Altos Ventures Musings

Celebrity Investors, Board Members and Advisors

"The quality and quantity of the financial backing that HomeGrocer.com has received for this latest round of financing clearly indicates that we have a model that is both viable and sustainable." 

- Homegocer's CEO in 1999 Press Release announcing $100mm round 

Chris Dixon's blog post from today about how to select your angel investors talks about a common mistake entrepreneurs make - choosing an investor based on their "celebrity value (by "celebrity" I generally mean in the TechCrunch sense, not the People magazine sense)." 

The same is true for choosing VCs, board members and advisors. We've invested with plenty of famous VCs and board members who were extremely well connected to the CEOs and boards of companies such as Microsoft, Oracle, Cisco, Intel and many other Fortune 500 companies. 

In our experience, celebrity investors and board members do little to help entrepreneurs do what they need to get done. They offer little in the way of strategic or practical advice about hiring, firing, product development, closing deals and financing. Even worse, sometimes the advice can be out of touch with what is going on in the industry or company but due to their celebrity status, some off the cuff comments can carry too much weight. 

Perhaps the most value that celebrities bring to the table are connections (even Chris in his blog post applauded "connectors" who can "introduce you to key people when you need it"). In practice, however, most people with great connections guard their rolodexes. 

Even when an intro is made directly to the CEO of a BIG company, it will get passed down the organization (usually down several levels) to the real decision makers. If the company is well run, the CEO will let his/her people make the decisions. 

If you do choose to use high level connections to force a deal through you should be warned that such a deal can backfire. If you don't take the time to build real support with the right people in the organization, they can do many things on a day to day basis which can ultimately sabotage the deal down the road (and distract you from what you should have been doing in the first place). 

My advice to entrepreneurs is to build your own buzz, based on fundamentals (an excellent banker advised one of our companies to "build your own heat" - it was good advice). You have to deliver real value! 

Also, please, please, please focus on generating your own leads. No matter how big your board or how well connected your advisors are they will NEVER produce the quantity or quality of leads your own team (and sales/marketing engine) will produce for you if you are going to be successful building a real business. 

In my experience, the entrepreneurs who see the most value from celebrity investors/board members and "advisors" build nothing of real value themselves. On the flip side, the best entrepreneurs see little value from celebrities (in fact, they probably find them distracting, if not somewhat annoying). 

Ironically, celebrities begin to embrace entrepreneurs once they think they are going to be successful anyway - with or without them. As it turns out, most celebrities need you more than you need them.

As far as I'm concerned, the real stars are entrepreneurs who create something from nothing.

Disclosure: As Chris D. admitted, as a non-celebrity but hard working small investor, this post is almost entirely self serving.

Overcommitted

Hard working entrepreneurs and their companies often feel over-committed. There are always too many things to get done and not enough resources.

One of our companies that is growing at 200%+ this year was feeling that way and we had a serious discussion about various options. One was to do a better job of account management so that expectations of customers and partners do not get ahead of our ability to deliver. Another option was to raise more funding and hire more people. A third option was to make tough decisions about what to cut (this is not an exhaustive list but will give you a flavor for the discussion).

The third option is a hard one to swallow, especially when things are going well. We have customers lining up and a window of opportunity that may close if we don't go for it - NOW! An easy answer would be to raise more money and ride the momentum.

After much discussion/debate, we made a decision to cut. We did not cut people. In fact, we will continue to hire. But we cut some very promising initiatives and we will have to turn away customers that are ready to pay (or have already paid).

Cutting can be scary, but it can also be liberating. It is not 100% clear that we made the right decision but here are two interesting quotes to think about, if you ever find yourself in a similar discussion with your board/investors:

"The essence of commitment is making a decision. The Latin root for decision is to 'cut away from,' as in an incision. When you commit to something, you are cutting away all your other possibilities, all your other options."
    -The Lombardi Rules, Rule #6 - Be Totally Committed 

"A great company is more likely to die of indigestion (from too much opportunity) than starvation (from too little)."
    -David Packard ("Packard's Law")

A Modest Proposal for the Venture Industry: Better Customer Service

There has been much talk lately about the demise of the venture capital industry.  Big funds are imploding after a decade of poor industry returns.  The causes are many: wacky capital markets, Sarbanes-Oxley regulation, ballooning fund sizes, misaligned incentives, generational turnover, etc.  Reviving the industry was such a big topic at this year’s National Venture Capital Association meeting that NVCA leaders issued a bold set of proposals to jumpstart the industry.

I haven't spent much time trying to dissect the causes of our industry’s current malaise.  But one thing I know for sure is that we are doing a lousy job of basic customer service.  How bad?  If you google “venture capitalists suck” you will get more results than “United Airlines sucks”.  A totally inaccurate measure to be sure, but to be anywhere near United Airlines on the suckage scale is not something that our profession should be proud of.  I think we can do better. 

So let me make a more modest proposal.     

We venture investors could do a lot for the reputation and health of our profession by getting back to the basics of good customer service. 

Many of us have forgotten that our business, after all, is to serve investors who entrust us with their capital and entrepreneurs who entrust us with their dreams.   Having raised money at three start-ups before starting in venture, I have more than a few opinions on how venture professionals could act more, well, professional.  Let me start with a few simple ones:

1.    Return calls (and emails)
One of the classiest and most successful venture investors I’ve ever met is Brook Byers of Kleiner Perkins.  Early in my career, I asked him at a panel discussion to share the secret to his success.  He explained that one of his basic rules of doing business was to call people back by the following day.  It sounds so simple, yet every week I talk to entrepreneurs who drive themselves insane wondering when the VC they met is going to call them back.  I’m not talking about unsolicited inquiries (only the appropriate ones of which deserve a response); I’m talking about getting back to people with whom we’ve already met.   Email overload is no excuse.  Not when we’re checking our Blackberries every five minutes.

2.    Pay attention
Which brings me to my next suggestion.  I vividly recall pitching my third startup to a famous Sand Hill venture capitalist back in 1999.  We had studied his portfolio, prepared a customized presentation and shown up early for the meeting, only to have him spend the hour distractedly munching a bag of peanuts and tossing the shells on the table in front of us.  Now that a decade has passed and peanuts have given way to Blackberries, it is a rarity that I sit through a meeting where a VC is not checking email, surfing the Web or popping out to make a phone call.  What’s the point of making all the physical effort to get face-to-face only to be mentally absent?  I’m as guilty as any, so let me resolve immediately and publicly to put my Blackberry away when meeting with entrepreneurs, or at least use it as a drink coaster.

3.    Just say NO
Given that we need to turn down 99% of the ideas that come our way, you would think that VCs would be pretty good at saying “no” to entrepreneurs.   The best salespeople and entrepreneurs know that a quick “no” is better than a long “maybe”.  Some of my VC colleagues don’t like to say “no” to keep their options open for a potential investment, but the vast majority just don’t like using the two-letter word because they are nice people.  They hem and haw and say something about having to “talk to the partnership”, then worry for weeks about how to make up a reason for declining the opportunity.  I’ve resolved to either tell entrepreneurs in the meeting or get back to them within a week.  It sure has made my life a lot easier and I hope it’s helped them waste less of their precious time.

4.    Be accountable
All this is easy to say, but aside from some community rating sites like thefunded.com, venture capitalists are simply not accountable to entrepreneurs.  At Altos, we’ve begun measuring the time it takes us to get initial and follow-up responses to entrepreneurs, but we are by no means perfect.  For a profession that generates all of its returns from the hard work of entrepreneurs, we sure do a lousy job of customer service.  So hold me to what I say.  Call me on it.  If I (or my partners) don’t follow my own advice in this blog, just email alee@altosventures.com and you’ll get a response from me.  If I still don’t get back to you, then you should probably give up on us and try United Airlines instead.

Burn the Ships!

The past 6 months have been two of the toughest quarters in decades. Almost every company is struggling - but some are surviving and some are not. What separates them?

I want to share an observation. There seems to be one common theme across every Silicon Valley company that I've seen go out of business. For some reason, the management of companies that abruptly shut their doors thought that they would get more funding. It could have been VC funding, debt financing or some other source of outside capital. That was their back-up plan. They were counting on it.

If you are an entrepreneur, you should have the attitude that there will be no-one to save you. There will be no outside capital. You have to generate revenues, cut costs, make the business model work - or find some way to survive until you do.

This doesn't mean that entrepreneurs should not raise any debt or equity financing. It just means they should never, ever count on it.

In Silicon Valley, it almost seems as if entrepreneurs count on VC as a business model. They aspire to become adept at raising VC money and "exiting" in a few years. What ever happened to the idea of building a real business, funded by paying customers? How about building a company that can stand alone, built to last?

In a book called Predictable Irrational, I found a story that every entrepreneur should think about.

In 210 BC, a Chinese commander named Xiang Yu led his troops across the Yangtze River to attack the army of the Qin (Ch'in) dynasty. Pausing on the banks of the river for the night, his troops awakened in the morning to find, to their horror, that their ships were burning. They hurried to their feet to fight off the attackers, but soon discovered that it was Xiang Yu himself who had set their ships on fire... With their ships gone, the soldiers had no route of retreat. Winning was the only option. 

They won 9 battles in a row before defeating the mighty Qin forces.

If you are an entrepreneur and you think that you will need some more funding to survive - or thrive - I have one piece of advice for you. Burn the ships.

RIP Good Times? A Different Perspective

Rip Good Times A Different Perspective

View SlideShare presentation or Upload your own. (tags: venture capital)

I put this presentation together to encourage a group of entrepreneurs I was to speak to at a conference in Reno, NV last week.

It's funny how times change.

People who have been following our blogs over the past 2 years know that we've had a more pessimistic, contrarian view of the venture business, even as the number of VC investments, fund sizes, deal sizes and valuations had been going up.

Now, of course, the world is totally different. Whether or not you believed that we were in a Web 2.0 technology bubble, Sequoia declared that the good times were over and it's now time to hunker down and fight for survival. In their widely publicized "RIP Good Times" meeting, they extolled the virtues of cash conservation to all of their CEOs and told them that they had to change in order to survive.

Now, we are contrarians again.

Our companies did not need Sequoia to tell them cash is king. They had been operating that way for years. In fact, more than a third of all of our companies are on track to be profitable this quarter. Many have been maintaining profitability while growing for many years.

The reason that we feel like we are contrarians again is that we have not seen such a good environment for building companies in years. Entrepreneurs are more focused on getting to profitability and building companies based on solid fundamentals. Before, we felt like lonely voices in the VC world, which seems to be filled with people working toward billion dollar exits for money losing companies.

Over this entire year, we've noticed a trend. Some of our companies started seeing a steady flow of high quality resumes from competitors. I think it's now about to turn into a flood! It will be much easier to hire great people who are more hungry and realistic about compensation and how long it will take to build shareholder value.  

For entrepreneurs in it for the long haul, this downturn just bought them more time. Impatient VCs won't be hounding them to take more risk, to grow faster, to get more aggressive. Remember, as an entrepreneur, you have one company. You don't have a portfolio of companies. You can't afford to play venture lotto.

Remember what we said back in 2006 about Foxes and Hedgehogs in Silicon Valley?

"Foxes are great at raising capital - they thrive in bubble markets. Hedgehogs would rather bootstrap - they do far better during the inevitable crashes."

For all you hedgehogs out there, this is your time to shine!

Don't Worry, Be Scrappy

“Don’t worry” does not exactly sound like responsible advice at a time like this. After all, we often remind our CEOs of Andy Grove’s famous adage that “only the paranoid survive”.

But it is a serious piece of advice that we are giving to all of our portfolio entrepreneurs. Over the last two weeks, many of our portfolio CEOs (and fund investors) have been asking us for our take on the current financial crisis. So here it is:

The bad news

Let’s first understand that things will be bad – really bad. In fact, this downturn will almost certainly be deeper and longer than the post-Bubble “nuclear winter” of 2001-2004 that so many of us struggled through as entrepreneurs and investors. That crash was precipitated by a financial bubble seeded largely by the venture/technology markets and abetted by all-too-willing public investors. But despite the fall in IT spending and concurrent drop in the NASDAQ index, the general economy kept humming along. In the five dark years following NASDAQ’s peak on March 9 2000, the Dow Jones actually went up. In the same five year period, the national housing price index nearly doubled. Most Americans hardly noticed the Internet Bubble and crash.

Now this is a totally different story. This economic crisis is about all of us. It’s about a fundamental realignment in global asset values. Whatever happens to venture/technology will be collateral damage, but will likely be worse than what we in tech experienced after the Internet Bubble. If that felt like a nuclear winter to tech companies, this one may well be an ice age for all of us. We may be wrong about this, but we’d rather be wrong on the upside than wrong on the downside.

The good news

As an entrepreneur, there are a lot of factors that figure into your success or failure. Some you control and most you don’t. Macroeconomics is one that you certainly don’t. So if, like me, you believe in worrying only about the things you can control, then this is a great time to get focused on building your business and stop fretting about the economy (see Focus on the Controllables).

In fact, a recession is probably the best time to start a company. Great companies like Disney, GE, HP and Microsoft were all started during recessions. As the clever folks at Google like to say, “creativity loves constraints”.

Why?  Bad times can build good DNA.  A down economy does not leave room for entrepreneurial sloppiness. It forces entrepreneurs to be honest about how good their products are. It mandates financial discipline. In other words, it is a perfect time to get focused, get real and get lean.

After the giddy NASDAQ highs of March 2000, it took most people way too long to come to grips with reality. I had personally just joined the venture business and my first company, Evolve Software, went public in August 2000 – a full half year after the peak. Most companies did not start cutting back until late 2001 and by then it was too late. The smart and lucky ones survived the ensuing five years and some became big winners. But most companies just ran out of money and ran out of time.

The rules

Plenty of smart people have already made prudent recommendations to their teams about what to do in this environment, so I won't repeat. See in particular Sequoia’s doom and gloom presentation to their portfolio CEOs earlier this week and Jason Calacanis’ email. But let me summarize with just two simple rules that we've tried to impress upon all of our CEOs:

Rule #1: Don’t run out of cash.

Rule #2: See Rule #1.

Then, go out and build the next great company.

Ousting the Founder

I was shocked to learn this week that Diane Greene, the co-founder and CEO of VMWare was ousted. I was not alone. Except for senior management (who found out very late, the night before) the employees of VMWare read about it, just like I did on Tuesday morning.

I guess $1.3B in revenues, $14B market cap, 50% growth rate and market dominance was not good enough for the board/EMC. One slight miss in one quarter and BANG! You're out. Perhaps the board believed industry pundits and worried about competition from Microsoft. So they brought in a "heavy hitter"...former Microsoft exec Paul Maritz as CEO.

I'd guess that the more likely reason was that Diane Green was a difficult person to deal with. There is no doubt that she was a controversial CEO. It was her way or the highway and she churned through senior execs (especially in sales and marketing). She never gave much respect to the folks at EMC either (who owned the vast majority of the stock - and controlled the board).

Some other hard-headed, "controversial" founder/CEOs that come to mind are Bill Gates, Larry Ellison, and Steve Jobs. These founders may be difficult to deal with but I'd rather go with them than take my chances with a new hired gun CEO.

Over the years, we've observed that it's difficult, if not impossible, to match the passion and commitment that founders bring to their companies. It's not just a job for them. It's deeply personal. The difference in commitment is akin to the differences you might observe between missionaries and mercenaries (or hedgehogs versus foxes).

Look, I have nothing against Paul. I'm sure he's a very smart, capable and hard working guy. But this whole situation reminded me of the time Steve Jobs was ousted from Apple more than 20 years ago.

As co-founder and CEO, Diane Green built one of the all time great successes in Silicon Valley. Very, very few companies ever reach $1B in revenues. Even fewer in the technology industry. Even fewer in the software industry. And even fewer ever exceed $10B in market cap.

Why the hell would you fire her?? No, don't tell me...I've heard all the reasons. VCs oust founders all the time. I've been in plenty of board level discussions around this topic!

It's almost a rite of passage in Silicon Valley. As a founder, you start a company, get VCs to fund you, recruit a "world class" management team...and eventually, find your replacement (or get ousted).

What people seem to miss, however, is that just about every great company ever created - in technology as well as low-tech, was built by a founder (or a CEO who happened to join the company very early in its growth phase) and a team of dedicated people who grew with their companies.

I don't believe in "world class" management in the generic sense. "World class" in what??

What I believe in is people who learn on the job and become - over time - the best at what they do. Along the way, they make plenty of mistakes. But that's part of the learning (and perhaps the luck of it - because the mistakes happen to be not fatal for the survivors).

Think about it. Some examples of great companies led by founders for decades are GE, UPS, FedEx, Wal-Mart, Southwest Airlines, HP, Intel, SAP, SAS, Apple, Oracle, Microsoft, Adobe, Sun, Dell, Qualcomm, Broadcom, Nvidia, Dolby, Amazon.com, Salesforce.com, etc.

There are some great companies where the original founder(s) did not grow the company but the CEO who grew the business to $1B+ in revenues joined very early on in the life of the company (typically below $10mm in sales): IBM, McDonald's, Starbucks, Veritas, Cisco and Google are examples.

It'll be interesting to see what happens. Even a founder hanging on to the bitter end won't save some companies (i.e. Wang, DEC). But I'd rather take my chances with the founder who built a $1B business from scratch than go with someone new.

The average tenure of the CEOs in our three largest companies is 9 years. They learned on the job. None of them had been CEO before we started working with them. None had much experience in their industry - the market did not exist, and the technology and business models had not yet been invented. But they are guys who took us this far (average sales of nearly $90mm this year) and we will gladly stick with them as long as they still want the job.

I'd rather take my chances with the people who built the business and grew their companies than the "professionals" - the hired guns - the mercenaries - coming in, after the fact, to "fix" things or to "take it to the next level."

We tell all of our companies this - if you want to build the leader in your industry, you have to have the world's leading experts in your field working for you. But do NOT expect to find them outside of your company. Someone senior from the outside won't come in to show you the way. They won't save you.

Think about it. If you can go outside and hire a CEO or other very senior executives to come in to YOUR company and tell you what to do and how to do it - better than you - then you've created nothing special. There is no secret sauce and you have NO CHANCE of building a truly great company.

We like to tell all of our companies this - the world's leading experts in your business will be the people you develop. The young people you hire today will be your future leaders. Five to ten years from now, they will BE the world's leading experts in your business. You will have to figure it out - together - along the way.

Don't count on those mythical "world class" managers to come in to save the day. Not only are there no guarantees, I believe they will end up hurting your chances of building a special, lasting company. If you do try to hire them anyway...good luck. What I will guarantee is this - they will negotiate HARD for a nice severance package.

Failing Fast

Lately, I’ve been telling all our companies to fail.  Fast.

It’s not that I’ve decided to throw in the towel. Quite the contrary. After doing startups for a dozen years, I’ve come to believe that the best way to maximize the chance of a big success is to fail often and fail fast.

Thomas Edison was one of history’s most successful failures. He failed more than a thousand times before inventing the incandescent light bulb. When Edison finally figured it out, he famously said: “I didn’t fail a thousand times. The light bulb was an invention with a thousand steps.”

The idea of taking a thousand steps is core to our investment philosophy here at Altos.  We’ve come to understand that every company goes through a series learning processes – about new markets, products, distribution strategies, etc. My partner Brendon wrote a great post on the fact that there is just no substitute for time when going through these learning cycles. Sometimes, the outcome of learning means tweaking the product to meet unforeseen customer needs; other times it means completely scrapping the business model and starting fresh. In fact some of our most successful companies started with one business and ended up with something entirely different. Put a smart, tenacious team against a big market opportunity with enough operating runway, and you have a decent formula for success.

Failing fast is even more imperative in the world of Web-based software and services. Back when I was a rookie product manager, I’d spend months perfecting product requirements documents (PRDs) that would disappear into an engineering organization only to emerge months or years later as a finished software product. Nowadays, that one-shot, monolithic approach is just not a competitive option.

Failing fast requires companies to think about perfecting their products differently. To quote LinkedIn founder Reid Hoffman, “If you are not embarrassed by the first version of your product, you’ve probably launched too late.” Perfecting a product the first time out is impossible, but getting it out and iterating a thousand times just might get you close.

Some of our best development teams cull user feedback into new priorities to build/test/release on a weekly cycle. It doesn’t really matter whether they are using newer lightweight tools like Ruby on Rails and Adobe Flex or “heavier” Microsoft-centric stacks. The key is to obsessively listen to and incorporate feedback from Web users who aren’t afraid to tell you if their release sucks (or not). Keep what sticks, toss what stinks.

Of course, just failing a lot is no guarantee for success. There are plenty of teams that just fail all the way to a big fat zero. These teams either spend too much time and money failing or don’t fail in the right ways. Let me elaborate:

One corollary to failing fast is failing cheaper. Josh Kopelman has a good post (and investment model) on this, so I’ll let that him tell you all about it.

A second corollary to failing fast is failing well. Systems that fail well compartmentalize and minimize a failure so that it does not impact the whole system – for instance, a sealed chamber in the hold of a cargo ship that allows a single area to absorb damage without flooding the entire hold. Failing well is a lesson most of us learned in high school chemistry lab: isolating experimental variables by using a scientific control. Similarly, start-up teams that fail well run multiple experiments to get small, controlled failures. These teams understand that failure is a desirable and necessary byproduct of the learning process. They are humble, smart and fast.

So don’t be afraid to fail. Don’t even be afraid to be embarrassed. It’s all just part of being successful.

The Ramp Phase, Jack Welch and a Coin Flip

The "ramp phase" is a period that my partners and I define as a hyper-growth phase somewhere between $10mm and $100mm in sales. It is perhaps the most exciting period in a young company's development. After years of hard work and tinkering, getting the product, packaging, pricing and positioning right (or at least good enough), you think that your company is finally ready to scale. By the time you reach this phase, you have a business model that is starting to work and lots of raving customers. Most companies don't even make it this far, so you are feeling great about things...

At this phase, most VCs are ready to invest big dollars and encourage entrepreneurs to be aggressive. They say, it's time to break through or get left in the dust. VCs don't invest in lifestyle businesses, you have to go for it!  Don't sand bag. Shoot for the moon! Those projections are not exciting enough...it's not BIG enough...the stakes are getting bigger...yada, yada, yada.

Let's get real.

Something that we see all the time when we drill down into sales projections of start-ups is a failure to take into account hiring mistakes that inevitably occur as companies ramp a sales-force.

Sales is typically the department which has the highest turnover in companies going through the ramp phase. Over the years, we've seen hundreds of sales reps get hired (last year alone, our companies hired 200+ sales reps) only to see most of them struggle, get fired or quit at some point along the way.

Based on our experience, less than one out of two new sales reps end up working out. Whether you have voluntary or involuntary turnover, the end result is the same - you end up with fewer sales reps than planned.

Given the time spent on each hire (plus recruiting fees) a lot of precious start-up resources are wasted. Some of this waste is unavoidable. It's just the cost of doing business. However, we believe that most of the waste can be avoided if companies apply some realism.

For example, when it comes to making sales rep or any other types of hires, the sobering reality is that many mistakes will be made. In fact, it's a virtual coin flip according to Jack Welch (who recently discussed this issue with one of our CEOs).

What exactly did he mean by this?

Basically, Welch thought that he was no better than 50/50 early in his career. Half of the hires he made were good and half were mistakes (which he tried to correct as quickly as possible).

Think about it. If Jack Welch (one of the most respected and talented businessmen of his generation) thought that his hiring decisions were no better than a coin flip, what are your odds?

Over the course of his career, Jack, of course, did get better (he was a learning machine and tried to mold GE into a learning organization). How much better?  Well...after 40+ years of hiring and firing people, Jack thought that he got to 70/30 for really important hiring decisions - such as a CEO hire.

In other words, even at the end of his career, he was very aware of the fact that he can (and would) make hiring mistakes a large percentage (at least 30%) of the time - no matter how hard he tried to avoid them.

The bottom line is this - making good hiring decisions is extraordinarily difficult to do. It's a super high risk activity. The risk level is higher, of course, when you're looking to fill critical positions (like CEOs) but even for lower rank, more "cookie cutter" hires (like sales reps) the risk is high (at least much higher than most people perceive).

So, as a CEO or VP Sales of a start-up projecting that "shoot for the moon" sales ramp, you have to ask yourself this question....are you going to be much better than Jack Welch at sizing people up?

If not, you had better plan for at least one in three new hires NOT working out. If you want to be realistic, plan on every other sales rep not producing for you (and try to correct your mistakes ASAP). If you actually planned for this, how would you modify spending in the rest of the company? How would you change your plans on ramping marketing, customer support, R&D, etc?

If you are indeed a superstar (or just super lucky) and you end up making better hiring decisions than Jack Welch...good for you. Use the extra cash-flow generated by your sales-force to reinvest for even faster growth.

But for planning purposes...I would not count on being much better (or luckier) than Jack.

LEARNING TO GIVE A DAMN

Almost every venture capitalist I know lists passion as one of the most important traits they look for in entrepreneurs.  Most VCs, I am sure, also talk about their own commitment and passion when pitching themselves to limited partners.

My personal lessons in observing people with real passion came from my Army days as a 22 year-old lieutenant in charge of about 40 people.

On one Saturday night approaching midnight, my boss called me at home. He said, “LT (that is what we were called, especially when he was angry about something), come over to the motor-pool right now.” The motor-pool was where we kept all of our equipment such as trucks, tanks, dozers, etc. When I got there, I saw my boss standing nearby a truck with a flashlight. As he saw me approaching, he threw a maintenance book at me, and said, “We are going to go through the standard maintenance inspection of this truck…together.”

When we got done, we found the truck with only half-filled gas tank (it is supposed to be full at all times when inside the motor-pool), malfunctioning fire extinguisher, and without several items that belonged in the truck at all times. After the inspection, I was embarrassed. My boss then smiled, held up a cigarette butt, and said, “LT, I knew one of your trucks was due in around 11PM. So, I just came by and looked inside the truck. And I found several cigarette butts and empty coke cans. I knew then I had to teach you an important lesson on leadership. That is to give a damn.”

He then explained, “If a soldier does not care to clean up the truck when he reports back in, then he probably did not bother refueling. Furthermore, there is a high probability that he is not taking care of the truck every day.” At that moment, he grew very serious, and said, “You have to care. You have to make sure your soldiers care. Otherwise, you and I will be explaining to the soldier’s loved ones why his truck ran out of fuel, did not reach the destination, and got killed by enemy fire.

My second lesson came from a sergeant who was at least a decade older than me. On the first night of our field exercise, he got me up in the middle of the night. He said, “Sir, get up. You don’t have time to be sleeping. Come with me.” He then took me around every guard post, checked to see if anyone had wet boots (and when he/she did, immediately had them change socks and boots and personally applied foot powder), and talked with them about family, girlfriends/boyfriends, and football teams, etc.

After checking with every guard, he then said, “Sir, the guards change every two hours. You should get some shut-eye now. But in thirty minutes, I am going to wake you up. And you are going to do what I did with every set of guards.” My sergeant truly cared about his soldiers. He wanted to make sure I also learned to give a  damn.

My Army days feel distant as I go through my days as a venture capitalist. The risks VCs take on are far from matters of life and death, but the lessons I learned in giving a damn gives me proper conviction to stick to what we call a responsible way to build companies.

I wonder ...what would all VCs do if they gave a damn?

If VCs gave a damn, they would be more interested in building special companies than flipping them, just to make money. They would pay attention and not spray and pray their investments, hoping to get lucky.

Also, they would not over-commit by taking on too much money, too many companies and too many board seats. They would capitalize companies responsibly, not according to how much money they had to invest.

Finally, they would take the time to get to know the businesses and people involved. They would focus on developing talent and not rush out to hire mercenaries looking for quick fixes. There are no short cuts. It is critical to make the proper trade-offs between growth, profitability and sustainability.

Fear of The Living Dead in Venture Capital

It was not until I got into the VC business that I found out about the terrible, dreadful "living dead" - a term used to describe companies that merely survive, without future prospects. Normally fearless VCs fear the living dead. So do our LPs (the people who invest in VCs) who worry that we might waste our time (and their money) on a bunch of little companies that go nowhere.

Venture Capital is a "shoot for the moon" - go for the homeruns - business (for more on this topic see Swinging For the Fences). Most deals won't work out but great VCs bounce back quickly and easily. They focus on the winners and waste as little time as possible on the losers. When you think about it, the living dead might be far worse than the total losers because they continue to go on and on...potentially sucking up valuable time, energy and resources...indefinitely. Yikes! No wonder VCs fear the living dead!

The bigger you are (whether in size of wallet or ego) the more you will think that wasting time and money on little ideas and small deals is not worthwhile. For example, Larry Ellison believes that there will be only a handful of survivors in the software business - Oracle, Microsoft, SAP and IBM. To Larry, all others in the software business are as good as dead (or the living dead).

BUT, if you're really dead, then you have no chance.

In the VC business, all of our companies, even the very best, follow a rather bumpy and windy road. In the beginning, every company looks like a struggling little company with uncertain prospects.

The best approach to take in venture capital is to relish in uncertainty and to have a little humility.

There is no way to control outcomes in the start-up game. What you can control is whether or not you do your best and make sound decisions (like spending your time and money wisely) and just deal with problems (and take advantage of opportunities) as they come. If you stay hungry and learn along the way - and just manage to somehow survive - you give yourself a chance to make course corrections, take advantage of changes (often unexpected) in market conditions, or just get plain lucky once in a while.

So let's get back to basics...if you really want to have a chance at a homerun, you have to, first and foremost, make sure that your company survives.

Surprisingly, this is not obvious to some people.

One prominent LP once told me that he would rather have us return NOTHING than to play it safe. He was serious - dead serious. He wanted "volatility" because that's what is expected from the so called VC "asset class."

When I first heard this advice I was a bit shocked!

At Altos, rather than worrying about the dead, the living dead or the homeruns, we focus our early stage companies on getting to 1st base - typically around $10mm in revenues - without burning through a lot of capital.

If we can get to 1st base, then we might start to believe that there could be an interesting business forming. In our experience, most companies don't even make it that far, especially if people get obsessed with creating the next BIG whatever.

After reaching 1st base, some companies might go out of business (the equivalent of getting tagged out at 1st), or get bought out, or start slowing down. Only a minority of the companies that make it to $10mm, make it to 2nd base, or $40mm in revenues. At that level, we start to be fairly certain that we will have a winner...but we still don't know whether or not we have a homerun.

At this stage, some more companies might get acquired and others will start flattening out in growth (start-ups rarely go out of business at this stage but, as in baseball, you CAN get tagged out from 2nd base). Again, only a minority of companies break through to the next level...this time to 3rd base, or $100mm in revenues.

Once 3rd base is reached, VCs will typically get a 10x return on investment (sometimes 100x-1,000x, depending on market froth/timing). By that time, we also know that management is competent, scrappy and adaptable, through multiple iterations of products, strategies, business models.

By the time a company gets to 3rd base, at least 5 years (sometimes 10+ years) have passed. In the technology industry, that's an awfully long time! Whether or not a $100mm company can become a much larger company depends on countless factors that are largely unknowable at the time of investment.

We will submit that there is no way to know - a priori - which company will turn out to be a homerun at the time a company starts out (or when VCs invest).

Here is a thought experiment.

If you were really great at predicting the homeruns (and the losers), what would happen if you abandoned the VC business and started a hedge fund? If you can predict the winners and losers when companies have insignificant revenue streams, then you should be even better at predicting when companies reach $100mm (around the time of an IPO). Hedge fund managers can invest tens or even hundreds of millions of dollars at a time - buying or shorting public companies.

If you had invested in companies such as Oracle, Microsoft, SAP, Dell, Cisco and dozens of other companies shortly after their stocks were publicly available, you could have made 100x or more on each deal. So why waste time investing single digit millions in puny little companies?

As VCs, we love investing in tiny little companies started by passionate founders in interesting, dynamic markets. They always start as small, obscure, insignificant little companies that struggle along the way. The path is NEVER smooth!

It is a fact that most VC backed companies won't even make it to 1st base let alone home plate. But if we build solid businesses, based on sound fundamentals, we've seen that some do break through...to 1st, then 2nd, then 3rd, before reaching for home. We just don't know which ones will break through, often for many years after we invest.

We have ten year funds because it takes time as well as a great deal of hard work and suffering, enduring the ups and downs that come along for each and every company as they grow.

But hey, I'm not complaining about all that suffering (didn't Buddha say that "life is suffering"?). We actually love the bumps and bruises we get along the way. Some might say it builds character. But that's not the real truth. To actually LOVE IT, I'd say that great entrepreneurs, as well as VCs, are a bit quirky (some might even say that they are mentally imbalanced).

Rational or not, it has taken me a while to get over my fears...I fear not, the living dead.

The Peter Principle

The Peter Principle is often cited as a cynical view on management. Basically, it says that people are promoted until they reach a level of incompetence after which further advancement is not possible. Taken to the logical extreme, at some point everyone will be incompetent - it will only be a matter of time!

The funny thing is, I actually view the Peter Principle as an optimistic view on  management. Reality is worse (which is why Scott Adams came up with the Dilbert Principle, but I digress).

I would love to see the Peter Principle at work. In the old days, you had to work your way up from the bottom. For example, at UPS, you might start at the loading docks and if you were successful, you would become a truck driver. Eventually, you might get promoted to management - at first, managing a single warehouse, then a district, then a region, etc. The CEO and senior management have decades of experience from the bottom up.

Successful entrepreneurs (the ones who actually build their companies long after the start-up phase) are the ultimate bottom up guys. I've seen entrepreneurs goto Fry's Electronics to buy parts, crawl under desks to install wires, move furniture, clean up conference rooms,...heck, they might even scrub toilets. They do whatever it takes. 

A good friend of mine (and experienced serial entrepreneur) once remarked that "80% of the work at a startup is mundane & inglorious, and exactly the type of work that most people will put off for months in their daily lives (the equivalent of balancing the check book)."

Perhaps making progress one step at a time is not so glorious. These days, young people are in such a hurry to take short cuts that it's hard to find people who actually did demonstrate competence before they were given a chance to take the next step.

How many times have you met a manager who had no clue what their employees did? If companies followed the Peter Principle, at least a former programmer would manage programmers so that they would understand technology and be able to mentor young programmers. If companies followed the Peter Principle, at least a guy managing sales reps would have carried a bag before and would know what it felt like to handle rejection after rejection.

Unfortunately, as we enter yet another bubble (at least in certain sectors of the venture economy), we're seeing people with scopes of responsibilities far beyond even their Peter Principle level of incompetence.

But the problem isn't just caused by MBAs and young whipper snappers looking to skip a few rungs of the ladder as they climb to the top. It's also caused by investors, boards and corporations looking for quick fixes.

In corporate America high profile mercenaries are hired into businesses with obscene compensation (and severance) packages. It seems that even if they destroy value, they can walk away with millions of dollars (hundreds of millions in the case of Bob Nardelli and Home Depot).

The same goes for investors. How many VCs and other money managers are handling large sums of money far beyond what they are capable of managing? It seems that every Joe who has a decent track record with a small pile of money tries to raise much larger funds.

The world might be a better place if the Peter Principle were really true.

At our best companies, we avoid mercenaries who enter from the top. We try to hire smart, young people, challenge them, nurture them, and develop them over many years. It takes great patience, dedication, and commitment (on both sides) but it's well worth it. These people will become the future leaders of our companies.

Even if every hire doesn't work out or even if many of them eventually reach their levels of incompetence, to me, the Peter Principle doesn't seem all that bad. We're never at that theoretical "end point." We're always in transition, striving toward the next goal. If people are actually competent and have the patience to demonstrate competence at every step along the way, we might be much better off.

Cargo Cult Capital

During a Caltech commencement address one of my childhood heroes, Richard Feynman, introduced a tribe of people who practice a peculiar form of science. Here  is an excerpt:

"In the South Seas there is a cargo cult of people. During the war they saw airplanes with lots of good materials, and they want the same thing to happen now. So they've arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head to headphones and bars of bamboo sticking out like antennas -- he's the controller -- and they wait for the airplanes to land. They're doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn't work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they're missing something essential, because the planes don't land."

In past articles, we've described VC investments as "controlled experiments." We don't build new businesses through random trial and error; we develop them through a process of deductive tinkering. We try things out and perform tests against market realities, the way that scientists set up experiments to test hypotheses - and iterate and adapt along the way.

Unfortunately, almost three hundred years into the scientific revolution most people still don't get it. Perhaps this should not be a surprise. From a genetic perspective, humans beings are still pretty much identical to neanderthals who honed their instincts roaming the Earth for more than two million years.

Using Feynman's analogy, many people practice a form of business which I call "cargo cult capitalism." Delusions in the business world have been covered in books such as "Fooled by Randomness," "Hard Facts" and "The Halo Effect" so I'll focus on a special form of cargo cult capitalism practiced right here in Silicon Valley.

In our neck of the woods, the planes revolve around "top tier" venture capitalists who have become mini celebrities...sort of like in college sports, where coaches tend to be the stars (in the big leagues players are the stars). If entrepreneurs are fortunate enough to get funding from a Silicon Valley celebrity, their company might gain instant credibility and become branded as the next hot thing.

There are service providers who market the fact that they have "access" to the top VCs. There are later stage funds who raise money based on claims that they can access deals of the top firms. There are also angels and "feeder funds" who hope to co-invest with top VCs by courting them from the other side. They cultivate relationships with powerful deal makers and give them first looks at deals so that they might invest once key "milestones" are met.

The cargo cult capital wheel keeps spinning around and around...as the crowds scramble to "get in" to what is hot (or what they speculate might get hot). Once funded, some entrepreneurs might feel like they are playing with the big boys. They retain the top law firms, the best PR agencies, and the most exclusive recruiters.

Armed with prestigious backing and exclusive relationships of kingmakers, the hottest companies hire the best talent that money can buy. The hired guns then create more frenzy...attracting even more capital to support ballooning headcounts and lofty salaries.

There are definite patterns followed by the cargo cult crowd. The form is perfect - the top deal makers, "world class" talent, a hot sector and business model du jour. Yet, ironically, I'd bet the next Bill Gates, Michael Dell, Phil Knight, Chuck Schwab, and Sam Walton are quietly going about doing their own thing...building companies based on business fundamentals.

Real entrepreneurs cut through the hype - they know what is essential. Their sense of pride doesn't come from who they know or what others think - it comes from making a contribution and creating value. They will do it their own way - which won't include wads of cash from outsiders. They figure out how to do more with less by using their brains, guts, and sweat.

Disruptive new entrants that topple giants belong to determined, frugal and independent minded entrepreneurs - and in their minds, the true stars are the customers they serve and their tireless co-workers who help turn dreams into realities.

Focus on the controllables

I came across this great quote by a guy whose father ran a jewelery store during the Great Depression. He carried on to build Helzberg Diamonds into a big enough (and wonderful enough) business that Warren Buffet eventually wanted to buy it:

"When growing up, I was intrigued that my father only concerned himself with those business elements that were controllable. He refused to acknowledge the Depression and did quite well during that period. He was unwilling to talk about recessions or 20-inch snowfalls. He only thought about and talked about those conditions within his control. I saw this daily in Dad’s actions. I never knew when the country was in a recession because Dad wouldn’t talk about it. People would suggest we close the store on Labor Day because everyone would be out of town. He’d say, “How many will be gone?” Of course, we’d stay open and do just fine. He taught us to concern ourselves only with those things over which we have control. I thought he was unique in this until I realized this is one of the key common traits of highly successful people. Those folks are never victims; they take what comes and handle the situation. The rest is a waste of time."

        - Barnett C. Helzberg (from "What I learned Before I Sold to Warren Buffet")

This quote hit me like a ton of bricks. Barnett Helzberg, in describing about his father, simply and concretely described a prototypical "hedgehog entrepreneur" in a way that I could not. (See Foxes and Hedgehogs).

Hedgehogs don't concern themselves with a lot of nonsense. They know what matters. They ignore the rest.

There are some clever foxes who see themselves as intellects who have a mission in life to combat oversimplification. They like to say, "well, actually it's a bit more complicated than that." True. Unfortunately, in the process they may obfuscate the issues.

Albert Einstein once said, "any intelligent fool can make things bigger, more complex and more violent. It takes a touch of genius - and a lot of courage - to move in the opposite direction." Most people understand that it takes intelligence and deep knowledge to simplify (if you can't explain something simply, then you really don't understand it). But why does it take "a lot of courage"?

Reducing complexity involves making decisions. If you choose to march down a certain path, it means you are cutting off your other options. In business and life, we always have to make decisions in environments of uncertainty. The need to choose can create fear, anxiety and paralysis. The choices can be tough.

By choosing, you are rejecting other options. You live with the consequences. Sometimes, it can be a matter of choosing between the lesser of evils. It's never black or white. We live in a Machiavellian world - full of greys (whatever his faults may have been, Machiavelli was a realist. He tried to see the world for what it was, not what he wished it to be).

Some people will find Heltzberg's advice not useful at all. They will ask, well, just what is controllable? What is not? What is knowable? What is not? What is important? What is not? The answers depend on the situation. There are no easy answers, no one size fits all formulas.

To quote Einstein again, "make everything as simple as possible, but not simpler." There are no pat answers. Think for yourself. Each situation is different. The only universal truth is that there is never a clear roadmap, no pre-defined plan (experienced venture capitalists know that business plans always change). Just be mentally prepared to "take what comes and handle the situation."

Great entrepreneurs thrive in environments with high degrees of uncertainty (like the Depression). They tinker, experiment and figure things out along the way. They stay vigilant because they know that change is constant and the world is full of risks and uncertainties. Robert Ruben, the former co-head of Goldman Sachs and Secretary of the Treasury had this to say:

"some people I've encountered in life seem more certain about everything than I am about anything. That kind of certainty isn't just a personality trait that I lack. It's an attitude that seems to me to misunderstand the very nature of reality - its complexity and ambiguity - and thereby provide a rather poor basis for working through decisions in a way that is likely to lead to the best results."

The best entrepreneurs know how to simplify. It doesn't mean that things are so easy. It's never easy. There will always be randomness (if you don't understand what is going on things will appear random). Clever foxes sometimes try to anticipate those twists and turns in life. They seek certainty and control, put together fancy models and perform calculations to Nth degrees of precision. Those poor foxes often have a tougher time of it than hedgehogs who honestly don't think that they know as much (perhaps this makes them more immune to illusions of control).

Hedgehogs keep their noses to the ground. They stay in tune with reality because it's a matter of survival. They do learn along the way. They do adapt - but they don't dart around (like those quick and clever foxes). Hedgehogs know what they know (which is not a lot) and they know what they don't know. They know that there are always things are beyond their knowledge and control - like luck - yet they keep moving forward.

Everyone will have their share of luck - both good and bad. Some people will be prepared when opportunities pass by. Others will be asleep...or perhaps darting the other way (in the wrong place at the right time...or at the right place at the wrong time).

Hedgehogs are not simpletons who over-simplify. They get it. Which is why they are so effective. They don't waste time or effort. They make decisions and move forward. They get shit done.

Monkey See Monkey Do

A few weeks ago, a fascinating New York Times article described observations of morality in the behavior of apes. For example, Chimpanzees, who cannot swim, have drowned in zoo moats trying to save others. Given the chance to get food by pulling a chain that would deliver electric shocks to a companion, rhesus monkeys will starve themselves for days.

Apes are social creatures. So for the good of the species, evolution has wired them to act in unselfish ways which can be interpreted as moral or ethical. Since we are also social creatures, it might be nice to think that perhaps humans have also developed "good" DNA like those apes.

With the invention of language, logic and technologies (such as the printing press, invented almost six hundred years ago), human societies and cultures have been evolving at rates far faster than evolutionary pace. Even though culture is a human creation rather than a biological one, culture now has a powerful influence over us.

For example, economists demonstrated the influence of culture by studying data from New York City on parking tickets issued to U.N. diplomats. From an economic point of view, diplomats should not care how many tickets they get (due to diplomatic immunity). However, according to the data analyzed between 1997 to 2002, certain diplomats committed hundreds of violations while "not a single parking violation by a Swedish diplomat was recorded...Nor were there any by diplomats from Denmark, Japan, Israel, Norway or Canada."

The reason for such wide variations is that we are not merely products of DNA or economics. Human beings are shaped by cultural and moral norms. According to the article, "if you're Swedish and you have a chance to pull up in front of a fire hydrant, you still don't do it. You're Swedish."

I'm no expert on Swedish culture, but I'd guess that there is a sense of honor and values which influence behavior more so than rules and regulations. In fact, Sweden perennially ranks among the least corrupt in Transparency International's Corruption Perceptions Index.

In modern society, I believe there is a third powerful influence - it is the culture of our workplace. The corporate entity is a relatively new invention dating back to the mid 19th century. Before then, liability was not limited to a corporate entity so owners and managers often risked all of their personal reputation and assets. (What would happen to the venture capital industry if we had to risk far more than invested capital?).

An example of a company with a powerful culture is Toyota (now worth more than GM, Ford, and Chrysler combined). According to Michael Cusumano, a professor of management at MIT, “the founders and the managers created and refined Toyota company culture, which is far more powerful than Japanese culture. It does build on many things that are Japanese — precision, quality, loyalty. But the Toyota culture dominates.”

With corporate scandals over the past few years our confidence in corporations has been shaken. Isn't it ironic to think that apes may have a sense of right from wrong, but humans need more and more laws and regulations? It seems a whole new profession is thriving these days - that of corporate ethics and compliance officers.

Unfortunately, I think we are barking up the wrong tree. New ethics and compliance officers won't shape human behavior any more than new regulations, motivational posters or "core values" statements on plaques. Anyone who has worked for different companies knows that companies have very different and distinct cultures. Whether good or bad, corporate cultures influence behavior.

In the "HP Way", David Packard did not talk about ethics and morality (and certainly not about compliance). He did talk about values - integrity was presumed. Packard promoted mavericks - people willing to buck the system and go against the rules (in order to create a great product and rise above bureaucracy). But when it came to ethical issues, everyone knew Packard had a "zero tolerance policy."

Both Hewlett and Packard set the tone for decades. HP was a highly ethical company long before there was a "Chief Ethics and Compliance Officer" (a new position created by Mark Hurd, after the recent board scandal). So where did they go wrong? As a society, where did we all go wrong? Answering such questions probably requires a book rather than this short blog post.

As VCs, we work with entrepreneurs and managers who shape the culture of companies from day one (whether they intend to or not). For example, I recently noticed that one of our companies has a peculiar culture - most employees get to work by 7:30am. That's unheard of in Silicon Valley, especially for engineers. Well, it turns out that the founder is an early riser and often gets to work by 4am. That company had only one employee last year. Now that it has a few more people, we can start to see the culture forming. (It'll be interesting to see how it evolves).

Over the years, we've observed that the behavior of management has a huge influence on the values and cultures of companies (what they DO, not what they say). If we want more honorable behavior by corporations, we don't need more regulations (and we don't need more compliance officers). What we need is better leadership. Character, integrity and leadership should go hand in hand. Being ethical is also more profitable in the long run. (Even merchants and traders from centuries ago figured out that a great reputation was the only way to build a great business).

Entrepreneurs have always had huge influence over the rate of innovation and the growth of world economies. I believe they can have even a more profound impact. Just as DNA can impact entire species starting from a single cell, start-ups can be the beginning of new corporate entities which can change our lives. It is much easier to get it right from the beginning than it is to change a fully grown entity. Entrepreneurs are the future. They can set the tone with the example they set in the companies they build.

Raising Sheep

"We're raising sheep in our educational system, not independent thinkers and doers."
      - Paul Orfalea, Founder, Kinkos

Have you ever wondered why so many successful entrepreneurs didn't get the best grades in school?  Even in the technology industry, where education is paramount, many of the best known entrepreneurs were college drop-outs (i.e. Bill Gates, Steve Jobs, Larry Ellison and Michael Dell). Maybe there's some truth to the saying - the A students work for the B students, the C students run the companies, and the D students (or dropouts) dedicate the buildings.

I don't want to diss the best students because we need them. They become our engineers, doctors or lawyers (OK, maybe we don't need any more of that last category). Overall, the conventionally successful will do quite well. Last year, I heard Eric Schmidt talk about "the premium for competence" as he described how Google was able to access top talent they could not attract when they were small. He explained that some people are so competent that they don't have to settle. They can wait to see the data (look for the sure thing) rather join a risky start-up. Good for them.

On the business track, the most popular (and highest paying) jobs graduates of top MBA programs pursue are in management consulting (McKinsey, Bain, and BCG are the most prestigious), investment banking (Goldman Sachs and Morgan Stanley are tops), private equity (just about any firm), and, these days, the most coveted jobs are at giant hedge funds (how depressing).

In school, there are discrete tests with answers that determine the grades. The real world is more complicated. Fundamental tenants such as "be honest" or "work hard" are too simple (and overlooked) to be useful. Good advice can even sound contradictory like "get the facts, do the analysis" versus "trust your gut." The real world is full of apparent paradoxes. There are no black and white answers, just shades of grey, and even being right may not be good enough.

In the business world, the cold reality is that being good - or even great - may not be good enough. The key to winning is differentiation. Great entrepreneurs have an edge  - but it doesn't come from higher IQs or greater imagination. The best entrepreneurs might even be considered simple minded (see the post on Foxes and Hedgehogs.) However, they do possess special qualities. They think and act differently. They don't go along with the crowd. Peer pressure is not their thing. Not only are they willing to be different, they ARE different.

Nature versus nurture?

In some cases, there could be biological differences. For example, dyslexia, a neurological condition which causes difficulty reading and writing, is a learning disability which afflicted entrepreneurs such as Paul Orfalea (Kinkos), Richard Branson (Virgin), Ingvar Kamprad (IKEA), Craig McCaw (McCaw Cellular) and Charles Schwab. Perhaps, as a side-effect of their condition, they were forced to work harder, see things differently, and do things in unorthodox ways.

Whatever the cause, most of the time, there is no scientific proof of biological differences - but let me try to characterize these very special people who turn out to be extraordinary entrepreneurs.

This great country was founded by people who possess characteristics inherent in great entrepreneurs. Such people are rebels at heart. They are willing to fight for what they believe in.  They have the courage to stand up and say that the emperor has no clothes. They never use the excuse "everybody else is doing it." Throw out convention! They can be brash and stubborn. They don't pine to be popular. One might say that they just don't give a damn what others think.

They are skeptics at heart. They won't take your word for it - they always ask probing questions. They are incessantly curious. They look beyond the surface. They dig deeper. They don't fear the truth or the unknown. They don't fear change, they crave it. They strive forward, relentlessly, toward an expansive future, not with uncertainty and doubt but with faith and optimism. In fact, one of their most special qualities is that rare combination of forward looking idealism with a skeptic's realism.

However, contrary to what you might think, they are not driven by the desire to stand out or the courage to be different. They're driven by the courage to be true to themselves - it takes self-awareness and integrity. They are 100% genuine - the real thing - authentic, original, and refreshingly unique.

The willingness to go down an unconventional path requires CONVICTION. As investors, something we have in common with entrepreneurs is this - to win BIG you must have conviction (great fortunes are made through concentrated portfolios, while a diversified portfolio makes it easier to keep). Of course, in the investing world, it takes judgment to decide when a deal makes real sense. (Confused people tend to rely on stock charts or "comps" rather than fundamentals and valuations).

My wife likes to say that I have "an incredibly high tolerance for risk" (she prefers a much bigger safety net). But what I consider to be extremely conservative might appear risky to people who don't see what I see. That's exactly how entrepreneurs feel! They don't feel that they're taking incredible risk. When Bill Gates dropped out of college, he did not see himself as taking tremendous risk (although his "parents were very concerned"). If entrepreneurs don't believe in what they're doing, they shouldn't be doing it in the first place.

It's fascinating to observe people who possess that rare combination of conviction and open-mindedness. Conviction keeps them charging ahead while their questioning nature allows them to constantly learn and adapt. Balancing these paradoxical qualities is one of the keys to entrepreneurial success. 

Qualities such as intelligence or the ability to "think out of the box" are over-rated. You don't need to be smarter or more creative, but you must have your own point of view. This is NOT the same as being contrarian, which can be just as mindless as being conventional (just the mindless opposite).

The crowd is not always wrong. In fact, under the right circumstances, the crowd can be more wise than even the smartest individuals. According to "The Wisdom of Crowds," three conditions must be met for crowds to be smart - 1) diversity of opinions, 2) independent thinkers, and 3) decentralization. Ironically, Surowiecki's book contains many examples of the stupidity of crowds (when such conditions are not met). More examples can be found in "Extraordinary Popular Delusions and Madness of Crowds."

Herd mentality?

Sand Hill Road is full of people who got the best grades from the best schools (VC and private equity shops are full of Harvard and Stanford MBAs). It's a small, tight knit community (the "old boys club" as some might say). They graze the same grounds and talk about the same stuff - big markets, passionate entrepreneurs, connections, relationships, proprietary deal flow, experience, adding value, home-runs, and being part of the "top quartile" (the last point is important because average VC returns have been less than impressive).

The VC industry is full of rules of thumbs and conventional wisdom. The industry moves in herds. Variations of the theme epitomized by the classic (outdated) phrase "you don't get fired for buying IBM" seem to be the mottos most people live by. These days, the most popular deals involve social networking, user generated content, wireless, China and India. Look, I'd never short a tidal wave (like China or the Internet) but the herd mentality (and the lack of originality and depth) is real.

As Yogi Berra says, it feels like deja vu all over again. The conferences and cocktail parties are buzzing from Shanghai to Silicon Valley (see comments from last month's post). Just don't expect to meet the best entrepreneurs at such events. They are too busy to attend. The real entrepreneurs are out there doing their own thing.

At first, what great entrepreneurs do might appear uninteresting, mundane, strange, unimportant or too early (or too late). In the beginning, companies like Southwest Airlines, eBay and Craigslist seemed strange. HP, Wal-Mart and Intuit probably seemed unimportant. RIMM, Qualcomm, and Pixar looked too early. Cisco, Dell and Google were thought to be too late.

In Silicon Valley, the heroes are the technologists ("the suits" are thought of as necessary evils). Unfortunately, in the real world, entrepreneurs must have a nose for business. The great ones always figure out how to make money (even as teenagers, they often have track records - from running newspaper routes, writing code, buying stocks or selling stuff).

Entrepreneurs like Sam Walton, Bill Hewlett, David Packard, and Herb Kelleher didn't care about what investors wanted (or about changing the world or their industries). In the case of Kelleher, a middle-aged lawyer who sketched out his plan on a cocktail napkin, Southwest Airlines operated in the fringes, in small, under-served markets. No one took them seriously for years. They just kept plugging along, posting 34 consecutive years of profitability in a volatile, cyclical industry marred by enormous losses and bankruptcies. (Southwest also outperformed ALL public companies in stock market performance over the 30 year period starting in 1972).

One of the paradoxical qualities of great entrepreneurs is that they are actually conservative at heart. They say "show me the money" - in some ways, they might have more in common with those frugal, skeptical farmers from Missouri than most entrepreneurs and VCs running around Sand Hill Road. Our Venture Lotto article contained this characterization of entrepreneurs:

"The best ones we know are much more risk-averse than conventional wisdom might suggest. They don't take foolish chances. They spend money as if it were their own. They observe, listen and adapt; but fundamentally, they strive to control their own destinies, which is best done by generating profits. They do need a little capital, but they want help and advice even more. Being an entrepreneur is, at times, a very lonely endeavor."

However, this talk about profits should not take away from the most special quality of great entrepreneurs - they inspire others. Don't think of them as shrewd opportunists who read the fine print on every contract, looking to take advantage of every deal. Such people might do well (for themselves), but they won't build wonderful and enduring companies. Great entrepreneurs bring others along. They grow the pie, rather fight for a bigger piece (or the crumbs).

To go back to the example of the founding of this country, problems (like taxation without representation) may stir the pot (like inciting riots or unrest) but revolutions are ultimately inspired by values and ideals (like life, liberty and the pursuit of happiness). In the business world, a problem may lead to an invention or a new company...but exceptional companies are built on a foundation of core values and dreams of entrepreneurs.

If you want to be an entrepreneur, just remember this - follow a different path - your own path. The most successful entrepreneurs win with or without VC funding - they go out and just do it. Forget about the cocktail parties, the hot sectors, hot deals, or what's popular with investors or anyone else - think for yourself. If you do, you just might come up with something that you will pursue with all your heart and soul. Conviction, rather than convention, is the key.

Outsourcing and Offshoring

Last week, I was invited to speak on a panel at Stanford's Conference on Entrepreneurship to discuss "Leveraging Low Cost Locations."

This was not the most popular topic of the conference, but it seemed like a timely one. The day before the event, Cisco announced a big push into India, including relocating upto 20% of executives by 2010. (BTW, the HOT topic was Web 2.0 - of course! People like Mark Zuckerberg and Chad Hurley drew big crowds just as Larry Page did a few years ago).

Not long after the last bubble burst, VCs started pushing the idea of saving money by moving to offshore locations. One VC even claimed that "there isn't a board meeting that goes by that we don't ask, 'Why aren't you being more aggressive (with software development) in India and China?" 

The funny thing is, I don't remember such discussions. What we have observed is that China and India are hot and US-based VCs have been launching overseas funds at a fast and furious rate (I guess it makes for a nice fund-raising pitch).

I have a different point of view - forget about costs. It's not that frugality or having a cost advantage doesn't matter, because it's DOES, but start-ups do NOT gain cost advantage by outsourcing or offshoring!

Why?

Start-ups don't compete on cost savings from outsourcing or offshoring (big companies do it with much more experience and management infrastructure). We compete based on the ingenuity and creativity of our people. If we deliver so little value that we must arbitrage labor rates, we will never make it in the long run. Any start-up's biggest challenge is lack of sales, which you get by solving problems for customers. But even that's not enough to WIN. We beat established competitors (like Cisco) by delivering more value. We can't be 10-20% better, we strive to make at least an order of magnitude leap or do something really special or remarkable. Such breakthroughs hinge on talent, not cost. (The paradox is that great talent and low-cost are tightly linked. Great people HATE waste and inefficiency! The brute force method - spending lots of money - is not how special companies get built. Great companies are capital efficient and profitable).

Last year, when one of our companies looked to hire developers with Peoplesoft experience, we found a great team in Argentina (they worked with the founders of our company years ago, when they worked for Peoplesoft). It's one of many, many examples which have convinced us that it does not matter where people come from - and cost is NOT the critical factor. It's all about getting access to the best people and fitting them together into winning (global) teams.

Some people believe that offshoring is bad for America. Even as a very small VC firm, our companies have over a thousand employees (and/or contractors) overseas. (In fact, 2007 will be the first year that our companies employ more people overseas). Perhaps that's an alarming fact. However, if we do not leverage the best talent, no matter where they are in the world, our companies could not be competitive. Then, sooner or later, we may lose all of our good jobs.

Some people also believe (or wish) that Americans have a lock on ingenuity, creativity, and craftsmanship. Perhaps our companies would always win - IF it weren't for those pesky, copy cat, low-cost competitors overseas - who don't respect IP rights, don't have to deal with XYZ regulations, don't have high healthcare costs, - or some other excuse of the day.

I just don't buy it.

I have an example from the Stanford conference. One of my fellow panelists was the founder/CEO of a company which manufactures goods in the USA and China - identical products produced in two locations. The quality of the products made in China is significantly better at a fraction of the cost.

The fact is, the rate of improvement at the Chinese factory is higher - creating a gap that will WIDEN over time. Perhaps, the Chinese workers are happier to have jobs or maybe they are more hungry - more motivated - to learn and improve. Whatever the reason, the advantages of the Chinese factory over the American one have little to do with cost. The American factory is not competitive - regardless of cost. The advantages of one location over the other have more to do with the creativity, passion and commitment of people.

A counter example is Harman International, a company which has remained competitive even while manufacturing in "high-cost" locations. Harley Davidson is another example of the triumphs of design AND manufacturing in America. In the case of Harman, labor as a percentage of costs has decreased from 20% to 5%. They've accomplished this by leveraging the talents of an inspired workforce who possess a relentless drive to learn and improve (I'd recommend Sidney Harman's book). Eventually, when labor gets down to 1%, what would be the point of squeezing labor costs?

In our portfolio companies, we have not seen material differences in productivity or quality across different countries or cultures. Output is more closely tied to the quality of input - by which we mean good management and leadership. Our managers put together winning companies by finding, nurturing, and developing great people.

You can't treat offshore employees differently than onshore employees. By this, I don't mean being insensitive to different cultures or backgrounds. We have tremendous diversity right here in our own back yard. We've seen Israeli engineers working side by side with Palestinian engineers at start-ups - this kind of stuff only happens here in Silicon Valley. This is a HUGE competitive advantage.

It's unrealistic to think that we can just give the low-cost, non-mission critical work (i.e. the "shit work") to offshore or outsourced workers and expect to be able to attract and retain great talent. In unproven locations, we may start with more boring, less risky projects (for example, a software company might start with Q&A rather than core development). But over time, we MUST give them more interesting work. If great people do not feel like they are learning or tackling meaningful work (some call it the "fun stuff" which keeps them on the leading edge) they will lose interest and look elsewhere.

As managers, if we treat employees as faceless resources useful only because they are cheap, sooner or later, we will get what we deserve - low productivity, zero loyalty, and high turnover. Don't treat workers like mercenaries! The most common reason people quit is not because of compensation, it's because they don't like their supervisors. Ultimately, the outcome hinges on management.

Some of our companies have experienced incredibly low turnover rates even in places like India (which has a terrible reputation for turnover) while other companies seem to have revolving doors. Even when we work with non-employees (i.e. with an outsource vendor), we treat them the way WE would want to be treated. We listen, care, communicate honestly, include people in decisions, share in the upside, etc. In certain cases, we've even given stock options to contractors.

It's a level playing field.

As Americans, we can be very competitive. But to keep jobs here, we have to deserve it! We have to stay hungry and be willing to work just as hard (if not harder) than our competitors abroad. That may be a scary (or depressing) proposition for some people - but it should be seen as a wonderful challenge. Silicon Valley was built on this competitive spirit.

Whether on-shore or offshore, it's comes down to management basics: first and foremost, attract and hire great people wherever you can find them - and then STOP doing dumb things to de-motivate already self-motivated people. Provide opportunities for them to learn and grow. Help them find fulfillment in their jobs. If we want to remain competitive on a global scale, there are no tricks or secrets. It takes great people, hard work, sound judgment and good management.

Bad managers fail on-shore as well as offshore (we've experienced this pain first hand).

Good managers succeed on-shore AND offshore, (in-source AND outsource).

The good news is that America (and especially Silicon Valley) has a tremendous wealth of creativity, experience, and talent. I believe, we will continue to attract some of the best and brightest from around the world (I doubt Chinese or Indian immigration policies will lead to a huge influx of talent from other cultures).

To conclude, Tom Peters has been reciting the following quote for several years:

"A focus on cost-cutting and efficiency has helped many organizations weather the downturn, but the approach will ultimately render them obsolete. Only the constant pursuit of innovation can leverage long-term success."

    - Daniel Muzyka, Dean, Sauder School of Business, British Columbia

In our business - the start-up business - it's not about cost. The key to long term success is innovation, which comes from the hearts and minds of great people - bonded together - to form winning teams.

Leggo my ego

"If I were only a little more humble I'd be perfect."
     - Ted Turner

One of my pet peeves is false modesty. So when I saw the Ted Turner quote in Business Week, I had to tip my cap to him. You certainly can't accuse that guy of false modesty!

Ego is a wonderful thing. I was blessed with a relatively healthy one (although some might say too healthy). For entrepreneurs, a healthy ego is essential. If you get discouraged easily or start listening to the naysayers, you'll never make it. It takes a thick skin and genuine belief in yourself to take the risk to start something new - and stick with it.

Yet, even the Ted Turners of the world realize that ego - at least too much of it - is not a good thing. I've known people who offer great advice to other people. But for some reason, they don't seem to be able to give that kind of advice to themselves. I attribute their failings to ego, rather than lack of judgment. When egos are not involved, it's easier to be objective and realistic. However, when egos get in the way, judgment gets cloudy.

The ego's influence is insidious. Even the most well adjusted people I know - people of good character and judgment - can get tricked and manipulated by their egos. A healthy ego can be a great asset but it can also be a huge liability. Egos can be so fragile and debilitating at times.

Recently, someone referred me to a book called Egonomics. The book is not finished but their website offers a preview. Some early warning signs of ego getting in the way are - being comparative/competitive, being defensive, showcasing brilliance, and seeking acceptance. The book's outline also provides some hints of ways to combat ego - curiosity, humility, and veracity.

For me, I try to keep it simple. I will always remember the advice I got from John Gardner from my days as a student. He said, "be interested." He observed that, at settings like cocktail parties, everyone wants to be interesting. But it's more important to be interested.

In the technology industry, we often come across people who are not so interested. Perhaps, that's why the term NIH (Not Invented Here) is used. Some entrepreneurs who start believing their own press clippings may also suffer from this syndrome. But it's not just about curiosity - being interested also helps with humility and veracity.

For instance, if you think that you know it all, you won't listen. I've observed certain  people in conversations and wondered if they were really listening or just trying to figure out when to jump in, thinking about how they will respond in brilliant fashion. It's easy to be interested if you're more humble - if you genuinely believe that you have something to learn.

There is a funny story that Jim Collins likes to tell about Sam Walton. Years ago, Sam Walton was sitting at a diner in Bentonville when a guy walks in. He points over and says (and I paraphrase) "That's Joe. I really admire Joe. Joe used to be a truck driver. And then, Joe went into business for himself and now raises chickens. Joe is really successful. I'd like to learn from Joe." At the time, Sam Walton was worth eight billion dollars (on his way to creating the largest fortune in the world). To listen to this story (Jim tells it much better), click on this audio file.

Sam Walton certainly had a healthy ego. People underestimated him for years - but he believed in himself and persevered for decades. He didn't open the first Walmart until he was in his forties and the company didn't go public (at a very modest valuation) until he was in his fifties. Yet, even as he became successful beyond anyone's wildest dreams, he always looked for ways to learn from others.

Being interested also helps with veracity. If you don't want to hear the truth, you won't be interested in finding out what is really going on. The truth can hurt. It can be ugly and unpleasant at times. Unfortunately, ego can get in the way of facing brutal realities - which is suicidal for entrepreneurs (as well as venture capitalists). Being genuinely interested in facing the truth will help combat ego from getting in the way. If you have the stomach for it, it simplifies life as well as business.

As is often the case, our greatest strength can also be our greatest weakness. In the case of ego, I'm all for turning it into a strength. But it's important to work hard to make sure that it doesn't also become a weakness. I've learned to leggo my ego - but I also know that it will keep coming back, rearing its ugly head at unexpected moments. So I have to keep letting it go...until it becomes habit.

Sports, character, and business.

"Sports don't build character. They reveal it." - Heywood Hale Broun 

I heard that quote the other day driving in my car. It grabbed me for some reason. I had always thought that sports helped build character. It made me think.

To my wife's dismay, I'm a total sports nut. I tell her that I hate watching it on TV - except during the Olympics, the World Cup, March Madness, the Majors, the playoffs, the World Series, and the Superbowl. Certain moments should not be missed. Of course, she points out that there is one of those every weekend. Thank goodness for Tivo.

I will always remember ABC's Wide World of Sports and its stirring beginning - "the thrill of victory, and the agony of defeat." I loved it. However, I love watching sports because it's not just about the final score.

Michael Jordan once said "I missed more than 9,000 shots in my career. I've lost almost 300 games. Twenty-six times I've been trusted to take the game-winning shot and missed. I've failed over and over and over again in my life and that is why I succeed." Not everyone can be like Mike, but character is revealed at every level. I vividly remember a friend recounting how his daughter finished her long-distance races in last place, long after the other kids had finished. She never quit. She finished every race, sometimes in near-darkness. (She also stopped coming in last).

Talent flows naturally for some but character is a matter of choice, not chance. Choosing the right path is not easy. It takes discipline and hard work - self-sacrifice - and a willingness to test yourself. If you've ever been on a team, ask yourself whether personal gain was more important than the team's gain. Everyone deserves recognition and a pat on the back, but character is revealed, not built, at certain moments. As you observe, it's important to be honest with yourself. As you make decisions, character is initially revealed to no-one else but yourself.

Abraham Lincoln once said that character is like a tree - the real thing - while reputation is merely its shadow. John Wooden advised his players to "be more concerned with your character than your reputation, because your character is what you really are, while your reputation is merely what others think you are.” Vince Lombardi echoed a similar theme when he said that one cannot simply copy someone else's character. "Character must fit our own personality and characteristics if it is to withstand trial by fire."

There are almost endless analogies between sports and business - competition, teamwork, leadership, strategy, talent, preparation, execution, determination, blocking and tackling, etc. Business is a team sport. People in business inevitably face conflicts of interests and decisions about how to compete. In the heat of battle, decisions are made and character is revealed. Actions speak louder than words.

In business, statistics are tracked and recorded almost every moment of every day. Ultimately, keeping score is simple - it's all about money. Without profits, companies die. Money losing companies create desperation and despair; money making ones create options. With profits, companies can use it to do many things - create jobs, serve customers, pay taxes, and give back to their communities. Venture capital helps build companies; and if we do our jobs, those companies create value. They give back more than they take.

Paradoxically, even though business is “all about money,” the playing field embraces those who are not driven by it. If people are only driven by money, they eventually sell out, cash out, or peter out; they go away. To quote Jack Welch: "You know the type. They bank vacation days. They hand in slips of paper noting how many half-days or holidays they’ve worked. They remind bosses and colleagues of company policies regarding overtime....they are not working for fun or the passion to win. They’re just logging hours."

As business reveals character, we find that people not driven by money keep going and going. Sometimes they have to quit certain pursuits to find something more meaningful - more aligned with who they are - but they eventually get there. It's not just a trite lesson on perseverance and determination, there is something much more. A few years ago, I heard an entrepreneur make a comment which stuck with me: "I started my company 28 years ago, and I haven't worked a day since." (He was a Hedgehog entrepreneur).

People of great character love what they do and seem to have a passion for life. We've also observed that they develop into great leaders (and great entrepreneurs). They inspire others. They push hard yet bring out the best in people. They care. In the end, we believe that they will come out ahead, and certainly enjoy the journey more. Our favorites don't always win, but they persevere because they love the game. We're big fans and we cheer them on - because in our business, there is nothing more important than people.

As a final note, my wife always reminds me that not all people are competitive (yes, I can get way too competitive). She has a good point. As in sports, it's not just about winning or losing. As Warren Buffet once said, "your inner scorecard is more important than your outer scorecard... The people who ascribe too much to the outer scorecard sometimes find that it's a little hollow when they get all through."

However, even if you don't like the idea of keeping score, businesses need to get things done, and interestingly, great character helps drive results. If you know what's important to you, it's easier to focus and be more effective. If you're trustworthy, it's easier to develop great relationships. If you seek the truth, it's easier to get your ego out of the way and cut through the clutter. If you believe in what you're doing, it's easier to drum up moral courage and the kind of strength that money can't buy. Ben Franklin got it right when he said honesty is the best policy - it's just good business.

Entrepreneurial Brilliance

"With few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact." - Warren Buffet

In the VC community, there is an age-old debate - are people or markets more important in determining success? Our firm is a big believer in people. But even great people will struggle in a bad industry. Don Valentine once observed,

“I've always been mystified by the critically important disc drive industry, without which the PC is a useless device. You have to be brilliant in electronics, you have to be brilliant in magnetics and you have to be brilliant in mechanics to get all that memory capacity in a very little place and do it for next to nothing. That market has never been rewarded financially for its brilliance."

Warren Buffet learned a similar lesson in textiles. He wrote to his shareholders, “a textile company that allocates capital brilliantly within its industry is a remarkable textile company - but not a remarkable business.” After concluding that financial results will be more of a function of "what business boat you get into than it is of how effectively you row," he exited the business as Berkshire Hathaway diversified.

There is no doubt that Warren Buffet is an amazingly disciplined, patient, and brilliant deal picker. The investing world is full of deal pickers. However, there are not enough company builders and this is where venture capitalists are supposed to step in. The VC's job is to help entrepreneurs build companies, and those companies create products, create jobs, create wealth, and even create new industries.

To build great companies, there is nothing more important than people. It is by far the most important factor when we consider new opportunities. The founders and early employees set the values and culture of companies, whether they intend to or not. We've learned that if we partner with great people - those who think big, but act small, keep the burn-rate low, and keep trying - we can figure out the business. (Even textiles couldn't keep Buffet from inevitable success). Working with great entrepreneurs is also what makes our jobs so interesting and fun.

However, even great people are likely to fail if they find themselves in bad situations. VCs often invest in entrepreneurs without much business experience. Entrepreneurs come to VCs for advice as well as capital. That's part of our job spec. For this reason, we should feel a tremendous sense of responsibility. The DNA of great, enduring companies are formed in the earliest years and our actions and influence can have huge multiplier effects.

Unfortunately, even brilliant entrepreneurs are likely to fail in a bad system. We believe that the venture capital industry is setting up far too many people to fail. Even when companies don't fail, the blueprint for success seems more focused on great deals rather than great companies. Our next post will discuss the game of venture lotto.