Altos Ventures Musings

Replacing CEOs

I regret to say that I've personally served on a dozen boards of venture backed companies that have replaced CEOs. It's usually not a good sign. It doesn't mean those start-ups were doomed; but it does mean drastic change was needed.

The decision to replace a CEO is never taken lightly. Replacing any CEO is difficult enough. Replacing a founder/CEO is even more traumatic and fraught with risk.

Although I have never seen a case in which a CEO, even a founder, is indispensable, over the years, my partners and I have formed a strong preference for founders.

Most founders have never been a CEO. Some may have never even had a corporate job (Mark Zuckerberg, for example). Yet we prefer to work with them as they learn on the job. 

I won't get into why we prefer founders (not the main topic of this post) but I'd recommend checking out these articles discussing the merits of founder CEOs: 

• I first wrote about our preference for founders three years ago: Ousting the Founder 
• Ben Horowitz wrote this more recently: Why we prefer founding CEOs 
• Steve Jobs' Law: Why Founders Make the Best Leaders

When my partners and I first got started more than 15 years ago, we replaced CEOs quite often (though I'd esimate it was about average for the VC industry as a whole. I'll share actual data later in this post). In contrast, my eight most recent boards have yet to replace a CEO.

One data point which reflects the presence of founder CEOs in venture portfolios is CEO ownership. When we tell people that the typical CEO in an Altos backed company owns more than twice the equity of a typical venture backed CEO, they assume it's because we invest less money (resulting in less dilution). While this is true, the bigger factor is that most of our CEOs are founders.

On average, the minute a board replaces a founder/CEO, that company's CEO ownership percentage drops. For example, when Eric Schmidt was hired at Google, the CEO ownership stake dropped to 4%, far lower than Larry Page's stake. 

Another reason we replace CEOs less often is selection bias. We are less likely to invest in the first place if we believe a new CEO will be needed. I'm always surprised when a VC submits a term sheet that calls for the retained search for a new CEO from day one.

We'd rather not make an investment, if we don't know who the CEO will be. As the saying goes, "go with the devil you know versus the devil you don't." We must believe, at least in the beginning, that the person we're backing can develop into a great CEO.

In the case of backing a "professional CEO" we must believe that the person has what Warren Buffett calls "owner mentality" (it might not be as good as founder mentality, but it's better than most). 

Of course, this does not mean that we will never fire a founder or replace a CEO. We make plenty of mistakes. To see if we might learn from them, I decided to look at some data from our current and past funds.

After studying a data set of more than 60 companies, I found that the probability of a CEO change increases dramatically with each new round of financing, unless a company is already profitable. A CEO who can control her own destiny is much less likely to get replaced. 

Given that the companies in this data set have raised more than a billion dollars from over a hundred different venture firms, I suspect that there is a similar pattern for the entire VC industry, even if specifics vary from fund to fund. 

In the chart below, each bar represents a group of companies based on how many rounds of funding were required to get to profitability or exit. The height of each bar represents the percentage of companies that replaced CEOs. 

  In companies needing only one or two rounds to get to profitability or exit, CEOs were replaced less than 14% of the time. At the other extreme, if a company needed four rounds or more, the replacement rate sky-rocketed to 85%. For companies that required three rounds, the rate was 53%, which is about average for the industry (see article below). 

Given this data, I'd advise start-up CEOs to get their companies to profitability sooner. Control your own destiny. Otherwise, deliver an exit before you run out of money and have to raise another round. 

Other Factors:

When a CEO is replaced, the rationale is usually quite subjective. "The team has lost confidence" or "lack of leadership" are typical quotes from board members considering a change. 

For me personally, I've learned that my stress level about any particular company goes up and down with confidence in the CEO, regardless of how the company is doing. Let me try to explain. 

Even if a company is doing really well, if I do not have confidence in the CEO, I tend to worry a lot because things might fall apart; and sooner or later, the shit usually does hit the fan.

In contrast, even if a company is struggling, if my confidence in the CEO is high, I stress less because I know there is a smarter and more capable person staying up at night not only worrying about things but doing something about it. 

That said, other than obvious reasons such as lying, cheating or stealing, I believe the following are other, more objective, factors correlated with change in CEOs:

1. Time - eventually, all CEOs retire, die or get fired.
2. Lack of growth - a flat profitable business might be OK for some but not for VC backed companies that promised high growth to investors.
3. Employee turnover - higher than normal turnover happens for two reasons: great people are hired but are repelled or mediocre people are hired and must be replaced. Successful companies typically have turnover rates that are significantly lower than industry averages. 
4. Burn rate relative to cash balance (key metric we track is months of cash remaining)

More Data:

The following article has some interesting statistics. Out of 50 high-profile VC-backed companies in 2010, 54% had replaced founder CEOs: "Do VCs usually fire founder CEOs?" 

I'd also recommend checking out these questions on Quora for more info and discussion:

1. On average how often do founding CEOs get replaced by a VC controlled BoD?
2. How do VCs eventually come to the conclusion that they need to replace the CEO?
3. What skills does a CEO of a growing company need that a founder CEO might not have?

Final Note

I'd like to emphasize that the data points out a strong correlation, not causation. For example, it's possible that VCs are more likely to replace CEOs in companies that run out of money and have to raise more rounds. It's also possible (and very likely) that start-ups that hire professional CEOs tend to raise more money and go through more rounds of funding.

Founders are much more sensitive to dilution compared to professional management that are granted more options if a company goes through a massively dilutive round. Founders also want to maximize control. The biggest fortunes have been amassed by founders who have been able to retain quite a bit of control over their companies, sometimes decades after the IPO.

The punchline of the article should be "get profitable" rather than "avoid the 4th round."

They Can't Tell You How To Soar

Customers will always tell you they want better products and lower prices. They might even be able to articulate how much better certain products should be. But don’t expect them to be able to tell you how different those products could be. More importantly, don’t expect them to tell you how you should surprise and delight them.

This was an insight from a book called Different, Escaping the Competitive Herd written by Youngme Moon (I won't review the book but I'd recommend it for entrepreneurs and marketers fascinated by inconic brands such as Apple, Harley Davidson, IKEA and InNOut Burger). 

As Clayton Christensen explained in the Innovator's Dilemma, there is a predictable pattern in just about every product category. Innovation leads to products that improve to a point where customers are over-served (the web browser might be the latest category to reach this level).

From a vendor's perspective, the problem is that over-served customers become so skeptical about the differences between products and brands that differentiation is rendered meaningless. Most customers become not only bored but unhappy.

In category after category, over-served, bored and unhappy customers would love to discover something delightful, remarkable and refreshing. And marketers spend billions of dollars trying to rise above the competitive noise.

Ironically, intense competition only quickens the pace toward blandness and a herd mentality in markets. This trap is hard to escape. The herd phenomena is seen in self-organizing systems as disparate as ant colonies, bird flocks and stock markets. 

Paradoxically, the best way to stand out, might be to NOT focus on beating the competition. At the 1997 WWDC, before he rejoined Apple as CEO, Steve Jobs stated the following (32:43 of video):

"...the other thing I feel very, very, very strongly about is, it's incredibly stupid for Apple to get in a position where for Apple to win Microsoft has to lose. That's really dumb... Apple can win without having to have Microsoft lose."

Don't focus on being better. Don't fret over differentiation. Think Different. Be different. Transcend boundaries. Stand alone. Walk down a very lonely path. 

Something that every entrepreneur should keep in mind is what Jerry Garcia once said: 

"You do not merely want to be considered just the best of the best. You want to be considered the only ones who do what you do." 

What will you do? How will you be different? One place to start, is to be yourself. Be genuine.

To really, really soar, don't just be better, faster, cheaper. You can do better than that. And please, please, please, don't aspire to be "the Mint of XXX category" or "the AirBnB or YYY category" or the "Groupon of XYZ category."

Passion

Fred Wilson wrote a post yesterday talking about Mission Based Businesses and how critical passion is to building a successful business.

Which comes first? Passion for a great mission or a successful business?

Conventional wisdom is that passion comes first (or is more important). I have a different point of view.

For every great business, there are countless well meaning, passionate entrepreneurs who don't make it.

Even great entrepreneurs can lose their passion. Tony Hseih, CEO of Zappos, is a great entrepreneur. In his book, Delivering Happiness, he shares how he lost passion for LinkExchange, his first startup, before selling to Microsoft.

There are good businesses and bad ones. One saying we have at Altos is "it's hard to fall in love with a crappy business."

To remain passionate, it's critical that you build a successful business. You will find that it is easier to fall in love with the business and love what you do.

I've observed many companies start with great missions that go nowhere. I've also seen companies grow their aspirations and missions to something far bigger than they had imagined in the beginning.

Rather than spending much time thinking about a mission to inspire employees and customers you don't yet have, focus on delivering a great product or service. Build a successful business. It all starts there.

Entrepreneurs like Bill Hewlett and David Packard did not set out to change the world. They just wanted  to work together. They built a product and started selling. They had no business plan. No grand mission. They took it one step at a time.

One final word about passion and love. The love you feel for a startup is like the passion in a new relationship. Such passion is intense but it can fade away.

What you want is the type of passion that grows in a great marriage. Marriage is tough. You have to work hard at it and you will go through many ups and downs. But in the end, you just might find true love.

Another Bubble

There is lots of talk about a new bubble forming...countless blog posts and discussions over the past year which I won't revisit. 

The latest theory is that the DST investment in Facebook in 2009 was the Netscape moment of the Web 2.0 era, which means this year might be like 1997 (two years after the Netscape IPO and another 3 years before a crash).

The thing about bubbles is that no one knows for sure. That's why we have bubbles...and pops.

Assuming we are headed into another bubble, some people are giving advice. They say that you should act differently during this bubble.

They will say "it's different this time" - an addressable Internet market of a BILLION people, cloud computing, mobile computing, titanic shifts in ad dollars, unprecedented growth in real revenues and profits, etc. 

To be or not to be lean?

The lean start-up movement has been terrific. Following the crash of the Internet bubble, a new generation of lean entrepreneurs, building capital efficient companies, was born.

But now people are confused. They are again debating the benefits of going fat vs. staying lean. Even some leading proponents of lean are advising entrepreneurs to behave differently (see Steve Blank's post on "new rules for the new bubble").

The problem is that changing your behavior with the times could a recipe for disaster. It is not honest either - certainly, not genuine or authentic.

Strive to do something which might stand the test of time. Do something which will last beyond the next bubble (and the inevitable crash).

Don't worry so much about what others are doing. Let them raise lots of money and spend it on PR or advertising. Why worry about things you can't control? Focus on what YOU need to do.

This will be hard to do. The behavior of everyone around you will change. You will feel new pressures from all around, even from very smart people and trusted advisors.

Here is an example - pressure to raise more money than you need. One of our portfolio companies was approached by prominent investors who wanted to "get in." They tried flattery (a very high valuation). Then they tried a threat (they may invest in a direct competitor rumored to be raising more than $100 million).

Try to resist such pressures. Resist temptation; and above all, resist envy. It is the most insidious of sins. Envy feasts on bubbles even more than greed or fear (of missing out). 

Don't fret about timing. People who try to time it get it wrong. They invest when things get hot. They pull back when things look bleak (i.e. buy high and sell low, even though they were trying to do the exact opposite thing).

Trying to take advantage of the greater fool, means, by definition, that you are a fool. That said, I do have some advice.

If you are going to sell your company, this is a pretty good time to do it. Valuations are high, buyers have cash, they are hungry and they are moving quickly.

If you need to raise money, now is a good time to raise it - equity or debt - the terms are favorable. But remember to be careful when taking advantage of this environment. The time to be cautious is when everyone else is bullish. 

The next few years will be very interesting...

Overused and Misunderstood - Capital Efficiency

"Capital efficiency" is such an over used term these days I don't even know what it means anymore.

Some startups think that burning $100k per month is too high while others think $100k/mo is close enough to zero that it's "near break-even."

Vinod Khosla has proclaimed that a company which burns less than $100 million is "capital light" (he was referring to clean tech). At $100k/mo, it would take almost 3 generations to burn that much money (each generation is about 30 years).

The problem is that the monthly burn rate or total funding doesn't say much about efficiency. The return on capital is the key metric needed to determine capital efficiency and most startups have no clue because they don't even know if they have a business (yet). 

Another problem is that startups are not efficient. In fact, they are so inefficient that their trajectories are often referred to as "drunken walks." 

Big companies are built for executional efficiency. Startups are built for innovation. It requires a certain mindset. A willingness to experiment, endure mistakes, allow for some slop and forgo efficiency. 

Steve Blank likes to describe startups as organizations formed "to search for a repeatable and scalable business model" (others might add a step - find product/market fit, then look for a business model).

While I like Steve's definition, it's important to emphasize that the goal of a startup is NOT to stay in a limbo state of experimenting, learning, pivoting, and searching for product market fit or business model.

The goal is to find something that works and scale it.

For some entrepreneurs, this is when the fun ends. For others, this is when the fun begins. It's funny how some entrepreneurs feel like they are just getting going long after they've built billion dollar companies (examples include the founders of companies such as HP, Intel, Microsoft, Apple, Oracle, Amazon, Google, Facebook).

As a startup grows, more and more parts of the company will make the shift from exploration/learning to execution mode. At first, it might be just the founders and engineers, then the sales team, then the marketing team and eventually the entire company. 

So, rather than capital efficiency, perhaps we should think about constraining the capital in startups...until they are ready to scale? For example, at Y-Combinator, founders are initially paid roughly the equivalent of a grad student stipend - barely enough to pay for meals and a shared apartment.

At the right right time, there is no question that a startup should raise the capital needed to take advantage of the opportunity at hand. In fact, I'd recommend raising a bit extra, to allow for ample cushion and a margin for error.

But until then, "capital constraint" or "capital restraint" might be better terms to think about than capital efficiency. 

 

Fat Startup Watch

I'd like to start tracking the best fat startups to see how they do over time. Please email me suggestions of the latest and greatest fat startups. You can also submit suggestions as a comment to this post (which is how I plan to update this list over time). 

To qualify, the company must raise at least $10mm before they achieve product-market fit. For example, companies such as Facebook, Twitter and Zynga would not qualify as fat startups since they raised the vast majority of their funding after they had significant traction. 

In contrast, a good fat startup example is Tom Siebel's latest company, C3, which is still in stealth mode. I believe they raised $10mm in an initial seed round from individual investors. Since then, they've raised a lot more funding from some great institutional investors at much higher valuations which I cannot disclose. 

Here is an article from the Washington Post talking about C3 closing another $26 million in funding and landing Condoleeza Rice on its Board. Such a high profile person joining a tiny company is not a surprise since one of the defining characteristics of fat startups is an impressive roster of "proven" and/or famous people on the management team and board. 

The second fat startup I'd add to the list is Workday, which is founded by Dave Duffield, former founder/CEO of Peoplesoft. To date, they have raised more than $150 million. I believe the last round was at around $400 million dollar valuation. Good for them.

Let's see what happens...

What Did Bill Gates Worry About? Lean or Fat?

I found this from the transcript of a Charlie Rose interview with Ken Auletta, right after "Googled" was published. It is interesting to hear about what Bill Gates worried about back in 1998, near the all time peak of his power (and the peak of the fat startup era). 

CHARLIE ROSE: And are they on the cutting edge of exciting stuff or are there two more kids in a dormitory room at Stanford that are about ready to come up with something that’s going to blaze new trails? 

KEN AULETTA: Well, we don’t know that. That’s the great thing. I mean, I think I may have told the story when I was on your show, I tell in my book that Bill Gates in ‘98, when I asked him what he worried about, he didn’t say the obvious, which is "My competitors, Netscape, or Oracle or Apple." He said "I worry about someone in a garage inventing something that I haven’t thought of." 

(LAUGHTER)

That year there were two guys in a garage. 

CHARLIE ROSE: Sergey and Larry in a dorm, yes.

KEN AULETTA: Google has the same reason to worry. What is that new technology? One thing they are conscious of is social networking and that could pose a problem for search. 

 

Now, I should also point out that Mark Zuckerberg started Facebook in a dorm room while Kleiner Perkins and Benchmark funded Friendster and Sequoia funded Plaxo during the very early days of social networking.

I feel like a broken record but this is something I wrote in 2006 in Venture Lotto:

The most sought after deals are led by proven managers. Especially popular are entrepreneurs who have made money before - they get investors lining up like sheep.

Ironically, the people who end up creating the blockbusters are usually unproven managers. They emerge from the fringes, and start small, in niche or overlooked markets. They take time to learn and iterate and burn very little capital before turning profitable. They follow a slower, but lower-risk path. In our own portfolio, the companies which raised less funding not only performed far, far better but had much lower failure rates.

Entrepreneurs can't count on a portfolio. 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. 

Ben Horowitz Makes Compelling Case for Lean

Like many of you, I've been following a fascinating and important debate between Ben Horowitz and Fred Wilson over the past couple of days. To recap, it all started with this post: The Case for the Fat Startup.

Fred then responded with Being Fat is Not Healthy which has received a lot of comments worth reading, including some comments from Ben. 

Then earlier today, Ben responded with the best post of all The Revenge of the Fat Guy.

After reading through the posts, I've come to the conclusion that Ben and Fred actually agree on the fundamental points. In fact, the most important point was already made by Steve Blank last year in Lean Startups Aren't Cheap Startups.

Steve, a key figure in the lean startup movement, felt the need make the case that you cannot confuse lean with cheap. He concludes with the point that if you confuse the concepts "when you do find a repeatable and scalable sales model, you will starve your company for resources needed to scale."

The reason I love Ben's latest post is that he helps debunk some myths about Product-Market Fit, which, according Marc Andreessen, is "the only thing that matters" Along the way, he also makes a compelling case (though perhaps unintentionally) for staying lean. 

Ben's post should be a warning for entrepreneurs and VCs who put too much faith behind the magical product market fit concept. Here are some things to watch out for:

1. Product market fit is NOT a discrete, big bang event. If you are fortunate to find product market fit, you will most likely get there through lots of hard work "through partial fits, a few false alarms, and a big dollop of perseverance...there’s no formulaic answer."
2. It's NOT obvious when you have product-market fit. "It’s usually not black and white."
3. Once you achieve product-market fit, you can lose it.
4. Once you have product-market fit, you still have to "sweat the competition."

All of these points should serve as a warning for people with too much money to spend (or invest) and eager to step on the gas once product market fit is found. Given all of the uncertainties, it would be prudent to maintain some humility even if you believe that you've found product-market fit (you can also reach the opposite conclusion - even when in doubt, step on the gas - it's just not the path I'd recommend). 

Ben's last point is important to consider because, on the surface, it makes a case for the fat startup. Since "the best markets are usually the ones in which competition is fierce" you should invest aggressively to make sure you win the market."

I would ask, how much should you raise/invest? How about a billion dollars as Webvan did?

In any huge new market, there is no question competition will heat up. But even a billion dollars is nothing when you are talking about competing against the big guys. 

Rather than focusing on how much money to raise, how about focusing on producing profits and creating a sustainable business model?

When I look at competitors, the ones that scare me are the ones that have found ways to make money and scale at the same time. The "fat startups" that are burning through millions or tens of millions of dollars a month don't scare me.

Ben says that you can't win the market by saving your way there. I totally agree. But conversely, you can't win by spending your way there either. Even if you raise hundreds of millions. For every Loudcloud/Opsware, there are dozens of craters. As David Packard liked to say, "more companies die from indigestion than starvation."

There is no question that Ben is a great entrepreneur who knows first hand how difficult it is to build companies. He knows that it often takes more money and longer than you'd like. So it would make sense to raise more money than you think you need. If someone offers to invest boatloads of money in your company at a great price, you should consider taking it. I agree. But even Ben has said that it should not be your plan A.

If you are one of the very fortunate entrepreneurs who is able to get boatloads of funding at a great price, you should be careful to resist pressures to spend that capital from excited investors. You need to also do your best to resist your own temptations to pursue every great idea that you and your great team comes up with to win the market. A company growing on profits just tends to be much more disciplined than one growing based on boatloads funding.

Just as Ben agues that Twitter is the exception, not the rule, I'd say that Loudcloud/Opsware is the exception, not the rule.

Even Loudcloud/Opsware is not a very compelling case for the fat startup. They raised $346mm in 15 months and went public in March 2001. By September 2002, market cap had fallen to $28mm, which was less than cash on hand and about 8% of capital raised to date. That sounds like value destruction to me. If you were an investor or employee, you'd be pretty bummed right about then.

Then an amazing thing happened. From 2002 to 2007, the company raised no more capital and created tremendous value - great job Ben! They exit for $1.6B in September 2007! I would guess that there was a lot of great technology created in the prior 2 years that helped. But I would also guess that the thought of running out of cash was pretty scary when you are at a $28mm million market cap. If I were in their shoes, I would have been more determined than ever to get to profitability so that I would never have to raise more funding. 

To recap, during the first era (Loudcloud), hundreds of millions are raised and return almost nothing. During the second era (Opsware), if you bought stock, which was publicly available, so any of you could have participated - you did NOT have to be a famous entrepreneur or a hotshot VC to get a chance to invest - you would have made a spectacular return.

Ben Horowitz just reinforced my belief that "fat startup" is not only a bad idea but a dangerous one. Just as the lean startup concept can be harmful if people misunderstand the key points, the fat startup concept can also be harmful. In fact, it can be a LOT more harmful to the VC industry. Entrepreneurs will also suffer from excessive dilution, recaps and wasted lives pursuing bubbles and false dreams.

I'll end with a concept Warren Buffet has repeated over and over again - don't count on the kindness of strangers to save you. Make sure you have enough cash on hand. To me, that is not an argument for the fat startup, it's an argument for the lean startup.

So What's With All This Talk of Failure?

Have you noticed all the talk and blog posts about failing? Here are some examples: 

• Peter Rip: Fail Fast, Fail Often
• Josh Kopelman: Failing Cheaper
• Brad Feld: The Best Entrepreneurs Know How to Fail Fast 
• Scott Wolfgang: Even VCs Should Learn to Fail Fast 
• Auren Hoffman: To Grow a Company You Need to be Good At Killing Things 
• Anthony Lee: Failing Fast 

The main message is this: it's not only OK to fail, but it might be the smart thing to do if you do it quickly and cheaply and learn from the experience. 

In a book called The Dip Seth Godin takes it a step further and advocates the idea of quitting or killing off something early before you even have a chance to fail. To be fair, he also says that - many times - the right thing to do is to keep pushing ahead (because you are just hitting "the dip" before you reach eventual success). But that's just conventional wisdom right? It would not sell many books or drive page-views.  

Mark Suster in his recent post called Why the 'Fail Fast' Mantra Needs to Fail calls bullshit on all this talk of failure. So does Jason Fried who wrote the following in Rework: 

“In the business world, failure has become an expected rite of passage. You hear all the time how nine out of ten new businesses fail. You hear that your business’s chances are slim to none. You hear that failure builds character. People advise, ‘Fail early and fail often.’

“With so much failure in the air, you can’t help but breathe it in. Don’t inhale. Don’t get fooled by the stats. Other people’s failures are just that: other people’s failures."

What people are talking about when they espouse "failing fast" is fairly basic. Before you become great at something you might stumble along for a while. If something's not working, try something new or different. As Einstein said, the definition of insanity is doing the same thing over and over again expecting different results. 

My 3 year old son seems to have no problem grasping this concept. He doesn't have fancy terms like experimentation, iteration or pivoting to describe what he's doing; and he certainly doesn't think he's failing. He's absorbing, learning, trying new things and having fun.  

To become good at anything, you need to give it a shot, experiment, practice, learn, iterate. No big deal. Let's NOT call it failure. Let's call it what it is. Mark's suggestion was "launch and learn" or something else. I hope people take his advice.

Having said all that, I'd like to provide an example of the best fail fast (or quit early) story I've heard in a while and explain why it does make sense to cut your losses sometimes. I also want to explain why I believe the "fail fast" meme took off in the venture community. 

The story was told to me over lunch last week by Glenn McGonnigle who recently started TechOperators, with other proven entrepreneurs and executives in Atlanta. I think they are one of the best VCs in the world in the security market (they are co-investors in a recent deal). 

In the mid 1990s, Glenn started an online backup company. I think you'd all agree that he was a bit early! After some struggles, one of his angel investors Kevin O'Connor approached him to have a little talk. Kevin hinted that the market might not be ready for what he's doing so perhaps he should consider joining a couple of other companies that he was working on. It was totally up to him to decide what to do (but read between the leaves, there will be no more funding).

After thinking it over, Glenn came to the conclusion that he was too early and decided to shut down his company and take up Kevin's offer to check out his other ventures. The first company was targeting the Internet advertising market, which was still in its infancy in 1995. The other company was also in a nascent market for network security and penetration testing software. Glenn decided that he didn't know anything about the ad business and joined the latter as VP Sales. The company had just $50k in angel funding from Kevin and had hired Tom Noonen as CEO (Tom is a co-founder of TechOperators with Glenn). 

In their first year of operations the company did $300k in revenues. The next year they sought their first round of funding. Glenn didn't know any VCs except for one guy he used to work for - Bob Davoli - who had recently joined Sigma partners. The other VC was Dave Strohm of Greylock, who happened to be the only VC that Tom knew. So, in 1996, a little company named Internet Security Systems (ISS) based in Atlanta raised $3.5M from Boston and Bay Area VCs. 

The following year they raised Series B from Kleiner Perkins Caufield and Byers (Ted Schlein, who was formerly with Symantec and knowledgeable about the security space, led the round). The year after that (1998) they completed an IPO and the stock shot up 70% the first day. The year after that ISS completed a BILLION dollar secondary offering. At its peak, ISS reached a market cap of $4B. Even after the Dotcom crash they continued to grow to $400mm in revenues and were eventually acquired by IBM for $1.4B in 2006.

It was an amazing return for everyone especially Kevin O'Connor who bought an initial 30% stake in the company for $50k. Given that Kevin recruited both the CEO and VP Sales that took the company public, I'd say that he deserved it (the technical founder, Chris Klaus, was a student out of Georgia Tech). 

BTW, the company that Glenn passed on is the company that Kevin O'Connor is better known for - DoubleClick, which also completed its IPO in 1998. They initially had a different name and were based in Atlanta before moving to NY where most of their customers were based. 

So, as it turned out, Glenn could have chosen either company and would have done great. The only wrong choice would have been to stick with his original company! 

The lesson in all this? Sometimes it is better to move on. However, as Mark Suster points out, when you take money from investors you have a moral responsibility. To just walk away and abandon customers, investors and other stakeholders would be "irresponsible, unethical and heartless" using Mark's eloquent words.  

Although I agree with Mark, I would like to point out something which helps explain why the fail fast meme took off in the VC world. In my experience, entrepreneurs are usually the last people to quit. VCs typically give up on companies long before entrepreneurs do! 

One example from my personal experience is the founder of Enwisen, one of our portfolio companies from 1996. Everyone gave up on the company except for the founder and his wife who were both in their 60s. They just refused to give up even with no more funding and no employees left in the building. 

The founder has since retired but the company lives on. All debts have been paid off and all VC and angel investors have a chance to not only get their money back but make a profit. The company has been profitable for years and grew 60% last year, even during one of the worst recessions in decades. The CEO gets calls all the time about potential M&A or growth equity rounds. Maybe one day they could even go public, like Financial Engines did today in the hottest IPO of 2010 (they were also founded in 1996). 

When you are working with true entrepreneurs, you don't have to encourage them to keep going. More often than not, you have to provide a different perspective, point out the realities and, as Kevin O'Connor did, provide some alternatives that might mean moving on.

It really should be up to entrepreneurs to decide whether to quit or to keep going. As a VC, if I picked the right person to back, I don't have to worry about him/her quitting on me. But, sometimes, I do have to have a little talk to point out realities that the ever optimistic and passionate entrepreneur might not see.  

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.

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.

Top 10 VCs on Facebook

We recently set up a "Page" on Facebook (we had to get 100+ fans before we could lock in the official URL www.facebook.com/altosventures).

Given that Facebook Pages is becoming a web within the web, I wondered how many other VCs had set up official Pages. As it turns not, not many. From browsing around, I came up with a list of the top 10 VC Facebook Pages. If I missed a VC firm that has a significant presence on Facebook Pages, please let me know. I'm curious to learn about how they are using Facebook to connect with entrepreneurs, LPs and others people in their networks.

Top 10 VCs on Facebook Pages (as of 8/28/09)

1. Accel Partners (1,407 fans)
2. Sequoia Capital (1,001 fans)
3. Union Square Ventures (947 fans)
4. Kleiner Perkins Caufield & Byers (383 fans)
5. First Round Capital (314 fans)
6. Altos Ventures (264 fans)
7. Greylock Partners (261 fans)
8. Draper Fisher Jurvetson (253 fans)
   
9. Benchmark Capital (153 fans)
10. Hummer Winblad (59 fans)

Then I decided to take a look at some random tech companies and brands to see how many fans they had. The results were surprising. Some very large companies/brands had no official presence at all (i.e. Apple). Some were definitely using Facebook in better ways than others (Stanford vs. Harvard is an interesting contrast). 

Notable brands and their Facebook Pages:

• Google (305K fans)
• Youtube (3.5M fans)
• Yahoo (84K fans)
• Microsoft (72K fans)
• Oracle (11K fans)
• Stanford (41K fans)
• Harvard (0K fans)
• Barack Obama (6.6M fans)

For comments on this or other blog posts going forward, please do so on the AltosVentures Facebook Page.

Fat and Happy

One of the biggest challenges that start-ups face is inertia. When you hear comments like “things are fine the way they are” or “there is no interest in making a change right now,” entrepreneurs, or any pioneer, will have a very difficult time making headway.

If you're an entrepreneur, I have good news for you. Fat and happy people are in short supply these days.

The world is ready for change. This means that you will be able to accomplish things that were simply not possible before. Isn’t this is one of the reasons that someone like Barack Obama got elected President of the United States?

Entrepreneurs are not only the agents of change, they are the beneficiaries (see creative destruction).

This is not a time to panic. This is the time to act and to take advantage of the great challenges and opportunities that lie ahead.

Over the past few months, I’ve sensed a subtle but real change in attitude. The ones who are not paralyzed seem more determined than ever. People seem more hungry, more creative, more open minded. They are also more realistic. They face problems with new resolve.

Of course, not all start-ups will do well during tumultuous economic times. But I also believe that it is during times like these, when everyone is NOT fat and happy, that the conditions are most ripe for great new companies – and perhaps great new industries - to come out of nowhere and help change the world.

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!

Financial Weapons of Mass Destruction

The events of this past week made me scrap the article I was working on to write about the crisis in financial markets.

Warren Buffet first wrote about "Financial Weapons of Mass Destruction" in Berkshire Hathaway's 2002 annual report. When it was published in March of 2003, there was quite a bit of press coverage, as there is every year after he publishes his annual letter to shareholders.

In an article written by the BBC, Buffet warned of "time bombs." It seems like the first of many bombs went off a couple of years ago, with the decline of the housing market (and housing stocks), leading up to many more bombs in the past few weeks.

If you read his words, Buffet is quite vivid. His warning was not about the housing bubble or sub-prime loans or even the trillion dollars in CMOs (Collateralized Mortgage Obligations), the pass-thru assets which helped create the mess in the banking industry. Buffet was criticizing ALL derivatives.

Warren Buffet thought some derivatives contracts must have been devised by "madmen." Charlie Munger would say it was sheer lunacy. Buffet talked about "mass destruction" and "spirals that can lead to corporate meltdowns" such as the one which took down LTCM in 1998. Buffet warned of "huge scale fraud" and compared the ENTIRE derivatives business to "hell...easy to enter but almost impossible to exit."

Despite the simplicity and clarity of Buffet's words, few people listened. Even now, people don't seem to understand the magnitude of the potential problems that lay ahead in the global financial system. The derivatives market has grown exponentially since 1998, the year LTCM blew up. The global derivatives market is now more than $500 TRILLION, up more than 10x since Buffet's initial warnings.

So my question is this: how is a $700B or even a $1 Trillion bailout by the US Government in the mortgage market going to make a dent in the overall $500 TRILLION dollar market of even more complex, esoteric derivatives contracts???

How depressing. This is why, as a VC, I don't usually think about or comment on macroeconomic issues. Entrepreneurs and VCs build one tiny little business at a time...and once in a while some of those turn out to be winners that impact the lives of millions of people.

Believe it or not, I'm still quite optimistic about our future. We will get through this. This is nothing like disease, famine or war (at least, there is no war on our soil). There are many companies that are still growing and generating profits and cashflow here in Silicon Valley and around the world.

Most start-ups have no exposure to derivativew contracts and little exposure to the overall financial markets. Yes, the IPO market is closed (for now) but if you have a company which generates cash, you will be fine.

For example, one of our companies - one which has been private for more than 10 years - recently issued a cash dividend which paid out more than our entire investment, just as they did last year. They generate multiples of that dividend in free cashflow every year. Every acquisition they've ever made was paid in cash so I'd suspect that they can continue to fuel organic growth as well as future acquisitions. If they continue to generate cash and pay out more than invested capital every year, it would not be so bad, would it?

If you are counting on bubbles or "madmen" to pay crazy prices for your company when you raise capital or when you try to "exit" you will be sorely disappointed in the coming years. You might even wind up in unemployed lines along with those well educated investment bankers. But if you have a real business, one which delivers value to customers who will keep coming back over and over again, I suspect that you will do just fine. Just keep focused on what you are doing and don't get distracted by the macro issues that seem to swing paper valuations wildly day to day.

The macroeconomic problems we face today are issues that even Warren Buffet can't figure out. That hasn't stopped him from going about his business every day. Those hedgehogs just keep moving forward one step at a time. Since that BBC article in 2003, Buffet has increased his net worth by more than 50% to overtake Bill Gates as the wealthiest person in the world.

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.

Do No Harm

In the medical profession, there is a code of ethics which says that the goal of a physician should be to help patients and, above all, DO NO HARM.

In the venture capital business, there is no established code, like the Hippocratic Oath, but VCs do follow an informal code of ethics and take great efforts to establish and protect their reputations.

If you browse the websites of VC firms, there are hundreds of VCs that talk about how they help entrepreneurs and their companies. Venture capitalists are supposed to be like no other investors. They "add-value" as they try to generate superior investment returns.

Value-Add?  How about Do No Harm?

Perhaps, a little humility is too much to ask from some VCs, but I find it surprising that most VCs don't consider the possibility that they could cause harm or destroy value in the companies they are supposed to help (to find examples, Google "VCs suck" - more than 100,000 hits will come up - or browse through TheFunded.com).

The Law of Unintended Consequences states that any action can produce unintended consequences. For example, in the medical profession, physicians are very much aware of the harm they cause, despite the best of intentions.

In fact, iatrogenic illnesses have become the third leading killer of Americans behind heart disease and cancer (the term iatrogenesis literally means "brought forth by a healer"). Every year, more than 250,000 Americans die from medical errors. Medical doctors are thousands of times more likely to kill someone than gun owners. No wonder that death rates actually go down during doctors' strikes!

I wonder what would happen to the death rates of start-ups if VCs went on strike?

Fortunately, the most savvy entrepreneurs are somewhat immune to the potentially harmful effects of VCs.  In the first place, they expect the least - even from the best VCs. According to Marc Andreesen (taken from his blog):

"It's important to really internalize that the founders of a startup are the ones who have to make a startup succeed.

The best assumption to make is that your VC's primary value add is the cash they are investing.

Then you'll always be surprised on the upside."

Another reason that a great entrepreneur is less likely to be harmed by VCs is that if a VC makes a bad recommendation - one which might steer the business in the wrong direction - the entrepreneur is able to diffuse the harmful idea and minimize distractions. No harm no foul.

Ironically, it is entrepreneurs who need the most help that are likely to be harmed by VCs. Entrepreneurs who hope for too much from VCs are more likely to waste time and energy following up on dumb ideas or stupid suggestions made by VCs who might stop by once a month in between dozens of other meetings.

My advice to entrepreneurs is that you should think for yourself, even as you seek help and advice from VCs and other "helpers." I certainly would not take any pill from my doctor just because he said I should. I always ask questions and take responsibility for my own health. 

Great entrepreneurs build thriving (growing) and healthy (profitable) companies - and they do it with or without the VCs.

My advice to VCs is that you should be much more aware of the harmful effects that can be caused by your comments and actions. VCs are often looked upon as "experts" when it comes to starting and building companies and take positions of great responsibility and fiduciary duty. Such responsibility should be taken on with great care.

Let's all keep in mind that even smart, well trained and certified medical professionals - who take an oath - have been known to cause great harm, despite the best of intentions.
 

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.