Altos Ventures Musings

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.

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.

Cashing Out

At a board meeting after a recent financing, one of the VCs picked up a stock certificate (delivered to investors during that meeting) and said that he hoped that this piece of paper will be worth something someday.

I responded by saying that the stock is worth something now. Our firm would be happy to buy all of the shares represented by that piece of paper. In fact, we had already bought some shares from existing investors.

When we made our decision to invest, we believed in the management and the direction of the company. Our desire was to take a significant ownership in the company. We got to our minimum % ownership...but we would have wanted to buy more if people were willing to sell.

The UPS Story

One of the stories I like to tell is that of UPS, which is celebrating its 100th anniversary this year. Founded in 1907, they did not go public until 1999 (it was the biggest U.S. IPO ever - $5.47 Billion worth at $50/share). For 92 years, as a private company, there was always plenty of liquidity for shareholders because the company was growing and profitable.

UPS is a remarkable company. Even while helping to spread Unions, providing healthcare benefits for part-time workers, paying for lifelong continuing education programs, and promoting employee stock ownership and sharing the wealth, they grew revenues and profits almost every year and never had layoffs - even during the Great Depression. With millions...and eventually billions in revenues and profits, they had no trouble finding buyers and sellers of their stock, even as a private company.

Over the decades, UPS has probably created more millionaires than Microsoft and Google combined (many UPS truck drivers became your typical "millionaire next door"). Unlike private companies such as Cargill or Bechtel, UPS ownership did not remain in the hands of a very small number of family shareholders. The shares belonged to tens of thousands of employees (now hundreds of thousands, as the third largest employer in the U.S.).

In the case of UPS, the founder, Jim Casey's various foundations are now worth billions of dollars supporting causes such as underprivileged children's education (Jim Casey had to work to support his family rather than attend high school).

What we like to tell entrepreneurs is this - if you build a company that generates cash, your stock certificates will be worth something. If the company is growing, then it will most likely be worth more the next year, and the year after that...

There are always buyers of stock in companies that are growing and making money. The higher the growth, profits, and competitive advantages, the greater the intrinsic value. It's as simple as that. It doesn't matter if the company is public or private.

When UPS was still private, the board determined the price of stock every quarter. They followed a rational process and valued their stock according to the same principles that we follow. These days, due to 409a regulations, we even bring in third parties to validate our logic in setting a fair stock price.

Rather than obsessing over cashing out and the "liquidity event" entrepreneurs would be better off if they focused on building value. The liquidity is secondary. There will always be buyers of stock in companies that are doing well. Sophisticated investors don't care if your company is public or private.

For example, Warren Buffet doesn't care if an investment is in a public company like Coca Cola or a private company such as See's Candies. He'll buy if he believes that 1) the business is great, 2) the price is fair, and 3) management is trustworthy, competent and passionate. He's not necessarily looking for bargain basement prices. (Buffet likes to say that it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price).

As VCs, we look to be co-owners of wonderful businesses with tremendous long term growth potential. Such businesses are rare - really rare. An opportunity to buy a significant stake in such a business is rare enough that there will always be plenty of buyers if some (or all) shareholders desire to cash out along the way.

Another example I like to tell people about is Vesta, one of our private companies that has grown to over a thousand employees in a decade (much of it during the post bubble crash). We've had more than 24 consecutive quarters of earnings growth and paid out tens of millions of dollars in dividends with excess cash, even after making significant investments to fuel continued growth (including several acquisitions - all for cash). The company has also bought back stock - just as public companies initiate stock buy back programs to reduce share count and increase per share earnings.

At another private portfolio company, one of our executives recently sold shares to buy a bigger house (his growing family needed it). The company is doing well (the common stock price has tripled in the past year) and there were plenty of buyers. In fact, some potential investors were almost begging to get in (at the price those shares traded, none of the other executives wanted to sell).

I can recite many more examples. We've bought and sold plenty of private as well as public company shares (common as well as preferred shares). Such transactions happen all the time.

The bottom line is this - build a great company and your shares will be worth something - a lot more than it is today. Don't worry about liquidity. The key is building sustainable, long term value.

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.

Swinging for the Fences

I recently sat on a panel with Howard Hartenbaum, the founding investor of Skype, which yielded a 1,400x return in 36 months. Howard humbly noted that he was fortunate to have had such a deal so early in his VC career. In his words, "Skype was not the deal of a lifetime, it was the deal of three lifetimes!"

Venture capital is a hits driven business. Over time, it's likely that only 20% of the deals will generate 80% of the profits. (The 80/20 rule originated from Vilfredo Pareto's observation that 80% of his peas were produced by 20% of the pods. He also noted that 20% of the people owned 80% of the land in Italy).

Apply the 80/20 rule to the top 20% and the Pareto principle says that 4% of the deals will produce 64% of the returns. Apply it again and less than 1% of the deals will produce more than half the returns. You get the picture? It’s all about the homeruns.

Given the concentration of returns, LPs are lining up to invest in the "top funds" who have hit the biggest homeruns. Top venture funds are over-subscribed because it is believed that those who produced great returns in the past will continue to do so in the future.

As time passes, the gap between the winners and losers often gets wider. For example, about half of all returns in the VC industry have been generated in public markets due to post IPO (or acquisition) run-ups prior to distributions. If lock-ups and holding periods were longer, the gap would get even wider.

However, in the frenzy to "get in" to top funds, people seem to have doffed their thinking caps at the door. Even as the most sophisticated LPs are cutting back from many so called "top firms," new LPs to the asset class are not only taking their place but piling on.

Impact of consolidation

Over time, consolidation happens in just about every industry and venture capital has been no exception. A small number of firms have been growing to control a large percentage of the capital. Even firms with mediocre track records have been expanding in both scope and scale (because they are still considered to be "brand name" firms).

It's hard to turn down all that money flowing in, especially once people get used to a fancy lifestyle, nice offices, support staffs, and lofty salaries. Assets under management has become the proxy for success and VCs are becoming accustomed to making more money from management fees than carried interest.

With growth, the mentality of VC investment professionals has changed. When people get paid for activity (putting money to work) rather than results (which may take years to sort out) you will get more activity. Compounding the problem, there are pressures mounting to hit even bigger homeruns.

VCs are making bigger bets than ever (which are needed to move the needle on larger funds). Unfortunately, this is leading to value destruction of unprecedented proportions. Between 1990-2001, 63% of invested capital resulted in almost total loss (the median deal lost money). In contrast, between 1969-1985, partial or total losses occurred in only a third of the deals.

Predicting the future

A VC's job is to pick winners that emerge out of a confluence of technologies and markets. Some people seem to think that they can keep doing it even with bigger piles of money. Let's get real.

Obsessed with the future, all types of investors attempt to predict the future (usually by looking in the rear view mirror rather than out the window) - like the direction of interest rates, inflation, deficits, markets, etc. Unfortunately, predicting the future is hard to do.

Alan Greenspan once said "It's very rare that you can be as unqualifiedly bullish as you can now." That statement was published in the New York Times on January 7, 1973, right before the two worst years for economic growth and the stock markets since the Great Depression (yes, even back then he was considered to be one of the nation's top economic forecasters).

Ever the contrarian, as Fed Chairman, Alan Greenspan warned us about "irrational exuberance" before the last bubble crashed. Unfortunately, he said it in 1996. If you had listened to him, you would have missed out on the greatest bull market in history (when most of the venture returns were made).

Creating homeruns?

Alan Kay once said that "the best way to predict the future is to invent it" so perhaps the VC's job is not to pick the winners but to create them. Go visit any VC website and you will see a lot of chest thumping about how great they are at doing this.

Perhaps past successes have gotten into people's heads (see Leggo My Ego). VCs have started to think that they can not only see the next homerun coming, but actually create it (I'd bet that more than 75% of VCs think that they belong in the top quartile).

As a fan of baseball, I've observed that good coaches can help manufacture runs, but they can't do much to create the homeruns. If homeruns in baseball are the outcomes of duels between batters and pitchers, homeruns in the VC industry are the outcomes of battles between entrepreneurs and markets.

In the quest for homeruns, VCs invest tens of millions of dollars, "add value," and put together "world class" management teams to build companies. The funny thing is that it takes less capital to start companies these days. You don't need to pour money behind the homeruns because they don't need it. The best companies generate cash, even as they fuel growth.

Some of the biggest homeruns were not even venture backed - they didn't need the money. Even for those which were venture backed, many were already profitable at the time of funding and, with few exceptions, ALL of them required very little capital to become huge.

Let's get real. VCs don't create the homeruns. The great VCs do help their companies...but there is a fundamental difference in mindset. It's all about the entrepreneurs. The big VC firms may try to inspire confidence (or strike fear), but the best entrepreneurs do their own thing with or without the VCs.

Deductive tinkering

The hands-on, "get big fast" approach is the most common practice among VCs. The opposite approach is a hands-off approach where lots of bets are placed across companies. There's a method to the madness and some unconventional investors have done quite well letting natural selection take its course. People have called this "spray and pray" or the portfolio of options approach.   

Unfortunately, a blind, random process (like evolution) can take a long time to play out. It is also risky particularly as bet sizes get bigger. To our knowledge, not a single significant company has ever been attributed to a spray and pray VC.

There are huge multiplier effects that stem from early decisions and we believe that it is critical to be hands-on. We believe there is a third approach. Venture capital should really be a process of deductive tinkering.

The best entrepreneurs are all classic tinkerers. They experience failures along the way (if you are not failing, you are not really experimenting), but they don't make foolish bets. They give themselves a chance to succeed (or get lucky) by making sure that they survive and stay in the game.

Thomas Edison failed in his first 100 attempts at making the light bulb...but he learned every time about what didn't work. We don't mind the failures. The key is to make the cost of experiments as low as possible. It's like flipping a coin where heads you win and tails you don't lose much. Flip enough times and the odds are that you'll come out ahead.

Some might argue that VCs invest big dollars AFTER the tinkering (to scale or "get big fast"). However, in our experience, the tinkering never stops. While we try to take out the greatest amount of risk with the least amount of dollars, companies take on new experiments at every level.

The idea that there is less risk at later stages is a fallacy. Competition to get into good later stage deals is far more intense (at later stages money is more of a commodity). Not only are valuations higher but a lot more capital is put at risk.

As our companies grow, we create new experiments within companies (it's like creating portfolios within portfolios). For example, several of our companies completed acquisitions or started new divisions over the past year. Our portfolio of experiments would grow even if we did no new deals as long as our companies grow in a capital efficient manner (where we reinvest retained earnings rather than other people's money).

Risk and uncertainty

Conventional wisdom says that in order to shoot for higher returns you have to take on greater levels of risk. We choose to follow a different path.

We look to invest in highly uncertain situations. We call such deals "experiments with unknown upside potential," where the range of possible outcomes is very large (on the upside) but require little capital. This is better than gambling or lotto which have defined, bounded upside. We'd rather take unknown/unbounded upside and known/limited downside.

One of the ways we like to limit downside risk is to invest in bootstrapped companies. In our most recent fund, more than half of our Series A investments have been made in companies that have been in business for several years. Such companies seem to learn more than companies that burn through millions of dollars. People with less money learn to use their brains more.

In other cases, we might even invest in companies that are already profitable but might need a little extra capital (and some assistance) to accelerate growth. Many VCs as well as "growth equity funds" who target bootstrapped, profitable companies have minimum investment sizes of $20 million or more. We look to invest less than a quarter of that.

A third type of investment is starting companies from scratch...but following a deductive tinkering process, rather than a conventional one (see Venture Lotto). The beautiful thing about our business is that we don't need to predict the future. We just keep our eyes open and learn along the way.

Learning requires an active, hands-on approach (so there is a cost) but it leads to value, often realized in totally unexpected ways. Some of our most successful investments are directly linked to a past a disappointment or failure.

We don't feel the need to take on big risks. One of the great advantages of venture capital  is that even multiple failures can't "blow-up" a fund (see articles on LTCM for how billions of dollars can be lost in a matter of days. Hedge fund and other types of blow-ups are discussed at length by Nassim Taleb in "Fooled by Randomness" and the "Black Swan"). There is a huge difference between high risk and high uncertainty. We prefer the latter.

The conventional VC strategy of investing tens of millions of dollars is a risky proposition. There are thousands of venture backed companies that burn through millions of dollars only to get to a point where they seek even more funding to grow. We have some (rather painful) personal experience with this. Some of our companies have gone through Series A, B, C, D...and then after running through most of the alphabet started over with Series 1 or A1.

After making more than our fair share of mistakes, we've realized that such impatient consumption of capital creates fundamentally weak companies. Compared to our bootstrapped companies, they seem to have a much lower chance of becoming a homerun, unless another bubble bails them out (depending on the greater fool is an awfully risky way to try to make money).

VCs cannot manufacture the homeruns by pouring tens or even hundreds of millions of dollars behind companies. It's like pushing on a rope. Such a strategy requires not only a lot of capital but a lot of confidence, ignorance or arrogance. Perhaps VCs should remember the words of the great hall of famer Satchel Paige: "It's not what you don't know that hurts you, it's what you know that just ain't so."

Expecting the unexpected

New technologies can lead to waves of creative destruction. Even in low tech industries, companies come and go. The vast majority of Fortune 500 companies drop off the list much faster than it took to get there - creative destruction is everywhere.

Small innocuous events can set off avalanches of changes which are inherently impossible to predict. Such unexpected changes are extremely dangerous for the giants (who have everything to lose and not a lot to gain). At the same time, they can be hugely advantageous for the hungry new entrants who have everything to gain and little to lose. The beauty of venture capital is that we can bet small but win BIG!

Experimentation and failures go hand in hand - so it's critical to limit the dollars. Lots of money is not required to get value out of experiments - it takes a little patience, an open and prepared mind (willing to observe, learn and adapt), and the right attitude toward risk and return.

Venture capital should not be about putting money to work. Over the years, we've learned that if we focus on the fundamentals and keep doing intelligent things, we can make money even if a company is sold for less than $50mm (the typical value of M&A exits in the VC industry). Rather than trying to predict or create the homeruns, the focus should be on the productivity of capital.

If we build good companies, we've also discovered that some of our companies will just keep growing and growing. We just have no clue which ones will take off (and keep going) and which ones won't at the time of investment. However, we have faith that some of our companies will become the dominant new market leaders (we have several promising ones so far). Creative destruction favors the new entrants. 

The key to great returns

One of the legends of the VC industry recently told me that to be a great VC "you must have the courage to walk away." Maybe it takes courage because mainstream VC investments are becoming so big that they seem too big to fail?

We have a different view. If you invest very small amounts and the experiments fail, it doesn't take much courage to walk away. Our "losers" seem to do a fine job of dying without much help from us - they don't need to be killed.

The key to great venture returns is not the courage to walk away but deep conviction and passion for the big winners (see our Raising Sheep article on the issue of conviction vs. convention).

To paraphrase another great VC...the key is to have a little teflon coating so that you don't get jaded...you have to have the ability to fall in love - with technologies, entrepreneurs and companies - even after you've had your heart broken. Great VCs are just as passionate as the entrepreneurs. It's personal, not just business.

However, perhaps paradoxically, it's also critical to be rational. The homeruns are rare - really rare. If you think that everything can be a homerun, you probably won't even recognize one when it stares at you in the face.

Over the course of decades (if we are lucky enough to be around that long), a very small number of our deals will yield more profits than all of our other deals combined. It's just the way the math works. We can only lose 1x, so if we have a 100x or a 1,400x along with a bunch of 3-5x winners, the overall numbers will be skewed toward the few big homeruns.

So in between the homeruns, the key will be to keep losses to a minimum, learning to a maximum, and generate decent enough returns to stay in the game. Such an approach might not sound terribly sexy or exciting, but we believe that the key to achieving great results is to stick to a rational strategy (rather than gambling money away).

The great investors and businessmen we know are all pragmatic practitioners. They first think about (and protect) the downside, before going for the upside. Following such a strategy takes a lot more faith and courage than you might think. It forces clear headed thinking and hard, disciplined decisions rather than sloppy, wishful thinking and shoot-from-the-hip betting.

Ultimately, it's not about how much we invest but what we own of great companies. We feel - in our bones - that only a few companies will really matter in our lifetimes (and they will NOT require a lot of capital). So, like every other VC we're swinging for the fences too...but we're not going to leave smoking craters in the field if we don't clear the fences.

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.