Over the last 30 years Wall Street’s appetite for technology stocks have changed radically – swinging between unbridled enthusiasm to believing they’re all toxic. Over the same 30 years, Venture Capital firms have honed their skills and strategies to match Wall Streets needs to achieve liquidity for their portfolio companies.
You have to wonder: does the VC you have on your board today have the right skill set to help you succeed in today’s economic environment?
What Do VC’s Do?
One of the biggest mistakes entrepreneurs make is misunderstanding the role of venture capital investors. There’s lots of lore, emotion, and misconceptions of what VC’s do or don’t do for entrepreneurs. The reality is that VC’s have one goal – to maximize the amount of money they return to their investors. To do this they have to accomplish five things;
1) get deal flow – via networking and legwork, they identify likely industries, companies and teams with the potential for rapid growth (less than 10 years),
2) evaluate those companies and teams on the basis of technology, market opportunity, and team. (Each VC firm/partner has a different spin on what to weigh more.)
3) invest in and take equity stakes in exchange for capital.
4) help nurture and grow the companies they invest in.
5) liquidate their investment in each company at the highest possible price.
Going Public
VC’s make money by selling their share of your company to some other buyer – hopefully at a large multiple over what they originally paid for it. From 1979 when pensions funds began fueling the expansion of venture capital, the way VC’s sold their portion of your company was to help you take your company “public.” Your firm worked with an investment banking firm that underwrote and offered stock (typically on the NASDAQ exchange) to the public. At this Initial Public Offering your company raised money for its use in expanding the business.
In theory when you went public, everyone’s shares were now tradable on the stock exchange, but usually the underwriters required a six month “lockup” when company insiders (employees and investors) couldn’t sell. After the end of the lockup, venture firms sold off their stock in an orderly fashion, and entrepreneurs sold theirs and bought new cars and houses.
Five Quarters of Profitability
During the 1980’s and through the mid 1990’s startups going public had to do something that most companies today never heard of – they had to show a track record of increasing revenue and consistent profitability. Underwriters who would offer the stock to the public typically asked for a young company to show five consecutive quarters of profits. There was no law that said that a company had to, but most underwriters wouldn’t take a company public without it. (On top of all this it was considered very bad form not to have at least four additional consecutive quarters of profits after an IPO.) While there was an occasional bad apple, the public markets rewarded companies with revenue growth and sustainable profits.
What this meant for entrepreneurs and VC’s was simple, profound and unappreciated today: VC’s worked with entrepreneurs to build profitable and scalable businesses. In this time, building a successful business meant building a company that had paying customers quarter after quarter. It did not mean building a startup into a company to flip or hype on the market with no earnings or revenue, but building a company that had paying customers.
Your Venture Capitalists on your board brought your firm their expertise to build long-term sustainable companies. They taught you about customers, markets and profits.
The world of building profitable startups as the primary goal of Venture Capital would end in 1995.
The IPO Bubble – August 1995 – March 2000
In August 1995 Netscape went public, and the world of start ups turned upside down. On its first day of trading, Netscape stock closed at $58/share, valuing the company at $2.7 billion for a company with less than $50 million in sales. (Yahoo would hit $104/share in March 2000 with a market cap of $104 billion.) There was now a public market for companies with no revenue, no profit and big claims. Underwriters realized that as long as the public was happy snapping up shares, they could make huge profits on the inflated valuations (regardless of whether or not the company should have ever been public.)
And some companies didn’t even have to go public to get liquid. Tech acquisitions went crazy at the same time the IPO market did. Large companies were acquiring technology startups just to get in the game at the same absurd prices.
What this meant for entrepreneurs and VC’s was simple– the gold rush to liquidity was on. The old rules of building companies with sustainable revenue and consistent profitability went out the window. VCs worked with entrepreneurs to brand, hype and take public unprofitable companies with grand promises of the future. The goals were “first mover advantage,” “grab market share” and “get big fast.” VCs or entrepreneurs who talked about building profitable businesses were told, “You just don’t get the new rules.” And to be honest, for four years, these were the new rules. Entrepreneurs and VCs made returns 10x, or even 100x larger than anything ever seen. (No value judgments here, VCs were doing what the market rewarded them for, and their investors expected – maximum returns.)
(And since Venture Capital looked like anyone could do it, the number of venture firms soared as fast as stock prices.)
Venture Capitalists on your board developed the expertise to get your firm public as soon as possible using whatever it took including hype, spin, expand, and grab market share because the sooner you got your billion dollar market cap, the sooner the VC firm could sell their shares and distribute their profits.
The boom in Internet startups would last 4½ years until it came crashing down to earth in March 2000.
The Rise of Mergers and Acquisitions -– March 2003 -2008
After the dot.com bubble collapsed, the IPO market (and most tech M&A deals) shutdown for technology companies. Venture investors spent the next three years doing triage, sorting through the rubble to find companies that weren’t bleeding cash and could actually be turned into businesses. With Wall Street leery of technology companies, tech IPOs were a receding memory, and mergers and acquisitions became the only path to liquidity for startups and their investors. For the next four or five years, technology M&A boomed, growing from 50 in 2003 to 450 in 2006.
What this meant for entrepreneurs and VCs was a bit more complex– the IPO market was all but closed (with the Google IPO in 2004 as a brilliant exception), but it was possible find a buyer for your company. The valuations for acquisitions were nothing like the Internet bubble, but there was a path to liquidity, difficult as it was. (Every startup wanted to believe they could get acquired like YouTube for $1.4 billion.) VCs worked with entrepreneurs to build their company with an eye out for a chance to flip it to an acquirer. The formula for exits was a variation of the formula they used in the Internet bubble, morphing into: brand, hype and sell the company.
In the Fall of 2008, the credit crisis wiped out mergers and acquisitions as a path to liquidity as M&A collapsed with the rest of the market.
So what’s left?
2009 – Back to The Future
The bad news is that since the bubble most VC firms haven’t made a profit. It may just be that the message of building companies that have predictable revenue and profit models hasn’t percolated through the VC business model. (Perhaps in direct proportion to the number of “freemium” and “eyeballs” web deals funded.)
It may be that the venture business will have to return to the old days of helping entrepreneurs build companies – not hype them, not spin them, but actually make them worth something to customers and investors.
The question is: do VC’s still have what it takes to do so?
Next time you sit in a board meeting with your VCs, step back a bit from the moment and listen to their advice like you are hearing them for the first time. Are these VC’s who know how to build a company? Is the advice they are giving you going to help you build a repeatable and scalable revenue model that’s profitable quarter after quarter?
Or were they trained and raised in the bubble and M&A hype and still looking for some shortcut to liquidity?
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Filed under: Customer Development, Venture Capital | Tagged: Entrepreneurs |
Steve –
Great post and really great advice. Thank you.
Jon
Steve,
Great insight for us young entrepreneurs.
I’d counter the title of your post with my own point, which is that why should a young entrepreneur trust a VC over 40 (maybe we shouldn’t trust any, period!) when these are the guys (and gals) who tend to be “made” already, and have little to gain from new deals? Wouldn’t younger VCs with the incentive to climb the ranks internally be better champions of one’s startup and more likely to want to fuel growth, regardless of the exit strategy? Unfortunately, regardless of a VC’s age, their business models are suffering and IPOs seem to be a thing of the past for at least a while longer.
For instance, I’ve been warned when being introduced by other entrepreneurs not to trust certain older VCs due to their disposition towards using young startups to do their friends favors, prove a point, gain some insight, etc. When you drive a $100,000 car, live in a $10MM house, got your wife plastic surgery and sent your kids to Stanford already, what is motivating you to grow some 20-something’s idea? These types seem dangerous, yet are often the ones needed on board to get the fund to invest in the first place, seeing that the younger partners naturally have less pull during the Monday round-ups.
Just food for thought– certainly this argument does not apply to all as there are some outstanding VCs out there.
M
Great B-day post!
thank You steve blank!!
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Best summary of the past, present and the future of venture business.
Excellent post, thx.
One minor footnote regarding the 2003-2008 M&A period… in addition to Google IPO, 2004 also saw the Salesforce.com IPO which did well both in initial trading and long run growth.
Hi Steve:
I agree 100% that the VC industry still has a tendency to think that raising money on the sizzle cures many ills whereas we know money is rarely the answer to anything when it comes to startups. But I wanted to share a very different experience from the last 10 years.
I got into VC at the worst possible time (99) with the worst possible background (hybrid derivatives at GS) … ironically because I thought the industry I was in (derivs) was not sustainable. Talk about getting market timing wrong 🙂
Anyway I willed myself into the world of entrepreneurship and essentially “grew up” in venture through a world of pulled IPO’s then pulled M&A’s then Sep 11 and then, the big one, March02/Worldcom and the giant sucking sound that ensued when telecoms capex collapsed.
My experience of 2001-2004 is very remote from what you are describing. The mantra was as follows: “no one is coming to save us, we are going to make it on our own”. The companies I was involved with as board member, such as Inxight Software (sold to BOBJ), were living on a high through the hype phase and had to relearn and retool themselves to make it on scarce resources and raw talent.
My personal perception is that 2000-2004 gave me deep scars and a sense of the value of each $1 spent that will always be with me as an investor, as we seek to prudently prove models and build solid foundations before we really scale hard, understanding hopefully well the return on effort expanded.
I actually don’t think age has anything to do with it. Many VC’s I know are simply not that hungry, they are the ones you should worry about most. You need relentless intent, focus, the willingness to challenge, the willingness to take measured risk. We have in our partnership a gent by the name of Barry Fidelman who puts us all to shame with his intensity.
Maybe more importantly, you need to accept that there are no rules to success, that most business books you should never have read, and that you must consider each situation in the unique context of its people and market opportunity, with common sense and humility.
As someone once put it to me, “the only thing I know for sure is that I am a better VC than last year and should be a better VC still next year.”
All the best
FD
[Oh yes, I am under 40 :-)))]
Fred,
Thanks for the thoughtful response. I forget that other people actually read this blog.
What inspired the post was encountering the same phenomena you pointed out, “Many VC’s I know are simply not that hungry…”
I would have finished the the thought and said, “Many VC’s I know are simply not that hungry are happy living off the management fees and operate like the “cargo cult” that formed in the Pacific Islands after WWII. They built airplanes out of palm trees thinking if they did manna would come in airplanes again. I find the same still going on with a few firms and partners.”
I think the economics of venture (limiteds committing funds over a long period) allows poor performers to remain in place longer than any other industry (certainly longer than non performing portfolio companies.) And given the “clubbiness” of the venture business there appears to be little self policing of steering entrepreneurs away from firms that are bad news.
That said, I agree with you (and other posters) that age is too broad a brush to label all VC’s and that there are world class VC’s who learned a lot and are much better for going through the bubble.
steve
whew, good thing I turned 40 earlier this year.
I think you bring up a number of great points
but I think it’s hard to paint this stuff with a broad brush. I’m a co-investor with folks over 40 (fred wilson) and under 40 (peter fenton, benchmark) and they both deliver a ton of value and are world class investors.
I feel the same about entrepreneurs. A number of VCs I know say that young entrepreneurs are the best to back. We have our share of 20-somethings but we also have serial entrepreneurs in their 30s & 40s. I’m proud to be in business with them all.
I think it’s hard to draw a line and make a call based on age.
steve, agree 100pc with the response. hail hail.
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Is 40 old enough?
Say that gives 15 years in business. How much of that in the domain, using pertinent skills?
I think that one of the good themes of this blog is that years != “dog years” in deep industries. We could for example, find warning signs in popular literature about e.g. finance suggesting rapid maturation in bond trading. Warning sign?
Say 40 years = 20 years real direct experience. At best. ~ Is 20 years enough?
My own metric is that you need experience >= 1.5 times the last whole business and credit cycle. (which is not a technology cycle, necessarily, though readers here are naturally biused towards those i would expect)
Thus, doing a startup in my all to early 20s, i was inclined to trust only those of age >50. How you discount the harmonic average is up to you 🙂
I’d also like to echo an obvious intrinsic to business: time to being able to talk about what you did, and hence really analyse it, with outside non – domain groups, such as are interesting when assembling a board, is not short in real industries.
I’m not quite 40. So i had better hold my peace!
To Steve B: thanks for a great blog, and connecting so many outlying or just plain uncorrelated dots.
But the essay did not live up to its vital and interesting title. A quick scope of VC economy is not an essay on evaluating by age or experience, the latter and original proposition for discussion being entirely more interesting.
– john
The theme of the post was whether young <40 old VCs have sufficient experience. How about views on the age of entrepreneurs to fund? Energy levels are higher with the <30, but domain expertise is acquired by older ones. And the best Rolodexes are possesed by the oldest right up to retirement. Who do you bet on?
On average I’d bet on the same age group that wins Nobel prizes.
Same idea – too young and naive to know it can’t be done.
A serious study here: http://www.google.com/search?hl=en&q=Aging%20and%20Creative%20Productivity&sa=N&tab=sw concluded that younger people being more creative is a highly predictable at the aggregate level. However, it is far more unpredictable at the individual level. The author concluded this has less to due with aging than to other factors, both intrinsic and extrinsic to the creative process (i.e. my “too young and naive to know it can’t be done theory.”
Marc Andreessen also covered the age topic here: http://pmarca-archive.posterous.com/age-and-the-entrepreneur-part-1-some-data
steve