What I Learned from Venture Capitalists
(I originally wrote this article for a now-defunct tech magazine for entrepreneurs named Midnight Engineering back in the late 1990’s, vintage early 1998 or so — check out the reference to the Apple Newton, which was before the dot-com boom really started to accelerate. Fifteen years prior to that date would have been 1983 when I first started work at a VC-funded tech startup company. Some of it may be dated, but I suspect much of it is still quite valid.)
Over the past fifteen years I have had a number of encounters with venture capitalists. I have attended presentations, worked at a startup, consulted for several startups, sought funding for my own business, and had a number of informal discussions. Whether you love them or hate them, venture capitalists are a major force in high-tech and you can learn a lot from them even if you do not take any money from them.
There are many things that I wish I had known during my initial experience at a startup, when seeking funding myself, and even when I decided to be self-funded. Looking back, I see a lot of painful experiences, near-disasters, confusion, anxiety, and lost opportunities which could have been avoided if only I had known more about the minefield around me. This article is really the article that I wish I had read fifteen years ago.
What is venture capital?
Your grand idea and moneymaking business is a venture. Money to fund your venture is venture capital. There are a variety of sources of venture capital, including your own money, individuals and families with money (sometimes called Angels although with all their lawyers and accountants the name just does not make much sense), individual corporations, and dedicated venture capital funds (or firms.) I will use the term for the latter in this article. The guys with the money are the venture capitalists. They are also known as vulture capitalists or simply VC. They invest money in your business in return for stock which you promise to turn into a large pile of gold within a few years.
Who is helping who?
First of all, VC are not there to help you. They are offering you money in exchange for a large quantity of valuable stock that they can distribute to their investors. A venture capital firm is really one or more limited partnerships (each one being a fund) whose limited partners are the real moneybags — primarily large banks, insurance companies, and pension funds. If you ever lose sight of their goal or fail to meet that goal, you will be in deep trouble. Great products, quality, and customer service are not the goals of VC, they are merely tools to achieve the real goal of a highly profitable and rapidly growing business.
Goal: $100 Million sales in five years
For a start. Most VCs are not interested in smaller businesses. They want people who are ready to think, act, and deliver in a big way. Do not waste time pitching a business that cannot realistically expect to achieve $100 million in sales within five years on its way to $1 billion in sales a few years later. Not that most VC-funded businesses achieve those goals, but if you are not thinking that big before you start, how well are you going to do as you encounter resistance in the market.
Take all the time you need
Well, not quite. VCs continually get burned by companies that are overnight successes but are not able to sustain that growth. Sustained growth and profitability are essential. But on the other hand, do not forget that VCs need to do a stock distribution to their limited partners in five to seven years. Typically they would like to see a business go public (an initial offering of stock, typically on the NASDAQ exchange) after about four years.
You need to be excited
Your chance of success is proportional to your competence times your level of energy. VCs are drawn to people with high energy levels, partly because enthusiasm can take a product from being a good success to being a great success.
Identify the key market opportunity
It is not enough to identify a need that your product can meet. The need may be too small a niche. Or maybe it is too easy for anyone to address the need. The VC want to see that you have identified a not so easily reproduced way to rapidly capture a significant share of a large market.
VC really like to invest in situations where the business has a unique competitive advantage. This might be a technological edge or a dynamite sales team that are prepared to move in and capture a market before anyone notices. Me too and clone businesses are frequently not very profitable and profit determines stock value.
Ready market versus missionary sell
VC want to know that sales will grow rapidly from the moment the product hits the street. They really do not like to deal with a product whose potential customers need to be slowly educated. It is nice to know that your product has a gigantic potential market, but you really need to be able to prove that a sizable segment will be ready to buy on day one.
Early bird gets the profits
Prices will drop as competitors enter your market. This means your profits (earnings) will also probably drop. It is said that being six months late to market will cost you thirty percent of the potential profits.
Market timing is everything
A great product is worthless if the market is not ready to buy it or if the market has become saturated. You have to be ready when the customer is ready. If you are there too early, you will be one of the pioneers with all the arrows in your back. And if you arrive too late you will get nothing more than the scraps.
Niche versus general markets
VCs prefer larger markets. Even if your product works best in a niche, try to find a way to expand its scope to a larger market. And show how your product will grow into an evolving product line.
Corporate versus small businesses
VCs like plans that target large, corporate customers who can turn into real cash cows. They hate businesses targeted at smaller businesses (such as doctors and lawyers) since the overhead of each sale does not yield a large enough profit margin.
Your customers are your best prospects
VCs like to see that you plan to pursue large organizations where there is potential for lots of follow-on business. It is not the number of customers you have, but your ability to leverage every dollar spent on marketing and sales. You typically need to have a two-pronged strategy of pursuing both smaller customers who are easier to sell short-term and larger organizations which require a more protracted sales effort.
Do not underestimate the sales effort for large organizations
Layers of management, turnover, risk aversion, office politics, and endless red tape can continually add new obstacles to achieving a sales breakthrough at large organizations. Just because you make an initial sale or have the backing of the key decision maker does not mean you are home free. Some organizations like to buy one of everything. And they do not mind telling every vendor that their product is hot and has a great future at that organization. It does not take much to upset your apple cart. Persistence and realistic assessment are the best approach.
Worry more about the market than technology
VC are less interested in how you are going to build your wonder product and far more interested in how well you really understand your market and its sales psychology. Their biggest fear is that the market does not turn out to be as receptive as your rosy plan. Certainly they must be convinced that you can build and ship the product, but they really do think of techies as being a dime a dozen and a top marketeer as worth their weight in gold. Your technical reputation is a mere required checkoff item that gets you in the door. Try to convince the VC that you think, eat, sleep, and breathe the market. Any lapses into extolling the wonders of the technology will hurt you dearly.
Convergence of technologies
Your product will fly only if the necessary technologies have matured to the point where you can bring them together to build the product. PCs and workstations illustrate how great a success can come from technological convergence. The Apple Newton is an example of what happens when the technologies have not quite converged. The Newton will not succeed until microprocessor performance goes up, power requirements go down, battery efficiency goes up, memory capacity goes up, display cost goes down, display quality goes up, wireless communications gets better and cheaper, cost goes down, etc. The hype did converge with reality though.
Given the VC bias towards quick and sustained profitability, the technologies required for a product must be at their convergence. Otherwise you will be stuck with a Newton. It is easy to identify the high-profile technologies for your product, but the real concern is all the details which can kill your product if they do not work out. Things like memory and compute requirements for a software product. Or the reliability of a component (hardware or software.) Watch out for single-source components. Even if technologies have converged to the point where you can build your product in the lab, are they stable enough for the convergence to be dependable? You must convince the VC that you understand how to deal with your dependence on key technologies.
In the startup I was at, they had decided to use an elegant, custom relational database and it all worked except that the performance was terrible. They shipped the product in that form, but had me start a crash project to retrofit it with a more primitive but effective approach. Besides being careful when picking technologies, do not be afraid to quickly drop a technology when disaster appears imminent. Do not assume you will be as lucky as we were that things worked out.
The second product is the hardest
Once your product is a success, you must develop the follow-on product, since few businesses succeed with just a single product. You had it easy when you designed the original product. There was no pressure, you were fresh, rested, and anxious to get started. You did it, you succeeded. You are under intense pressure, you are dead tired, and worried about keeping the product moving. So what do your friendly VC do? They ask to see your encore. Don’t these people ever let up? Nope.
Larger is better
Good VCs know that the success of a business is proportional to the level of attention the VC can give to the business. The level of attention from the VC needed for a small business is not much different than for a large business. They need to watch the same numbers, go to the same board meetings, ask the same questions, and deal with the same inflated egos for any size business. They must leverage their time since their return to their limited partners is proportional to the fixed amount of their time multiplied by the variable value of their share of your business.
You get more than just the money
Some people think the primary thing you get from VC is the money. Not true. As important as the money is, the VCs themselves are (or should be) a much more valuable resource. They have lots of experience and lots of contacts. They frequently bring other VCs into the deal so that you can get more money than a single VC might be willing to invest in your scheme. They can help raise future rounds of financing. They know lots of executives who might make be critical additions to your management team. They have been through the startup process before and can guide you through the maze.
Their skills and experience provide great advice for seemingly intractable problems such as entrenched competitors, stubborn customers, and knowing when to push harder and when to just be more persistent. When things look hopeless they can point you towards the light. When success at hand they can point out a new competitor who is about to eat your lunch. And if you do stumble and make a potentially business-killing mistake, they are there with the necessary skills to get your business out of trouble, unlike banks and other capital sources who do not understand how your business is any different than a new shoe store.
Simple is better
Complexity provides greater opportunity for failure. Keep your plan simple. Start with a simpler product than your dream product. Success in the market will provide money to fund your grander visions. A top-notch VC will be turned off when they see that you are depending on too many details that can go wrong. Besides, a complicated product will be harder to market and support.
A shorter plan is better
It can be tempting to present VC with a thick bound plan that covers all contingencies, but a simple two-page plan is better. The goal of the plan is to convince the VC that a significant business opportunity exists and that you know how to exploit it. The VC must be comfortable with you and your market. You need to come across as understanding the big picture, the essence of the market. Specific details have secondary importance. Do all the work for the big plan anyway, but hold it back and supply it as questions arise. You will look more credible.
Dealing with objections to your plan
It is tempting to answer a VC’s objections to your plan by convincing them that there is no problem. Usually an objection indicates a lack of comfort and that means you lose unless you change your plan or find another VC. It is also tempting to add detail to the plan to answer future objections before they are even spoken. This is also probably a waste of time since the real issue is that the VC is not comfortable with you or your plan. If you get the same objections from several VC then the VC are probably right and your plan is flawed. In some sense the VC are actually simulating the response of the market to you and your product. The bottom line is that if the VC is not quickly excited by your plan then you are out of luck. If you have trouble selling your idea to a VC then imagine the more difficult task of selling it to the market.
Quality: The customer’s perspective
Engineers love to design quality products. Customers love to use quality products. It is a match made in heaven. Wrong. It is difficult to balance the customer’s expectations and the sometimes conflicting perspectives of engineers, marketing, and management. The bottom line for the VCs is whether customers are satisfied enough to say good things about your products and buy more of them.
Intense pressure to ship a product before it is ready is not uncommon in startups. Management might decree that the product will ship by the designated date no matter what. This is extremely demoralizing to the technical staff. Only if the staff has been through a successful startup do they stand a chance of dealing with this approach in even a remotely rational manner. Your best shot is to do your homework and really understand the economics of the business and try to understand whether they are just tough managers or if they really are stupid enough to do what they said they would do.
In defense of management, engineers rarely understand what customers really expect and when they expect it. Not all customers use all product features, so a feature that the engineer knows is needed for the complete product may be totally irrelevant for a significant portion of the market. Besides, marketing may have demanded features without a proper economic justification for the expense and delay.
In the end, the guy at the top who makes the decision will balance their perception of the risk of less than 100% quality with the very real short-term loss of profits. You must convince the VC that you are the right guy for that decision.
VC do care about quality
They understand that delivering a mediocre product can result in unhappy (or non-existent) customers. They understand that a quality product is cheaper to maintain. Unfortunately, it is very difficult for them (or most managers) to tell whether the engineers are just whining because they want to build the perfect product (as they see it), whether the quality issues are relatively minor, or whether disaster is imminent. They depend on management to make the call. Most engineers are poorly trained in communicating effectively with management in these types of situations. And it is very difficult for the VC to tell how the engineers’ and management perception of quality relates to how the customer will see things. The bottom line is that VCs cannot afford for the business to destroy itself.
Ship no matter what?
There is a saying to the effect that in the history of every product there comes a time to shoot the engineers and ship the product. That is fine if the engineers are always just whining and trying to build the perfect product, but not okay when the engineers are telling the truth and product does not work. Lots of startups ship products that do not work exactly as advertised. Some are dead on arrival. Some are buggy. And sometimes the business lucks out and customers never stumble across the flaws. Sometimes the business wins by getting attention for first shipment of the product or they are just meeting a delivery commitment and know that it takes time before the customer comes up to speed and updates can be made before then.
From my personal experience, all I can say is that it happens and the results are difficult to predict ahead of time. You are just rolling the dice and hoping for the best. Sometimes you win and sometimes you lose. My best advice is to keep your projected release dates as flexible as possible and phase your development so that you can in fact ship a working subset of the product if needed.
If the word comes down that the product will ship no matter what, you get to make the kind of hard decision that can make or break a company. You can go along, whine, complain rationally, refuse, or leave. When I was in this situation at a startup it took me no more than thirty seconds to make up my mind and the next week they had my resignation. I also sent a nice, confidential letter to the lead VC detailing my view of the situation. My actions did have an impact. I consulted half-time for about six months before coming back full-time. Although they shipped a lousy product that hardly worked, they asked me to do a major redesign of the software, which prompted me to return. I lost a big chunk of my stock, but if I had not acted and had not been able to do the redesign, all of my stock might have been worth nothing. In retrospect, I should have realized my value and demanded all of my stock and then some.
Beware of invisible competitors
It is easy to do market research and identify your competition. It is much harder to predict who your competition will be off in the future. Just because you were smart enough to identify a hot new product and a ripe market does not mean that no one else will do the same. At any moment a seemingly non-competitor may decide to enter a new line of business and become your worst nightmare. You must convince the VC that you are prepared to deal with sudden changes in the competitive landscape.
The lead VC and the VC team
Not all VC are endowed with equally impressive skills. They frequently act somewhat like a team with one taking the lead with a particular investment and other VC chipping in smaller amounts of money. The lead VC may also be the primary contact with the business. It may be that the lead VC understands your business better and the other VC are willing to trust the lead VC’s judgment. Why would they do this? Simple. It goes back to leveraging their effort and it also allows them to invest in businesses that they would not feel comfortable in investing in alone. The advantage to you of this approach is that you can get more money and deal with fewer outsiders.
Although it might be a real ego boost to have several top VC on your board, if more than one wants to be lead, then you lose. A good strategy would be to focus initially on getting a lead VC and let them suggest the rest of the VC team.
People over technology
VC would much rather invest in a great marketing team with a so-so product than in a great product with a so-so marketing team. Although VC are good at replacing individuals to enhance the skill set of the team, they really do not want to rip out one team and then build a new one. That is your job. Think of the team first. Ask yourself how well the team can adjust to rapidly changing products, technologies, and markets.
Team over individuals
Although we all know of great individual contributors at companies, it is difficult and risky to grow a company around them. VC prefer a fluid team that can rapidly accommodate changes in the market and technology. If the business depends critically on an individual, then there is great risk to the business. They may die, be lured to another business, or be too comfortable with one technology and resist change. The talents of individuals should be exploited and nurtured, but the priority should be on an optimal team. VCs recognize that there comes a time for each individual to move on and the business should plan around that reality. You are expected to understand the same. I can remember an executive lamenting that a senior technical person had left the company and that there should have been some way to convince him to stay. The VC noted that sometimes it really is best to let them move on.
Filling key personnel gaps
Although you should have your team identified before you make your pitch, VCs can help identify and recruit key people to round out the team. You may be great techies and have identified a clear market opportunity but not know any truly great marketeers. VCs know lots of really good people. For example, your VC might know a hot marketeer who is stuck in some company which is having trouble making their technology work. But make sure you really do know what the market is even if you personally do not have the skills to do the marketing. It is debatable whether having a so-so marketeer on your team is better than letting the VC help you find one. While the VC knows that your marketeer can be replaced when necessary, replacing a founder can be unpleasant and messy.
VCs do not want to run your business
You frequently hear stories about businesses whose VC have stepped in and are running the business. This is not typical and usually means management has screwed up and is not on plan. A common reason is that the plan was either more than they could deliver or more than they are prepared to deliver. It may have required tradeoffs (such as quality or giving up some control) they were not prepared to make. But if you either stick to plan or are flexible when working things out with the VC then there is no reason they would step in.
A time to let others take over
In the initial startup phase, the founders and other key individuals are usually driving the business forward very intensely. Sooner or later it will be time to delegate responsibility to lesser individuals or to newcomers. It is very difficult for a hard-driving individual to hand over the reins to someone of lesser or unproven ability and a good VC can offer good advice. You do not want to cripple a successful business, but you do not want to burn it out either.
A particular challenge is moving through the various startup stages. The early startup requires a lot of vision and high-level design is important. Then lots of implementation is needed. Then customers need to be supported and product stability is critical. Then you design the follow-on product where customer input is even more important than any founder’s vision. Eventually you become a real company stage where planning, budgets, and decorum rule. Not every individual will be comfortable or flourish at each stage. Again, a good VC and remind you of the qualities to emphasize at each stage and when to let people move on.
Snoop around first
Before you stick your neck out and propose a hopeless plan, ask around, chat informally with some VC and founders of other companies, and possibly pitch your plan to an unlikely VC. The goal is to find out if your idea is completely unacceptable to the VC community. It may be that your plan sounds too much like past proposals that either failed or were poorly received by the VC. No sense repeating someone else’s mistakes. It is a good idea to cultivate some local VC contacts with whom you can periodically review your crazed ideas. Then when you really know what to pitch you have a higher probability of success.
You should also do your homework to determine that a target VC has interests related to your proposed business. But even if there is not a common interest, you still may be able to get a lead to other VCs or some business advice.
When I talked to VC about funding my plan to develop software for architects I quickly found out that VCs had a strong bias against architects who they consider flaky and cheap. They also pointed out that past attempts had not achieved great success and mentioned several cases where they had turned down proposals more than once. I tried to convince them that although I agreed with their view of specific examples, my proposal addressed their concerns. No luck. The bias had been firmly established and there was no way I could change the situation in any short period of time. In retrospect, I should have recognized the simple fact that the VCs were not instantly excited and moved on.
Revenue versus Cost
Engineers from larger, established companies are trained to think in terms of keeping product and maintenance cost down. But in a startup situation where the early bird gets the profits, the situation is reversed. The goal is to get the product to market as rapidly as possible, even if the initial production cost is higher. In simple terms, profit fuels growth and profit is what keeps the company running. As the business achieves success, there may be a transition to low-cost and that can be a painful transition. But the VC are most interested in how you fare before they distribute your stock to their limited partners. VCs are less interested in competitive markets that dictate pricing and costs and result in thin profit margins.
When a VC does invest in your business it is in terms of so many shares of stock at so many dollars per share. This means you are giving up a portion of your business (equity) for that money. And you do not even get that money yourself anyway. The size of their portion of the business is determined by their valuation of the business. The valuation will likely be based on market potential discounted by risk. A smaller market means they will want a larger share of the business for less money. The same for higher risk. VCs hate excessive risk and will not go near a deal if the risk seems too high. But even for attractive deals, higher risk means they want a larger share (at a lower valuation) for their money. And a zero risk proposal for a tiny market will not interest them. Your goal is to achieve as high a valuation of the company as possible so you give away as thin a slice of the pie as possible for the most return. But do not think they will give you what you want. The best way to get a good valuation is to identify a large market and focus on an initial product which has low risk.
Just because your business goes public with a stock offering does not mean that you instantly have a large pot of money to play with. There are usually restrictions on officers dictating how long they must wait before selling any of their shares. Most offerings provide that each officer will sell a specified number of their own shares at the offering. The proceeds of those sales may not be large enough to buy that mansion, sports car, and yacht on the same day. Your VC may also have induced you to sign an allocation agreement (e.g., you vest one eighth of your shares every six months for four years) which further restricts when you may sell shares and even that you must sell them back to the company at some ridiculously low price should you leave before your shares are fully vested.
You might consider a privately funded S-corporation where the profits are returned to the shareholders. Even with a much smaller business you could end up with more money in your pocket every quarter and with far less hassle.
It is never as bad as it seems
That is what the VC told me when I sent my nice letter about shipping no matter what. People tend to overestimate what is causing them grief. Things can look pretty gloomy sometimes at a startup. It can look hopeless. Maybe a key supplier has let you down. Or a key customer kicks you out. Or a new competitor appears suddenly. Or a key individual leaves. Or there are seemingly unresolvable conflicts within the management team. Just remember that if success was easy and predictable then anyone could achieve it and it would not be worth very much. Sometimes you need to just be patient or persistent. Sometimes you need to issue an ultimatum and be prepared to back up your words with action. Sometimes some outside help is needed. And sometimes the VC is best equipped to make a judgment as to whether to let the situation go on or intervene and force a resolution.
Good VCs are prepared to jump into the fray and unafraid to shake things up until the business works
As long as a business looks likely to achieve financial success, VCs are not likely to intervene. Besides, frequently a little conflict and competition can keep a company from becoming complacent and can force people to think very hard about what they think is truly important for the business’ success.
The role of a good bean counter
At the startup I was at, one of the first executive positions filled with help from the VC was the vice president of finance. His job was more than just accounting. His experience dealing with startups and their business plans was needed to keep the finances of the business in shape for an eventual IPO.
With all the stresses in a startup, with development wanting to hire more engineers and marketing wanting more money for advertising and the founders wanting to spend more money to get the product to market faster it is easy to lose focus. It is vital to have a strong-willed bean counter who understands their role and continually remind people of the real goal of the business: sustained growth and profitability.
So what if you cut corners on the budget or fudge the numbers a little (maybe even pack some bricks in boxes and ship them as inventory to a warehouse)? A scrupulous bean counter should be there to gently remind you of the risks. A lousy bean counter will do no better than give you all the rope you need and watch you hang yourself and the business.
In summary, a venture capital funded startup is an intense course in business, marketing, technology, and capitalism itself. We could do a lot better in our small businesses if we paid more attention to the lessons of large-scale startups.
Markets are ever-changing minefields and we need all the tools we can get to negotiate these minefields. Venture capitalists may employ these tools more efficiently and ruthlessly than others, but poor use of the tools can cause much self-inflicted pain for naive entrepreneurs.
(My bio from back then. Now I’m simply a semi-retired software consultant.)
Jack Krupansky runs a one person software business, Base Technology, which develops and markets the Liana object-oriented programming language and offers Windows software development consulting.