VCs Are Not Evil: What Entrepreneurs Need To Know
Venture capitalists are not evil. That is the message that Bill Bryant, the prominent Seattle venture capitalist and venture partner at Draper Fisher Jurvetson, had for Seattle technology entrepreneurs earlier this month at the STS (Seattle Tech Startups) meeting. In recent years VCs have been vilified as “vulture capitalists” among tech entrepreneurs for demanding ridiculous exits for the money they invest and forcing entrepreneurs to make “bad” decisions in pursuit of extravagant pay days when more reasonable paths to modest successes, that would assure personal wealth for entrepreneurs, exist. Speaking earlier, Chris DeVore, co-founder of Seattle-based Founder’s Co-op, referred to this phenomenon as a “terminal misalignment of interests” between venture capitalists and entrepreneurs.
Bryant explained that this is primarily because VCs are bad at picking winners. “Entrepreneurs need to understand that we are bad at picking out the winners a priori. Despite doing extensive diligence that leads to the conclusion that every investment we eventually make is going to succeed—otherwise we wouldn’t make the investment to begin with—for every 10 deals we do, we lose all of our money on 5 to 6, we make a modest multiple on 2 or 3, but we make a lot of money on 1 or 2.” Those two successes need to deliver at least a 10x return to compensate for all the losers.
“Unfortunately I have to penalize the winners because of all the losers—we basically price them all the same at the start since we don’t really know which one will end up in the winner category. I don’t plan for this. I make every investment fully believing that it will be a winner, otherwise I would not invest, but the reality is 5 to 6 out of every 10 will lose all the money we invest,” he reiterated. “When an entrepreneur tells me they are trying to raise $2 million for 15 percent of their company, the way I translate that request is that I now need to believe they have a reasonable chance of reaching at least a $90-$100 million exit, otherwise it doesn’t pencil out.”
For those who think this is unreasonable, he had these words of sage advice: “Investors and VCs come in all shapes and sizes. There are about 1,700 funds. Find one who makes sense for you. There are a lot of fantastic businesses that will never reach $100 million in revenue. They are just not for us. We simply do not have the time or resources to manage two thousand, half-a-million-dollar deals.” DFJ has about $5.5 billion under management across 20 funds; the typical DFJ investment target per deal is about $12-$15 million.
Entrepreneurs should realize that VCs have investors too and must produce results. VCs raise money from institutional investors such as pensions, foundations, and endowments for whom the VC investment is just a tiny part of their portfolio. “We are to these very large institutional investors what art collections, luxury boats, and sports teams are to super high-net-worth individuals,” said Bryant. “We need to produce competitive returns to maintain our place in the asset allocation of these investors.”
Unlike many Seattle tech events where you have a panel of experts who are all in agreement, this was a night of conflicting opinions. The main topic was predicting technology trends for 2010 and areas that entrepreneurs should pursue. One of the speakers, executive coach Michael Schutzler, painted a rosy picture of the future for entrepreneurs, citing the great exits that took place in Q4 of 2009 after a lackluster year—Amazon acquiring Zappos, HP acquiring EDS, and the pending Oracle-Sun Deal, to name a few. In addition, as of December 31, 2009, 92 S-1 forms (the document normally filed before an initial public offering) had been filed. In contrast there were only 6 and 11 technology IPOs in 2008 and 2009 respectively, whereas there are usually 60-80 in any given year. It was notable that none of the S-1s filed were by Facebook, Twitter, or Zynga, companies that have been rumored to be preparing to go public. As of January 4th, many of Schutzler’s clients have suddenly started hearing from VCs who would not take their calls the whole of last year. “These guys are getting desperate to invest and put their money to work” he observed.
Bryant disagreed and did not mince words. “Exits suck!” he said with finality. He thinks the near-term exit future is bleak for both entrepreneurs and VCs, noting that statistically, IPOs are at levels last seen in 1995 while M&A is down some 50 percent. He provided some data that in 2008, the last full year of data, there were approximately 125 companies that had material exits, while 950 companies received their first financings. “Over the last 10 years the entire venture capital industry taken as a whole has had negative returns. If VCs have lost money collectively, that means that entrepreneurs (of VC backed companies) have also not made any money since VCs have liquidation preferences and usually get paid first in the event of an exit.” To be fair, he also noted that the S&P 500 has had negative returns over the same period as well as all real estate purchased after 2003. This prediction of a bleak future for tech entrepreneurs reminded me of the famous Larry Ellison statement about the foolish notion among techies that somehow our industry will never mature and that we will continue to see the kind of successes from the dot-com and Web 2.0 eras.
As for predicting technology trends, Bryant believes cloud computing is a hot area with lots of opportunity. “To me, cloud computing represents an important paradigm shift in how computing takes place. When you look at the history of computing, it is defined by successive paradigm shifts. From mainframes to the mini, then from mini computers to desktops. From desktops to the client-server architectures and then to the Internet. I think cloud computing is such a shift and every enterprise technology needs to be thinking about the cloud aspect to whatever they are doing.”
Schutzler doesn’t think so. In fact, on one of his slides he had a large red X superimposed on top of the cloud computing icon. “Talking to investors about cloud computing is like saying, ‘I stink really badly. Run away from me.’” He instead feels that mobility is that paradigm shift, especially with the launch of the new Nexus One Google phone. “In the past if you wanted to port a popular game or application to the mobile platform, you needed to develop a SKU [stock-keeping unit] for each carrier, each handset, and each platform. In some cases you might end up with 18,000 SKUs. Not anymore, with the launch of the new Google phone and the open platform.”
Bryant, again, differed. “Mobile does not scale. I don’t know why people think mobile scales. There will never be anything that even approximates the Wintel [Windows operating systems and Intel architecture] write once-run everywhere platform.” Drawing on his background with Qpass, he noted that a mobile developer has to be concerned with supporting Symbian, Windows Mobile, J2ME, Linux, Android, BREW, iPhone, Palm, and other phone OS to reach scale.
While Bryant thinks cloud computing is a fertile area ripe with opportunity, he does not believe in “theme” investing where investors pursue a strategy in specific trendy sectors. “Thematic investing is like chasing last year’s hemline. One year it’s the mini skirt, the next the maxi. Likewise, incremental improvements and features are not interesting as investments.” He posits that investors are not well suited for predicting trends because they know just a little about a lot of things.
He prefers to fund entrepreneurs who have spent a lot of time in a given area, have deep domain expertise, and are intimately familiar with the challenges customers are facing. As an illustration, he told the story of Sujal Patel the founder of Isilon Systems. In the late 1990s while at RealNetworks, Patel had worked on rich media serving for Real’s largest media customers and came to the realization that they didn’t have a serving problem, but rather a storage problem that related to large files. The file systems of the day had been designed for much smaller files and were inherently inefficient for storing and making available large rich media files. A storage file system designed just for large files would solve most of the challenges. Sujal went on to found Isilon Systems which had a successful IPO in 2007, winning against EMC and Network Appliance, the two giant gorillas in the storage market. They excelled by focusing on only digital media storage and creating a product 10 times more compelling than the general purpose storage systems offered by their competitors. Bryant recounted, “I made one reference call about Sujal and his boss told me, ‘He represents about 15 percent of the intellectual property of the entire company [Real Networks], which had over 300 engineers at the time.’ That sealed the deal for me.” Incidentally, this story was also told to us by Matt McIlwain when we pitched our product Meosic to the partners at Madrona.
Bryant also noted that DFJ prefers “change the world” types of ideas. Examples of this are the Elon Musk-led Tesla car project where they are reinventing the electric automobile from the ground up—the transmission, the drive shaft, the battery, and everything. DFJ also has investments in Synthetic Genomics (human genome sequencer Craig Venter’s company), Space X, BrightSource, and Redfin. According to Bryant, the Synthetic Genomics team is trying to invent new forms of microorganisms that have never existed before in nature. In China and India, DFJ has investments not in technology, but in consumer driven propositions like home delivery, travel agencies, bakery chains, and fleets of taxis. These nations have large populations that are rapidly consumerizing, and consumer plays are the most promising opportunities.
“What do you think about entrepreneurs catering to theme investors in order to get funded? Why swim upstream trying to create something new, when someone is willing to fund ideas in a given sector?” someone in the audience asked.
Bryant strongly advised against this. “You really need to have conviction in what you are doing in order to be successful. What are you going to do when the fad changes and the thematic investor loses heart? If you didn’t really believe in what you were doing, you will fail. The resistance and rejection to true innovation usually lasts about 12 to 18 months but if your idea is any good eventually people will come around to seeing it your way.” He gave the example of a theme-chasing company that decided to compete with Seattle-based Opscode and is failing to keep up with their early market leadership. “Opscode foresaw a world where all devices would be managed from the cloud and went after that opportunity early. These other guys decided to copy the approach and are getting crushed.” He did not mention the name of the company. [Bryant helped lead DFJ’s investment in Opscode last spring—Eds.]
The one thing all the speakers agreed on is that venture capital firms are closing down and consolidating. This is a trend that will continue. In particular, Bryant predicts that it is the mid-sized firms in the no-man’s land of venture capital that will collapse. “Smaller firms like Union Square in the $100 to $250 million range will continue to do well,” as will his firm DFJ with about $5.5 billion in assets under management. “It is the $400-600 million firms that should be worried.”
In favor of so-called “theme” investing, DeVore said that Founder’s Co-op is actively seeking entrepreneurs in the lead generation space, arguing that “it may not be sexy, but it is very profitable.” Founder’s Co-op was founded to address the misalignment of interests between venture capitalists and entrepreneurs mentioned earlier, and generally invests $100,000 to $500,000 for roughly 20 percent of an early stage company. For those who think VCs are evil, these guys might be a much better fit. They also like funding engineer-driven companies because they are capital efficient and can accomplish a lot more with smaller amounts. “Funding business people to hire engineers is not capital efficient,” DeVore says.
Have a lead generation idea? Chris and Andy Sack (the co-founder) run the popular Open Coffee event at Louisa’s Cafe every Tuesday morning from 8:30 to 11:00 am and will gladly listen to your pitch. And because they are angel investors, they will not be evil!
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