fancy valuations, there are a couple of telling constants. Sure their product strategy and execution was terrific, but in addition their understanding of how to beat the competition in a variety of ways was superior. By building multiple barriers to competitive attack, they were able to survive the occasional slipped product release or a competitor's surprise announcement. Startups that rely only on product superiority are very vulnerable.

**Your Competition Is Much Broader Than You Know**

I have a friend who helped lead a venture-backed company offering software in the medical field. The team was terrific, the product stellar, the sales force first rate, the services group outstanding. Customers all agreed this was something they need desperately. Yet many years ago the company was straining to achieve their growth objectives. How could that be? The answer was simple - Y2K. For those too young to remember, this was the software Armageddon predicted for the year 2000. The hospitals and clinics that were desperate for my friend's software had a much larger problem - one that was draining all their capital budgets as well as their human resources. Those customers had to not only test and upgrade all their huge legacy software systems, they also had to test all their electronic instruments, patient monitors, anything that might have had a year 2000 bug that could be life-threatening if not found in time.

At that point, the company's competition was not just other medical software players. It was anything or anyone that competed for precious capital dollars and the staff needed to evaluate, recommend, and rollout their products. Fortunately, my friend's company was very well financed and could afford to grow more slowly than they might have liked for a year or two until this problem passed. Most startups are not so lucky. Every new firm has to compete to get up their customer's priority list in order to get products purchased. It behooves all young companies to try to determine what customer projects and priorities are above them on the list. They are your competition too!

Know Your Customer

In the late 1990's, three major technology waves (Internet, broadband and wireless communications, and biotechnology) hit the beach at the same time, coupled with a buoyant public stock market and a booming economy. That's as close to a perfect world as we'll ever see. By the dawn of the new millennium, everyone wanted to be a venture capitalist. It looked like easy money, and for a time it was. In March 2000, it all started to come apart. The public markets contracted, and then crashed. The IPO window slammed shut. Those companies expecting the public markets to provide the cash necessary to cover their losses suddenly looked very naked. And venture capitalists suddenly looked not so smart. We went from cover stories of hubris to cover stories of debris in less than a year. What happened?

It was actually rather simple. It was not, as some have reported, only a matter of greed - not that there's anything wrong with that! Nor was it a matter of speed - not that there's anything wrong with that either. It was, in fact, a matter of need. Venture capitalists and the public forgot for a while that major successful new businesses are built neither on the fact that some new technology enables them to exist nor on the fact that someone may want them to exist.

Companies thrive only when they serve a real, sustained, compelling need in the marketplace. While it is easy to pick on some of the fallen stars of yesterday, they do provide good examples to prove the point. The Internet enabled a company to let you buy Puppy Chow from the comfort of your home. A few people may have even wanted to do so. But clearly there was no compelling need to do so. The shopping experience, product availability and consumer knowledge necessary to decide on dog food were all in good shape through existing channels. Whither Pets.com? The same could be said for gardening tools and a host of other retail items. There were no needs, only wants and greed, and so the ventures failed.

On the other hand, in some retail categories there was a need for a different model. In books, the selection was so overwhelming that the ability to "browse" on line made book-shopping a better and more convenient experience for many people. Hail Amazon! There was a similar story in consumer electronics, where a truly rotten retail experience with pushy yet unknowledgeable sales clerks allowed firms to carve out a sustainable on-line position. Retail is a tough business through any channel. But serving a need where there is one is a good place to start. Many venture capitalists broke their own business models by trying to ride those easy-to-start businesses rather than truly needed businesses.

But some VC firms were more selective. They chose companies where the potential customers were clearly crying for something new and better. In many areas that newness was driven by the need for new technology - such as optical networks, Internet-enabled commerce, wireless infrastructure, and biotechnology. In others, it was the chance to break down old barriers between customers and suppliers - a la eBay. Wherever these new businesses flourish, the common theme is that their product or service is needed not just wanted, by their customers.

For venture capitalists bandaging their wounds, the message was clear. It was not back to the drawing boards, but it was back to basics. What worked in the years leading up to the Internet bubble still works, now many years later. Find great teams, serving compelling needs, in explosive markets. Two out of three isn't good enough. You need all three – every time.

For entrepreneurs seeking venture capital, the same rules apply. Think back to the "nice-to-have versus have-to-have" commentary in earlier chapters and make sure your company is addressing not just a need, but a compelling need. So how do you tell the difference? When doing your research on exactly what product or service you are going to offer, ask your prospective customers this question: "If we bring this product to market, what other current area or project are you likely to draw dollars from in order to squeeze us into your budget?"

If the customer does not know what he'll give up to buy from you, you are still in the "want" category and have not yet made it to "need." If she tells you, "We don't know where, but we'll find the money," you've made it to need. If she says, "I can think of two or three projects we will defer to buy your product," you just hit pay dirt! Not surprisingly, those questions and answers come from what we ask in our standard due diligence on prospective new investments.

**But don't listen to your customers too much!**

Wait a minute? Doesn't this contradict the most fundamental business premise? In a way, it does.

One area where we are often called upon to counsel our portfolio companies relates to how much they should modify their original product and market plans to satisfy a key early account. This is a tough issue, because while we can say "focus-focus-focus" all we want, out of the other side of our mouths we are saying, "Get some customer traction if you want to see the Series B check!" In the end, it usually comes down to a matter of degree, and a matter of how skilled the new management team is in bending but not breaking.

For example, we have a portfolio company that very nearly broke themselves and us to capture that key anchor account. The customer – the clear industry leader in their space, originally said they would go with our firm, right during the time we were doing our due diligence. It was the triggering event that got us over the hump to invest. But then, interesting things began to happen.

The account found the company's "standard" product was not exactly what they wanted. They wanted some "changes." By the time it was all done, there was a custom design for them, which took a year to deliver, against a six month plan, and another year to get all the bugs out. No one had assumed such a massive redesign, and so no one built in any "beta" phase for this fully committed customer, nor any NRE (non-recurring engineering) payments. It was a two year delay to revenues and cash – and we as investors nearly threw in the towel en route.

The good news is that with all the trials here, the outcome was positive. Not only did the major account end up happy, but the new design was a real advance that will be incorporated into future products for general release. This was an industry leading account after all, and they knew their stuff!

Still, it is a cautionary tale – we have also seen the outcome go the other way. When it comes to landing that first big customer, start-ups have to tread a narrow path between responsiveness to customer requests and de-focusing.

The key is to manage the process, as well as the customer!

Your IP Is Patently Ridiculous

For startups and small businesses, patents are unimportant....except when they're not! Is that clear?

Seriously, what we've found over many years in venture capital is that the value of patents varies widely. Here, we'll try to outline some of the parameters that weigh on their value, to help you decide how much emphasis to put on them in your company.

However, first a disclaimer: I am not a lawyer nor do I "play one on TV." For good legal advice on this subject, find yourself a good IP (intellectual property) lawyer. Also, this section is excerpted from a chapter I wrote for David Orange's fine book, _Great Patents_ published by Logos Press. He is a lawyer, and his book is a great place to start.

So, how can we say that patents are ever unimportant? Because we've seen company after company spend many thousands of dollars to document, file and sometimes be awarded patents that neither deterred competitors, nor attracted acquirers. Perhaps this reflects the bulk of our portfolio over time being in the Information Technology space. Much of the value-added in that arena has been in software, and software has proven to be a very murky area as far as the value of patents. Since software is by its very nature highly malleable, it is remarkably easy to find other ways to accomplish the same result, and so working around patents is reduced to an art form by clever engineering teams.

So, how can we say that patents are sometimes very important? Because we've seen other companies either live by their patents, or die by other people's patents. The overwhelming majority of those companies have been either in the Medical arena, or more recently in Clean Technology. And their patents have tended to center on composition of matter such as new drugs, or techniques to efficiently create certain compositions of matter such as catalysts or enzymes.

Perhaps the most efficient way to cover this subject is to share with you a number of real-world examples (occasionally disguised to protect the innocent) and then draw some more generalized conclusions from what we observed.

**Inventor, steal thyself**

Let's start with the wild-haired inventor who knocks on our door looking for venture capital. He has his patent in hand, and based on that assumes we'll fall all over ourselves to give him money. Not very likely! It turns out that patents by themselves are rarely valuable. Only when they are reduced to products, and the products are part of a company, and that company can compete in substantial markets, do those patents have value to people like us. A simplistic way to think about this is "ideas are cheap, but execution is precious."

Of course, this is not always true. Sometimes a core patent is worth a lot of money on its own if it stands in the way of major industry giants, and in turn they are willing to pay a royalty for its use. But, companies built on royalty streams are notoriously hard to get to scale, and notoriously hard to get liquid for their investors. They may be very nice income-stream vehicles for friends and family, but not likely to attract significant institutional capital.

So, when do you know which you are? Perhaps the easiest way is to see what "offers" come your way when you go out to raise money with your invention/patent. I know of an entrepreneur who, in my judgment, played this exactly wrong.

Turns out he does have a patent that may be fundamental to an important industry. He was out trying to raise money for a startup to commercialize that technology, and because he had no team around him, and no business experience to give credence to his propensity to execute, venture capitalists held back. During that process, he was approached by a large industrial player in the field, offering to buy the rights to the patent.

They offered him $10 million. And he turned them down!

Here's why I think he's crazy. First, $10 million is a life-altering sum for most of us. To say "No" to that means you have to be remarkably confident that the probability of a much larger pay-day is high. But it isn't. Let's do the math...

If he is successful in getting his company funded by institutional sources, by the time he's raised all he actually needs (probably at least double what he thinks he needs), and hires the management team he needs, and gives them an equity stake in the firm, he'll more than likely own something in the 5%-10% of the enterprise. That may seem small to you, but that is the way the world usually works.

So, for him to be indifferent to the $10 million offer today, he will need to see an enterprise value at some future liquidity event of $100 million to $200 million. Is that possible? Certainly! But, is it highly likely? Not a chance. As a venture investor, I said earlier we back fewer than 1 out of 100 opportunities we see. Of those we invest in fewer than one in five end up with a triple digit millions enterprise value. So, we're talking a less than 1 in 500 chance that his "bet" to forego the $10 million makes economic sense. That is entrepreneurial zeal (or blind spot) in the extreme.

**What's old is new again**

OK, let's move past the crazy inventor to a more established business. In this case, the company was in a capital equipment sector, with a series of patents around process and materials technology that could yield a step function in productivity for potential customers, if it could be commercialized. The company raised multiple rounds of venture capital to pursue this goal, totaling in the tens of millions of dollars, and had the good fortune to have a principal inventor who was over the age of 65.

Now, if this is news to you, consider the next few sentences worth the price you paid for this publication. A little recognized part of the patent law can offer you tremendous potential dividends. It seems US patent law and Social Security share a common attribute. Both set their age metrics back when 65 was the average life expectancy, and haven't really adjusted very much to better health care and longer life expectancy in modern society. In the past, the patent office didn't want to be issuing patents to people who died waiting for them to act. So, if you file for a patent, and you are over 65, that application goes right to the head of the line! Instead of a multi-year wait to even get an office action, you might be looking at multiple months to get a patent fully issued. It's a case of "old guys and gals rule."

So, this company with the "old" prolific investor was racking up patents like mad. And some of these patents were very fundamental, broad claims. But at the same time, it was having difficulty getting past the "R" stage of R&D to the "D" stage, much less getting to a finished product that could be sold and supported.

Finally, the venture investors began to run out of patience and willingness to continue to fund the beast. A consultant was hired to estimate how much the patents were worth, in case the best answer was a shut-down with a sale of the intellectual property. The result was a shocker. After tens of millions of dollars invested, and the issuance of many tens of patents, the "salvage" value of the IP came in at slightly over $1 million.

If there ever was testimony to the point that "ideas are cheap but execution is dear" this is it. Had this company been able to take the next step, and commercialize some of those patents and been able to demonstrate customer demand for the resulting products, that intellectual property might have risen in value by 100-fold.

** **

**What do you call 1000 lawyers at the bottom of the sea? A good start!**

Apologies to my lawyer friends, but that old joke reminds me of a truism for young and/or small companies. Remember if you are basing your company value on the value of your patent portfolio, said value is only as large as your ability to enforce your position. Put another way, if you plan to go to war (aka to court) against an opponent who has more lawyers on staff than you have employees, or more cash on hand than you can count, be prepared to lose. It doesn't matter how strong your position is, or how certain you are of ultimately winning. You have to survive the battle to win the war. Most small companies don't.

Instead, think of your IP position as trading stock. If you are being infringed upon, look to do some horse-trading with the offender before you look to slap a lawsuit on them. It may not work, but more often than not I've seen this play out to the benefit of everyone who isn't billing by the hour. To avoid litigation you can get some useful IP from the other guy, and maybe even a one-time cash payment or on-going royalty. And it is often the case that while the other side may be infringing to some degree, even with a license to your patent, they are missing something they need to fully exploit it. Your inventor(s) who know where the bodies are buried along the path to the patent filing may have proprietary knowledge on how to implement that technology that keeps the other side at bay. In fact, years ago I was told that the best way to kill a competitor in the software business is to give them your source code. Without the engineers who wrote it, most companies break their pick trying to figure out how it actually works.

But wait. We've all seen published reports of companies that have extracted significant sums from large competitors who were trampling their protected positions. When do you know if it's time to make war rather than make friends?

One circumstance I've witnessed where it makes sense to fight is when cash is sitting there to be had, and people are willing to pay a "small" portion of it to take home the rest of it. A good example is the escrow portion of M&A transactions.

We had a portfolio company with some proprietary IP that appeared to have been obtained improperly by a competitor. Neither firm was particularly strong financially, but the other firm was definitely more substantial. If we sued them, we might both go down in flames as the lawyers battled it out. But then a miracle occurred. They got acquired by a company with deep pockets, and their venture capital investors were looking at a significant payday. But, as with all such deals, a portion of the transaction was held back in escrow against any potential claims against the assets of our original competitor.

Our company was happy to oblige. They filed suit against the new parent firm, with the request for monetary damages in an amount that fit within the escrow hold back. Since the venture investors on the other side had already received 80% of the deal value, they were more than happy (OK, probably not happy, but willing) to part with some of that remaining 20% to release the remainder for themselves. In this case, that "small" portion of the escrow amounted to about $10 million, and funded our company for years.

The take-away here is that sometimes when you choose to defend your intellectual property can be more important than whether you choose to do so.

**Now you see it, now you don't**

After a few decades in the venture business and another on the startup side of the street, I thought I'd seen everything when it came to patent issues. Not so.

We had a company in the biotech arena that lost a key piece of value of a patent because it didn't proof-read the patent application carefully. This was a company with a terrific IP law firm, an in-house counsel steeped in the art, and a set of world-renowned scientists. So, all of them knew the drill and it was certainly not the first time they had dealt with the complexities of filing patent applications.

Everything was going swimmingly until the company was in serious negotiations with a major pharmaceutical company about licensing this IP. Of course, the big firm put their team on the diligence process, with fresh eyes.

If you follow this field even casually, you know that all DNA consists of the four nucleotide bases – adenine, cytosine, guanine and thymine – usually represented in the literature by their respective first letters: ACGT. And if you know that (or do now) you may also know that the strings of these (in differing order) to describe a particular biological compound may extend into the many, many thousands. AGTCTTGTCAATGGGACCAGTTAACCGTAATAC...

Sadly, during the drafting of the patent application, someone transposed two of those letters, and it wasn't caught by anyone looking over the documents. The patent office actually has a period of time after you file during which errors can be corrected, but that clock had run out. So, when the potential strategic partner noticed the error, it was too late to fix it, and the intellectual property of the compound was essentially now in the public domain.

So, even when you are sure you have a patent, you may not! More commonly, it is amazing how often we find that patents our firms have can be invalidated, or at least called into question, by prior art elsewhere. We do that to competitors as well, of course. Just know that for all your good efforts and sincere research to prove you have a unique idea, there are bright people out there who will dig and dig to prove you wrong. Sometimes, they are even right.

**Here come 'da judge**

I mentioned at the beginning of the chapter that we've seen companies live and die by patents. Here's a case in point.

Since this is all on the public record now I'll name names. The company in question was CellPro, a biotech equipment firm in Seattle, with technology coming out of the Fred Hutchinson Cancer Research Center there. The firm had developed technology to aid in bone marrow transplantation. Historically, those about to undergo such a procedure for cancer treatment had a bunch of marrow extracted from their hip and then they were blasted with radiation or chemotherapy or both to kill the cancer cells in their body. But that also killed off all the good cells in the remaining bone marrow. So, after the harsh treatment, the extracted bone marrow was reintroduced into the patient, where after a scary period where the patient had essentially no defense to infection, the stem cells in it regenerated and hopefully led to a full recovery.

The only problem was, in extracting that bone marrow, some cancer cells came along for the ride. So, the doctors always were re-engrafting not just healthy cells but unhealthy ones. CellPro had a column that the extracted marrow went through that separated the good cells from the bad, so only good cells were re-introduced into patients. This was clearly a life saving, life changing technology.

CellPro had a successful public stock offering on NASDAQ and was steaming along when hit by a patent infringement lawsuit by a very large firm. Of course, the suing company set the jurisdiction for the case in their own backyard. To make a long story short, even in the face of what CellPro thought was compelling evidence that their IP was valid, the judge ruled against them. The supposedly infringed big firm made our company stop selling the product, even though that firm had no competitive offering in the market. People died as a result of the ruling. So did CellPro.

Now whether the judge was right, or honestly wrong, or something else was going on locally behind the scenes, we'll never know. But it was a cautionary tale for sure. The only good news, well covered in the _Wall Street Journal_ at the time, was that ironically just before the company had to cease operations, its CEO was diagnosed with cancer, and needed a bone marrow transplant. He used his own product to save his life – and it worked!

The lesson we learned here, and I hope you'll find useful, is recognize that judges are people. They can be as right or wrong as any of us and perhaps even "influenced" in ways we'd rather not think about. If at all possible, find a way to settle whatever dispute you have over patents before you submit to that all or nothing outcome.

**Walk softly. Carry a big stack of paper**

OK, enough with the horror stories. Here's one that demonstrates just how valuable good patents can be. We're involved in a company that has a terrific patent portfolio, and one in particular sits squarely on the head of its arch enemy. The enemy, to be fair, has some interesting patents of their own and while we're quite sure we should win any battle, we still remember the CellPro lesson and would like to find a better way to exercise our options. And the arch enemy also has some very interesting products farther down the development curve than some of ours, some of which infringe our IP.

So, the CEO of our company has gone out and rounded up an exclusive license from a third party to yet another piece of intellectual property that will make life exceedingly difficult for this competitor. Now it's time to apply the squeeze. The competitor is about to have a major transitional event, for which it needs a clean IP situation. But they don't know about our firm's new license, nor do they seem to understand how the patent we had issued already has them in a defensive mode, or if they do, they certainly haven't signaled that.

We have another "transitional event" in mind for them. Perhaps we "make them an offer they can't refuse." We simply give them a choice: either we merge the firms, with our company being the surviving entity, or we file suit and make their lives a living hell! As they also said in _The Godfather_ , "It's nothing personal, just business."

**The circle of life**

There you have it. Patents can be useless, useful or all powerful. You've seen how and when they are used can be as important as if they are used. And you can see how, depending on the circumstances, they have very different value in the eye of the beholder.

My closing advice is to think hard about what you choose to patent, and think about patents as much as defensive weapons as offensive ones. And if you have inventors over 65 on your team, threat them well!

****

# Chapter 8

# Run: The Sale's the Thing

What if you gave a party and nobody came? It's a risk every startup faces. Your product is ready. Now, will the dogs eat the dog food? Will the dogs pay for the dog food? Who is going to feed the dogs, anyway?

Sales DNA – It's in the Genes

Organizations are like people. They are born. They grow. They develop and mature. How they grow and mature is subject to direction and guidance by their parents (the founders) and coaches and teachers (their Board). Just like humans, however, organizations have inherent strengths and weaknesses that only so much coaching can change. Like all of us, organizations have a basic makeup that in many ways predetermines how far they will go and how large they will grow. When making an investment decision, venture capitalists try to figure out that special "makeup" of each company. The reason we do this is that we have discovered, sometimes after great pain and suffering, that there is indeed a consistent key success factor for start-ups. It is a factor largely missing in the vast majority of those technology firms that never make the leap to greatness. It turns out that the winners have a common genetic marker!

**"Watson, Come Here. I Want You!"**

No, we don't mean the famous sidekick to Alexander Graham Bell. The Watson we are looking for here is the James Watson who teamed with Francis Crick to discover DNA. Just as those two scientists unmasked a very complex, yet simple way to describe how all living matter was built, venture capitalists follow suit when they take apart a start-up. In our experience, the best start-ups all have a common DNA fragment.

That genetic marker is a large number of senior people in the firm for whom the notion of reaching out and selling something is as natural as breathing. These folks recognize that, as a famous person said long ago, "Nothing happens until somebody sells something." It means that indigenous to the organization is a notion that product differentiation is not just marketing's job; it is everyone's job. The same goes for sales and customer support. It's the drive to make deals happen. Everyone has to know and believe at a visceral level that nothing matters more to a company than becoming a successful, scalable selling machine.

**Sales Is Not a Function—It's a Mind-Set**

Having sales DNA does not necessarily mean having an experienced sales executive in the CEO slot, or any particular slot. It means sales-oriented individuals in every senior management position, as well as some not so senior. It means that even though most high-technology start-ups find their genesis in the fertile minds of engineers or scientists, somewhere in those people or those they surround themselves with beats the heart of a hustler. The thrill of the hunt is not just the hunt for the perfect product. Rather, it is the hunt for that most elusive of creatures in the business jungle: the brave soul who will buy an unproven product from an unknown vendor. Nabbing one of these early adopters, and finding a way to repeat that process, is the key to every successful start-up's growth.

**A Simple Paternity Test**

If you want to know whether you have sales DNA in your organization, there are two simple tests you can run. First, look at your business plan. Sales-savvy entrepreneurs know that successful selling involves not just serving customers but also beating competitors. Does the competitor section of your plan cover anything other than product comparisons? If not, you've made the implicit assumption that the best product always wins. Do you believe that? Do you know how your business economics stack up to your competitors'? Can they cut prices to hold you at bay? Do you assume that your selling and marketing costs will be half of theirs? Do you believe that? How about distribution channel strategy? Many a good start-up has died for lack of a scalable sales channel, or by running into the buzz saw of a very well-tuned competitor's channel.

If your business plan doesn't express a full understanding of how and why customers buy, beyond product features, you have a sales DNA problem. Of course, if you think you don't have any competitors at all, you have a more serious DNA problem. You had better freeze that DNA of yours because you'll soon be extinct.

A second test deals with how you behave as an organization. When the company gathers—for staff meetings, for all-hands meetings, or around the cappuccino machine—what do people talk about? Is the primary focus on product and technology or on orders and delivery and making all accounts reference-able? What comes up first in the weekly agenda? Is there a "company-making" deal that can put you on the map? What topic gets cut if time becomes short? If sales and marketing issues have trouble fighting their way up the meeting agenda, there is no way you have sales DNA. Product and technology issues are indeed critical to a young company. But if they become the end itself, rather than the means to an end, you are in trouble.

**Breaking the Genetic Code**

So what do you do if you run one of the tests above and you find that you are short a few key protein strands? First, step up and acknowledge the weakness to yourself, your management team, and your board. Then go about fixing the problem in the only way we've ever seen it successfully fixed. Get yourself a transplant. This is not about hiring the token sales guy or gal. It turns out that just as in living creatures, DNA mutates very slowly on its own, taking many generations for a change to permeate a class of living things, or a company. You need biodiversity at the core. If you inject a heavy dose of "the right" DNA into the organism, you can dramatically speed up the process. Just as gene therapy shows great promise for medical breakthroughs, the best way to solve a company genetics problem is to inject more than one key executive with the right stuff, into the right place, right now.

Pay attention to the sales DNA in your firm and you'll see your progeny go forth and multiply!

" **Time Kills All Deals"**

The quote above comes from a Sales VP for whom I have great respect. And it rings true in every definition of a "deal."

• If you are a Sales VP selling your company's product or service, and the sales process with a specific customer seems to drag on and on for reasons you cannot ascertain, you're in big trouble.  
• If you are the CEO pitching your company's stock to VCs or angels and can't seem to get the investors to make a decision, you're in big trouble.  
• If you are an Engineering VP and are attempting to get your CEO to spring for a new set of development tools, and that CEO seems to be taking forever to get back to you, you're in big trouble.

The harsh reality is that all sales processes have a cadence. If you have properly qualified your target, and then stay within that cadence, there is a reasonable chance you'll get to "yes." But if not, you are almost certainly going to, someday, get to "no."

We see this all the time in our portfolio companies. One firm was informed on June 24 they were going to get an order for over $1 million on July 24. As that day approached, they were told that a reorganization had occurred at the customer and the order would have to wait until the new boss arrived and blessed it in September.

When he arrived, that new boss had many other higher priorities on his plate, and so finally in December was ready to review the proposal. But the team that had championed the proposal had not taken to the new boss, and had moved on to other firms. So, the new boss said he'd get their replacements in place, and let them re-propose if they wanted to.

The replacements were hired in February, and after a few months of getting their feet on the ground decided to proceed. They went as far as a detailed work plan and deliverables set - including not just the first order, but a follow-on planned for the next year. But, still no order appeared.

Then it was revealed that the new team was going to go to the rank and file employees who would have to work with the new product to be sure to get their buy-in. That meeting happened, but no feedback was received for weeks. Finally, almost a full year after the initial near win, an email arrived saying the potential customer had decided to "go in a different direction."

It should not be a surprise. Any good sales leader can tell you that the scariest thing to hit a sales cycle is a management change. Here, we saw at least two. But more important, any deal that goes from "you'll have the order on date x" to silence is a deal that has a very low probability of closing - whatever the reason for the silence.

What do you do about it? First, you need multiple communication channels into the decision maker(s). This doesn't matter if they are internal or external to your organization. Our firm in the example above had too much reliance on one or two "champions" - who, when they went silent, or later went away entirely, left our company blind to what was going on at the customer.

Second, you need to be very realistic on the probability of success when the sales cycle suddenly takes a detour, when you suddenly feel like it has broken cadence. Take that potential "deal" and assign it a much lower probability immediately. Refocus your efforts on other deals that are still marching to the drummer you want to hear. Don't let "hope" replace "likelihood."

So, what about raising money for your company? As venture capitalists, we sincerely try to get you a crisp answer in a reasonable time. But we, too, fall victim to the law of priorities of the moment and sometimes the law of the crow (oh, a shiny new object!). If you have pitched us, and we break cadence and go dark on you, it's a bad sign. You should feel free to call us on it and ask for clarification. But if you don't get a rapid response, assume the worst and move on. We actually tend to get to "yes" fairly fast, with lots of building to yes signals along the way. If you aren't getting those signals, assume time is killing your deal.

Pricing For Fun and Profit

**Are You Leaving Money On The Table?**

For all the detailed work that goes into product planning and development in start-ups, I'm always amazed at how little effort is put into pricing those products properly. Yet, it is the act of pricing that determines what value you ultimately receive for all the hard work to spec and build your "next great thing."

Think about it: How did you determine the price of your product? Was it a multiple of cost? Was it sort of what others are charging, maybe plus something because you deem your product superior, or was it minus something to get market entry? If you are pricing for a land grab strategy, how much is that land costing you? And if you are creating an entire new category with your product, then what do you do?

It turns out that while pricing can be more art than science, there is science that can be applied. Here's an approach that has been shown to work...

Take a description of your product's features, functions and benefits to about ten potential customers. Ask them for no more than five minutes to answer the following five questions:

• At what price would you consider this product expensive?  
• At what price would you consider this product inexpensive?  
• At what price would you consider this product too expensive, in that you would not buy it?  
• At what price would you consider this product too cheap, so you would question its quality?  
• What few features would you add that would increase the product's value to you?

Now, plot the data points from questions 1-4 for each respondent and connect each question's points with a line. What you will tend to see is a four-sided figure that describes the effective price zone you should be considering.

If your current price plan is outside that range, time to go back to the drawing board. If your price point is inside, good! Now look at the answers to question 5 to see if you can slide the four-sided figure to a higher level with very little increase in development cost or time.

With that, let me share a story that still resonates on this issue. Many years ago, I was a young division marketing manager in a $1 billion revenue high technology company (Tektronix, now part of Danaher). Senior management decided to bring in a pricing consultant, Dan Nimer, to see if he could help us get more value for our efforts. In the room were all the division marketing heads, and the firm's Executive VP who was sponsoring the day. After some introductory exercises to get us relaxed and into the flow, the consultant posed this question:

"I'd like to see a show of hands of those of you who think you could raise the prices of your respective products by 1%, just 1%, without suffering any loss of volume."

Most of us, including me, thought for a moment and said to ourselves, "Well, sure. Just 1% probably wouldn't make much difference to our customers. They appreciate our product features and high quality enough for that." Essentially everyone raised their hands.

The consultant immediately turned to the EVP and said, "Your marketing leaders just told you they are knowingly keeping $10 million a year off your bottom line with no loss of market share. How do you feel about that?" Needless to say, you've never seen more hands come down faster in the second or two that followed - not to mention all marketing types now with tight stomach muscles hoping the EVP wasn't looking directly at them.

But Dan had made his point. None of us really had enough of a handle on our pricing decisions to know one way or the other what a change in price would mean. And if our initial hands-up responses were even close to accurate, that ignorance was keeping material profits off our income statement.

So, before you get that same tight feeling in your gut that you are leaving money on the table, put the same kind of energy into product pricing that you do into product features. It will pay for itself.

When should you "Buy the business?"

We've all been there.

You and your start-up company have worked your tails off to land that signature account which will not only provide validation for your investors, but signal to the marketplace that you are real and that your product is indeed superior. Then, at the last minute, or sometimes even later than that, a competitor - usually larger and well-financed - drops their price to levels that the potential customer cannot ignore. Even if this happens after the official call for BAFO (best and final offer) - you find yourself in a spot where the prospect essentially says, "Sorry, but either you adjust your cost down, or I'll have to buy from the other guy!"

What do you do? Do you take all the profit out of the sale, or stand your ground? And if you do drop your shorts, how do you explain that to your venture investors? How do you keep that unsustainable price from becoming your new ceiling in the market at large?

My experience says that while you certainly want to carefully analyze the situation, make sure this isn't just a tough purchasing agent playing games with you, and continue to argue for price based on value - in the final analysis it is usually better to "buy the business" than let your competitor do so.

The reasoning is simple. History shows us that market share is a much more powerful and lasting phenomena than one would expect from simple product competitiveness evaluations at points in time. Switching costs for customers tend to be higher than they think, higher than you think, and higher than are easy to calculate. So, once you've got customers, you tend to keep them. Also, there is ample evidence that market share momentum does impact the purchase decisions of others. So, the fact that you bought the business in one account will tend to allow you to win the business elsewhere, often without the same price pain. In fact, once your competitor knows that bombing the price won't work, they usually stop trying.

Here's a real example: One of our portfolio companies worked for a year to land a major account. In this area, two giants own about 33% of the market each, with others 10% or less. This customer was one of the "big 2," widely viewed as the innovative leader in the space. After the BAFO process was complete, and our firm was told they had won, with a reasonable gross margins on the deal, the other finalist - a public company, offered an EBATTWRMIFO (even better and this time we really mean it final offer). The customer apologized for the break in protocol, but indicated as a business decision they had to take the new offer seriously.

Our firm thought long and hard about it, but finally decided this account was too important to lose, and so dropped their price - not as low as they thought the public company had, but within hailing distance. The customer jumped at it. The gross margin on the deal was close enough to zero as to make it essentially a pass-through. Ugh!

But, here's what happened over time. First, the customer signed up for an 18 month commitment, but didn't meet their volume projections. So, after that initial contract period, they negotiated in good faith for a better price. It still wasn't quite up to the original "win" level, but at least now measurably positive. Then, a 10% market share player selected our firm's product, at standard pricing. Six months later, the other of the "big 2" players finally rolled over and bought from our company, again at standard pricing for their volume. Our company now has a commanding position in the segment, and with reasonable profitability to boot.

So, if you are small and hungry, go ahead and behave that way. If your big competitors force you to take scraps of profit initially, such is life. Over time, buying the business usually pays off.

When Should You Hold The Line On Price?

This is the counter-point to when you should "buy the business." In many ways, this is a much tougher call, because it is always easier to drop price knowing you are likely to win than to hold the line and then hold your breath to see if you made the right choice.

We recently had a very good example of a portfolio company who played this about as well as one can, and got the price they wanted. Here's how they did it....

This company is offering a new product that has very clear technology advantages over current suppliers, albeit some of which may require the customer to do things a bit differently. Because of their advantages, our company was planning to charge a premium for the product. However, while doing their evaluations the big customers in the space all were making noises about how the price had to be BELOW current alternatives to get them to switch suppliers. Those big fish were exercising their market power to try to get a better product at a lower price.

Our company hung tough, but did so in a non-pugnacious way. They simply kept working with those potential big customers to make sure the technical evaluations were successful, while not forcing the issue on price. This was hard because clearly price negotiations were needed to actually close business, which we as their investors were pounding on them to do. But in parallel, the company went after some much smaller faster moving fish, those who were looking to swim upstream against the industry heavyweights. Eventually, they got a start-up to select them, at what was essentially list price. That start-up did not have the purchasing power and volume potential we might like, but they did set a price level that the company could then go out and legitimately say, "Others are paying this price."

The next step was to move up the market power ladder (or is it a fish ladder?). Customer #2 was signed a few months later at product volumes 10 times higher than Customer #1. In fact, Customer #2 is an established market player (a medium-sized fish), while still trailing the top two or three volume leaders. But now, our company can look the big fish in eye and say, "we have multiple customers, including one of your primary competitors, paying prices like this."

It is too soon to know if one of the big fish will bite. But our portfolio company has been very wise in establishing the price-value relationship. They started with little fish and moved up. It's a model you might want to emulate.

Navigating the Channel Waters

Developing sales channels is a challenge for most start-ups, especially for companies targeting the small to medium-size enterprise (SME) market. To help three of our portfolio firms and test a few investment hypotheses, we recently interviewed a number of Value Added Resellers (VARs) and Managed Services Providers (MSPs). We gathered many insights from these executives, but here are a few highlights:

VARs' criteria for selecting new product vendors:

• They are looking for vendors with a clear, focused VAR strategy.  
• Some level of channel protection, especially from corporate resellers.  
• Product margins of 20-30 points, reasonable volume and opportunities for services revenue.  
• A stable, reliable product, which solves real problems and is easy to set-up/use.  
• But most importantly, we heard, "VARs need consistent touches." Good working relationships are critical.

When we asked if these criteria have changed over the past 5 years, one person responded, "The need has always been there. Vendors are just getting smarter about it. You have to think about which VARs would be a good fit for your product. The shotgun approach doesn't work."

MSPs have slightly different selection criteria than VARs:

• They are focused less on margins and more on reducing risk. MSPs are customer representatives – very solutions oriented and support driven.  
• Some MSPs only recommend products to avoid conflict of interests.  
• Like VARs, MSPs are looking for unique technologies which are reliable, scalable and easy to use.  
• But they also require products that are built around MSPs' need to manage from one central site and technologies that cover liabilities and provide back-up security.  
• Service-rich opportunities are essential.  
• MSPs also expect excellent working relationships, especially good training and experienced technical support.

This project underscored the value of talking with distribution partners. In addition to learning how to be more effective working with VARs and MSPs, we got a few great new product ideas, and many of the interviewees wanted to learn more about our portfolio firms' solutions. Not a bad return for a few phone interviews! Perhaps you can extract similar value from calls into your potential channel partners.

Branding: Should You Change Your Company Name?

Many times in our experience, start-ups wrestle with the issue of whether their company name should be changed. It struck me that we have an interesting laboratory regarding the value and/or wisdom of that, right within our own portfolio.

I did a very unscientific piece of research that begs the question of cause and effect, but still has potential for discussion. Looking over our last couple of funds, I broke the companies into two categories:

• Those that never changed their name  
• Those that did (once or multiple times)

The sample size here was over 50 start-ups, so it can be argued to be statistically significant.

Then, I simply measured the returns on invested capital in each group, or for those firms still developing, I put them into either a "likely winner" or "likely not" category given the best available data we have at the moment. The results were rather startling:

Companies that did not change their name show a much higher rate of success than those that did change!

Now to be fair, this is not prescriptive, as I can point out examples of name-changers who did (or are doing) quite well. But on balance, the trend is clear. If you change your company name, you are much less likely to be a success than if you don't. So, is there any reason to believe there is cause and effect here, or is this just the randomness of start-up failure at work?

Perhaps we can speculate on why it might be a sign of something fundamental. A name change can come from a number of factors.

• You are a very technical team and thought a very technical name for your company initially made sense. And you think marketing is either very easy, or for sissies.  
• You are a very clever technical team and loved the idea of a series of letters that were available as a URL that sounded like a real word, but spelled differently. For an off-the-wall example: ghoti pronounced as fish - gh as in the word "enough," o as in "women," ti as in the suffix "tion." I know, no one would be that crazy, but you get the point. You think marketing is about clever letter and word-play, even if no one can find you with a web search.  
• You started life with a company name that was either too broad (Enormous Enterprises), or too narrow (Ruby-on-Rails-templates.com) and need to reposition to what you do now.  
• Your product name, which was different than your company name, became more well-known than your company name - and you yielded to market forces.  
• You hired a new CEO, or new VP of Marketing or Sales, who decided they just had to put their mark on the company.

I think a case can be made that in every bullet item above there is a business flaw or weakness that is getting reflected in the name change. And so those that didn't make those mistakes may have had a higher probability of success.

Perhaps in the name game, like start-ups in general, getting it right the first time matters.

Three Universal Truths

I was chatting with two of our portfolio CEO's recently, as they asked for advice in handling some specific situations that either were new to them, or at least wanted to make sure they were in alignment with the Board before acting. It struck me that my answers centered on three notions I've shared many times with other CEO's, hence the "universal truth" label. They are:

**Go for the gold**

What I mean here is if someone offers you cash find a way to say "yes." It doesn't matter if it is a VC or a customer. This is not always as easy as it sounds, because sometimes that gold comes with strings attached. The goal is to be creative enough to get the strings to not pull you in directions you don't want to go, or keep you from going in a direction you do want to go. So, adjusting those strings in the negotiation for the cash is vital. But remember that the only thing that kills you in business is running out of cash, not the strings attached to the cash. So, optimize for cash above all else.

Here's a relevant example from those CEO discussions. This company had recently done a financing where OVP was the preferred investor. After the deal closed, a potential investor who had not been selected came back still wanting to invest. Some more cash could be helpful, but the firm didn't require all the cash this investor needed to put in to own a meaningful percentage of our new portfolio company. So, what to do?

The company worked with this new investor to split the investment between new capital for the firm and money to buy out some old, tired angel investors at a profit. In addition, we even let management take a little of their Common stock off the table, while keeping the vast majority of their holdings as incentive to stick around and help us make this a very big deal. Normally, we don't like to do that, but in this case it was all part of "getting to yes" - and going for the gold.

**Go for the talent**

One of the CEO's who called was asking about hiring above the current Board-approved headcount budget. He raised the question because a big player in the industry was undergoing some dramatic upheaval and they have senior executives and individual contributors jumping off the ship. Our experience says that truly top people are worth many times what a regular good person is. And the opportunity to grab bunches of top people all at once happens very rarely. So, if you can hire them, do - independent of whether you have official job openings for them today, or even in the next six months. (this relates back to truth #1 - have the cash to do this).

In this specific case, one key employee of the firm in duress would be a direct replacement for a very solid contributor at our portfolio company. But he would be clearly a step up in capability the company would value as it scaled. So, again, what to do?

My advice was to interview that person and see if he measured up to the resume and unsolicited recommendations we had received. If so, then we might be faced with a painful decision - but one that we indeed needed to face. It is always the CEO's job to put the best team on the field possible. If that means (using the same analogy) we needed to trade one of our good performers for a star player, then that's our responsibility. If it comes to that, it is also our responsibility to respect the loyal good performer and either find them another challenging assignment in the firm, or treat them very well upon departure.

**Go for the throat**

It is very rare in business, and especially for a start-up, to have the opportunity to kill a competitor. I mean really make them go away, permanently. History says, in this competitive ring if you get one on the ropes, and you let them get to their corner and recover, they may come back and hurt you badly in a later round.

One of our portfolio companies was in just such a situation. They had a competitor that appeared to have wobbly knees. But, to truly knock them out might take a punch that would hurt us in the gross margin line for a while. What do you do?

By now, you know my answer. Throw the punch. Eliminating the competitor would more than likely eliminate some of the price competition in the segment, as crowded segments always tend to see a race to the bottom on price. I told the CEO that we'd give him a pass on his gross margin targets for a bit if he used that flexibility to put the competitor on the mat (this relates to truths #1 and #2, have the cash and the talent to throw that punch).

Go for the gold, go for the talent, and then go for the throat. Three universal truths indeed!

****

# Chapter 9

# Run: To Your Reward

The Price-Progress Paradox

From time to time, there has been wailing and moaning and gnashing of teeth regarding an apparent dichotomy in the venture capital business. Why is it that there is so much money out there, but not so many early-stage companies are being funded?

Besides licking our collective wounds from the pummeling we've sustained over the years, venture capitalists are analyzing backward while looking forward. We've even done the unthinkable and applied some of the same due-diligence discipline to our business models as we have inflicted on unsuspecting entrepreneurs. And we found a smoking gun!

You may want to jump back to Chapter 3, in the "Incoming Term Sheet" section for a quick reminder on the definitions of pre-money and post money valuations before you go on!

Buried in the reams of data about the venture capital business is a simple set of relationships, remarkably stable over time that in large part explains why it seems to be harder to get VCs to jump on a Series A (first round) deal today. It turns out that we have not been getting paid for the risk we take and the time our money is tied up. The way you can figure this out easily is to look at the post-money gap between valuations after a Series A and Series B round of cash.

While there is some variation over time, on average the "gap" is about $7 to $8 million. In other words, _after the money goes in_ , the average second-round deal ends up valuing a company at about $7.5 million more than the deal was valued after the first round was completed.

Initially, you might be tempted to think that this makes perfect sense and should be a comfort to venture capitalists. Progress was being rewarded with higher prices, was it not? No, it was not! The italicized words above are there for a reason. Let's take a typical early-stage start-up as an example. Hotshot Networks has assembled a number of very credible folks who plan to address the emerging market for wireless networking. They've written a business plan and now need cash to go into product development. They agree with their venture backers to take $4 million in a Series A round at a $4 million pre-money value, which equates to an $8 million post-money valuation. So far, so good for all concerned.

A year later, Hotshot Networks has its beta product ready, and a few beta sites signed up: a fairly typical amount of progress in a deal going well. The entrepreneurs now go out to raise their Series B round to build their sales force and scale the enterprise. They think they need about $8 million to do so (cash raised in round two is very often about double that in round one). From the numbers above, they can expect a post-money valuation in the neighborhood of $15.5 million.

But that equates to a pre-money valuation of $7.5 million, or essentially the same (or slightly less) than the valuation after the Series A done one year earlier! The entrepreneurs have worked their tails off for 12 months, with no up-tick in valuation to show for their efforts—a real hit to employee morale. But the VCs are even more discouraged. They took the product development risk, took the competitive risk that someone might come along over the intervening year and leapfrog the idea, and had their money tied up for a year with the IRR clock running. Yet the price per share of the stock for the Series B is going to be the same as the Series A. Great progress was made, but no price premium was realized.

If you were a venture capitalist, you would have been smarter to sit on the sidelines, let someone else do the Series A, and then come along a year later and pick and choose among the best of those now less risky deals.

So why have venture backers managed to do so well historically in spite of this arithmetic? First of all, these are averages, and everyone knows that the venture capital business is not about hitting for average; it is about hitting home runs. A few terrific deals pay for all your sins of omission and commission. Getting in early gives you differential access to getting on that home run team. That said there is still something useful to be learned by both entrepreneurs and VCs from the simple math above. **Capital efficiency matters a lot.**

In the scenario above, if instead of raising $8 million in the Series B, the company raised $4 million at the same post-money of $15.5 million, the pre-money would have been $11.5 million rather than $7.5 million, or a 53 percent increase from the $8 million post money Series A in one year. A 53 percent annual IRR is something to smile about! If Hotshot Networks could find a way (and there are many ways) to grow while not consuming as much capital, both the entrepreneurs and VCs would come out on top, and progress would be rewarded. Smart entrepreneurs and smart venture capitalists are focusing on growing capital-efficient businesses. If you want to succeed and avoid the price-progress paradox, that is the way to play.

A Pull-through Financing May Pull You Through

Most people involved in the start-up scene know all about seed rounds and Series A or B financings. But, unless you've run into the situation yourself, very little is said about a variant on follow-on rounds called a "pull-through." While these tend to happen more in challenging times than in good times, a pull-through just might get you and your company out the other side of a problem period to see happy days again.

Imagine one of these situations - or a blend:

• You have raised venture capital from a couple of firms, perhaps over a round or two. Your company has hit a few bumps in the road and now you have some investors willing to write the next check, with others not or not so sure.  
• You have raised venture capital from a couple of firms. You are doing a follow-on round, with a new outside lead investor to price it, but one of your existing investors has run out of cash, or their fund has gotten so old they can't/won't invest.  
• You have raised venture capital and hit a few bumps along the way. Your investors are still hanging in there for the next round, but a couple of early employees/founders have departed. They own a material amount of the Common stock, but are no longer adding any value. This is inhibiting your ability to offer meaningful shares to new people ready to do the heavy lifting.

The challenge becomes to attract the new money in a way that provides incentive for investors to play and punishes those who don't, while rewarding employees who are pulling their weight yet punishing those who aren't. If you are not careful, you can end up chasing your tail with a simultaneous equation problem with more unknowns than equations. But, there are some simple ways to approach this that savvy investors know, that entrepreneurs should know.

Recently, I was crafting one of these pull-through deals (mostly the first scenario above, with a little of the third thrown in). The firm has three VCs and a strategic investor. The strategic had reset its attitude towards venture investing, and was probably not going to participate. One of the other two VCs had a partner change on the deal, and so pride of authorship was gone. The bumps the company was experiencing were giving that new individual serious concern. Finally, a founder had departed with a large block of vested stock. The lack of performance to plan was scaring off new investors, at least for now. The only way to finance the company was with an inside round. In addition, we had to make it clear that without new money, the company would have to be shut down, and all investors would lose everything. The goal was to get as many to play as possible.

What I did was put together an inside "Series B" financing that did the following:

• The pre-money value was set to market, which was (sadly) well below the last round post-money due to the problems in execution the firm had experienced. In this case we calculated the new pre-money by looking at what the new implied post-money would be (again: pre-money plus new cash going in), then imagining the company made its plan for the next 12 months, and then guessing what the pre-money value of the next round would likely be based on the company's performance. The post-money from this round could not exceed the pre-money for the next round, unless we were going to be foolish enough to set ourselves up for yet another down round. We were not. This was a carrot to the investor syndicate.

• The previous round was offered to be pulled though into the new lower-priced Series B for those who participated in the new round, but only 33 cents on the dollar. This incentivized the original investors to play, without crushing the existing employees. It was another investor carrot, albeit a partial one.

• For those not participating, their original Preferred was converted to Common, and reverse split 10:1.That's a wipe out. In the end, the Series A would cease to exist. As opposed to the carrot, this was the stick - a BIG stick.

• We did the math and for a few key employees we needed to refresh their Common options somewhat, and so we had to build up the option pool. We didn't bring them all the way back to where they were (everyone in this scenario shares some pain) - but we did to appropriate levels for their roles, after a typical Series B.

• The departed founder was diluted by all this, of course, although he still held a share of the company that could be of material value if the new team finally delivered on the original vision.

This is one of those classic cases where the "right answer" was for everyone to end up equally uncomfortable, but for the company to get the cash it needed to continue. If the firm can now "pull through" on its operating challenges, the pull through financing will have helped make that happen.

While a pull-through financing isn't an option in every situation where you have a syndicate with differing appetites or ability to invest, it's another tool in the VC tool kit that can help entrepreneurs and their backers get through the proverbial knot hole.

When is Taking Corporate Strategic Money Like Baseball?

One of the thorniest problems in taking investment dollars from corporate strategic investors is the risk of "selling the company without selling the company." You want the money, you want the benefit of the power that corporate partner can bring, but you don't want to be arbitrarily capping your upside. However, the corporate partner has a set of worries, too. They don't want to give you money so you can make yourself so valuable they can't afford to buy you later, when you have grown into a significant enterprise. So, how to you deal with these conflicting issues and goals?

Recently, I saw a negotiation settle around a tried-and-true model from the world of sports - baseball binding arbitration. The model worked like this: The strategic investor would put some money in for X% of the company. In addition, they received an option to buy the entire startup at any time over the following three years, unless the company filed for an IPO.

Now for the tricky part: How do you set the price today for a possible event up to three years from now without either capping your upside (if you are the entrepreneur) or paying for value you helped create (if you are the strategic investor)?

Here's where the arbitration comes in. At any time in the three year window, the strategic investor can propose an acquisition. They then must put their price in a sealed envelope. The company puts its price in a sealed envelope as well. The independent arbitrator opens the envelopes together and the following rules apply:

• If the numbers are within 20% of each other, the arbitrator splits the difference, and the deal is done.  
• If the numbers are farther apart than that, the arbitrator picks the one he or she thinks is closest to market value. If it is the strategic investor's bid, the company must accept. If it is the company's bid, the strategic must either accept, or lose its option forever.

So, how does this serve both parties?

• It keeps both sides honest in their bidding. If one goes way out of range, they risk the other number being chosen, with the consequences attached.  
• It allows for a rational process not based on performance metrics that can't be fully understood when a startup is still in its early days.  
• It maintains relationships going forward that will be crucial if the company is acquired, since the rules are defined and the decision is with the arbitrator, not between the parties.

In business, we all can fall into the trap of using sports analogies to describe our situations. Here's one where a sports model really is helpful!

Exit, Stage Right

As an entrepreneur, you are the lead actor in a play that only you can write. Be ready for your lines. Know your position on the stage. And above all, know when and how to exit. That said, when we meet with a start-up, this is one of the first things we tell them: Lose the term "exit" from your business plan and your PowerPoint pitch. This is about liquidity, not an exit. "Exit" implies an end—that you can neatly wrap up the package and be on your way. Not so!

If the liquidity event is an initial public offering ("IPO"), it is not an exit. In fact, it is just the beginning. The scrutiny you face from accountants, regulators, and shareholders in a post-Sarbanes-Oxley world can be daunting. It requires nerves of steel and a commitment to the company for the indefinite future. Don't let your new public stakeholders down by looking for a quick exit.

If the liquidity event is an acquisition by a public company, it may look like an exit, but do not be confused. The acquiring company expects to receive value for its cash or stock. That value is measured not just at the time of the closing, but going forward. You should expect to join the acquiring firm and be locked into an employment contract for a number of years. You should expect to have some portion of the purchase price tied up in escrow—to be released only if what the acquirer "bought" turns out to be what you "sold." Remember, in a play the only time an actor doesn't make it to the end of the performance is if he gets killed off en route! Be ready to go the distance.

**Start With a Clean Script**

Great playwrights know how the story will end before they write the first scene. There isn't a lot of scrambling around at the end of the performance to tie up loose ends. A similarity for start-ups is to keep your financial house in order from day one. Realize that there will come a time when you will need clean financials, a clean capitalization table, and clean contracts. If you never let them become "dirty," you will have little to do when it comes time to prepare.

So what does "clean" mean? First and foremost it means doing everything in your power to be not just on the right side of the line of legality and ethics, but so far on the right side of that line that it is not even in view. It means evaluating every transaction using the test that you would not be embarrassed if the details showed up on the front page of your local newspaper. It means being a company you would want to invest in even if you weren't part of it.

In the area of capital structure, this means a simple, straightforward equity model, with investors few enough in number that you can name them all. As one of my colleagues once said, sagely, "With three or four individual investors, you have angels. With a dozen, you have hell." The same holds true for VCs—except cut the numbers in half.

**Timing Is Everything**

On stage, good timing makes the difference between lines falling flat and a play coming to life. In exits, timing has every bit as much to do with those providing the liquidity as it does with what you are doing. The "right stage" is in the eye of the beholder. So we have a house rule: "Sell when the customer wants to buy."

**There are two great points to realizing liquidity in a start-up business:** first, when the business is all promise and no problems, and second, when the business is all progress and proven promise. The difficulty is that the period between point one and point two is often measured in three to five years. Once the initial promise period is past and the problems that all start-ups encounter are evident, there is often a sustained drop in the perceived value. So the best period might come when you have made your initial sales and customers will provide testimonials for your product, but before the reality of building a complete sales channel stares you in the face. The second point of time might come with clear traction and sales ramping and an obvious path to profitability.

The external world matters, too. Roughly every four to five years, the public markets will pay you just for showing up. When the IPO window opens, you should go through it if you can. That low cost of capital will probably not be repeated in a relevant time frame for you. But don't confuse going public with being successful.

There are also times when market consolidation is in vogue, and large public companies will be eager to take you off the street. This is a game of musical chairs, so it is best to grab a chair early. The longer the game goes on, the less likely you are to get a chair with large sums of cash attached. Usually the first and second players to get consolidated (i.e., acquired) get paid well. The rest don't.

**The Plot Thickens**

We all know how tension rises as a play nears its climax. For your investors and yourself, liquidity certainly qualifies as a climax point. So now the stock is in your investors' hands. What happens? Studies have shown that the best returns have been gained by VCs that sell "blindly" after the IPO or merger lockup expires, often 180 days, versus those who think they can outsmart the public markets. Now, blindly doesn't mean stupidly—as in dumping all the equity at once.

The best model seems to liquidate 25% every quarter or two, where the VCs initially sell or distribute their holdings in segments, without upsetting the stock price. This notion makes sense for entrepreneurs, too. Once your lockup or restrictions have been lifted, you can expect strict "trading windows" that allow you to buy or sell your company's security only during specified times. This avoids both the reality and perception of any insider trading behavior. But be forewarned: If there is material information that is not public, and materiality gets measured retrospectively, you might not be able to trade even within the approved window, or the next, or the next.

For that reason, I recommend the Bill Gates model of liquidity for entrepreneurs. Long ago, Bill announced that he was going to liquidate his Microsoft stock position very slowly and systematically, selling a reasonably fixed amount every year. He adhered to the program. At first, there were comments like these in the press: "Gates is selling. It must be a bad sign for Microsoft." Over time, however, he continued selling and Microsoft continued growing, to the point that his sales didn't even raise an eyebrow. Bill made sure that his character's role didn't get in the way of the play's success.

**Take a Bow**

With a lot of hard work and a bit of luck, you'll be looking at a good exit (oops, liquidity event) down the road. If you build something of lasting value, you will get to share in that value. If you go into your start-up not for the exit, but for the journey, you will find yourself facing liquidity with a sense of satisfaction that transcends the money.

**But, take the money anyway... and run!**

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