Customer Development: Past, Present, Future

The Lean Startup Circle is a Google discussion group (anyone can join) centered on Customer Development/Lean Startup strategy, tactics and implementation. They were kind enough to sponsor a meet-up in San Francisco.

The Times Square Strategy discussion I had with Eric Ries, was still top of mind, so instead of my standard Customer Development lecture, I offered my thoughts on: the origin of Customer Development, where we are today, and where does Customer Development go, and how you can help get it there.

The video below was my presentation to the group.

The slides below go with the video. Just click through them as you watch the video. Extra credit if you know the back-story of slide 1 and why it’s appropriate for founders and their team.


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Thursday is Thanksgiving Day in the U.S.  I’ll have a non-entpreneuership post about family and reflection.

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Closure

For those that know me, I’m kind of a “life is too short” kind of guy. I liked to fail fast, move on, and not look back.

However, in catching up with the VP of Sales of Ardent last night, I was reminded one of the few times I did return for closure.

National Supercomputer Centers
For a decade starting in 1985, the National Science Foundation (NSF) established and spent a pile of money (~$50 million/year) on four supercomputing centers in the U.S. – Cornell University; University of Illinois, Urbana-Champaign; the Pittsburgh Supercomputing Center at Carnegie Mellon University; and the San Diego Supercomputer Center at the University of California at San Diego. The ostensible goal of these centers was to allow scientists and researchers access to supercomputers to simulate commercial phenomena that were too expensive, too dangerous or too time consuming to physically build.

The reality was that the U.S. Nuclear Weapons Laboratories used supercomputers to run their hydrodynamics codes for nuclear weapon design and the National Security Agency used them to decrypt codes. But with the cold-war winding down these agencies could no longer be counted on to provide Cray Research with enough business to sustain the company. Commercial applications needed to be found that could take advantage of this class of computers.

The search for commercial supercomputer applications was good news for Ardent, as this was our business as well. But bad news was that the supercomputing centers had concluded that they could justify their existence (and budget) only by buying the biggest and most expensive supercomputers Cray Research made.

We Lost the Deal
At Ardent we were building a personal supercomputer powerful enough to run and display numerical simulations just about the time the National Science Foundation was funding these centers. I remember that the Pittsburgh Supercomputing Center had put out a request for a proposal for a supercomputer to replace the Cray X-MP they installed in 1986. In reading it, there was no doubt that it was written only in a way that Cray could respond.

I realized that given the amount of money the Supercomputing Center wanted to spend on buying the new Cray Y-MP (list price $35 million,) we could put an Ardent personal supercomputer next to every scientist and researcher connected to the university. I responded to their RFP by proposing that Ardent build the Pittsburgh Supercomputing Center a distributed supercomputing environment with hundreds of Ardent personal supercomputers rather than a monolithic Cray supercomputer.

As one could imagine this was the last thing the supercomputer center management wanted to hear. All their peers were buying Cray’s, and they wanted one as well. We had support from the scientists and researchers who had bought one of our machines and were beginning to see that distributed computing would ultimately triumph, but bureaucracy marched on, and we lost the bid.

In my career I’ve been involved with lots of sales deals, and for some reason losing this was the one deal I never forgot. Maybe because a win here would have meant success rather than failure for the company, perhaps because I really believed we could make the impossible happen and win. For whatever reason, I hated that particular Cray that got installed in Pittsburg.

Closure
Fast forward 15 years. Retired for a year, I ran across an article that said, “$35 Million Dollar Supercomputer For Sale for Scrap.”  It was the Pittsburgh Supercomputing Center Cray Y-MP that had beaten me at Ardent.  It was for sale on Ebay.

I bought the Cray.

It took two semi-trailers to deliver it.

It sat in my barn next to the tractors and manure for five years. I had the only farm capable of nuclear weapons design.

Cray called two years ago and bought it back for parts for an unnamed customer still running one.

Closure.

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Times Square Strategy Session – Web Startups and Customer Development

One of the benefits of teaching is that it forces me to get smarter. I was in New York last week with my class at Columbia University and several events made me realize that the Customer Development model needs to better describe its fit with web-based businesses.

Dancing Around the Question
Union Square Ventures was kind enough to sponsor a meetup the night before my class. In it, I got asked a question I often hear: “What if we have a web-based business that doesn’t have revenue or paying customers? What metrics do we use to see if we learned enough in Customer Discovery? And without revenue how do we know if we achieved product/market fit to exit Customer Validation?”

I gave my boilerplate answer, “I’m a product guy and I tend to invest and look at deals that have measurable revenue metrics. However the Customer Development Model and the Lean Startup work equally well for startups on the web. Dave McClure has some great metrics…”  It was an honest but vaguely unsatisfying answer.

Union Square Ventures
The next morning I got to spend time with Brad Burnham, partner at Union Square Ventures talking about their investment strategy and insights about web-based businesses. Bill and his partner Fred Wilson have invested in ~30 or so companies with 27 still active.

They’re putting money into web services/business – most without early revenue. It’s an impressive portfolio. By the time the meeting was over I left wondering whether the Customer Development model would help or hinder their companies.

Eric Ries in Times Square
For any model to be useful it has to predict what happens in the real world – including the web. I realized the Customer Development model needs to be clearer in what exactly a startup is supposed to do, regardless of the business model.

Luckily Eric Ries was spending a few days in New York, so we sat down in the middle of Times Square and hashed this out.

What we concluded is that the Customer Development model needs an additional overlay.

Four Questions
Just as a reminder, the Customer Development has four simple steps: Discovery, Validation, Creation and Company Building.  But it also requires you to ask a few questions about your startup before you use it.

The first question to ask is: “Does your startup have market risk or is it dominated by technical risk?”  Lean Startup/Customer Development is used to find answers to the unknowns about customers and markets. Yet some startups such as Biotech don’t have market risk, instead they are dominated by technical risk. This class of startup needs to spend a decade or so proving that the product works, first in a test tube and then in FDA trials.  Customer Development is unhelpful here.

Lean Startup

Use the Lean Startup – When There’s Market Risk

The second question is: “What’s the “Market Type” of your startup? Are you entering an existing market, resegmenting an existing market, or creating an entirely new market?” Market Type affects your spending and sales ramp after you reach product/market fit. Startups who burn through their cash, usually fail by not understanding Market Type.

Market Type Affects Spending and Sales Ramp

The third question (and the one Eric and I came up with watching the people stream by in Times Square): “What is the “Business Model” of your startup?” Your choice of Business Model affects the metrics you use in discovery and validation and the exit criteria for each step.

 

Slide4

Business Model Affects Metrics and Exit Criteria

Web-based Business Model Exit Criteria
In a web-business model you’re looking for traffic, users, conversion, virality, etc – not revenue. Dave McClure’s AARRR metrics and Andrew Chen‘s specifics on freemium models, viral marketing, user acquisition and engagement both offer examples of exit criteria for Customer Discovery and Validation for startups on the web.

Eric and I will be working on others.

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“Lessons Learned” – A New Type of Venture Capital Pitch

I joined the board of Cafepress.com when it was a startup. It was amazing to see the two founders, Fred Durham and Maheesh Jain, build a $100 million company from coffee cups and T-shirts.

But Cafepress’s most memorable moment was when the founders used a “Lessons Learned” VC pitch to raise their second round of funding and got an 8-digit term sheet that same afternoon.

Here’s how they did it.

Fail Fast and Cheap
Fred and Maheesh had started 9 previous companies in 6 years.  Their motto was: “Fail fast and cheap. And learn from it.” Cafepress literally started in their garage and was another set of experiments only this time it caught fire.  They couldn’t keep up with the orders.

Tell the Story of the Journey
The company got to a point where additional capital was needed to expand just to keep up with the business (a warehouse/shipping center collocated with UPS, etc.) Rather than a traditional VC pitch I suggested that they do something unconventional and tell the story of their journey in Customer Discovery and Validation.  The heart of the Cafepress presentation is the “Lessons Learned from our Customerssection. Their presentation looked like this:

  • Market/Opportunity
  • Lessons Learned Slide 1
  • Lessons Learned Slide 2
  • Lessons Learned Slide 3
  • Why We’re Here

Cafepress Sequioa Pitch-1Telling the Cafepress Customer Discovery and Customer Validation story allowed Fred and Maheesh to take the VC’s on their journey year by year.

Cafepress Sequioa Pitch-2After these slides, these VC’s recognized that this company had dramatically reduced risk and built a startup that was agile, resilient and customer-centric.

Cafepress Sequioa Pitch-3The presentation didn’t have a single word about Lean Startups or Customer Development. There was no proselytizing about any particular methodology, yet the results are compelling.

The VC firm delivered a term sheet for an 8-digit second round that afternoon.

Your results may vary.

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Relentless – The Difference Between Motion And Action

Never mistake motion for action.
-Ernest Hemingway

One of an entrepreneur’s greatest strengths is their relentless pursuit of a goal. But few realize how this differs from most of the population. Watching others try to solve problems reminded me why entrepreneurs are different.

Progress Report
Last week I happened to be sitting in my wife’s office as she was on the phone to my daughter in college. Struggling with one of her classes my daughter had assured us that she was asking for help – and was reporting on her progress (or lack of it).

She had sent several emails to the resource center asking for help. She was also trying to set up a meeting with her professor. All good, and all part of the “when you’re stuck, ask for help” heuristic we taught our kids. But the interesting part for me was learning that in spite of her efforts no one had gotten back to her.

She believed she had done all things that could be expected from her and was waiting for the result.

I realized that my daughter had confused motion with action.

This reminded me of a conversation with one of my direct reports years before my daughter was born.

Status Report
At Ardent the marketing department was responsible for acquiring applications for our supercomputer. This required convincing software vendors to move their applications to our unique machine architecture. Not a trivial job considering our computer was one of the first parallel architectures, and our compiler required specific knowledge of our vector architecture to get the most out of it. Oh, and we had no installed customer base. I had hired the VP of marketing from a potential software partner who was responsible to get all this 3rd party software on our computer. Once he was on board, I sat down with him on a weekly basis to review our progress with our list of software vendors.

Think Different
I still remember the day I discovered that I thought about progress differently than other people. Our conversation went like this:

Me: Jim, how are we doing with getting Ansys ported?
Jim: Great, I have a bunch of calls into them.
Me: How are we doing on the Nastran port?
Jim: Wonderful, they said they’ll get back to me next month.
Me: How about Dyna 3D?
Jim: It’s going great, we’re on their list.

The rest of the progress report sounded just like this.

After hearing the same report for the nth week, I called a halt to the meeting. I had an executive who thought he was making progress. I thought he hadn’t done a damn thing.

Why?

The Difference Between Motion and Action
One of Jim’s favorite phrases was, “I got the ball rolling with account x.” He thought that the activities he was doing – making calls, setting up meetings, etc. – was his job. In reality they had nothing to do with his job. His real job – the action – was to get the software moved onto our machine. Everything he had done to date was just the motion to get the process rolling. And so far the motion hadn’t accomplished anything. He was confusing “the accounting” of the effort with achieving the goal. But Jim felt that since he was doing lots of motion, “lots of stuff was happening.” In reality we hadn’t gotten any closer to our goal than the day we hired him. We had accomplished nothing – zero, zilch, nada. In fact, we would have been better off if we hadn’t hired him as we wouldn’t have confused a warm body with progress.

When I explained this to him, the conversation got heated. “I’ve been working my tail off for the last two months…” When he calmed down, I asked him how much had gotten accomplished. He started listing his activities again. I stopped him and reminded him that I could have hired anyone to set up meetings, but I had brought him in to get the software onto our machine. “How much progress have we made to that goal?”  “Not much,” he admitted.

Entrepreneurs are Relentless
Jim’s goal was to get other companies to put their software on an unfinished, buggy computer with no customers. While a tough problem, not an insurmountable one for an entrepreneur focused on the objective, not the process.

This was my fault. It had taken me almost two months to realize that other people didn’t see the world the same way I did. My brain was wired to focus on the end-point and work backwards, removing each obstacle in my path or going around them all while keeping the goal in sight. Jim was following a different path.

Focused on the process, he defined progress as moving through a step on his to-do list, and feeling like progress was being made when he checked them off. The problem was his approach let others define the outcome and set the pace.

The difference between the two ways of thinking is why successful entrepreneurs have the reputation for being relentless. To an outsider it looks like they’re annoyingly persistent. The reality is that their eyes are on the prize.

Teaching Moment
If you’re not born with this kind of end-goal focus, you can learn this skill.

My wife and I called our daughter back, declared a family “teaching moment,” and explained the difference between motion and action, and asked her what else she could do to get help for class. She realized that more persistence and creativity was required in getting to the right person. The next day, she was in the resource center having figured out how to get the help she needed.

Lessons Learned

  • Most people execute linearly, step by step
  • They measure progress by “steps they did”
  • Entrepreneurs focus on the goal
  • They measure progress by “accomplishing their goals”

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Raising Money Using Customer Development

Getting “funded” is the holy grail for most entrepreneurs. Unfortunately in early stage startups the drive for financing hijacks the corporate DNA and becomes the raison d’etre of the company. Chasing funding versus chasing customers and a repeatable and scalable business model, is one reason startups fail.

This post describes how companies using the Customer Development model can increase their credibility, valuation and probability of getting a first round of funding by presenting their results in a “Lesson Learned” venture pitch.

It should go without saying that this post is not advice, nor is it recommendation of what you should do, it’s simply my observation of how companies using Customer Development positioned themselves to successfully raise money from venture investors.

Product Development – Getting Funded as The Goal
In a traditional product development model, entrepreneurs come up with an idea or concept, write a business plan and try to get funding to bring that idea to fruition. The goal of their startup in this stage becomes “getting funded.” Entrepreneurs put together their funding presentation by extracting the key ideas from their business plan, putting them on PowerPoint/Keynote and pitching the company – until they get funded or exhausted.

Fund Raising.jpg

What are Early Stage VC’s Really Asking?
When you are presenting to a VC there are two conversations going on – the one you are presenting and the one that investors are thinking as they are listening to your presentation. (If they’re not busy looking at their Blackberry’s/iPhone’s.)

A VC listening to your presentation is thinking, “Are you going to blow my initial investment, or are you going to make me a ton of money? Are there customers for what you are building? How many are there?  Now?  Later?” Is there a profitable business model? Can it scale?”  And finally, “Is this a team that can build this company?”

The Traditional VC Pitch
Entrepreneurs who pursue the traditional product development model don’t have customer data to answer these questions. Knowing this venture firms have come up with a canonical checklist of what they would like to see.  A typical pitch to a venture firm might cover:

  • Technology/Product
  • Team
  • Opportunity/Market
  • Customer Problem
  • Business Model
  • Go to Market Strategy
  • Financials

Given that the traditional pitch has no hard customer metrics, (and VC’s don’t demand them,) you get funded on the basis of intangibles that vary from firm to firm: Do you fit the theme or thesis of the venture firm? Did the VC’s like your team? Do they believe you have a big enough vision and market. Did the partner have a good or bad day, etc.  Tons of advice is available on how to pitch, present and market your company.

I believe all this advice is wrong. It’s akin to putting lipstick on a pig.  The problem isn’t your pitch, it’s your fundamental assumption that you can/should get funded without having real customer and product feedback. No amount of learning how to get a VC meeting or improving your VC demo skills will fix the lack of concrete customer data. You might as well bring your lucky rabbits foot to the VC meeting.

Customer Development – Getting Funded After You Find a Repeatable Model
In contrast, if you are following a Customer Development process you have a greater chance of getting listened to, believed and funded.

Just as a refresher.  The first step in Customer Development was Customer Discovery; extracting hypotheses from the business plan and getting the founders out of the building to test the hypotheses in front of customers. Your goal was to preserve your cashwhile you turned these guesses into facts and searched for a repeatable and scalable sales model. Your proof that you have a business rather than a hobby comes from customer orders or users for your buggy, unfinished product with a minimum feature set.

If you’re following Customer Development you are now raising money because even with this first rev of the product you think you’ve found product/market fit and you want to scale.

Customer Development Fund Raising

What VC’s Really Want But Don’t Know How to Ask For or Get
Mike Maples at Maples Investments observes that the quality of pitches from entrepreneurs get better as you climb the “Hierarchy of Proof.”

  1. On the bottom, and least convincing are statements about your “idea.”
  2. Next are hypothesis – “I think customers will care about x or y “
  3. Better are facts from customers – “We interviewed 30 customers with 20 questions”
  4. Even better is “Customer Validation”– “We just got $50K from a customer” or “we got 100,000 users spending x minutes on our site”
  5. Finally if you’re ever so lucky – “Everyone’s buying in droves and we’re here because we need money to scale and execute”

If you’ve actually been doing Customer Development at a minimum you’re at step 3 or 4.  If not, you don’t have enough data for a VC presentation.  Get out of the building, get some more customer feedback, spin your product and go back and read the book.

“Lessons Learned” – A New Type of VC Pitch
A Customer Development fundraising presentation tells the story of your journey in Customer Discovery and Validation.  While your presentation will cover some of the same ground as the traditional VC pitch, the heart of the presentation is the “Lessons Learned from our Customerssection. The overall presentation looks something like this:

  • Market/Opportunity
  • Team
  • Lessons Learned Slide 1
  • Lessons Learned Slide 2
  • Lessons Learned Slide 3
  • Why We’re Here
IMVU's Original VC Presentation - Will Harvey & Eric Ries

IMVU’s Original VC Presentation – Will Harvey & Eric Ries

Here’s What We Thought, What We Did, What We Learned
Notice that each of the “Lessons Learned” slide has three major subheads and a graph:

  • “Here’s What We Thought.”
  • “Here’s What We Did.”
  • Here’s What Happened.”
  • A Progress Graph

Here’s What We Thought is you describing your initial set of hypotheses. Here’s What We Did allows you to talk about building the first-pass of the products minimum feature set. Here’s What Happened is the not so surprising story of why customers didn’t react the way you thought they would. A Progress Graph on the right visually shows how far you’ve come (in whatever units of goodness you’re tracking – revenue, units, users, etc.)

Telling the Customer Discovery and Customer Validation story this way allows you to take VC’s on your journey through all the learning and discovery you’ve done. After three of these slides, smart VC’s will recognize that by iterating on your assumptions you have dramatically reduced risk– on your nickel, not theirs.  They will realize that you have built a startup that’s agile, resilient and customer-centric.

Your presentation doesn’t have a single word about Lean Startups or Customer Development. There is no proselytizing about any particular methodology, yet the results are compelling.

This is a radical departure from a traditional VC pitch. It will blow the minds of 70-80% of investors.  The others will throw you out of their office.

Guaranteed Funding – Not
Will this type of presentation guarantee you funding? Of course not. Even if you have the worlds best Lessons Learned slides you might find out that your particular market (i.e. consumer Internet) might have a really, really high bar of achievement for funding.

In fact, just trying to put three Lessons Learned slides together showing tangible progress will make most startups realize how hard really doing Customer Development is.

Try it.

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Lean Startups aren’t Cheap Startups

At an entrepreneurs panel last week questions from the audience made me realize that the phrase “Lean Startup” was being confused with “Cheap Startup.”

For those of you who have been following the discussion, a Lean Startup is Eric Ries’s description of the intersection of Customer Development, Agile Development and if available, open platforms and open source.

Lean Startups aren’t Cheap Startups
A Lean Startup is not about the total amount of money you may spend over the life of your startup. It is about when in the life of your company you do the spending.

Over its lifetime a Lean Startup may spend less money than a traditional startup. It may end up spending the same amount of money as a traditional startup. And I can even imagine cases where it might burn more cash than a traditional startup.

Lets see why.

The Price of Mistakes are Inversely Proportional to Available Capital
In times of abundant venture capital if you miss your revenue plan, additional funding from your investors is usually available to cover your mistakes – i.e. you get “do-overs” or iterations without onerous penalties (assuming your investors still believe in the technology and vision.) In times when venture capital is hard to get, investors extract high costs for failure (down-rounds, cram downs, new management teams, shut down the company.)

The key contributors to an out-of-control burn rate is 1) hiring a sales force too early, 2) turning on the demand creation activities too early, 3) developing something other than the minimum feature set for first customer ship. Sales people cost money, and when they’re not bringing in revenue, their wandering in the woods is time consuming, cash-draining and demoralizing. Marketing demand creation programs (Search Engine Marketing, Public Relations, Advertising, Lead Generation, Trade Shows, etc.) are all expensive and potentially fatal distractions if done before you have found product/market fit and a repeatable sales model. And most startup code and features end up on the floor as customers never really wanted them.

Therefore when money is hard to come by, entrepreneurs (and their investors) look for ways to reduce cash burn rate and increase the chance of finding product/market fit before waste you bunch of money. The Customer Development process (and the Lean Startup) is one way to do that.

Repeatable and Scalable Sales Model
In Customer Development your goal is not to avoid spending money but to preserve your cash as you search for a repeatable and scalable sales model and then spend like there is no tomorrow when you find one.

This is the most important sentence in this post and worth deconstructing.

  • Preserve your cash: When you have unlimited cash (internet bubbles, frothy venture climate,) you can iterate on your mistakes by burning more dollars. When money is tight, when there aren’t dollars to redo mistakes, you look for processes that allow you to minimize waste. The Customer Development process says preserve your cash by not hiring anyone in sales and marketing until the founders turn hypotheses into facts and you have found product/market fit.
  • As you search: Customer Development observes that when you start your company, all you and your business plan have are hypotheses, not facts –and that the founders are the ones who need to get out of the building to turn these hypotheses into customer data. This “get out of the building” activity is the Customer Discovery step of the Customer Development Model.
Customer Development

Customer Development Model

  • Repeatable: Startups may get orders that come from board members’ customer relationships or heroic, single-shot efforts of the CEO. These are great, but they are not repeatable by a sales organization. What you are searching for is not the one-off revenue hits but rather a repeatable pattern that can be replicated by a sales organization selling off a pricelist or by customers coming to your web site.
  • Scalable: The goal is not to get one customer but many – and to get those customers so each additional customer adds incremental revenue and profit. The test is: If you add one more sales person or spend more marketing dollars, does your sales revenue go up by more than your expenses?
  • Sales model A sales model answers the basic questions involved in selling your product: “Is this a revenue play or a freemium model going for users? Something else? Who’s the customer? Who influences a sale? Who recommends a sale? Who is the decision maker? Who is the economic buyer? Where is the budget for purchasing the type of product you’re selling? What’s the customer acquisition cost? What’s the lead and/or traffic generation strategy? How long does an average sale take from beginning to end? Etc.”
    Finding out whether you have a repeatable, scalable sales model is the Customer Validation step of Customer Development. This is the most important phase in customer development. Have you learned how to sell your product to a target customer? Can you do this without running out of money?
  • Scale like there is no tomorrow The goal of an investor-backed startup is not to build a lifestyle business. The goal is to reach venture-scale (~10x return on investment.) When you and your board agree you’ve found a repeatable and scalable sales model (i.e. have product/market fit,) then you invest the dollars to create end user demand and drive those customers into your sales channel.

If you confuse Lean with Cheap when you do find a repeatable and scalable sales model, you will starve your company for resources needed to scale. Customer Development (and Lean) is about continuous customer contact/iteration to find the right time for execution.

The Customer Development Venture Pitch
At this point I often hear entrepreneurs say, “We don’t have the money to scale. We’ve been running on small investments from friends and family or angels. How do we raise the big bucks?”

How to raise real money with a Customer Development presentation in the next post.

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The Secret History of Silicon Valley 12: The Rise of “Risk Capital” Part 2

This post is the latest in the “Secret History Series.”  They’ll make much more sense if you watch the video or read some of the earlier posts for context. See the Secret History bibliography for sources and supplemental reading.

This is the second of three posts about the rise of “risk capital” and how it came to be associated with what became Silicon Valley.

———————–

The First Valley IPO’s
Silicon Valley first caught the eyes of east coast investors in the late 1950’s when the valleys first three IPO’s happened: Varian in 1956, Hewlett Packard in 1957, and Ampex in 1958.  These IPOs meant that technology companies didn’t have to get acquired to raise money or get their founders and investors liquid. Interestingly enough, Fred Terman, Dean of Stanford Engineering was tied to all three companies.

Varian made a high power microwave tube called the Klystron, invented by Terman’s students Russell and Sigurd Varian and William Hansen. In 1948 the Varian brothers along with Stanford professors Edward Ginzton and Marvin Chodorow founded Varian Corporation in Palo Alto to produce klystrons for military applications. Fred Terman and David Packard of HP joined Varian’s board.

Terman was also on the board of HP. Terman arranged for a research assistantship to bring his former student, David Packard, back from a job at General Electric in New York to collaborate with William Hewlett, another of Terman’s graduate students. Terman sat on the HP board from 1957-1973.

Ampex made the first tape recorders in the U.S (copied from captured German models,) and Terman was on its board as well. Ampex’s first customer was Bing Crosby who wanted to record his radio programs for rebroadcast (and had exclusive distribution rights.) Ampex business took off when Terman introduced Ampex founder Alex Poniatoff to Joseph and Henry McMicking. The McMicking’s bought 50% of Ampex for $365,000 (some liken this to the first VC investment in the valley.) McMicking and Terman introduced Ampex to the National Security Agency, and Ampex sales boomed when their audio and video recorders became the standard for Electronic Intelligence and telemetry signal collection recorders.

Meanwhile on the West Coast – “The Group”  1950’s
When Ampex was raising its money, in 1952, an employee of Fireman’s Fund in San Francisco, Reid Dennis, managed to put $20,000 in the deal. Five years later Dennis and a small group of angel investors who called themselves “The Group” started investing in new electronics companies being formed in the valley south of San Francisco. These angels who were all working in their day jobs at various financial institutions, would invite startup electronics companies up to San Francisco to pitch their deals and they would invest an average of $75 -$300K per deal.

The Group is worth noting for:

  1. Investing their own private money,
  2. Reid Dennis would found Institutional Venture Partners in 1974
  3. First group specifically investing in the valley’s electronics industry

SBIC Act of 1958
During the cold war the launch of Sputnik-1 by the Soviet Union in 1957 both traumatized and galvanized the United States. Having the first earth satellite launched by a country that been portrayed as a third-world backwater with a bellicose foreign policy shocked the U.S. into believing it was behind the Soviet Union in innovation. In response, one of the many U.S. national initiatives (DARPA, NASA, Space Race, etc.) to spur innovation was a new government agency to fund new companies.  The Small Business Investment Company (SBIC) Act in 1958 guaranteed that for every dollar a bank or financial institution invested in a new company, the U.S. government would invest three (up to $300,000.) So for every dollar that a fund invested, it would have four dollars to invest.

While SBIC’s were set up around the country, companies in Northern California including Bank of America, Firemans Fund and American Express (Reid Dennis of the Group ran theirs), began to set up SBIC funds to tap the emerging microwave and new semiconductor startups setting up shop south of San Francisco. And for the first time, private companies like Continental Capital, Pitch Johnson & Bill Draper and Sutter Hill were formed to take advantage of the government largesse from the SBA. Like all government programs, the SBIC was fond of paperwork, but it began to formalize, professionalize and standardize the way investors evaluated risk.

SBIC’s were worth noting for:

  1. The good news – government money for startups encouraged a “risk capital” culture at large financial institutions.
  2. The better news – government money encouraged private companies to form to invest in new startups
  3. The bad news – the government was more interested in rules, regulations and accounting then startups (because some SBIC’s saw the government funds as a license to steal)
  4. By 1968 over 600 SBIC funds provided 75% of all venture funding in the U.S.
  5. In 1988 after the rise of the limited partnership that number would be 7%.

Limited Partnerships
By the end of the 1950’s there was still no clear consensus about how to best organize an investment company for risky ventures. Was it like George Doriot’s ARD venture fund – a publicly traded closed end mutual fund? Was it using government money as a private SBIC firm?  Or was it some other form of organization? Many investors weren’t interested in working for a large company for a salary and bonus, and most hated the paperwork and salary limitations that the SBIC imposed. Was there some other structure?

The limited partnership offered one way to structure an investment company. The fund would have limited life. It would charge its investors annual “management fees” to pay for the firm’s salaries, building, etc. In a typical venture fund, the partners receive a 2% management fee.

But the biggest innovation was the “carried interest” (called the “carry”.) This is where the partners would make their money. They would get a share of the profits of the fund (typically 20%.) For the first time venture investors would have a very strong performance incentive.

Venture Capital In 1958 General William Draper, Rowan Gaither (founder of the RAND corporation) and Fred Anderson (a retired Air Force general) founded Draper, Gaither and Anderson, Silicon Valley’s (and possible the worlds) first limited partnership. The venture firm was funded by Laurance Rockefeller and Lazard Freres, but after some dispute lost to the sands of time, Rockefeller pulled his financing, and the firm was dissolved after the first fund.

The first limited partnership that lasted for a while was formed by Davis and Rock in 1961. Arthur Rock, an investment banker at Hayden Stone in New York (who helped broker the financing of Fairchild) moved out to San Francisco in 1961 and partnered with Tommy Davis. Davis (an ex-WWII OSS agent) then a VP at the Kern Land Company got involved with investing in technology companies through Fred Terman. Davis’s first investment in 1957 was Watkins-Johnson (the maker of microwave Traveling Wave Tubes for electronic intelligence systems) where he sat on its board with Fred Terman. Rock and Davis would raise a $5M fund from east coast institutions and while they invested only $3.4 million of it by the time they dissolved their partnership in 1968 – they returned $90 million to their limited partners – a 54% compound growth rate.

Limited partnerships are worth noting for:

  1. By the 1970’s the limited partnership would become the preferred organizational form for venture investors
  2. The “carried interest” (the “carry”) assured that the venture partners would only make real money if their investments were successful. Aligning their interests with their limited investors and the entrepreneurs they were investing in.
  3. The limited life of each fund; 7-10 years of which 3-5 years would be spent actively investing, focused the firms on investments that could reasonably expect to have “exits” during the life of the fund.
  4. The limited life of each fund allowed venture firms to be flexible. They could change the split of the carry in follow on funds, add partners with carry in subsequent funds, change investing strategy and focus in follow-on funds, etc.

Silicon Innovation Collides with Risk Capital
Lacking a “risk capital” infrastructure in the 1950’s military contracts and traditional bank loans were the only options microwave startups had for capital. The first semiconductor companies couldn’t even get that – Shockley and Fairchild could only be funded through corporate partners. But by the 1960’s the tidal wave of semiconductor startups would find a valley with a growing number of SBIC backed venture firms and limited partnerships.

A wave of silicon innovation was about to meet a pile of risk capital.

More on this in Part XIII of the Secret History of Silicon Valley.

The Secret History of Silicon Valley 11: The Rise of “Risk Capital” Part 1

This post is the latest in the “Secret History Series.”  They’ll make much more sense if you watch the video or read some of the earlier posts for context. See the Secret History bibliography for sources and supplemental reading.

This is the first of two posts about the rise of “risk capital” and how it came to be associated with what became Silicon Valley.
———————–

Building Blocks of Entrepreneurship
By the mid 1950’s the groundwork for a culture and environment of entrepreneurship were taking shape on the east and west coasts of the United States. Stanford and MIT were building on the technology breakthroughs of World War II and graduating a generation of engineers into a consumer and cold war economy that seemed limitless. Communication between scientists, engineers and corporations were relatively open, and ideas flowed freely. There was an emerging culture of cooperation and entrepreneurial spirit.

Slide1

At Stanford, Dean of Engineering Fred Terman wanted companies outside of the university to take Stanford’s prototype microwave tubes and electronic intelligence systems and build production volumes for the military. While existing companies took some of the business, often it was a graduate student or professor who started a new company. The motivation in the mid 1950’s for these new startups was a crisis – we were in the midst of the cold war and the United States military and intelligence agencies were rearming as fast as they could.

Yet one of the most remarkable things about the boom in microwave and silicon startups occurring in the 1950’s and 60’s was that it was done without venture capital. There was none.  Funding for the companies spinning out of Stanford’s engineering department in the 1950’s benefited from the tight integration and web of relationships between Fred Terman, Stanford, the U.S. military and intelligence agencies and defense contractors.

These technology startups had no risk capital – just customers/purchase orders from government/military/intelligence agencies.

This post is about the rise of “risk capital” and how it came to be associated with what became Silicon Valley.

Risk Capital via Family Money   1940’s
During the 1930’s, the heirs to U.S. family fortunes made in the late 19th century – Rockefeller, Whitney, Bessemer –  started to dabble in personal investments in new, risky ventures. Post World War II this generation recognized that:

  1. Technology spin-offs coming out of WWII military research and development could lead to new, profitable companies
  2. Entrepreneurs attempting to commercialize these new technologies could not get funding; (commercial and investment banks didn’t fund new companies, just the expansion of existing firms,) and existing companies would buy up entrepreneurs and their ideas, not fund them
  3. There was no organized company to seek out and evaluate new venture ventures, manage investments in them and nurture their growth.

Several wealthy families in the U.S. set up companies to do just that – find and formalize investments in new and emerging industries.

  • In 1946 Jock Whitney started J.H. Whitney Company by writing a personal check for $5M and hiring Benno Schmidt as the first partner (Schmidt turned Whitney’s description of “private adventure capital” into the term “venture capital”).
Jock Whitney writes himself a check to fund J.H. Whitney Co.

Jock Whitney writes himself a check to fund J.H. Whitney Co.

  • That same year Laurance Rockefeller founded Rockefeller Brothers, Inc., with a check for $1.5 million.  (23 years later they would rename the firm Venrock.)
  • Bessemer Securities, set up to invest the Phipps family fortune (Phipps was Andrew Carnegie’s partner,)

These early family money efforts are worth noting for:

  1. They were “risk capital,” investing where others feared
  2. They invested in a wide variety of new industries – from orange juice to airplanes
  3. They almost exclusively focused on the East Coast
  4. They used family money as the source of their investment funds

East Coast Venture Capital Experiments
In 1946, George Doriot, founded what is considered the first “venture capital firm” – American Research & Development (ARD). A Harvard Business School professor and early evangelist for entrepreneurs and entrepreneurship, Doriot was the Fred Terman of the East Coast. Doroit had the right idea with ARD (funding startups out of MIT and Harvard and raising money from outsiders who weren’t part of a private family) but picked the wrong model for raising capital for his firm. ARD was a publicly traded venture capital firm (raising $3.5 Million in 1946 as a closed-end mutual fund) which meant ARD was regulated by the Securities and Exchange Commission (SEC.) For reasons too numerous to mention here, this turned out to be a very bad idea. (It would be another three decades of experimentation before the majority of venture firms organized as limited partnerships.)

The region around Boston’s Route 128 would boom in the 1950’s-70’s with technology startups, many of them funded by ARD. ARD’s most famous investment was the $70,000 they put into Digital Equipment Corporation (DEC) in 1957 for 77% of the company that was worth hundreds of millions by its 1968 IPO. It wasn’t until the rise of the semiconductor industry and a unique startup culture in Silicon Valley that entrepreneurship became associated with the West Coast.

Georges Doriot the first VC

Georges Doriot the first VC

Doriot and American Research and Development are worth noting for:

  1. Some of the very early VC’s got their venture capital education at Harvard as Doriot’s students (Arthur Rock, Peter Crisp, Charles Waite.)
  2. ARD was almost exclusively focused on the East Coast
  3. ARD proved that institutional investors, not just family money had an appetite for investing into venture capital firms.

Corporate Finance
One of the ironies in Silicon Valley is that the two companies which gave birth to its entire semiconductor industry weren’t funded by venture capital. Since neither of these startups were yet doing any business with the military—and venture capital as we know it today did not exist, they had to look elsewhere for funding. Instead, in 1956/57, Shockley Semiconductor Laboratory and Fairchild Semiconductor were both funded by corporate partners —  Shockley by Beckman Instruments, Fairchild by Fairchild Camera and Instrument.

More on the rise of SBIC’s, Limited Partnerships and the venture capital industry as we know it today in Part XII of the Secret History of Silicon Valley here.

Ardent War Story 6: Listen more, talk less

At Ardent we assembled an amazing group of talented engineers to build personal supercomputers to sell to scientists and engineers. (Context here.)  The company failed.

Getting Out of the Building Wasn’t Entertainment – Discovery and Validation
Now that I was the master of the “facts” about customer needs in these specialized vertical markets, and with my team of vertical marketers, I thought I had achieved absolution and redemption. Opinions had been eliminated as part of marketing’s dialog inside the company; we had achieved “fact nirvana.” But there was one fatal flaw. As I enjoyed my post-graduate vertical marketing education, I had forgotten the real purpose of spending time in the field.

While understanding how customer’s do their work was one key part of Customer Discovery, I neglected the other key component – Customer Validation – to understand whether there were sufficient number of customers who had a problem that needed to be solved – and would pay to solve it. I had needed to ask customers four simple questions.

  1. Did the customers know they had a problem?
  2. If so, did they want to change the way they were doing things to solve that problem?
  3. If so, how much would they pay to solve the problem?
  4. Would they write us a Purchase Order now before our supercomputer was even complete, to be the first to solve their problems?

In hindsight, these questions seem blindingly apparent yet not asking them led to the ultimate demise of Ardent.  I just assumed that since customers were talking to me and spending time with me, it must mean that they agreed with our new company’s vision and would spend piles of money with us. At this point in my career I didn’t understand that the goal of getting outside the building was not only finding markets with potential customers to sell to but also confirming the company’s vision, business model and product/market fit.

I had done a good job of Customer Discovery but failed at Customer Validation.

Ignoring the Red Flags
While I had lots of people willing to talk to me, we never really pushed hard to see if any customers were willing to buy and pay for the product before it shipped.

Early startup customers are visionaries just like the founders selling to them. If your startup’s vision is compelling enough, these early customers want to buy into the dream of what could be, and they want to get in early. They will put up with an unfinished system that barely works to get a competitive advantage outside their company (or sometimes a political one inside their company.)  They will count on your startup to listen to their needs for subsequent releases or follow-on systems that actually deliver on the initial promise.

All industries, markets and segments have these visionary, early adopters. It is one of the wonderful intersections between human nature, capitalism, and startups. Not finding a sufficient set of these early visionaries is the biggest red flag a company can encounter.  Ignoring these warning signs is fatal.

Product/Market Fit
Getting out of the building is not to collect feature lists from prospective customers nor run tons of focus groups (I had passed this test.) Instead it was to validate the product/market fit by discovering if their were enough customers who would buy our product as spec’dThis was where I had failed at Ardent. Once we had found our target customers we spent our meetings describing our new personal supercomputer and what it could do for these researchers instead of listening and truly understanding whether what we were offering was a “nice to have it” or “got to have it.”

If I had had actually been asking “Were we solving a problem these scientists and engineers felt they had?” I would have gotten a half-hearted “maybe.” If I had followed that up with a “If our personal supercomputer delivers as promised, would you write me a check now, before it ships?” I would have seen that no one was falling over themselves to be the first to buy our product. Another clue: lots of people said, “We’d try it if you give it to us.”  That answer is always a dead give-away that you don’t yet have a product compelling enough to build a business.

As often happens in a startup, we confused our own vision and passion with the passion of our potential customers.

I had talked too much and listened too little.

What did the company do when we heard customer input that contradicted our business plan and assumptions?  More in the next post.

Lessons learned:

  • We had “discovered” Ardent’s initial markets and customers
  • We spent too much time selling our vision and not enough time validating whether customers would actually buy
  • A lack of early, eager purchasers is a red-flag – time to revisit your business model

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