Update 11/3/03: I've noticed most of the inbound traffic to this article comes from a site called 'Anti-Venture Capital'. If your concern in visiting here is to figure out whether it's worth your time looking for VC, I suggest you also look at this post which specifically talks about which businesses don't fit the venture model. Here's a list of all of the VC oriented posts that have appeared in this blog. Might I also recommend VentureBlog, run by the August Capital folks. Read it all in as a cold a blood as possible, considering it's just your livelihood on the line, remember the guy who sent you here has something to sell as well - not that there's anything wrong with that - and make your own decision. And may I wish you the best of success in whatever venture you have in mind?
Since the last few posts have been serious geeking, I thought I'd try something more related to the day job. The following is edited from a post I wrote for an old college friends' mailing list last November, so it should be 'suitable for general audiences.' I've updated where necessary. I should say I'm relatively junior in this biz, at it for three years, so I'm sure a lot of veterans will look at this and think 'Well, duh!' But then one of the few advantages of being a newbie is the possibility of reflecting on your work before it becomes completely internalized. Anyway, here's a bit of analysis of the VC scene from the points of view of 1) transaction cost economics, 2) internal efficiencies of VC firms and 3) the current post-bubble funding environment.
1) Venture capital activity in general, and early stage private firms in particular, are what economists call very 'specific' goods. There are valid reasons that the Congress and SEC have made it impossible for most investors to give their broker a CUSIP number and get a few shares of SmallPrivateAmazingWidget Co. or even Joe Beet's VC Fund. The majority of these firms are talking about filling needs that aren't yet proven, in markets that may not exist, with products and services they haven't built yet, with financial plans that are often - ummm - sketchy. Getting enough information to put a fair price on that kind of deal, even if it's real and not a fantasy, is a full time job and very easy to get wrong even then. Same goes for VC funds themselves, figuring out who can pick and manage early stage deals is itself a bit of a chore.
In economic terms, the transaction costs of this kind of deal are quite high. Finding the deal, assessing its value, negotiating it, and then making sure it goes vaguely according to promise constitute big overhead. Economic theory suggests that in these circumstances, transactions don't happen in open markets (like the NYSE) instead they proceed through one-off contracts (or are funded internally in existing firms - that's called R&D). Sure enough, almost all VC deals are defined by one-off contracts called 'term sheets', though these are constructed from more-or-less standard sets of terms and conditions Another thing suggested by economic theory is that in the face of uncertainty, contracting parties will try to mitigate risk by trust. So here's one open secret of the trade: venture capital is not at all an open market, it is a trust network. Get this straight and you'll know more about VC than most of the financial writers out there.
In the face of all the uncertainty elements I gave above, deals are often made or broken based on direct or indirect personal connections among the parties involved, because reputation is the best assurance of both diligent performance, and good faith in sustaining the deal if things don't work out as planned (a 99% probability). One of the best sources of trust is "He made me money before". (By the way, there's even a private VC database called VentureSource where you can find out who was involved in most any deal and how it fared. Need to check up on someone? Find out what deals they've done, and you'll almost surely known someone who was involved directly or at one remove. )
As far as I can tell, though, being from the right sorority or fraternity gets you bupkas, at any rate no one has tried to give me a secret handshake yet. The networks that count in Valley VC, in rough order are:
A) associations among VC firms and partners and seasoned entrepreneurs
B) who you worked with before, and what they thought of you
C) ethnic networks
D) the ol' school tie, sometimes
E) non-business networks like soccer parents, public affairs clubs and religious affiliations
(A) is fairly obvious. If you do deals with other firms you find out what kind of thing they like, what and who they know, where their expertise lies. Got a deal that's maybe interesting but you can't evaluate efficiently? Toss it to a friend who knows the area. If it works out he'll offer to cut you in on the deal, even if not he'll toss one your way someday. This is part of our economic function - we're a message passing utility that tries to line up people, money and opportunities in the presence of huge amounts of noise and uncertainty. Once you've been an successful entrepreneur at the CEO or exec VP level, you're also in this network. (Being an officer in a public company does not necessarily make you part of it.)
(B) is the most powerful in terms of quantity. Work with someone in a tough job and you'll know what he or she is made of - it's the business equivalent of 'foxhole loyalty.' If I worked with and trusted good old Joe, and he in turn tells me someone works like a dog and knows his stuff, then he'll get a look. There are large companies that have notoriously strong cultures - and high turnover - and thus become a network nexus of referred trust. I'm a member of the Apple Mafia, having served 8 years there. I can probably check up on any former Valley employee of Apple in no more than two hops. One of my partners is Intel Alumni, that's even better. Big Valley firms create a secondary public good (externality) by putting diverse people into pressure cookers and turning up the heat, forming trust networks.
(C) is part of what keeps this from degenerating into an ol' boy club. According to my friend AnneLee Saxenian at Berkeley, over 25% of Valley startups now have CEOs of Indian or Chinese descent. (Lame local joke: "The Valley is built on ICs. Yeah, Indians and Chinese!") One of my partners is Indian, so he's tapped into the so-called TIE crowd. (TIE = The Indus Entrepreneur, both Indians and Paks). These guys are awesome networkers. Being Israeli or Korean or Brit also helps, but not quite so much.
(D) the school thing, is variably useful. Being from a smallish, select, tight school setting does help, say Stanford business school. Being from a large, diffuse, not-so-select school doesn't usually help unless there's something like a work relationship as well.
(E) Trust and introductions spill over from social settings, but usually have to be corroborated through business networks. Can get you in the door, though. We've looked at deals picked up from a partner's cabinetmaker, and via a friend's daughter's fiance. I you want to leave your work at the office, this is not the place for you.
(I should also mention geography as a negative selector. Since early stage investing is inherently hands-on, many funds won't do early deals very far from their home offices. Our rule is now 'Pacific time zone only.' Distance also makes the networking more difficult, even in the Internet age.)
If you're an entrepreneur trying to get a listen, you really need someone on the team that connects into the VC community as far up that list as possible, with as strong a recommend as possible. Remember that person is putting their reputation on the line when they connect you, so treat them well. And if you repeatedly can't find that connection, go look in the mirror, the world may be telling you something.
2) Second big topic, and another open secret of VC: One part of operational VC success is saying 'no' efficiently. Consider the following: We fund about half of 1% of the deals we see at some level. This number is typical or even a little high. When I pick up an unknown plan, my prior probability that I'm going to dump it is 99+%. My cost is the time I may take reading it or checking up on the idea, the market, the people. A 'false positive' is the penalty case, I spent that cost with no reward. You can see why I'm a priori biased to drop it if anything looks amiss. This is one reason that VCs get the deserved reputation for being opinionated: If I decide I hate a market or technology area, that becomes a reason to reject deals, and makes me more efficient. Maybe I was wrong? It won't be obvious for 3 or more years, and investors seldom see what deals a fund drops. There are NO penalty functions for false negatives at this stage, unless you never do any deals at all! Unlike many VCs, we list some of the things we dislike right on our website, hoping that people won't bother us with them - not that it seems to stop anyone.
Suppose I do like the first sniff of the deal, and have them in for a meeting, and then back for a meeting with the rest of the partners, and then do a little diligence on the people and competition. Just like a pharma company working up a drug for market, my costs go up at each step. I will spend lots more of my time, hire a diligence consultant to check up technology details or a foreign market, burn up favors at other firms asking for their opinions or referrals. And suppose I do get ready to call for a vote on the investment from my partners. What is my penalty case then? Why it's once again a false positive - put your investor's money into a turkey and the penalties are big. False negative, once again little cost. The only way you'll even know is if someone else funds them and the deal wins - then you'll laugh about it over drinks five years in the future.
You can see how this works with (1) above to make it a brutal proposition. Don't have an 'in network' connection? Unless there's something eyecatching about the plan, and no obvious problems, it won't make it through the first stage of the process above. Though most every VC firm has a website and other ways of sending in cold call plans, it's axiomatic that plans from the 'slush pile' are crap, because we all know the yield is far less than personally referred plans. Since we're early stage, we may look at a larger fraction of the slush pile than the bigger firms, but I've had only one plan survive first reading in over two years of operation.
Second moral of the story: Every VC firm and every partner has different trivial reject rules, and you don't know them. They may have decided they hate a particular market or technology area. They may be ready to make an investment in a competitor. They may have decided they are overweighted in the market or technology you represent. Who knows? Remember, the prior probability of getting 'no' is 99+%, so hearing it doesn't give you much information unless the fund supplies some details (we try to be good about this, when it's something fixable by the company, but no is still no). Your only hedge on this is to keep trying, because everyone's tastes differ. If you get similar 'why' replies after four or five tries, then get a clue. Again, a network connection will get you more diagnostic data than a cold call every day.
3) And some comments on the current state of play: The VC world is still somewhat in shock. I thought I had seen the bottom in sentiment last spring, but it seems like everyone came back from summer vacation 2002 in an even lousier mood. A friend who is partner at a larger firm explains it this way, paraphrased: 'Last fall (2001) everyone understood that the market was overinvested and that we were in for some nasty triage. We merged or killed off the hopeless cases, patted the ones doing well on the back, and got to work on the ones where TLC might make a difference. This year we came back again and realized that 80% of the those cases are going to die, and we have the whole miserable thing to do over again.' I'll add that though the noise made by the 'dot-com' implosion was large and noticable in the popular press, since many companies were publicly visible, there is more capital being written off in busted switch, router, and optical component companies, because end customer demand in that whole area has imploded. The net of all this is a VC business that is emotionally biased toward the downside. And we honestly don't know where the real capital demands of information technology innovation are going to stabilize. We're now back to the 1995 investment run rate, and no one really knows if that's the baseline, if we have undershot, or have further to fall. (My guess is we are somewhat undershot, but I have no way to prove it.)
Just to compound the angst for early stage guys, there's also the spectre of the 'down round' or 'pay to play.' Glossing over some details, this is where a later stage investor in a company offers a much lower valuation for the company than in previous rounds of investment and/or demands that earlier investors put in more money or see their stock be converted to 'common' as well as being heavily diluted. There are a lot of such deals around now, since valuations have fallen overall, and the economic conditions have made it hard for startups to make sales even if everything else is working right. This is of course terrifying to early stage funds like ours, and even more to individual 'angel' investors. Unless we reserve enough money to keep playing in later rounds, we can lose all the value of the cash and effort we put into the earlier stages. The reaction of the smaller funds is to circle the wagons by forming funding syndicates for each company, that have enough capital to carry through to profitability even if no larger funds offer favorable terms for later funding rounds. This of course takes more time to assemble a syndicate, more chances of trivial rejects, etc., etc. If this continues indefinitely, it means the whole idea of stage specialized VCs was bogus and a figment of the bubble. I'd prefer to think not, being obviously biased, but only time will tell.
This last set of conditions feeds directly back into the two big areas above. Apparent risk level in all deals has been raised not only by the negative market for technology in general, but also by internal factors in the VC industry that are causing a lot of funds to be running more aggressive 'trivial reject' filters that reflect the kind of syndicates they believe they can assemble. With apparent risk up, the person to person trust network element of this kind of investing is an even stronger factor than usual right now.
