VCs vs. entrepreneurs

To be successful, any sort of business deal must align conflicting interests. In thinking about venture capital, the decision of entrepreneurs to seek (and accept) VC investments assumes that both parties want the company to succeed, and the only conflict is over the terms of the investment (particularly the dilution).

However, a couple of recent blog posts highlight a second, equally important category of conflicting interests: control over the timing of exit.

On AngelBlog, Basil Peters recounts an example of a tech startup with a chance to exit via acquisition, one that would produce a 3x return for VCs, and perhaps 10x for the angels and 100x for entrepreneurs. The problem is that the VC needs a bigger return (the home run) from its winners to cover its losers. This is consistent with the story of VC investment math told by Bob Zider a decade ago in his HBR article, “How Venture Capital Works.”

Of course, such an early offer may mark a peak in the company’s valuation — in an increasingly competitive segment (as in the Peters example), the total return will only go down. Once faced with an obviously worsening situation — whether firm-specific problems or an increasingly unprofitable industry — VC are known to pull the plug prematurely, saving management attention for the likely winners rather than spending more time salvaging a “dog.” In my SD Telecom study, we had to interview one founder in the final few days before the VCs closed the door forever.

The other point is that, come hell or high water, the VCs will liquidate their investment before their investment fund matures and must return capital (and earnings) to its principals. As VCs freely admit, this means they seek a quick exit — ideally 3-5 years, with 7 years at the outside. Blogger Sigurd Rinde of Germany notes the disconnect between achieving VC objectives, and the goal of many tech entrepreneurs of creating long-term value.

I had a slow growth, bootstrap startup, which never sought (nor was suitable) for VC. This had its pluses and minuses, but it’s clear (as I used to say back then) that taking VC is like starting a time bomb: you have to come up with an answer before it goes off, or you’re dead.

Best business planning books

This semester I’m teaching a business plan course for the first time since I left UCI in 2002. (I did use a business plan assignment in a 2006 strategy class — more on that later.) The course is an elective for both our undergraduate entrepreneurship and management majors, although I have a few students from other colleges on campus. At the suggestion of a local VC, we are shifting the title and emphasis of the course from strictly business plans to “Planning the New Venture.”

Although I use textbooks for core courses to cover the recommended corpus of knowledge, where possible I try to use regular (i.e. trade paperback) books for electives. They tend to be more readable, cheaper, more likely to be kept after graduation and more representative of what students will read after they graduate. So in preparing for the class, I searched on the Internet and Amazon for books related to business plans.

In 2006, I asked students to write business plans without much information on how to do it, other than walking them through our standard template, which was derived from the U. Maryland BPC. Both versions were derived originally from the standard MBA entrepreneurship textbook by the dean of entrepreneurship scholars, the late Jeff Timmons.

This year, I wanted to give them more help on the two most difficult tasks — estimating revenues and estimating costs — while also covering the broader questions of starting a new business. After buying five books and getting a 6th from the library, I eventually settled on three books.

The first book I picked was the smaller (and cheaper) Timmons paperback, entitled Business Plans that Work. It‘s not complete, but for an undergraduate course it gives a good consistent way of looking at the problem, and (not surprisingly) matches well to our (i.e. Timmons) BP format.

The second book I chose was Bankable Business Plans by Edward Rogoff. I did not expect to like the book, and with its “action steps” (rather than chapters) it’s a bit of a scattershot. However, I found it a nice complement to the Timmons text. In some areas, it’s much more concrete than Timmons, including one of the most important blind spots from 3 years ago — setting up a sales process.

These two books would have been enough for our 15 week course, if I had built a reader with 4-6 other articles to supplement the gaps in coverage. Together, they are only $28 at Amazon — a steal for anyone involved in entrepreneurship.

However, I wanted to give students a little more of the big picture of starting a business, including a sense of why they want to be entrepreneurs in the first place. In the end, I decided to use Guy Kawasaki’s The Art of the Start, which turned out to be much more substantive than any previous Kawasaki book I’d read. Still, I see Kawasaki and this book as a motivational speaker — identifying some important tricks and traps — rather than providing a business plan checklist.

One problem I’ve found in teaching entrepreneurship — with all the work of Timmons, and also many competing academics — is too much of an emphasis on venture capital-funded IPO-oriented startups. Kawasaki nicely balances this out with an entire chapter on bootstrapping, which (as he notes) can also be used by VC-bound companies to bridge between 3F money and their first professional capital. This nicely fits my course goal, which is to help students to identify the most appropriate funding approach for their idea and industry context.

The VC-centric counterpart to Kawasaki’s book is Raising Venture Capital for the Serious Entrepreneur by Dermot Berkery, a former McKinsey consultant turned VC and MBA lecturer in Dublin. It came highly recommended on Amazon, and after reading it, I saw why. It really walks entrepreneurs through the funding process — as VCs see it — and explains what they must do (and why) to put their best foot forward.

I decided not to use it this year for two reasons. First, it’s so VC centric that it would have undercut my message about being funding agnostic, and secondly, it’s more suitable for those already in business or graduate students. I would strongly consider it if I were teaching high growth-startups in the Stanford or Berkeley engineering school, and I’ll also recommended it for our new venture finance class.

Beyond the classroom, I would also recommend both the Berkery and Kawasaki books for those already in a startup. Despite 20+ years thinking about startups (as a founder, research, teacher and consultant) I picked up valuable tidbits from both — either things I didn’t know, or different ways of thinking about familiar problems. For example, Chapter 2 of Berkery’s book emphasized the importance of identifying 3-4 alternative exit strategies, so that investors (and founders) can still succeed if the initial plan is blocked.

One book that did not fit my immediate goals was The Business Plan Is Dead by Jeffrey Wofford. I’ll write more about it some other time.

Raising capital in difficult times

In the past six months, it’s become even more difficult for otherwise promising tech startups to new or follow-on funding. On October 7, the now-infamous Sequoia PowerPoint deck advised their (mainly high- tech) portfolio companies:

New Realities
$15M Raise @ $100M post[-money valuation] is gone
Series B/C will be smaller raises
Customer uptake will be slower
Cuts are a must
Need to become cash flow positive

While some suggested this was a bargaining tactic by Sequoia to lower valuations, startup companies now face a double-whammy of declining demand by business and consumers and less availability of investment funds.

Of even more concern to the VCs, exit strategies will be more rare, less lucrative and more time consuming:

Increased Challenges
M&A will decrease
Prices will decrease
Acquiring entities will favor profitable companies
IPOs will continue to decrease and will take longer

Since VCs won’t be able to cash in their investments for a long time, they must set aside more money to keep alive a smaller number of companies.

In Thursday’s Wall Street Journal, veteran tech industry reporter Pui-Wing Tam wrote about [also here] the dilemma faced by a small Oakland-based VC fund:

Claremont Creek Ventures recently had to decide which of its young to forsake.
…
Amid the financial crisis and the plunging stock market, Claremont Creek decided to focus on the fund's best investments and stop backing the less-promising start-ups. It wanted to be sure it had enough cash for the next few years for the winners. The venture firm ranked the start-ups in the fund's 16-company portfolio with an A, B or C grade.

"We're doubling down on the As and likely won't invest any more capital in the C companies," says John Steuart, a Claremont Creek managing director. "The portfolio is competing against itself and it's survival of the fittest. It's brutal."

Angel investor and fellow SJSU entrepreneurship teacher Steve Bennet is one of the few who has beat the odds. In his ProfessorVC blog, he explains how one of his portfolio companies raised $6 million in Series C funds.

For those that have already tapped 3F money and can’t raise professional money, the choices are pretty clear: sell the company, stop operations or find a way to bootstrap.

Steve will be moderating a March 9th panel on bootstrapping at the Silicon Valley Center for Entrepreneurship. More details on the program when they are available.

Tech startups are always an experiment

Last fall, I taught entrepreneurship for only the second time since I got to SJSU. (I’d previously taught it as an adjunct at UCI, building more on my experience as an entrepreneur than any formal preparation).

About 2/3 of the way through the semester, as part of making a point about the lack of sufifcient information in any startup situation, I wrote on the board

Business is an experiment

which will become the mantra for all my future entrepreneurship courses.

To explain my thinking further:

• if you’re doing something new whether new to the firm or new to the world — the answer doesn’t exist;
• in a startup, for many questions you won’t have the time (or money) to get a definitive answer; so
• you need to make and implement a decision with the recognition that the experiment may fail — and thus both look for signs of failure and find an expedient way to mitigate against (rather than prevent) such failure.

That leads me to an an interesting quote from Carol Bartz (newly appointed Yahoo CEO). It came from her 2001 talk at Stanford about encouraging entrepreneurship in established companies: at that time she was CEO of Autodesk, the CAD software company.

As an aside, I’d disagree with her use of the term “entrepreneurship”: if you use the term to refer to any form of innovation or business initiative, then the term doesn’t have any real meaning. While “corporate entrepreneurship” is a bit of an oxymoron, at least it demarks a form of initiative distinct from starting a new company.

However, I couldn’t agree more with her on the philosophy she brought to Autodesk to deal with the turbulent dot-com era, a philosophy she called “Fast Fail Forward.” As transcribed by Scott Fulton of Beta News:

I had to do this during the dot-com time, where everybody panicked and decided that you guys [Stanford students] were going to rule the world. … [P]eople got even more cemented in and scared to take risks, because what did it mean in an established company?

So we started this thing called 'fail-fast-forward,' and the whole idea is, listen, failure is very acceptable. When it happens, make sure you identify it quickly, and hopefully it's in a forward motion. And then start going again.

In other words, nothing new happens without risk, and the only way to deal with risk is to accept it rather than try to completely prevent it.

Hat tip: to Scott M. Fulton, III of BetaNews.