March 12, 2007

Startling VC Statistics!

Posted in finance at 11:47 am by scottmaxwell

Don Dodge has done some great analysis in his post Venture Capitalists and Angels invest $40 Billion per year but see only $18B in exits. The bottom line is that it appears that the relationship between investments made by VCs vs. the exits that have been generated suggest pretty significant losses (unless the market cap of VC portfolios is significant!). While it is difficult to match investments made with actual results, Don’s conclusions are difficult to argue with. There is probably a lot of accumulated value in VC portfolios that is not evident in the data yet, but there will have to be some pretty significant increased M&A and/or IPO activity in order to get positive multiples out of the industry (i.e., your average exits over time divided by your average investments needs to be greater than 1!).

Don’s analysis raises a some issues:

  • Strange that every VC I talk with has great results yet the totals look so poor…how can this be?
  • Is it possible that the market value of VC portfolios is multiples of past years?
  • If the conclusion from this analysis is correct, how does the industry get back to equilibrium? Fewer VC firms? Fewer VCs at the firms? Less capital at the firms? More firms moving into private equity?
  • Are the large companies seeing such low ROI from their investments in new technologies? If so, should they be doing less R&D and acquiring more, thereby allowing the VCs to fund their R&D?
  • Do current VC portfolios (not taken into account in the analysis) represent such a large value that there will be a flood of exits in the next few years?

It should be an interesting next few years in the industry…

February 25, 2007

10 best ways to burn capital

Posted in Economic Model, finance, management, Planning at 6:35 pm by scottmaxwell

Sometimes seeing how best to achieve the opposite of what you want to achieve can help you to clarify what you should do:

10 best ways to burn capital

  1. Hire a complete set of senior managers ASAP after forming your company. The great thing about senior managers is that they will want to hire other managers and you will end up with more layers of management to spend money on!
  2. Hire the senior managers from large companies. They are even more inclined to spend money on additional management layers as well as many different staff functions.
  3. Locate your team in an expensive city. Your staff will need more cash comp to live, so your salaries will be higher. Also, your rent (and everything else) will be higher!
  4. Ramp up your staff quickly in anticipation of high demand. Your current staff will spend more of their time recruiting and training (lowering productivity) and your new staff will have a lower utilization as well. If you do this really well, you will build a long-term culture of not being productive that will last through all phases of your company’s evolution.
  5. Use your marketing resources on branding and try to brand what you don’t have. Focussing your marketing efforts on lead generation and product marketing will have too much capital efficiency to meet your goal of burning capital.
  6. Use your sales resources on field sales and large company partnerships. These are the activities that cost the most and take the longest to turn into revenues. Activities like telemarketing, inside sales, and developing the natural business partners are too capital efficient!
  7. Put a large development team in place and then focus your development staff on the core technology and ignore the packaging and UI considerations…then hire some professional services, training, and customer service staff to help your customers implement, configure, train, and resolve issues.
  8. Do not hold staff meetings or company-wide meetings or other communication methods to help focus your team (e-mail, IM, etc.). This will create too much clarity and resolve too many questions.
  9. Get backing from 2 or more VCs with very large funds…the larger the better! They have a need to deploy more capital and will own more of your company over time, so will be less resistant to these ideas.
  10. Never, ever, ever put in place management systems such as budgeting, metric management, or incentive systems that drive the right activities. If you do put in place the management systems, be sure not to focus them on the key drivers of your business.

December 22, 2005

How David Can Beat Goliath- Summary of Strategies

Posted in culture, customer service, David vs. Goliath, Economic Model, finance, management, marketing, Metrics, Product Development, Sales at 11:50 am by scottmaxwell

This post is an overall summary of the David vs. Goliath Series and meant to act as a pointer to all of the posts in the series. There are three overarching points for the series:

  1. Emerging growth companies have several natural advantages over larger companies that they can amplify,
  2. Large companies have several advantages that emerging growth companies can minimize, and
  3. Emerging growth companies can (and should) take a series of specific short-term actions that over time will accumulate into a long-term defensible competitive advantage (by amplifying their advantages and minimizing the large company advantages)

I can’t emphasize enough how important it is for emerging growth companies to think through these issues and develop a clear point of view on what they are trying to achieve. Regardless of the long-term goal (a sale of the company or remaining independent), building a defensible advantage will make life much better for you (easier time in the product markets, better growth, better bottom line, higher valuation, etc.). Of course, once you know what you want to achieve, you need to execute against it!

The Nine Major Themes:

  1. Create an Information Advantage. The emerging growth company has the natural advantage of being closer to the customer that the large company. You can truly capitalize on this advantage by taking steps to increase the information flow into your company even more.
  2. Create the Time Advantage. The large company has a disadvantage as it grows, as solid communication between employees gets much much more difficult as companies grow. This communication difficulty turns into a time advantage for emerging growth companies, as larger companies have difficulty doing anything quickly, while emerging growth companies, with their smaller staffs, can turn on a dime. The emerging growth company can take several steps to capitalize on this natural advantage.
  3. Create the Scope Advantage. The emerging growth company has the ability to focus on one product market. The larger companies naturally need to increase their scope in order to sustain growth. The emerging growth company can exploit this natural advantage by staying focused and continuously improving “ownership? of its product market.
  4. Create the Scale Advantage. Large companies have difficulty seeing and/or addressing small markets, even if they are very high growth. This gives the emerging growth company time to establish a foothold in the market as well as create some level of defensibility before the large company enters the market.
  5. Create the Innovation Advantage. Large companies have difficulty executing against certain types of innovation (for example, innovations that cross department boundaries, such as new products with new channels of distribution and new customer service approaches). If emerging growth companies innovate against these natural advantages, they can create an edge against the large companies.
  6. Set Your Operating Point Closer to the Funnel Singularity. This is the strategy of allocating your resources against nailing the customer experience at low price points to the customer instead of allocating significant resources against sales and marketing activities. If you do this well in the right markets, you can create a large, profitable business that is very difficult for the large companies to compete against. This is a classic strategy, but the internet-based sales and marketing approaches now allows the strategy to be executed more aggressively.
  7. Attenuate Goliath’s Strengths. The large company does have some natural advantages itself. The posts below address each of the large company advantages as well as what the emerging growth company can do to minimize the large company strengths (and in many of the cases, create an edge):
  8. Defend Against Goliath’s Attack. No matter what you do, if you are successful then Goliath will eventually attack. These posts address the nature of Goliath’s attacks as well as how the emerging growth company can set up in advance to defend against the attack. I point out that the results of the attack will be determined well in advance of the attack! The two posts are:
  9. Execute Against Execution. All of the prior posts are about what the emerging growth company can do to create a strategic advantage. This post is about how to maximize the pace of your company toward the series of goals that you have set for your company. The higher your pace toward your goals, the faster your company will develop into a large profitable company with a defensible competitive advantage.

I am going to take a breather from this series for now, but I do intend to put together the implications for each department so that some of the more esoteric points will be made more tangible for each functional group. When I post each of the functional implications, I will place a link on this post below so that this post will act as the index of the major strategies in addition to the specific implications for each function.

December 3, 2005

Attenuate Goliath’s Scale and Scope Economies Strength

Posted in David vs. Goliath, finance, management at 8:00 am by scottmaxwell

This post is part of the overall posting “How Can David Beat Goliath?- Strategy #7: Attenuate Goliath’s Strength“:

The large companies have economies of scope and economies of scale. This is true. But, fortunately for the emerging growth company, in most cases these are economic benefits but not strategic benefits for the large company (see the strategic benefits for the emerging growth companies in “Create a Time Advantage,” “Create a Scope Advantage“, and “Create a Scale Advantage,” for example).
The emerging growth company can compete with the larger company’s scale and scope economic advantage by following the thoughts in my last post on attenuating Goliath’s financial strength advantage, as scale and scope economies lead to a better economic model and, therefore, better financial strength. The emerging growth company competes with, and attenuates this large company strength by running a very efficient business and having plenty of capital to take it through tough market climates, which I discussed in that post.

Attenuate Goliath’s Financial Resource Strength

Posted in David vs. Goliath, finance, management at 7:42 am by scottmaxwell

This post is part of the overall posting “How Can David Beat Goliath?- Strategy #7: Attenuate Goliath’s Strength“:

Financial resources are probably a large company’s greatest strength vs. the emerging growth company. They have more staying power and a larger bank account than the emerging growth company. If they choose to (or are just clumsy), they can severely hurt the economics of any product market that they enter.

Attenuating the large company’s financial resource strength…

With respect to financial resources, all you can really do is to set up your company not to run out of cash, even in the difficult situations. Some thoughts:

  1. From day one, set your pricing and business model at a point of efficiency that will be difficult for the large company to meet. This will reduce the large company’s interest in the market and set you up in a very economically defensible position if the large company does enter your market (see “Aiming Toward the Economic Singularity” for some ideas on this).
  2. Get cash flow positive as soon as possible. If you need or want to invest in growth and can’t be cash flow positive, be in a position to either
    • Dial down the investment expenses quickly, or
    • Have plenty of cash to make sure that you do not end up in a tough financial situation, or
    • If you do not want idle cash, make sure that you have deep enough pockets (your own, your bank and investors) to ride through a market storm (I would be careful relying on others to fund you during a storm, however…it is not a good time to request capital).
  3. Develop several contingency plans for the business and make sure that you can successfully get through those scenarios financially. These plans should include the scenario of a large company coming into your market and underpricing you (even if you follow the advice in point 1 above).
  4. If you have developed to a point that this issue has become important, you probably need a strong CFO (or equivalent analytical talent) to help you understand the cost model of the business and how you can continue to make it more efficient. The CFO should develop a model (with both activity metrics and economic metrics) for the business based on historical calibration points (this is important, as a model that has not been calibrated isn’t accurate!). The model can be used for various purposes:
    • Determining the efficiency of various groups and processes (to find opportunities for improvement)
    • To chart progress vs. predicted progress and understand the implications (this is highly valuable!)
    • Determining cash flow under various business growth scenarios
    • Determining cash needs during a tough market situation
    • Determining opportunities to reduce the price paid by users.

None of this is particularly difficult and part of running a well oiled long-term business. The major point is that you can take steps to have plenty of cash to get through good times and, more importantly, bad times. If you take these steps and have enough cash to get through the tough times, you will attenuate Goliath’s financial resources strength!

November 3, 2005

Choosing a VC- You need to squeeze the avocado!

Posted in finance, management, VC Roles at 2:44 pm by scottmaxwell

I wrote a post the other day on whether the need for capital is changing among emerging growth companies. As I read the comments and looked at some of the other postings on the topic (MikePK has a write-up and some good links to others, so I won’t repeat them here), I realized that another issue is that some (many?) companies might be more happy not having a VC (for them, it wasn’t that they were happy not to need the money, but rather they were happy not to need the VC that came along with the money).

My view is that with all of the different types of VC firms and individuals that make up the industry and with all the different companies, products, and situations that companies find themselves in, the range of possible outcomes is extremely large. When there is a solid fit between the management team, the VC, and the situation, the outcome is generally good (that is, the market opportunity is maximized and everyone feels good that they worked well together to optimize the outcome). When the fit isn’t right, many things can (and do) go wrong and/or the process and results do not meet the ingoing expectations.

Determine the fit before the deal closes!

I am a strong believer in making sure the fit is right for both sides in any VC/management team relationship. As an expansion-stage VC (that is, I invest in companies once they have a product and some customers), I learn as much as possible about the market, the company, the products, the distribution approach, the customer relationships, and the team. I also spend enough personal time with the senior team so that we can build a working relationship and to make sure that we share similar views on how to build a great company.

From the company’s view, I am a huge believer in having the management teams “turn the table” by doing due diligence on both my firm and me to make sure that they understand how we work and how we compare to others. (It actually worries me when they don’t do their work, as I start to wonder if all they want is the money, which is not the basis for great relationships!)

No two VCs are alike…

VCs are diverse, as are the firms that they work for. There are several major differences that are relatively straightforward to determine prior to closing an investment that can help you determine if you have the right fit.

The best due diligence that the senior management of a company can do is to call several of the CEOs that have current or former investments from the VC (the VC will give you a list or you can look them up online and cold call them) and ask them a number of questions (note: most, if not all, of them will say they are happy with the VC and that the VC is great. In order to truly get something out of the interview, you need to ask them much more specific and fact-based questions…see some suggestions below). Also, take the time to understand the individual VC and the firm. Ask to speak with other partners and members of the “value-add” team. Ask them all the same questions. It is a great exercise and you will have additional relationships to call upon once your investment closes!

The Differences- What to look for…

  • Market Focus– What is the market focus for the VC? The more closely the VC’s market focus matches your company, the better the fit. Also, the more focused the VC on particular markets (or business/economic models), the better the VC will understand the market. You can easily determine market focus by looking through the VC’s portfolio and asking the VC what interests them (note: You should not depend solely on the portfolio here, as it is a “rear view” mirror of the VC’s interest in particular markets. Talking through the issue with the VC should help you understand current interests…some VCs study a new market for a long time and gain some level of expertise prior to making an investment in that market and many markets are new, so no VC will have the direct experience.)
  • “Stage” Focus– What situations are the VCs most familiar with? The skills and network necessary to help very early companies are different than the skills necessary to help companies at the expansion or later stages. Also, while most VCs are growth investors, some investors are extremely good with turnaround situations or other special situations. Again, examining the VC’s portfolio and asking the questions to the VC will help here.
  • Past and Current Investments– Understanding the VC’s portfolio is another great way to understand the VC. Most VCs portfolio investments are online, but you might want to ask the VC for the entire list or visit the wayback machine to make sure that you have captured all of the VC’s past portfolio companies (this is also a great vehicle to find out how consistent the VC has positioned itself over time). Call (or, better yet, visit) several of the CEOs of these companies and ask as many questions as you need to get the detailed information.
  • Culture and Reputation of the VC Firm– Is the VC firm/individual engineering oriented, distribution oriented, financially oriented or some mixture of skills? Is the firm focused on adding value or more passive in nature (almost everyone says they are “value add,” so you need to dig deeper to truly understand what they mean by it)? Do the partners help out on each other’s deals in a true team manner, or are there silos? Do people in the industry want to work with the VC’s portfolio companies or do they shy away from them? Lots of good questions to ask here!
  • Background, Skill, Intellect, Personality, Current Interests and Passion of the individual VC– The partner involved with the deal, who will most likely be sitting on your board, is the most important individual to evaluate fit with and get to know. Some firms, including mine, assign a full team to a portfolio company. When this is the case, evaluated each of the team members and make sure that the fit works and that you are going to enjoy working together (at least as important as money in my view). Ask the portfolio companies about the individuals and spend as much time with the team as possible before the investment. Also, ask each team member individually the same questions. It is always good to see the consistency of the answers.
  • Engagement Approach– How does the VC work with its portfolio companies? Does (s)he show up daily, weekly, monthly, Quarterly? Are they formal or informal? Is there a team of experts behind the VC that helps on various functionally specific issues? How do they work with the companies? What is the relationship between the VC and the company (do they partner well or does the VC expect to be the “boss”)? Do they engage when asked?
  • Philosophy/Values– This is not a throw away touchy-feely point, as mismatched expectations are important to identify up front. Is the VC conservative or aggressive when it comes to deploying capital? What is the “right” level of profitability? What is the “right” growth rate? How does the VC think about the “operating points” for the “dials” of product development, sales/marketing, and customer service? Is the VC looking for “control”, to set up a multiparty governance structure, just a “seat at the table”, or some other approach to the control issues? Does the VC want to replace senior staff, work with current staff, or see how the individuals and company evolve? What is the “exit” philosophy (“reasonable exit” or go for the grand slam, sale or IPO)?
  • Available time– Most VCs are extremely busy people. They are trying to digest a huge amount of information every day to stay on top of the “news”, build their networks (that are extremely helpful to the portfolio companies), build relationships with the large technology companies (again to help their portfolio), work directly with their portfolio companies, and find new investment opportunities. Just how much time are they going to spend with you? There are a few approaches that I would recommend to get a basic understanding. First, find out how many companies the VC is personally involved in and/or sits on the board of. Second, take the full staff of the VC and divide it into the number of portfolio companies (to get a staff per company calculation). Third, take the full staff and divide it into the new portfolio companies over the last 12 months (to get a staff per new company…this is important because the VC is generally the most intensive the first 18-24 months of an investment). These three stats can give you a basic idea of what to expect, especially if you are evaluating relative to other VCs. Also, ask the current portfolio company CEOs for the details on how much time they get with the partner and the team in general (again, ask for the details!). Finally, ask the VC directly and get his/her commitment early on of the amount of time (s)he will be spending with you…setting expectations early is good!
  • Level and type of Value Add (most important)- All of the points above add up to the value add (or value minus) that you can expect to get from the VC, but there are two more questions to ask both the VC and the VC’s CEOs to get the most detailed understanding possible:
  1. Can you give me a detailed list of the value add that the (current portfolio) company has received from the VC in the last week, month, quarter, and year?
  2. Can you give me one or more difficult issues involving the portfolio company and VC and how you worked through those issues?

I believe that you will find that most good VCs will accept, even encourage, your due diligence effort. I encourage the effort for every company I talk to, as I believe the fit is a truly important vehicle for success. I know some truly amazing Venture Capitalists and I believe the process that I outline above will help you determine the right one for you…

Additional thoughts on the process

I can’t help but point out two other relatively obvious points on how emerging growth companies can set up for the most favorable outcome in working with VCs:

  • Don’t get your company in the situation that you “need” the money (I know, easier said than done in some circumstances). This will allow you plenty of time to determine if you have the best VC partner.
  • Get yourself the best deal lawyer with the best experience that you can find. A good lawyer will be in a position to help you understand the terms (it is just math and logic, but the words are unfamiliar and the lawyer can point out where terms are “off market”). From the VC perspective, it makes the legal documentation process a lot easier as well.

Take the time to do your work!

Choosing a VC is similar to going to the supermarket to get an avocado (I hate overripe avocados and am too impatient to wait for an avocado to ripen). I have only figured out one way to tell if an avocado is ripe (not too soft or too hard)…You need to squeeze the avocado!

November 1, 2005

Is the Need for Venture Capital Changing?

Posted in Economic Model, finance, management, VC Roles at 5:29 pm by scottmaxwell

I met with Jan Hichert, CEO of Astaro, over breakfast yesterday morning. As we were catching up on industry gossip, he asked me the question if VCs were becoming unecessary for internet start-ups. We had a good discussion on the topic and then I came back from breakfast and read Rebecca Buckman’s article, Many Internet Start-Ups Are Telling Venture Capitalists: ‘We Don’t Need You,’ in today’s Wall Street Journal (October 31, page C1).

The article was about Venture Capital effectively becoming superfluous. The basic argument of the article, and the question posed by Jan, was that the cost of getting to “product” release in an internet start-up has gone down considerably over the last decade (which it has by at least an order of magnitude) and many companies, therefore, do not need Venture Capital. It cites Flickr as an example (which was sold to Yahoo for an estimated $25 million). Clearly a good payoff for the management of the company and it looks like a wise purchase for Yahoo. Everyone involved won. And no VCs involved…cased closed. Right?

Some Good Points…

The article (rightly) points out that the current issue is at least true for a subset of companies that, perhaps, focus on the consumer market. We also have seen many B2B companies bootstrap themselves with services revenue or low cost product downloads and get to a level of revenue and profitability with very little capital consumption before we invested in them.


My view on this issue is that it all depends on the goal for the company. If your goal is to build something useful (a feature that belongs in another company’s hands, for example) and make a reasonable amount of money from a sale (or create a lifestyle business), then clearly partnering with a VC is not for you (it is also not for the VC). But if your goal is to build a meaningful long-term enterprise, I would surround myself with as many smart, helpful, networked people as I can (good VCs fit in this category), and you will most likely need and/or want outside capital.

Expanding a Company- Uses of Capital

If you want to build a meaningful long-term enterprise, there are several uses of capital, even for profitable companies (yes, there are extreme outliers, but the following simple math is generally true):

1. As your revenues grow, your receivables grow, creating the need for working capital (cash turns into receivables). This point is generally true, but not true in certain consumer businesses that take credit cards and receive customer payments prior to paying suppliers (the negative working capital companies such as If you run a financial model on your business including the balance sheet, you will get a good idea of the relationship.
2. As you grow your Sales and Marketing, the expenses are generally paid before the revenue/gross profit is received. Most great companies have the opportunity to grow (with a positive Net Present Value using a high discount rate) their companies faster than they can self-fund (that is, using the free cash flow of the business to fund this expense) sales and marketing. Again, the credit-card payment model is less sensitive to this point (due to days receivable outstanding being 3-5 days), but it still exists. On the other end of the spectrum, the B2B Software as a Service (A.K.A. On-Demand or ASP) “subscription” model ( is my best example), uses a lot of capital as the sales and marketing ramps up, as the timing for cash flowing out is much earlier than the timing for cash flowing in (btw, this is an extremely attractive business and economic model as Salesforce has been demonstrating in the public markets…my point is that it used capital to grow).
3. Experiments and “mistakes” use capital. Generally, as companies build-out, there are two major areas of expansion, one on the product development side and one on the product distribution side. I think of these build-outs as “grand experiments,” as you can do all of the up-front analysis that you can, but it is all theory until you put it into practice and see the results. Long-term sustainable businesses need to continue evolving their products’ feature/functions, build new products, and build out their channels of distribution. All of this takes capital, as the uses come before the benefits…even more capital if you make a few “mistakes” (and everyone does).
4. Missed Quarters (sometimes) Use Capital. Most emerging growth companies miss their quarters at some point. You want to make sure that you have “rainy day” money on the balance sheet to be used in circumstances like this.
5. Acquisitions use Capital. Several companies that I have been involved in have made small “tuck in” acquisitions, mostly to expand their product footprint. Generally, these types of acquisition candidates want at least a portion of their consideration in cash.
6. Large Enterprises want to see Capital on the balance sheet. If you are selling to a large enterprise customer, they generally are spending a large chunk of change on your product and many times will be integrating your product with some of their systems. They do their analysis and want to make sure that you are going to be there to serve them several years from now. Once of the items that they ask about is your company’s capitalization (note: my sense is that this issue peaked about 18 months ago and is now on the decline. I do still here about the issue periodically, however).
7. Finally, Founder Liquidity uses Capital. Many founders of great companies find themselves in the situation where a significant portion of their net worth is tied up in the business. Some VCs (including my firm) will make investments in a company to partially/fully liquidated certain shareholders (the key is that all key employees have enough of a financial stake in the company post the transaction that they remain highly incented). These types of transactions are useful to founders, as it allows them to take more risk (that make business sense) without worrying about their nest eggs.

I believe I have captured the major uses of capital as companies grow. I did not get into things like the company being subscale, but this implies that a company is unprofitable, which clearly requires capital.

I am actually a strong believer that VC is more about the help than the money, but given the question of capital need was raised, I thought I would direct my comments in that direction.

Is the need for venture capital changing? My answer for companies that want to build meaningful businesses over time, regardless of sector, is “no”…