Seeing Both Sides

Fred Wilson comes to Harvard Business School

It was a treat to host Fred Wilson of Union Square Ventures at Harvard Business School today - his first time attending a class at the school.  Fred, as most readers of this blog know, is a venture capital legend in the making and the investor in some of today's leading consumer Web properties, including Twitter, Zynga and Four Square [Fred's post on his visit can be found here].

Fred and I had a discussion about lean start-ups and pattern recognition with the HBS students in Professor Tom Eisenmann's class "Launching Technology Ventures".  If you want to see some of the Tweets that came out of the class (imagine a professor encouraging students to grab their smart phones and live Tweet in class!) you can check them out here (#hbsltv was the hashtag).

A few takeaways from our session that I thought were particularly insightful:

• Early on in a start-up, entrepreneurs should be hunch-driven more than data-driven.  If you are only data-driven, the risk is that you will move too slowly.  It's more important to have a hypothesis about what might work and what might not work and then see what happens in the marketplace to prove or disprove that hypothesis.
• Lean start-up as a methodology or approach is very useful, but isn't a guarantee for success by any stretch.  Think of the methodology as a machine.  If you have garbage inputs, you will still have garbage outputs.  There's no substitute for good strategy, great entrepreneurs and a very large market opportunity.
• When considering when to monetize your new product/service, think carefully about whether the monetization strategy actually improves the service or is a distraction.  Banner ads on Facebook are a distraction (as Zuckerburg supposedly said in the movie Social Network, "No ads. Ads aren't cool.")  But, for example, on Etsy if someone pays for a product, it inspires producers to create more products.  Thus, the monetization is harmonious with building the service.
• If you are going to fail, and certainly with more start-ups being created and seeded we will see more failure, be sure to fail gracefully.  How you handle yourself as you unwind / seek a soft landing will reflect heavily on you and will cement your reputation.
• Don't worry about whether you are building a feature, a product or a company.  Build something great, have huge passion for it, engender affection with a large customer base, and let the rest follow.
• If you get traction, transform your company into a platform.  The most valuable companies are those where third parties help you grow by plugging into your services like a utility.
• VCs don't make companies successful.  They can believe in and support a company, but ultimately the entrepreneurs make or break the company's success and don't let anyone (particularly an egotistical VC!) imply otherwise.

As we ended the class, we tried to inspire the students to "go for it" and become entrepreneurial.  I am always pushing students to consider if now is the right time for them (see my recent blog post:  "Should I become an entrepreneur?") and pointed out that this was a time in their lives where they could afford taking more risk.  Once they get married, have kids, buy a house and get a mortgage, it's a different ballgame.  Fred quoted a friend who once told him there were three addictions in life:  "calories, heroine and a paycheck".  If you can break the last addiction, you are well positioned to become a potent entrepreneur!

 

Inbound Marketing Comes To Health Care

The Wall Street Journal's article today about the existence of "alcoholism genes" and what the future might bring ("imagine you go to your doctor and say 'I'm drinking I need help.' and they do a blood test and, if you qualify [based on genetic markers], they give you medicine the next day.") is a part of a larger trend that will radically change the world's health care system.  With a nod to my friends at Hubspot, I'll refer to this future phenomenon as "inbound marketing comes to health care".

First, some background.  The cost of mapping your genes is falling rapidly.  Today, you can get your genes mapped and analyzed for $10k.  In 3-5 years, that price will fall to $1k.  Harvard Medical School Professor George Church, one of the great pioneers in this field, observed recently to one of my partners that, "people will spend $10k per year on insurance but over a 70+ year lifespan are not yet comfortable spending $10k for their genome to be sequenced." As the process gets cheaper and the data and analytics gets better, that will change.  I'd be shocked if you, dear reader, did not have an analytical report in your files somewhere in 5 years about your personal genome and insight into its health implications.

And that gets me to the concept of inbound marketing.  Inbound Marketing (as captured nicely in the book by Dharmesh Shah and Brian Halligan), is the notion that the new era of marketing is about pull, not push.  Rather than producers pushing their products onto consumers, consumers have the tools and means to show up at the producer's door "inbound" and identify their needs and interests.  

It's become very clear how this technique applies to products - consumers research their needs by searching this huge information database in the cloud called "Google" and find what products and services might serve their needs and proactively contact and, eventually, purchase those products.  This technique is why many companies invest so much money in search engine optimization (SEO) and search engine marketing (SEM) - a business that has grown to tens of billions of dollars and fueled Google's meteoric rise as one of the most successful companies and global brands in business history.  Businesses are redirecting their tens of billions of "push" marketing dollars  into other mechanisms that set themselves up to be found by intelligent, informed consumers.

Now, let's go back to health care.  Imagine that in 5-10 years that tens or even hundreds of millions of people have their genomic data stored in the cloud.  Imagine that this data can be indexed, analyzed, parsed, sliced and diced.  And imagine that it is very, very secure.

What might happen with that kind of large-scale genomic data available in that format?  Inbound marketing.  Rather than pharmaceutical companies pushing drugs through their large sales force, they can access this database and alert consumers as to what drugs might fit what genomic profile.  Rather than hunt for clinical trial candidates in hospitals throughout the world, drug companies can email the relevant 1000 patients that precisely fit the indication they would like to test. 

Let's make this very personal.  My father-in-law recently died of ALS.  His older brother also died of ALS a number of years ago.  Thus, there is a reasonable chance that my wife's family has some genetic predisposition to ALS.  In today's health care environment, where genomic information is expensive and sitting in silos, there is nothing much we can do about it but wait and worry.  But someday in the future, perhaps as soon as 10 years from now, we will have the opportunity to opt-in to a service that will alert us via email or text when ALS drugs that might address this particular issue enter clinical trials.  Or perhaps even approved by the FDA.  We might all register our genomic data into this service so that we can receive alerts and information about any range of insights or treatments that might be relevant to our personal make-up.  This is "personalized medicine" in the extreme.

One of our portfolio companies, Predictive BioSciences, is pioneering a urine biomarker technique - pee in a cup, and Predictive will tell you if you have cancer.  In the future, we might all be swabbing our cheeks, peeing in cups, and pricking our fingers to tell us much, much more.  And when that information is available to our trillion-dollar health care infrastructure, imagine the possibilities.

Should I Become An Entrepreneur?

When to become an entrepreneur is a common quandary for many.  For whatever reason, this issue has come up a great deal recently (recession-driven workforce dislocation?), so I thought I'd share a few thoughts that might help frame this critical decision.

I have concluded that being an entrepreneur is an irrational state of being.  If human beings were purely rational, evaluative, value maximizing individuals (see HBS Prof Michael Jensen's paper on self-interest and human behavior), they would not start companies.  If they sat down and did the expected value calculation by laying out the probability-weighted outcomes of being an entrepreneur as compared to taking a safe job, it would not pencil out.  

Yet, entrepreneurship is not simply a rational journey.  It is one that is defined by passion and personal satisfaction that transcends purely financial analysis.  And, of course, there is always the hope for the big payout, no matter how long the odds.

Despite popular wisdom to the contrary, age is not a major factor in the decision to start a company.  The Kauffman Foundation reports that the median age of founders is 39 - right at the midpoint of a typical professional career - and 69% are 35 or older.   Another study by Washington University professors of 86,000 science and engineering graduates showed that age was not a significant predictor of becoming an entrepreneur.

So when should you become an entrepreneur.  Here are the kinds of questions you should ask yourself:

1. Do you have an idea that no one can talk you out of?  When you bounce your start-up idea off your spouse, friends and trusted advisors, are they able to raise enough objections that you begin to doubt whether the idea has merit.  Getting honest, objective advice can be hard because the people you are likely to go to care about you and may be afraid to tell you what they really think for fear of offending you.  Thus, you need to get feedback from objective parties (e.g., advisors, experts, prospective angel or VC investors with whom you don't have a deep personal relationship).
2. Do you have a partner you trust with complimentary skills?  Starting a company is a lonely adventure.  Having a partner that you can trust and whose skillset and experience is complementary to yours can be a huge functional and emotional benefit.
3. Are you prepared to endure with modest or no salary for a few years?  Founding a company often means making personal sacrifices and below-market cash compensation.  All the talk about "lean start-ups" (which I'm a big fan of) sometimes obscures the practical reality of what it means to eat through your personal savings. 
4. Are you bored with your current work environment/life situation?  There is nothing boring about being an entrepreneur.  More apt adjectves might include stimulating, engrossing, obsessive, exhilarating, nerve-racking - but not boring.  If you are tired of viewing your work as a chore and if every day is a bit of a grind, then entrepreneurship is for you.  I find that the intrinsic motivation behind an aspiring entrepreneur is sometimes the simplest - because it's fun.  Seeking fun can transcend all other factors. 
5. Do you perform best in the absence of structure?  In my book, Mastering the VC Game, I describe a metaphor for the three stages of a start-up:  the jungle, the dirt road and the highway.  In the earliest stages of a venture - the jungle - there are no clear paths available and the skills required are to thrive in the midst of the chaos.  For those who possess that makeup, being a start-up executive is an excellent fit.  But for those that like clear paths with little uncertainty and a great deal of structure - the highway - an early-stage venture will feel like a very uncomfortable environment.

Reflecting on these questions, I find it intriguing to reflect on what kind of environment - either from the perspective of parents raising their children or policy makers thinking about encouraging entrepreneurial ecosystems - can be created to foster more entrepreneurship?  HBS Professor Noam Wasserman is writing a book called Founding Dilemmas which is coming out later this year (I've read early drafts and believe it will be a must-read for entrepreneurs).  In it, he quotes career guru Dr. Tim Butler who points out that signals from parents, mentors and local leaders have a large influence on whether people chose to become entrepreneurs.   “We receive very powerful messages [from those around us] about what’s important, what success is, what failure is, what counts for achievement and what doesn’t. "

Celebrating entrepreneurial success stories in our culture and putting folks like Steve Jobs, Bill Gates, Larry Page (the new Google CEO!) and even more accessible, local heroes on magazine covers and in front of audiences is obviously a huge factor.  Every college kid in America looks at Mark Zuckerburg and thinks, "Why not me?"  Why not, indeed?

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Walking Away From Liquidity

With big tech companies awash in cash, nearly every analyst out there is predicting that the M&A market will heat up in 2011.  At a (pre-blizzard) conference I attended today run by Gridley & Co, this theme was reinforced, with rosy predictions of an M&A boom.

If this boom comes to pass, everyone will cheer.  Yet a strong M&A market won't be a panacea for all.  It will cause good companies to face perhaps the singular hardest decision in their lives:  whether to walk away from an opportunity for positive liquidity. 

Two of my companies have just gone through this process.  In each case, a strong unsolicited offer came in that would have yielded "VC-like" returns (5-10x) and many millions for the founders and senior executives.  But in both cases, everyone around the table unanimously, courageously (and hopefully not foolishly) voted to turn down the offers and walk away.  Having just lived through two of these episodes in the last few weeks, and having lived through many others in the past, I thought I'd share a few observations on this classic conundrum.

When to sell a company is one of the hardest decisions a board and entrepreneur face, and it's a decision made even more difficult if there is a lack of alignment around the table.  If different investors have invested at very different prices, or if the entrepreneur has not made money before and this is their first shot, there can be greater tension inserted into a naturally tense situation.  For example, if the Series A investor has a blended average post-money valuation of $20 million across three rounds, they may be happy with a $100 million exit.  But the Series C investor who just invested at an $80 million post-money valuation would be bitterly disappointed.  Meanwhile, the founder who owns 10% is looking at a $10 million payday - a heady sum for someone who still has a mortgage and is worried about saving enough money to pay for her kids to go to college.

It's all very theoretical, of course, until an actual offer is put on the table and everyone starts to calculate their share of the proceeds.  There is no easy answer to help determine which path to pursue, but here are five considerations that can help an entrepreneur frame the decision:

1. Passion. Do you still love running the business? Does it feel like you can’t imagine doing anything else with your life? Do you still feel like you have something to prove or do you feel tired and worn out?  Do the problems in the business energize you or drain you?
2. Belief.  Do you still believe in the business’s potential? Does it appear that the major proof points are still ahead of the company?  Do you feel as if the value will be meaningful greater after you have achieved a few more milestones - and that those milestones are well within reach?
3. Economics.  How much is the offer as compared to what it might be a year or two from now if the company were to successfully execute on its plan and hit its numbers? What might the company’s value be in a year or two if it falls short of its plan by 30 percent? How would you assess the probability of either path and then calculate the expected value of holding on for a few more years as compared to taking the money off the table by selling now?
4. Dilution Risk.  Does the business require more capital and, if so, can that additional capital be raised easily at a reasonable (and therefore not too dilutive) price?  What must the business be valued at after the additional capital to be equivalent to your dilution-adjusted payout today?  In other words, let's say you own 10% today and can sell for $100 million.  If your post-financing ownership will be 5%, then you are betting that you can sell for more than $200 million down the road.  Risk adjust this number and take into account the time value of money, and then assess the trade-off.
5. Team.  Do the people around you (i.e., your management team, your VCs, your family) want you to sell out or are they encouraging you to keep going?  When you look your team in the eye and tell them they are walking away from $x million each, do they stiffen their spines and project bravado - or do they look at you longingly, with regret?

It can be hard for VCs and entrepreneurs to be aligned in these situations, because the VCs have the luxury of a portfolio approach to investing in start-ups - they are looking for home runs that can move the needle on their funds.  Entrepreneurs, on the other hand, have no such luxury.  This may be their one shot to change their lives and their family's lives.  

I have found that the entrepreneurs who have made good, not great, money in the past are more likely to be both hungry and risk tolerant enough to go for the big win.  Having saved enough money to pay down their mortgages and pay for the kids' colleges, these entrepreneurs are willing to take more risk to make the kind of money that can really change their lives.  That sweet spot tends to be $2-5 million in liquidity.  More and more, I have seen investors show a willingness to allow partial liquidity for founders who have built enough value to raise money at high prices to soften the sting of walking away from an outright sale.

So the next time you hear about how robust the M&A market is going to be, remember that the real trick is for founders and boards to find that right balance between taking advantage of the robust market, and putting their collective heads down and focus on trying to build a big company. 

Top 5 Great Apps in 2010 - Great Companies in 2011?

Thinking back on 2010, the smash hit of the iPad and the continued proliferation of great iPhone and Android apps was one of the most striking aspects of the year.  As a user, I have fallen in love with five apps and find myself using them almost daily.  Millions of others are discovering these apps - and others like them.

But the gap between product success and business success is a large one.  There's an old saying in the venture capital business:  "Fund great companies, not great products or great features." The key question for 2011, therefore, is whether these great apps will mature into great companies.  Will they cross the chasm and move beyond the early adopter market into the mainstream market?  Will they build sustainable business models?  Twitter and Facebook were in a similar position a few years ago - great utilities that initially felt niche, and are now on their way to becoming great companies (OK, some of you will argue that Twitter still has a ways to go, but you have to admit, turning down $1 billion from Google in April 2009 is looking like a good decision in retrospect given the latest round of financing, led by Kleiner Perkins, at a $3.7 billion valuation).

So, here are my picks for the Top 5 Apps of 2010 that will face the challenge of becoming great companies in 2011:

1. Flipboard.  If you aren't addicted to the Flipboard app on the iPad, you can't consider yourself an information junkie.  Beautiful graphics and layout characterize this app, but what makes it brilliant in my opinion is they way it turns Twitter and Facebook into curated content channels.  I am naturally interested in reading the articles the editors of the New York Times and the Economist think I should read.  But I am also interested in reading the articles my friends are linking to in their tweets and posts - they are also relevant editors and curators for my interests.  The Flipboard business model is obviously still evolving and the leadership and backing of this company suggest they need to be taken seriously as a next generation content curation cum general information browser.
2. FourSquare.  I have long admired FourSquare and as part of my part-time duties at Harvard Business School, I decided to co-write a case on the company, which I will be teaching in a few months.  As part of this effort, I had the opportunity to interview the management team and learn more about the company's history and future plans.  The vision for the company is compelling and what appears in the application today is a fraction of the possible (Dennis Crowley observed that he has only implemented something like 20% of his 2004 NYU thesis on location-based services).  2011 will be a pivotal year for the company to turn some of their business model experiments into something scalable. 
3. Instapaper.  The only one on my top 5 list that isn't venture-backed (as far as I know), I love this app.  It allows users to bookmark things to be read later and then turns those links into an attractive content layout - in effect, your own newspaper.  The benefit is immediate and obvious.  The long-term business model isn't  immediate and obvious to me yet, but perhaps it will emerge in 2011.
4. TweetDeck.  I am totally addicted to TweetDeck.  This leading Twitter desktop and mobile app claims to have millions of subscribers.  When I am visiting start-ups, I often notice employees have three apps open and running at all times - Google Chrome, Facebook and TweetDeck.  I use TweetDeck to pull in my Facebook updates so I can keep track of my friends and those I follow on Twitter in one app.  Again, 2011 will be a critical year for them to begin to scale their business model.  Twitter hasn't yet tipped mainstream but is well on their way.  TweetDeck is following close behind.
5. Disqus.  Another quirky pick, perhaps, but I think Disqus is awesome as a blog response tool.  I use it for my own blog and I love when I see it on others' blogs as it makes it so easy for me to respond via email off my mobile device and track feedback.  I don't know how they make money and I presume they're still in lean start-up mode given how little they've raised (only $500k according to Crunchbase), but as a user I'm finding myself as dependent on Disqus as I am on my blogging platform.

So those are my picks for great apps in 2010.  What are yours?  Will any of them  become great companies in 2011? 

Depressing Thoughts About Groupon’s Model

A great deal has been written about Groupon’s rejection of a supposed $6 billion offer from Google.  Most of the reports breathlessly describe the explosive revenue and customer growth the company has achieved in two short years and what a breakthrough the model represents (an example can be found in John Battelle's hagiographic blog post).  With over 40 million email subscribers, Groupon’s success is based on consumers responding to their daily deal emails, and sourcing high-quality offers that compel readers to respond. The story CEO and founder Andrew Mason told in his interview with Charlie Rose last week was that when they offered helicopter flying lessons in one of their daily email blasts, they sold 2,500 in one day. This compares to a business that had acquired only 5,000 customers in its 25 year history.

But haven’t we seen this movie before in the world of direct marketing? History has shown nearly every major new direct marketing paradigm sees impressive initial response rates, but depressing response rates over time. For example, when display advertising was innovative in the late-1990s (imagine websites without ads?), publishers saw click through rates in the 1-2% range, allowing advertisers to be charged a high cost per thousand impression (CPM) in the range of $35-40. Today, iMarketer and MediaMind report that display advertising click-through rates are 0.10 - 0.20% and CPMs of $2-3 – less than one tenth what they were ten years ago.  Email has shown a similar sharp decline over time. Average click through rates for the early years of email campaigns in the 1990s were as high as 30-40 percent. Today, they range from three to five percent, again, a 10x drop.

Groupon conversion rates, supposedly, are now in the three to four percent range. What will those same response rates to the same consumers look like in five years? Will daily deals follow a fundamentally different model than every other new direct marketing medium? The benefit of being only two years old is that you don’t have a lot of vintage data to analyze.

What has impressed me about e-commerce stalwarts like Amazon.com and Netflix is that they have stood the test of time and have grown ARPU (average revenue per user) over time.  Consumers continue to have an appetite for books and movies, year-in and year-out, and the volume of new content changes rapidly. In contrast, the merchants in my community and the ones I regularly do business with do not change all that rapidly.
 
That said, Groupon is building a huge consumer database, a massive set of merchant relationships and a super-talented management team. Just as Amazon and Netflix have innovated beyond their initial model, Groupon has the capacity to replicate these results. But if it the company is going to step into the multi-billion dollar winner’s circle, it will need to find a model that stands the test of time, and the reality of depressing response rates over time.

Frankly, I hope they figure it out. Now if you'll excuse me, I have to sneak in a trip to the local indoor skydiving place before the holidays...

Stop Avoiding Conflict

One of my favorite business books of all time is Patrick Lencioni’s “Five Dysfunctions of a Team”.  Like all books by Lencioni, it begins with a short fable in a corporate setting of a management team that is operating totally dysfunctionally.  Then, he provides a framework that analyzes the situation and draws out the general lessons as to why teams operate poorly together, and how to systematically combat it.  The pyramid below summarizes his advice.



Each of the layers of the pyramid resonate with me (which is probably why I have this pyramid printed and hung up in my office), but the one that I always come back to and reread is “Fear of Conflict”.  Again and again, I see management teams and boards of directors shy away from conflict.

It is quite natural for humans to avoid conflict.  In fact, our deeply programmed “fight or flight” instincts are designed to protect ourselves and run away when we sense danger.  Interpersonal conflict is a danger we all prefer to avoid as it makes us uncomfortable.  Your stomach gets a little queasy, your heart beats a little faster, and you think, “How do I get out of this situation?”.  So, you tell a joke.  You change the topic.  And you feel a sense of relief.

When I see this happening in management teams and in board rooms, it makes me uncomfortable because I know where it leads.  It leads to mistrust, simmering issues, politics and dysfunctional behavior.  Here are a few techniques I've found help address this issue, particularly in start-ups.

1. Building Trust.  The foundation for handling conflict productively begins with building trust amongst the management team.  It's easy to say, but particularly hard to do in a start-up when people have been slammed together quickly and are so crazy busy, that it's hard to stop and take the time to understand each other more deeply.  One technique I have found very helpful here is to conduct a facilitated, day-long offsite where each management team member takes the Myers-Briggs test to help surface how each party thinks,  processes information and makes decisions.  I did this with my management team at Upromise and again when we were starting of at Flybridge and in each case found it helped us understand each other at a far deeper level.
2. Annual Reviews.  It's easy to be running so hard and so fast that CEOs and boards forget to conduct systematic reviews where a broad range of feedback is collected and tough development issues are addressed head on.  I try to do this at each of my boards and at Flybridge, the general partners conduct 360 degree reviews of each other.  Done correctly, these can be emotionally draining, difficult but very productive exercises where a safe forum for brutal honesty and constructive dialog can be developed.
3. Systematic Post Mortems.  In my early product management days, I learned the value of the post-mortem - the process of gathering all the relevant team members into the room to talk about what happened after a product ships and why errors or schedule issues occurred.  Extending the post-mortem process into all business activities can be very valuable.  It allows a clinical, unemotional examination of what has happened, how everyone operated under pressure, and what process improvements can be made for next time.  Whether it is done post product release, when an executive team member departs because things didn't  work out, after a board meeting in an executive session, or after an investment goes bad, an analytical examination of what just happened is a useful exercise that forces all parties to address difficult issues.
4. Go Direct.  At Flybridge, we have developed a mantra for addressing issues amongst the partnership:  "Go Direct".  When one of us has a concern about how another partner is handling a portfolio company situation or evaluating a deal opportunity, we don't allow indirect conversations.  If two partners find themselves talking about a third partner, we stop the conversation and bring in the third partner so that the issue can be addressed directly, out in the open  rather than it festering behind closed doors.  I learned this lesson as an executive team member at a start-up that was not good at going direct.  The VP of sales would come into my office and complain that he wasn't getting good support from the VP of marketing.  Ten minutes later, the VP of marketing would storm in and complain that the salesforce wasn't properly executing on our strategy.  The entire executive team avoided going direct because it was uncomfortable, so we had false harmony in our Monday staff meetings and deep divisions the rest of the week.

Conflict can be stressful, draining and uncomfortable.  Yet, it is incredibly natural, healthy part of life, particularly in a start-up.  And creating a culture that can handle conflict effectively clearly has a positive impact on performance, as recent research has shown (see i4cp study: "Leaders With Low Emotional Intelligence May Be Depressing Bottom Line").

If you want to avoid your start-up feeling like a Soap Opera, try out some of these techniques, and let me know if there are others you've employed as well.

Time For "A Millionare's Pledge"?

There has been a great deal of attention paid to the efforts led by Warren Buffet and Bill Gates to their pledge to give awway at least half of their fotunres to philanthropy.  This so-called "Giving Pledge" has garnered the support of 58 billionares, each of whom has signed up publicly to the pledge.

I am no billionare and will never be one, but today's news that the Bush tax cuts for the wealthy will be approved by the Senate has got me thinking that perhaps it's time for a "Millionare's Pledge".  The form of this pledge might go as follows: 

I promise to give away to charity the incremental tax break I will receive from the extension of the Bush tax cuts.

Philanthropy is a central part of our family's life.  We try to be very supportive to a range of non-profits, including our synagogue, Facing History and Ourselves (teacher-training organization), Progressive Business Leaders Network (progressive policy), Endeavor (promoting global entrepreneurship) and many others.  I know of many other families like me who are philanthropically oriented and have very mixed feelings about the tax cut exension. 

The simple calculus, as I understand it, is to take 5% of your annual income (upper income tax rates would have gone back to 39.6%, up from 35%).  So if you make $200,000, that's $10,000 in incremental savings that you would direct to charity in 2011 and 2012 (and perhaps beyond!).  I know it's not nearly that simple with capital gains changes, estate changes, deductions, etc.  But let's keep it simple to make it easy for everyone. 

At this point, it doesn't matter whether you are for or against the extension of the tax cuts, the reality is that they will become law, so what should progressive, philanthropically-minded individuals do now that they have an unexpected windfall?

There are 371 billionares in the US, but 3 million millionares and 6 million taxpayers with income greater than $200,000.  Now that would be a movement.

Who's in?

A Tribute to Courage, Entrepreneurship, Grace

My father-in-law, Michael Doctoroff, passed away last week of ALS.  It's been a sad series of days in the Bussgang household and we are just beginning to recover and transition back into the real world.  I am finding that when you lose a loved one, it's hard to make the switch back into our frenetic, exciting, optimistic start-up world.  But, we are doing our best and I thought a memorial blog post would be somewhat cathartic.

My father-in-law was a remarkable man.  He was the middle child in a household with three boys, surrounded on both sides by over-achieving Harvard graduates (one became a judge, the other a successful doctor - the dream of every Jewish mother!).  Yet, he charted his own path.  Although on paper he had a marvelous career (corporate executive, professor, author of a management book - pictured above), in truth he never found his true professional calling until 16 years ago, at the age of 60, when he founded Trainers Warehouse out of his basement.

Don't let anyone ever tell you that you are too old to be an entrepreneur, too old to take the risk of starting your own venture.  My father-in-law worked alone and didn't take salary for years and years, eventually building the company into a multi-million dollar leader in the corporate training supplies market.   He raised no outside money, located the office 5 minutes from his house and employed his daughter - now president of the company - and wife as well as tens of others.  Even while battling ALS, he came to work every day to design creative products for trainers to bring fun and fulfillment into the workplace. 

Despite his entrepreneurial success, his career did not define him.  His relationships with his family and friends are what made him most remarkable.  He had an amazing relationship over the course of a 50-year marriage with his wife.  Their love for each other through his battle with the disease has been inspiring to observe.  He had three lovely daughters (my wife being one of them!) who have happy marriages and functional families as well (coincidentally, each of the three daughters married a college classmate).  And he was able to foster great relationships with each of his three son-in-laws - finding special ways to connect with each of us, despite our diverse interests (an entrepreneur-turned-VC, a scientist and an author).  I think it is the mark of a great man (in this case, in partnership with a great woman) who can create such a functional set of relationships across their entire family. Fostering close friendships was also paramount to his existence.  No less than five people came up to me at the funeral to tell me he was their best friend in the world.

In his final months, my father-in-law taught me a lot about grace and courage.  ALS is a horrible disease, slowly weakening your body while your mind remains sharp.  He was funny, irreverent and attentive to those around him to the end.  I don't think I'll ever forget the night he came over our house for dinner, a week before his death, when he drew a bone on his handheld white board (he could no longer speak) and motioned to my dog to see if he could get him to chase after it.  At Thanksgiving, he had his three year old grand-nephew chasing his wheelchair around trying to beat him in tic-tac-toe.

I feel blessed to have had him in my life.

IPO Anxiety - East Coast Version (part 2: NY)

Yesterday, I analyzed the Massachusetts IPO ecosystem.  Today, I look at NY. 

Unlike MA’s robust public company ecosystem, where I counted 33 companies with greater than $1 billion in market capitalization, I was shocked to discover how very few public companies in the Innovation Economy that exist in the Big Apple.  If you restrict the geography to 30-45 minutes driving distance and part of the “scene” (which encourages mingling and productive talent and idea sharing), you have to eliminate CA, IBM and Priceline.  I think that only leaves you with the following companies that have greater than $1 billion in market capitalization:

• AOL ($2B)
• Intralinks ($1B)
• TakeTwo Interactive ($1B)

I’m sure I must be missing a few, but my informal survey of NY VCs, bankers and entrepreneurs didn’t yield any others.  There are a few smaller public companies, like Travelzoo ($660M) and Medidata ($470M), but even the sub-$1 billion market cap list is uninspiring. Given the digital transformation of media and advertising, some may argue that the big media companies and advertising agencies should be included here and certainly they play a very important part of the NY ecosystem, but in terms of pure technology companies with entrepreneurial DNA and technology roots, it’s disappointing to see how few are in NY. 

That said, when you analyze the pipeline of IPO candidates, you begin to see a very different picture.  Not only is it quite robust – there are roughly 30 companies with estimated market values of greater than $100 million – but arguably full of companies that feel more promising and explosive than the MA companies.  The chart below is lifted from the Business Insider list, but I also cross-checked with AlwaysOn, Inc’s various lists and input from local members of the entrepreneurial community.

Rank	Company	Estimated Market Value (mn)	Estimated 2010 Revenue
1	TheLadders.com	$800	$100-120
2	Gilt Groupe	$750	$400-500
3	Everyday Health	$480	$120
4	FreshDirect	$300	$300
5	Etsy	$300	$30-50
6	Vibrant Media	$275	$125-150
7	Thumbplay	$260	$80-100
8	Yodle	$250	$70
9	SecondMarket	$250	$50
10	ideeli	$250	$150-175
11	Huffington Post	$200	$30
12	Tremor Media	$175	$60-70
13	Undertone Networks	$150	$65
14	Gawker Media	$150	$50
15	CafeMom	$150	$25-30
16	NextJump	$135	$20-30
17	Betaworks	$100	$0-5
18	Rent The Runway	$100	$20
19	Recycle Bank	$100	$10
20	Media6Degrees	$100	$20-22
21	Foursquare	$100	$0

As far as I know, none of these companies has yet registered to go public.  Everyday Health almost did, but then pulled out and raised a private round of financing instead.  Behind this list, there are tens of other strong NY-based start-ups with real revenue momentum (> $30m) and belong in the > $100 million market capitalization category.  Folks cite:

• 33Across
• Antenna Software
• BuddyMedia
• Clickable
• GLG
• LiquidNet
• MediaMath
• OLX
• Vostu
• Yext

The conclusion is that NY is missing, that robust public company ecosystem does not exist.  Unlike in MA, one doesn't see public company CEOs regularly mingling with their pre-IPO brethren at cocktail parties and industry gatherings.  If you fast forward two or three years, however, the NY-based IPO company pipeline appears quite promising – arguably more promising than MA’s – and bodes well if the investors and management teams have the courage to go all the way.  Then, the CEOs of these companies will need to heed the warning of many wise men and women before them who know that an IPO is not an exit, it’s a financing event.  The best is yet to come.

IPO Anxiety - East Coast Version (part 1: MA)

Bill Gurley’s excellent piece on Silicon Valley IPO Anxiety inspired me to take a companion look at the East Coast, particularly Massachusetts and New York, and evaluate the health of the local IPO economy and prospective pipeline.  Today, I'll cover Massachusetts; tomorrow, New York.

I first came across Bill when he was a Wall Street analyst and covered my company Open Market (IPO 1996).  I always admired his perspicacity, even if he didn’t like our stock all the time!  For purposes of this blog post, I am only focused on companies involving technology, whether software, Internet, health care or energy – which I’ll define as members of the Innovation Economy.  Note also that, for obvious reasons, I leave out any Flybridge Capital portfolio companies in my analysis.

Massachusetts

First, let’s look at my home state of Massachusetts.  By my count, there are 33 Innovation Economy companies with market capitalizations of greater than $1 billion (see chart below).  Some of these are important companies, leaders in their field, and full of great future prospects (EMC, Thermo, Genzyme, Akamai).  Others have seen slower growth, are a bit more tired, and may get gobbled up in the years ahead (Parametric, Novell, Progress).  A number of them are recent IPOs who are growing nicely and may become multi-billion dollar revenue companies in the years ahead (Acme Packet, VisaPrint, Athenahealth).  

Other recent IPOs, like Constant Contact ($720M), A123 ($960M), Insulet ($520M) and EnerNOC ($600M), are sub $1 billion in market cap, so not listed here, but are representative of a number of small market cap players in the community who have > $1 billion potential.  The headquarters of each company is within 30-45 minutes of each other, so the degree of talent concentration and social interaction is very high.  Further, acquisitions in the last 12 months such as Unica (IBM $480M), ATG (Oracle $1B), Netezza (IBM $1.7B), Phase Forward (IBM $685M) and Starent (Cisco $2.9B) show that there’s a vibrant M&A market for small cap technology companies in 2010 and will likely be a catalyst for talent to be recycled.

2010 Rank	Company	Market Value (mn)	2009 Revenue (mn)
1	EMC	$44,960	$14,026
2	American Tower Corp.	$20,730	$1,724
3	Thermo Fisher Scientific	$20,350	$10,110
4	Genzyme Corp.	$18,470	$4,495
5	Biogen Idec	$15,470	$4,377
6	Analog Devices	$10,490	$2,015
7	Boston Scientific Corp.	$10,290	$8,188
8	Akamai Technologies	$9,030	$860
9	Waters Corp.	$7,190	$1,499
10	Vertex Pharmaceuticals	$6,960	$102
11	Nuance Communications	$4,940	$950
12	Iron Mountain	$4,470	$3,014
13	Skyworks Solutions	$4,310	$1,072
14	Hologic	$4,190	$1,680
15	Monster Worldwide	$3,010	$905
16	Acme Packet	$2,800	$141
17	Bruker Corp	$2,540	$1,110
18	Parametric Technologies Corp.	$2,480	$1,010
19	Varian Semiconductor	$2,400	$832
20	Novell	$1,960	$862
21	Charles River Laboratories Int’l	$1,920	$1,203
22	VistaPrint Ltd.	$1,770	$670
23	Progress Software Corp.	$1,680	$494
24	Sapient Corp.	$1,660	$667
25	American Superconductor	$1,530	$316
26	Haemonetics Corp.	$1,450	$629
27	athenahealth	$1,400	$189
28	Cubist Pharmaceuticals	$1,370	$560
29	Parexel International Corp.	$1,170	$1,336
30	Pegasystems	$1,110	$264
31	GT Solar	$1,090	$733
32	Alkermes	$1,030	$178
33	LogMeIn	$1,050	$79

Yet, when you evaluate the pipeline of IPO candidates, the results in MA are less inspiring.  One interesting ranking comes from Business Insider’s list of the 100 most valuable private digital companies.  Although this is only one and skewed towards one industry sector, it contains only one company from MA in its ranks:  Brightcove.  In an informal survey of a number of Boston VCs and entrepreneurs, the same 10-15 names come up as IPO candidates in the next 2-3 years (the criteria I asked folks in my informal survey was to name companies growing fast, revenue runrate > $30m, profitable or converging on profitable and probably worth > $100M today).

They include (note – all estimates are my own judgment and highly disputable; for obvious reasons, I did not include any Flybridge Capital portfolio companies, so we are not investors in any of these):

• Brightcove ($50-60m)
• Carbonite ($60-70m)
• Communispace ($50-60m)
• CSN Stores ($300-400m)
• Endeca ($80-100m)
• Glasshouse ($90m) – registered for IPO  
• Globoforce ($80-100m)
• Hubspot ($25-30m)
• ITA ($150-200m) – Google acquiring for $700m
• Jumptap ($40-50m)
• Kayak ($150m) – registered for IPO
• Kiva Systems ($80-100m)
• Kronos ($700-800m)
• Litle & Co (>$100m)
• Name Media ($50-60m)
• Vertica ($25-30m)
• Zipcar ($130m) – registered for IPO

There are numerous divisions of public companies that historically resulted from acquisitions – like TripAdvisor/Expedia ($400-500m revenue), Shoebuy/IAC ($200-300m revenue) and Rue La La/GSI Commerce ($150-200m revenue) – but those are not included here as they’re not relevant to this analysis unless they get spun back out.

The conclusion?  There is a robust public company ecosystem in MA, which should serve as an inspiration and catalyst for other local private companies.  Strong public company talent is easily recycled at the most senior levels (see, for example, Akamai’s hiring of former Digitas CEO David Kenny as COO) and when you gather at networking events and see other CEOs who have taken their companies public, it is a wonderful inspiration.  

But, sadly, the private company ecosystem in MA is less inspiring, with only roughly a dozen private companies that could possibly be public companies in the next two to three years and only a half dozen with revenues of greater than $100m.

Tomorrow, I'll analyze the New York market, which yields a quite different picture by comparison.  

Tech-Business Divide - A Call To Arms

While Facebook founder Mark Zuckerberg’s decision to drop out of Harvard and move to Silicon Valley was a plot point in in the movie “The Social Network,” it looked like a watershed event to many in the local technology community. It was a call to arms for all who want Massachusetts to remain a competitive environment for entrepreneurs to build ventures that change the world.

Over the last five years since Zuckerberg’s emigration, there has been a transformation in the local start-up environment. The plethora of mentorship opportunities for entrepreneurs is mind-boggling — programs like TechStars and Mass Challenge, not to mention myriad business-plan contests. Despite these positive advances, though, the tech community is still less visible and engaged with the broader public in Massachusetts as compared with California, where tech executives Meg Whitman and Carly Fiorina recently made high-profile bids for statewide office.

In particular, there is a disconnect between the political system and the business environment, a disconnect that risks getting wider with time. It’s a natural outgrowth of the fact that the participants in the innovation economy — which includes biotech, Internet startups, and other tech-related firms — are often so consumed with building their businesses that they just don’t engage in our civic environment. And many of them view the local government as an irrelevant factor in their business.

This disconnect is also reflected on Beacon Hill, where so many movers and shakers walking the halls represent constituencies that have been active in state politics for generations. That’s not to say that these groups are not important, but it’s clear that the transformation in the local business environment has not produced much change in the local political system.

The transformation in the economy has been profound. Major technology companies like Microsoft, IBM, Oracle, and Google have acquired local companies and opened large offices here to tap into the local talent pool. Recently, Disney was seen scoping out space in Kendall Square to set up a research lab. Fourteen of the top 20 Massachusetts-based companies ranked by market capitalization and all of the top 10 growth companies are from the innovation economy — arguably a more concentrated industry sector than in any other state in the country. Interestingly, most of these companies did not even exist 30 years ago — they grew out of our start-up ecosystem that is so central to Massachusetts’ economy.

What can be done to bridge the civic divide between government and tech? Simply put, innovation economy leaders need to get more engaged in the local political scene. Business leaders who don’t think that the political system affects them are both naïve and missing the opportunity to affect real change. As one high-tech CEO observed to me the other day, “I realize now that if I’m not out there on the political playing field, someone else is playing my position!”

Groups like the Progressive Business Leaders Network (which I co-chair), New England Clean Energy Council, and Massachusetts Innovation and Technology Exchange are a good starting point, but need to elevate their impact on local policy. The need for better communication goes two ways: Mayors and state representatives need to get to know their innovation economy business leaders and learn how to help support their growth.

Right now, there is a mismatch between what our innovation economy start-ups need and what the employee base has to offer. Our unemployment rate is high, yet the job boards of local venture-capital firms show hundreds of job listings across their portfolios. Our companies desperately need more lab technicians, search engine marketers, online advertising salespeople, and software developers. How do we galvanize the public-university system to produce skilled workers that more closely match our innovation economy’s needs?  How do we tackle the mismatch between immigration reform, Washington-style, and immigration reform, business-friendly style - most glaringly evidenced by the lack of support still for the Start-Up Visa movement?

Facebook, Twitter, and other innovative forms of communication have had a profound impact on elections and public opinion. Now let’s find a way to engage the people behind those companies, as well as the next generation of emerging leaders closer to home, in transforming the local political system.

An edited version of this piece originally appeared in the Boston Sunday Globe

Attackers and Defenders

I met with a senior executive at a top 5 bank last week and he said something that has stuck with me all week.  When I asked him why he was interested in pursuing entrepreneurial activities after a nearly 20 year career at one firm, he replied, "I've decided the world is divided between attackers and defenders.  Over the last few years, I've grown tired of being a defender.  I want to be an attacker again."

This observation struck me because I heard it echoed by a senior executive at a top 5 media company who said nearly the exact same thing.  "Over the last 5 years, it's been clear that my job has turned into being a defender.  I want to be an attacker, instead."

There's something very profound about these statements.  First, it shows that the disruptive impact of the Internet and the Digital Age is still cascading throughout our economy.  The transformative power of technology is no longer merely impacting the narrow software industry, it is impacting huge swaths of our global GDP.  Second, there still remains unlocked, unrealized entrepreneurial energy embedded in our big companies.  

When mainstream senior executives are itching to abandon safe jobs for more challenging, dynamic environments, good things are bound to happen.  Ask yourself:  in your industry, are you an attacker or a defender?  And what will happen when thousands more talented people decide it's more fun, and rewarding, to be the former?

The ABCs of Starting an Investor Pitch Meeting – Always Be Credible

Malcolm Gladwell made famous the natural human reaction of judging other people in the first few minutes of an encounter with his book, Blink.  Like many other businesspeople, VCs and angel investors (“investors” going forward) blink and judge entrepreneurs very quickly in the first few minutes of an interaction.  That’s why the way an entrepreneur starts an investor pitch meeting is a key determinant of their success in that meeting.  Those first 10-15 minutes, where the entrepreneur presents themselves before they even present the idea, are very critical in establishing credibility and the right to continue to pitch to an engaged audience.

Yet, it is amazing to me how few entrepreneurs start investor meetings crisply and confidently.  The formula for the start of the meeting is almost always the same – you are trying to answer the simple question on the mind of the investors:  who are you and why are you here?  But when asked to review their backgrounds, entrepreneurs often fumble through incoherently, or ramble on tangents that aren’t relevant to the situation.

So, how should you start an investor meeting?  It’s as simple as ABC:  Always Be Credible.  Investors are looking for credibility – can we trust that you have a uniquely good idea or insight, are you capable of executing on it, and are you the real deal or full of bluster and BS?

When you talk to investors and ask about this opening gambit from entrepreneurs, you hear a consistent pattern about why they like a certain entrepreneur they’ve invested in. When you distill the inputs into a coherent pattern, here are the top three things you typically hear entrepreneurs should do:

• Be genuine and personable – Let your personality show, professionally of course.  At some point in the introduction, say something that makes you smile, which will make those around you smile.  If you don’t engage your audience, they’ll jump to their Blackberries.  For example, ZestCash CEO/co-founder Douglas Merrill is a charming character and, even putting aside the shoulder-length hair and tattoos, you can’t help smile when he introduces his background (raised dyslexic in Arkansas, followed an unlikely path of earning a Princeton PhD, leading Google engineering and IPO in his role as CIO for 5 years, and now has developed a vision to transform short-term consumer credit by blending online data with traditional underwriting techniques).

• Be crisp and on point – The most compelling background speeches are crisp, straightforward and very demonstrate relevant links to the opportunity at hand.  For example, SaveWave CEO/co-founder Dave Rochon gave the following brief narrative when pitching investors:  “I worked at Catalina Marketing for 10 years in sales and launched their Internet couponing business, then joined Upromise the year it was founded and built the grocery business for 10 years, serving for three years as president after the acquisition by Sallie Mae. I now want to transform the online and mobile grocery coupon business.”  Dave’s Series A round was way over-subscribed by folks like First Round, Ron Conway, Roger Ehrenberg, Founder Collective and I think it’s in no small part because his background and delivery were so crisp and relevant.

• Keep it short.  I find that the more impressive the entrepreneur, the shorter the introduction.  The worst situation – 20 minutes into the presentation, the entrepreneur is still bragging about some random product they launched in a completely irrelevant industry sector.  The VCs are already hitting their Blackberries and wondering how they can end the meeting gracefully.  And you run out of time to actually pitch the big idea.  Meandering introductions are the death of a pitch.

And here are the top three things to avoid:

• Do not exaggerate.  Assume that everything you say will be thoroughly checked out in due diligence.  If you claim credit for a company where you played a small role, it is bad form.  I recently called the CEO of a company that an entrepreneur bragged they had led during the pitch.  When the CEO told me they were a minor player and left after a brief two years, I stopped spending any more time evaluating the opportunity.  Remember, investors are professional BS detectors.  Err on the side of underselling your background because the BS alarm bells may ring in the first few minutes of introduction and spoil the rest of the presentation.

• There’s no “I” in team.   When entrepreneurs talk about themselves in grandiose terms in their introductions, it’s usually a sign of egotism.  When entrepreneurs talk about the teams they built and the smart people that somehow they were able to convince to join them in their cause, it’s a sign of great leadership.  Guess which of these two profiles investors are more attracted to?

• Don’t name drop.  Some investors are notorious name droppers, so this is a bit of the pot calling the kettle black, but investors get very turned off when the entrepreneurs name drop in their introductions.  We don’t need to hear every famous person you’ve met or pitched or worked with.  Establishing a few common points of contact is a good thing.  Acting like you are best friends with folks who wouldn’t recognize you if you bumped into them in the grocery store on a Sunday afternoon is not recommended.

Remember, be credible, humble and specific and you’ll do fine.  Take the 5-10 minutes time to establish that initial credibility, and then move on.  Investors like to back great people, so spend as much time thinking about how to present yourself in a compelling fashion as you would your idea.

My, What A Big Balance Sheet You Have!

In undiluted tellings of the tale, the Big Bad Wolf devours Little Red Riding Hood before running off into the woods. It’s worth remembering when considering the prospects for a wave of technology M&A to materialize.

Over the last few months, investment bankers have been eagerly reaching out to corporate buyers at the large public technology companies, as their burgeoning balance sheets have grown large enough to cause even a sangfroid, buttoned-down banker to salivate. 

The eight US-based technology companies with market capitalizations of over $100 billion (Apple, Microsoft, Google, IBM, Oracle, Cisco, Intel and HP) are sitting on over $200 billion in cash and short-term investments. Throw in the top three healthcare firms by market capitalization (J&J, Pfizer and Amgen) and the figure is $250 billion. Further, each of these companies is in a strong competitive position, competing in markets with positive secular trends thanks to the burst of innovation that is ahead of us. I can’t cite another time in the brief 50 years history of the technology industry when so many US-based companies were in such strong global leadership positions in so many compelling, growing markets.

With the economy modestly rebounding and fear beginning to seep out of the market-–the VIX index, a measurement of market volatility or fear, is down to as low as it was in summer of 2008–-it’s no wonder that many are forecasting a robust pick- up in M&A activity in the coming year. Private investors have held on to their good companies over the last two years when it was purely a buyer’s market. Meanwhile, large companies who have spent the last two years cutting costs and pushing for efficiencies are now eyeing growth. And the quickest way to grow? Buy it.

That said, private companies should be careful not to get too euphoric. A quick survey of my investment banker friends yields comments like, “a flight to quality”–-in other words, rational deals with market leaders get done, but unloading mediocre companies is not in the cards–-and “patience” or “inconsistent interest.” One banker reported to me that one or two buyers are at the table on deals that are getting done, not three or four. Further, no one appears to be in a rush. Strategic fit is being carefully analyzed and only top priority opportunities are being pursued.

So despite the fact that yields on cash are at a historic low, don’t expect those balance sheets to thin out anytime soon. And Little Red Riding Hood should still be very, very afraid.

Can VCs Be Value Investors?

Security Analysis is cited by Warren Buffet as one of his top four favorite and most influential books.  Written by Columbia University Professors Benjamin Graham and David Dodd, it was first published in 1934.  

The book is a thick tome that articulates the thesis of value investing – the analytical techniques for valuing securities and seeking to invest in those securities in the context of their underlying value.  The latest printing, the sixth edition, contains a foreword from the Oracle of Omaha himself as well as a preface from hedge fund investor Seth Klarman of The Baupost Group, who is regarded by many to be one of the modern masters in the art of value investing.

As a venture capitalist reading the book and trying to absorb its investment lessons, I wondered – can VCs be value investors?  After all, the philosophy of value investing, in theory, should cut across all asset classes and managers.  The precepts and principals therefore should apply to the venture capital business as well.

Sadly, they don’t.  

Klarman writes:  "Investing in bargain-priced securities provides a "margin of safety"-room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market.”  

Unfortunately, VCs don’t operate with a margin of safety, even if they are able to find and negotiate good deals. Later stage investors may have downside protection if they buy smart, but early-stage VCs do not.  If a portfolio company goes bad, there is typically barely any salvage value.  

As one of my partners is fond of saying, “A good price doesn’t help a bad investment”.  That is why VCs tend to emphasize “clean terms”, which are entrepreneur-friendly rather than focus on complex bells and whistles to protect downside.  And that is why you will see large loss ratios in VC portfolios, sometimes as high as 20-30%.  In fact, if a VC doesn’t have high a loss ratio, one might argue they aren’t taking enough risk.  As one Silicon Valley veteran put it to me the other day, “I can only lose 1 time my money.”

There is a see saw debate often heard in the hallways of VC firms – does success come from being a good stock-picker or company-builder?  In other words, will a VC generate strong returns because they are good at finding the best companies and entrepreneurs to invest in, or will the returns be generated by adding value to companies through shrewd strategic guidance and savvy recruiting and team-building?

The answer appears to be both, but even the debate itself is also framed incorrectly, I would argue.  Entrepreneurship is all about people.  The VC business has evolved into a world where the challenge is less about choosing the best entrepreneurs to invest in, bur rather convincing the best entrepreneurs to take your money.  This dynamic is unique as compared to other asset classes.  Imagine a world where the highest quality forests choose which endowment they’d like as their owner; or a public stock chooses which hedge fund they want to own 10% of their outstanding stock.  Sounds ridiculous?  That’s precisely what is happening when VCs compete with each other and chase after the best entrepreneurs, offering entrepreneur-friendly terms, supportive advice and value-add.

But although the VC business doesn’t lend itself to value investing, VCs would benefit from many of its lessons.  For example, placing an emphasis on thoughtful analysis and due diligence of business models and market dynamics rather than pure, instinctual speculation.  Further, in a world of multi-hundred million dollar exits and a weak IPO environment, exerting some price discipline makes sense for VC investors, who are often pushed by entrepreneurs beyond their limits (“If you like the deal at $20 million pre, why wouldn’t you like it at $25 million?”).  Deal prices must be scrutinized in the context of realistic growth assumptions, future capital intensity and target market sizes.  As Graham and Dodd put it, when an investor is blinded by the pursuit of growth, “Carried to its logical extreme, there is no price too high for a good [company], and that such an issue was equally ‘safe’ after it had advanced to 200 as it had been at 25.”

That’s why, in the end, the VC business is still a blend of art and science.  It is part financial asset class, part creative entrepreneurial endeavor.  And, under any analysis, is not for the faint of heart.

Why Entrepreneurs Seem to Be Growing Fangs

One of my favorite business school professors, Andre Perold, used to like to say that in every transaction in the financial markets, there are only two types of actors:  wolves and sheep.  As you might expect, the wolves have the edge in the encounter, due to superior market information or negotiating position.  If you find yourself in a market transaction and don’t know for sure that you are the wolf, then, sadly, you are the sheep.

Venture capital investors are historically accustomed to being the wolf.  During most periods, there has been a supply and demand imbalance that favors the VCs.  Entrepreneurs needed a lot of money, there were only a few VCs with money (it’s a shockingly small industry, with less than 500 or so active firms, according to the NVCA), and the VCs got to sit back and leverage their position of superior information and insight to choose their deals and drive favorable terms. 

In recent years, this imbalance has been turned upside down.  Entrepreneurs need less capital – even life sciences and cleantech start-ups are applying lean start-up methodology to be more capital-efficient – and information about VC deals is more transparent than ever (15-20% of all VCs now have blogs and the amount of information publicly available about how the business works is easily 100x as compared to 10 years ago, when I was an entrepreneur raising VC money).  Thus, for particularly “hot” companies, when there is momentum and competition, the entrepreneurs have become the wolves, and the VCs find themselves donning sheep’s clothing. 

As a result, many VCs – particularly bigger funds – are chasing “hot” deals aggressively, irrespective of price.  Facebook, LinkedIn, Groupon, Zynga, Twitter and many others are able to raise capital at extraordinary valuations.  For these investments to pay off, the investment thesis is based on a strong IPO in the future.  But the wrinkle in these momentum investments is that the currently weak IPO market is stretching out time to liquidity more than ever.  Thanks to their position as the wolf, founders (and angel investors) can often get liquidity from their late stage investors (particularly through Digital Sky Technologies – a Russian Bear in the transaction mix?).  

But the VCs, and in turn their LPs, are left holding an illiquid bag.  One LP complained to me the other day:  “The founders get liquidity, the angels get liquidity, and the pressure to go IPO is taken off the shoulders of the board and management team.  All fine and dandy – but where’s my liquidity?!”  A little IRR math shows the price of this elongated time to liquidity – a 5x return in 5 years yields a 38% IRR.  If the VCs decide to allow founder liquidity and put off an IPO, they’re likely taking on an incremental 3-4 year holding period (most major shareholders don’t get liquid until 1-2 years after the IPO).  To achieve that same 38% IRR in 9 years, a 20x return is required!  If the founders take money off the table, they are incented to go for the bigger win and don’t mind taking the time to get there.  But the early-stage VCs might certainly have preferred a $250 million exit and immediate liquidity to waiting four more years for the billion dollar exit – and the same IRR. 

Some VCs are well-positioned to chase the hot deals and patiently back the big winners.  Others are better off investing in capital-efficient businesses and taking the $100-200 million exits when they come along, even if it means selling their best companies too soon (“We are suffering from PME – pre-mature exit,” one micro-VC confided with me last week).  

Which path is the right one?  And who has the edge in the market flow in the coming years?  No one knows for sure, and every situation is unique and must be evaluated as such.  But with so many options to choose from, those entrepreneurs I’ve been noticing with larger fangs seem to be smiling more than ever before.

Two Venture Capital Industries - But One Lean Start-Up

Fred Wilson posted a blog last week regarding the "Two Venture Capital Industries" -- observing that the Internet/software industry, where he invests, has undergone great change due to the lower-cost model (commonly known as the "lean start-up" movement) but the more capital-intensive industries, such as life sciences and cleantech, where the fundamental economic model has not been altered.

The post is a great one, and it raises something I've been thinking a bit about lately, which is whether the lean start-up approach to building start-ups can be applied to industries beyond Internet/software.

HBS Professor Tom Eisenmann is creating a course next spring on "Launching Technology Ventures" where he is going to delve into lean start-ups, finding product-market fit, what are the key start-up activities before product-market fit and what are the most important activities afterwards, and other salient topics.

In my role as an EIR at HBS this year, I'm teaming with Tom on this course.  The case studies will go beyond Internet/software start-ups in exploring how other sectors can apply lean start-up theory.  One of the reasons I have so much personal conviction of the breadth of these theories is that there are two companies in our portfolio - one a clean tech and the other a life sciences - that have applied parts of the lean start-up methodology very effectively. Their stories help illuminate the opportunity for others.

The clean tech company is Digital Lumens, recent Innovation award winner at the World Economic Forum.  We seeded the company, and founding entrepreneur Jonathan Guerster, with a mere $500,000 to explore a thesis around software-controlled, industrial LED lighting.  Jonathan recruited a technical team out of Color Kinetics and built a proof-of-concept.  We then raised a $5 million Series A, hired an outstanding CEO (Tom Pincine), and the company built v1.0 of the product.  With the success of v1.0 behind it, the company sought out a few customers to work through the kinks.  Once that was done, and rapid product iteration cycles, the company raised a Series B and is now scaling sales operations.  If you didn't know the company was a demand-side energy technology company, you would think the above description applied to a Web 2.0 company.  Digital Lumens may require 10s of millions of dollars end-to-end, but just because it's a capital-intensive business, doesn't mean they couldn't apply lean start-up approaches to change the risk-reward profile for the early investors.

Similarly, Predictive Biosciences has been on a lean start-up path.  That sounds odd to say for a company that has raised a total of $56 million to pursue a very big vision for urine-based biomarkers (pee in a cup and Predictive will tell you if you have cancer - and what type).  But the initial investment we and Highland made was a mere $500,000 each to spin the IP out of Children's Hospital, hire an initial technical team to build the product/prototype, and figure out which market to target and how.  Only then did we raise a $10 million Series A, and even that capital was deployed in a very focused, test and learn fashion until the initial market (bladder cancer) was identified and vetted.  Again, many of the same lean start-up processes that Mint.com or Xobni or others have deployed in the Web 2.0 would feel very natural to  the dozen PhDs running Predictive.

So, yes, the cost revolution impact to one type of VC investing has been enormous.  But the lessons, frameworks and paradigms can be applied successfully to the "other" VC type of investing as well.

Back to School Blog: An Open Letter to Boston-Area Students

(Warning:  the following blog post will seem parochial for all readers outside of the Boston area.  Sorry about that.  The message applies to every aspiring innovation hub.)

Dear Boston-area student,

Welcome (back) to the Top City of the Global Innovation Economy!  It’s sure been quiet around here without you.  I know how excited you are to hit the books again – cram for exams, stress about your careers and freeze your butts off during the long winter months.  Good times.

But here’s what’s great about having you here.  You provide the fuel that makes our innovation economy hum.  Every year, you show up and shake up our assumptions about what’s new, what’s hot and give us a glimpse of what’s over the horizon.  And for that, we are super-grateful, even if we don’t always do a good job showing it.

So here’s a little advice for you – do us all a favor and plug in to the community that surrounds you.  Get engaged and integrated.  There are a crazy number of opportunities and venues for you to show up and network.  Close your laptops, turn off your iPhones, jump on the T and get out there and participate in the local innovation ecosystem. 

Here are a few of the things you should have on your must-do/must-see/must-read hit list:

• Stay in MA – this is a mico-scholarship program that allows you to attend the incredible array of industry networking events for free.  Just sign up and show up gratis to get savvy in your favorite area of interest, whether it’s clean tech, bio tech, web 2.0, mobile, whatever.

• DART Boston – The start-up game can be a lonely one.  DART Boston makes it social and fun.  It’s a group of 20-something peers who are engaged in the start-up game and hungry for knowledge, perspective, mentorship and dialog.  They get together periodically for social hangouts and learn sessions and are about as plugged in a group of young, ambitious folks as you can find in the city.

• Mass Challenge – Our governor, Deval Patrick, has huge religion when it comes to fueling the innovation economy.  As such, he helped create Mass Challenge, “the world’s largest start-up competition”.  Go to the waterfront, swing by the Barking Crab and buy yourself a lobster roll, and then walk over to Mass Challenge HQ and see the open start-up haven that is forming.  They have multiple events and guests every day to fuel the young start-ups that are being incubated there.

• Scott Kirsner’s blog at Boston.com – required reading for the start-up community.  Subscribe to his email and you’ll get a window into the community’s trends and players.  He’s been organizing Innovation Open Houses, which are great opportunities to visit companies and learn about different business models.  While you’re at it, make sure you read VentureFizz, XConomy, BostInnovation and Greenhorn Connect and you’ll stay up to date on all the local buzz.

• Other blogs and Twitter tips – There are dozens of blogs and valuable Twitter streams from local VCs and entrepreneurs.  One of the best summaries of them is here, provided by a local Google exec.  We have more VCs per capita than anywhere in the US.  You can’t grab a tall decaf latte in Cambridge, Back Bay or half of the western suburbs and not bump into a VC or angel investor.  They particularly tend to hang out at Harvard, MIT and Babson, so don’t be shy about visiting those schools and attending those talks if you don’t see them happening in your neighborhood.  I did a talk last year at HBS entitled, “What Makes Boston’s Technology Start-Up Scene Special?” which might be a useful orientation for you as well.

Look, there’s a reason Boston is consistently ranked as one of the top innovation cities in the world.  We value geeks (Bill Gates and Eric Schmidt draw bigger crowds than Lady GaGa when they come in town to speak), encourage rebellious thinking (see:  Minutemen, American History), worship start-ups (why else would a World Championship winning pitcher, Curt Schilling, aspire to become a successful start-up CEO as a second act?) and generate our fair share of big winners (see:  EMC, Akamai, Genzyme, TripAdvisor).

But, honestly, the real reason so many communities try to emulate what we have is because of you.  You keep it fresh, every September.  Thanks for showing up.  Now get out there and mix it up.

Who Will Champion Entrepreneurship?

I love Jackson Hole, Wyoming.  It is one of the most extraordinarily beautiful settings in the world.  One cannot help being in a good mood when observing the breathtaking wildlife, open sky and the awe-inspiring Grand Tetons.

Thus, reading the reports from the August annual economist confab in Jackson Hole could not have been more depressing.  If the practitioners of the dismal science sound this pessimistic amidst such an uplifting setting, what will their attitude be when they trade back in their cowboy boots for green eyeshades and return to their drab offices to stare at spreadsheets?  A usually staid Allen Sinai sounded positively hyperbolic, yet apparently spoke for many at the conference, when he told the New York Times, “I’m more worried than I have ever been about the future of the U.S. economy. The challenge is unique: poor and diminishing growth, a sticky unemployment rate, sky-high deficits and a sovereign debt that makes us one of the most fiscally irresponsible countries in the world.”

In his Oval Office speech on Iraq, President Obama acknowledged his concerns about the economy and declared, “Our most urgent task is to restore our economy and put the millions of Americans who have lost their jobs back to work…We must unleash…innovation…and nurture the ideas the spring from our entrepreneurs.”

So here’s what I don’t understand.  If everyone, including the president, believes that supporting innovation and entrepreneurship is the best path forward, why aren’t the policy leaders taking action?  Thomas Friedman of the NY Times has been hammering on this issue for the last year, calling on the president to “launch his own moon shot” and make innovation and supporting the start-up economy his top priority.

First, let’s review the data.  The Kauffman Foundation did a comprehensive study of historical job creation and, not surprisingly, found that small businesses are the main source.  “Without startups,” writes Senior Fellow Tim Kane, there would be no net job growth in the US economy.  This fact is true on average, but also true for all but seven years for which the US has data going back to 1977.”  See the following chart:

 

But despite the obvious data and the presidential rhetoric, we are not seeing any action from policy leaders on either side of the aisle. It’s almost as if the policy makers think speeches exhorting innovation is more important than doing the hard work of pushing forward legislation that will actually positively impact the innovation economy.

I’m no policy expert, but it strikes me that there is a clear innovation agenda that has been put forward by those who are the most knowledgeable about the issues.  A few of the ideas being proposed seem obvious, but are stagnating due to a lack of leadership.  For example:

• We need to make it easier for immigrants to start companies in the US.  The Start-Up Visa movement addresses this issue squarely in the head and yet the bill proposed by Senators Kerry and Lugar six months ago (!) appears to be caught up in the more partisan immigration debate.
• Sarbanes-Oxley needs to be reformed.  We may have had too little regulation of complex financial instruments like credit default swaps and other derivatives, but we clearly have too much regulation being imposed on the public selling of the securities of $100 million companies that are very simple for investors to understand.  Why haven’t Facebook, LinkedIn, Zynga and many others gone public?  It’s just too onerous and expensive.  You want to unleash innovation?  Make it one-third as expensive for small companies to comply with public regulations.  There have been numerous proposals in the past to rethink Sarbanes-Oxley, we need to see some form of them come to light.
• Other important policy ideas have been put forward by the National Venture Capital Association (NVCA) and others – such as patent reform, increased investment in broadband, increased investment in NIH funding, reforming the FDA approval process.

The amazing thing to me is that none of these ideas – and many others floating around the entrepreneurial community – require big dollars.  Instead, they require big leadership.  Where is that leadership going to come from?  Who will be our champion for entrepreneurship?  Ted Kennedy played this role in health care.  John McCain played this role in campaign finance reform.  Who will step up and be the champion for entrepreneurs?

 Here are a few other ideas:

• We have two former venture capitalists in the Senate and House (Mark Warner and Scott Murphy), a former high-tech entrepreneur in the Senate (Maria Cantwell) and a former venture capitalist running the Small Business Association (Karen Mills).  They probably know what to do to unleash innovation in this country, but they’re just not empowered.  Why not cut through the hierarchy of party leadership and have the president create a special Bipartisan Commission on Entrepreneurship – similar to what has been done on September 11^th and Deficit Reduction? 

• When President Clinton was elected in 1992, he convened a televised economic summit, bringing together the best minds on the economy and conducting, in effect, a “national teach-in” for the broader public.  Let’s have the president convene an Entrepreneurship Summit – invite top entrepreneurs, VCs, angel investors to sit alongside policy leaders – and have TechCrunch.tv broadcast it.  Discuss immigration reform, Sarbanes Oxley reform, FDA approval streamlining and all the rest.  Imagine the impact that would have and the focus this would provide. 

• Faced with criticism that he’s not in touch with business, President Obama has had a series of CEO lunches at the White House.  When you examine the list of invitees, it is shocking how few are entrepreneurs.  I counted two (Jeff Bezos and Howard Schultz) among 28.  And none of them are in the business of helping create the small businesses that create jobs.  The president’s lunch list needs to change radically and instead invite the leading thinkers in entrepreneurship and innovation to a series of lunches.  If accomplishing nothing else, it would force Brad Feld to wear a tie.

When you look at the exciting progress being made in global broadband access, the Human Genome, ubiquitous wireless access and devices, energy innovation and so much more – it is clear that we are living in an extraordinarily unique time, truly a golden age for technology and innovation.  If only we could get our policy leaders to take big actions to match their big rhetoric.  Then next year’s Jackson Hole conference might be a lot more fun for everyone.

 This blog post first appeared in PE Hub. You can follow me on Twitter: www.twitter.com/bussgang.