Skimming the recent spate of somewhat rosy newspaper and magazine articles touting the resurgence and benefits of angel investing, I was persuaded to dig through some of my older posts on the subject to examine whether my somewhat caveat emptor position on raising angel capital had been swayed. With a few exceptions, it hadn’t. This is not to say that I am a critic of the practice of start-up teams chasing investment dollars from individuals. Capital coming from private individuals is still how many, if not most, start-ups initially get off the ground. Additionally, in a challenging funding environment like the one we currently inhabit, finding individuals ready and able to “top off” institutional investment rounds is often a key element in getting those rounds closed at all. Indeed, one of my more popular posts over the last couple years, The Rise of the Pledge Fund, focused upon the emergence of “fundless” or non-committed funds that were targeting seed stage deals and offering individual angels the administrative, post-investment supervisory and deal flow benefits of a traditional venture fund without some of the drawbacks of being in a committed fund. On balance, I was a fan.

First, let’s define our terms: Most on the venture side prefer to delineate capital raised from well-meaning friends and family from capital being sourced from sophisticated private investors or assorted “angel funds” where there is no pre-existing personal relationship with the entrepreneurs to rely upon. While the money coming from either source may still be green, what it tells a professional (i.e. venture) investor about the opportunity is quite different. Your Aunt Bea putting $25k toward the development of your first prototype tells me she’s a pretty great Aunt and loves her nephew, but tells me nothing about how compelling your opportunity is and whether it’s right for venture capital– now or ever. That same $25k (or better, $250k) coming from well-recognized angel groups like Band of Angels and Tech Coast Angels, or from individual angels like Google backers Ron Conway or Andy Bechtolsheim, however, carries with it some significant gravitas. This is not simply because these groups and individuals have been highly successful and have been investing for many years, but also because each has a highly competitive screening and deal selection process which has the effect of winnowing mediocre deals from consideration. Whether I should admit it or not, all things being equal, a Ron Conway- or Band of Angels-backed venture will simply rise higher in the stack of Exec Summaries on my desk than will the summary of a company that did not secure capital from such recognizable investors. I would expect that to be case with most in the venture community. 

What I am referring to in this post are friends, family and fairly unsophisticated investors where, in my experience, the greatest pitfalls lie. Recognized, sophisticated angel investors aside, where things get a bit tricky is around how, when and upon what terms a young company should accept capital from these well-meaning investors. Generally speaking, the traditional investment path is that a young company collects anywhere from $25,000 to $1mm in friends and family funding to get through Version 0.0 and toward an offering demonstrating enough early validation that it can attract a respected professional investor that can put greater sums to work, open up its extensive rolodex of contacts, and accelerate the company’s growth. Of course, in the current environment these notions of what constitutes “traditional investment paths” are being widely re-evaluated and re-assessed as companies are confronting a particularly tight funding market and being forced to go back to early investors–often angels–and new potential angels to extend the runway, get the product/service further along, and hope the institutional funding market will open up in the months ahead. For those such companies, some pointers to consider:

1. Keep the Cap Table clean. I cannot stress enough to young management teams to do everything in their power to do things right the first time. Put bluntly, there’s rarely the time (or even the chance) to fix it later. Upon incorporation, hire good counsel, and get proper advice on how best to manage the early financings. Despite the best of intentions, it can get hairy fast. The $10k and $15k investments you might be receiving from your Uncle Ted and your college roommate could be the difference in getting things going in the early days, but make sure you have a clear, consistent way of recognizing those investments. There is also the likelihood that, being a cash-starved start-up, in addition to the stock options grants you will need to make to early employees you will need to compensate attorneys, landlords and other professional services providers with some combination of cash, stock, warrants and/or other derivatives. Be careful. Early stage VCs expect to see some small commitments from friends and family but if your Cap Table starts to look like the starting roster for the New York Mets with bits and pieces doled out to every Tom, Dick and Harry you’ve met since junior high school along with different pricing and different vesting schedules it can cause a deal to stall….or to fall apart completely. Cleaning up a compromised Cap Table is at the top of most “I hate to do” lists for many VCs. It tends to cast a pall on a potential funding because, apart from the headaches of cleaning up a messy Cap Table, it also implies a start-up team that is either desperate for funding, or unsophisticated, or likely both.

3. Be smart about who’s on your Board. Sun Tzu might have been right when he said, “Keep your friends close, but your enemies closer,” but he probably wouldn’t have made a very good venture capitalist. Building a well-assembled, complementary and collegial Board of Directors (BoD) is critical, but especially so in the early days when things are happening very rapidly, capital is scarce or non-existant, and everyone needs to grab an oar and help in any capacity they can–early customer meetings, investor introductions, crafting and gaining alignment on product strategy, recruiting, legal, etc. Dysfunctional BoDs are a disaster. Be cautious of an angel who is demanding a Board seat as a condition of his or her investment but cannot really bring germane operating experience, investor relationships, or more capital to the table. Early stage investors also become very leery if they perceive that upon investing in a company they will be inheriting a bad BoD or a problematic, unsophisticated or obstructionist Director that they will be tangling with to get things done. For many VCs, there aren’t that many “I have to do this deal” deals, so most will simply shrug and move on to another opportunity that doesn’t present itself with so many wrinkles that the VC will need to iron out once he or she joins the company’s BoD post-investment.

3. Insist on a No Bully policy. This is not quite the same as the No Jackass Policy I referred to sometime back in a recent blog piece of the same title. That piece was concerned primarily with bad hires. Bullies, on the other hand, tend to appear in the form of angel investors during difficult times. This is one of those times when the term “angel” could hardly be more of a misnomer. When there appears to be blood in the water with a young company, an “angel” can appear that seems willing to fund the company through the rocky patch until the markets improve, but the terms get more and more onerous each time an investment is discussed.  At first, the angel seems excited and willing to be part of the business. Correspondingly, the other Board members and investors are excited at the prospect of fresh outside capital coming into the company to help accelerate the business and get through the rough patch. In time, however, the angel perceives that there is no real competition for the deal and begins to insist on more term concessions until the ‘death by a thousand cuts’ phrase begins to get quoted and re-quoted at the BoD meetings when the investment prospect is discussed. Paired with the increasingly onerous investment terms coming from the angel prospect is often new demands on altering the company’s strategy or its mission, or even the principal business it is in. As company management perceives they could be losing the angel prospect, they often make the mistake of “single-tracking” the investment discussion at the risk of other, more promising prospects and investing hundreds of man-hours responding to document demands, diligence requests, and consuming thousands in legal fees. Inevitably, the terms get progressively worse: The new angel now wants a BoD seat, when that was never a deal point to begin with. Now the angel wants to demand the removal of another BoD member he perceives as “not on board” with the new strategy. Now the angel wants sweeteners and more warrants and a lower valuation and pro-rata investment rights and…and…and. It becomes the proverbial onion that stinks all the more with every layer that’s removed. Once that happens, it becomes a death spiral. Accepting the investment with all the new dreadful terms might buy the company some short-term runway but virtually cripples the business, substantially dilutes everyone’s ownership, saps enthusiasm and motivation from the team, and sets the stage for fights at the monthly BoD meetings where everything happens but the exchange of gunfire. Adding insult to injury, even if the business continues to grow and execute with this unwelcome dynamic at the company, should a professional investor show interest in the company for the next round of funding, that investor will almost undoubtedly lose that interest once he realizes that this less-than-angel investor crammed down the company severely at the last funding and now owns a significant percent of the company for his modest investment. Any experienced VC will sense that something is amiss at the company, that the “angel” and not the management team is driving the business decisions, and he will simply Control-Alt-Delete on participating in the investment.

In summary, capital from friends, family and outsiders still has a critical role to play in start-up development. It fills a key void that, even with venture fund sizes falling and more firms focusing on earlier stage companies, will not likely be filled by the institutional class anytime soon. Properly leveraged, it can fill essential gaps in a company’s development and pave the way for follow-on financings led by institutional class investors or, in some cases, even pave the way for long-term commercialization of a product or service. What is paramount, however, is to not let financial stress force the management team to compromise on the core values and mission of the business or to partner with someone whose brief capital support might only serve to damage the company’s long-term survival.

Every now and then I will come across a good VC-generated exposition (usually in the form of a PPT deck) on the subject I like to call “pitchcraft.” For me, at least, pitchcraft encompasses more than simply the act (and art, I should say) of standing in front of a handful of venture investors and walking them through your PowerPoint presentation. Engaging with a venture investor is a process that can go on for weeks, if not months, and involves email exchanges, calls, in-person meetings, product demos, diligence calls, and follow-up communications. All along that continuum there are opportunities for things to go off the rails. For that reason, it’s good counsel for promising companies to never take their proverbial foot off the gas during this process. Too often have I seen a promising pitch be undermined later when a company did not handle follow-up due diligence requests or meetings well.

For the purposes of this deck, however, early stage venture firm Canaan Partners focuses squarely on the nuts-and-bolts of the presentation function. Follow-up and due diligence matters are perhaps a subject for a later PPT. While there exists no shortage of primers in cyberspace on how to meet and pitch venture investors, I think this deck is one of the better ones. I have long maintained that many entrepreneurs would benefit from a ‘mechanics’ course on venture pitching before actually sitting down with venture investors and, while no one presentation is going to cover everything with equal depth, the Canaan folks have pulled together a good primer that is worthwhile viewing (and reviewing).

Belt-tightening tips must eventually be accompanied by a growth footing

In my last post, I offered five fairly straightforward tips for young companies to help weather the current market downturn. Because all lists must somehow number to ten, let me add five more. As in the first installment, some are pretty obvious and intuitive; others less so. Of course, executing perfectly on all ten suggestions is no insulation from failure. That said, incorporating even a couple into a company’s modus operandi can affect a variety of other changes in the company’s DNA that, at a macro level, can profoundly impact whether a struggling company can navigate these troubles waters and emerge on the other side a stronger, even dominant market player, or whether they will be tossed upon the rocks. With that in mind…

6. Reach out to Stakeholders.Human nature being what it is, when many of us encounter challenging times in our careers, in our businesses, or in our personal lives, we have a tendency to hunker down, put up walls, and isolate ourselves. This probably worked fine in our youth when the proper approach to preparing for a final exam or for drafting a term paper was to cloister ourselves in our bedrooms, free from temptations and distractions, and focus on the task at hand. As adults, however, this tendency can be disastrous. A time of crisis often demands that we reach out to others for advice, for networking, for sharing ideas, and even for aid and comfort. For stakeholders — be they investors, employees, or advisors –, there is nothing more troubling than company management being less than forthcoming about the organization’s financial and operating condition during a crisis. In the absence of clear and regular communication between CEOs and stakeholders, little things can get blown out of proportion or misinterpreted. The notion some CEOs have that approaching investors for guidance or when one is troubled is somehow a sign of weakness is nonsense. Now is the time to re-examine how you’ve been communicating to stakeholders and to make changes if there have been issues in the past.  The only thing worse than delivering bad news to a board of directors is delivering that news late when the issue is a fait accompli and the board is blindsided and can no longer really help correct the problem.

7. Re-open your old agreements. Did you sign a $6/sq ft lease last year when the market was frothy, but now the market rate for equivalent space is probably closer to $4? Call for a meeting with your landlord or commercial real estate broker and push for a rent reduction. Are they required to work with you on a new lease rate? Of course not, but they are business people and they’ll probably realize that it’s usually a lot cheaper to lower the rental rate than have a tenant break their lease or go out of business and have the space sit vacant for months on end. Do the same with any contractors or consultants where you think the softening economy might give you leverage for better terms.

8. Horde your cash; Use equity whenever possible. If you haven’t already done so, ask if your law firm will defer fees in part or in whole during this down cycle. If they won’t, consider changing your legal counsel – it could be that important! Do the same with any partnership or other service provider agreements you might have – PR firms, ad agencies, etc. Money is a proxy for time; the more cash you can avoid paying out, the more months you add to your company’s lifeline, and the longer your company will have to see its plans come to fruition and for you to turn things around. Now is the time to horde cash and pay out equity to any vendors or partners that are willing to accept it. Such arrangements also have the added benefit of aligning incentives all around. Everyone will have direct skin in the game in your company’s success. That gets people motivated in a way a cash-based fee arrangement never does.

9. Don’t Shoot your Golden Geese. In a downturn, the tendency is to give everything a budgetary haircut. Unfortunately, this can be done indiscriminately and can result in key functions critical to sales and revenue (your company’s lifeblood) being hobbled. Look closely at what directly interfaces with customers and partners and make sure those things remain as intact and high-quality as possible while you cut just about everything else. It’s much better to trade your high-end office furniture for used Salvation Army desks if it means your team can still afford to appear at that key trade show. Customers will almost never see your office. It is far better to move to a smaller space in a less desirable part of town if it means it will free up enough capital to keep on two rainmakers that are getting you intros to key partners. The right alliances could make or break your company. The talented BD or Corp Dev person that can bring you those relationships can be worth his or her weight in gold.

10. Pick your metrics, pick your plan, and stick with it.As the cliche goes, without a roadmap, will you know how to get where you’re going, or even that you are there when you arrive? If you’re doing things properly in concert with these ten tips, you have already assembled the key managers and stakeholders in your company and have actively engaged them in helping develop a strategy for how to manage through the current cycle. Now what is left is deciding what key metrics to focus on in order to determine whether your strategy is succeeding. Each industry has different indicators; find out what yours are – is it traffic? unique visitors? click-throughs? sales? RFPs? Whatever the key metrics are, define them in such a way that you can measure in real-time how things are tracking so adjustments can be made on the fly if things are under-performing. Also, once a plan is developed, make sure it has time to succeed, Don’t be one of those companies we all read about that’s on their fourth turnaround plan in as many months (and sometimes their fourth CEO also.) While it’s a serious mistake to hold on to a strategy that is not working, embarking on new plans too quickly can be just as damaging to morale, stability and credibility with investors.

5 Ways Start-Ups Can Weather The Storm

While it’s been several weeks since a handful of renown venture firms issued dire warnings about the state of technology markets and urged portfolio companies to buckle in for the coming turbulence, many start-up management teams have approached me at conferences and in airport lounges seeming unclear on how best to proceed. While every investor, it seems, has an opinion on what we can expect over the coming months, a far fewer number has followed up with concrete things start-ups can do to improve their bottom-lines and–by extension–their fortunes. Granted, it’s difficult to issue broad pronouncements on belt-tightening strategies for emerging growth companies given the diverse nature of these companies and their wildly differing cost structures. That said, there are some common sense principles and direct actions that start-up teams can take now that apply across market sectors and industries and can have lasting impact.

1. Get Your Hands Dirty.When the proverbial poop hits the air conditioner, some feel it is best to bring in professional turnaround consultants or crisis managers to grab a mop and begin the process of layoffs and other sundry unpleasantness that must accompany the right-sizing of a young company. For the most part, I say that’s overkill and sometimes counterproductive. In my decade or so around emerging growth companies, I can only think of two or three occasions when the circumstances around a company in distress absolutely required the services of an outside consultant. In contrast, I can summon many more occasions when the presence of such a consultant was detrimental to the company–other times, unnecessary, at best.  

There is a strong case to be made for start-up CEOs being directly involved with most, if not all, of the painful and unpleasant tasks associated with dramatically reducing cost structures in a downturn. Getting outside advice is invaluable, but executing on that advice should be done by the management team itself. Don’t outsource the dirty stuff. There is nothing more distasteful for an employee that’s given his or her blood, sweat and tears to a new company than getting laid off from said company by some junior flack in human resources or, worse yet, a faceless consultant who will likely pitch tent at another drowning company a week from now. If there are doubts about this, ask anyone who has ever been fired or laid off. It’s an excruciating and cathartic event–even if the employee had sensed it was coming. Having the CEO or, at least, the employee’s direct supervisor break the news to the subordinate provides an opportunity for the newly laid off employee to vent some of his or her issues and frustrations and provides for closure. It also has the effect of preserving the relationship with the employee in the event there is an opportunity to rehire the individual later on when things improve, and it can improve morale among those employees who get to keep their jobs. Witnessing their boss actively engaged in the painful process of layoffs often makes employees respect that boss more than learning that the process was outsourced so the boss could personally avoid the fallout. Getting blood on one’s hands and getting through to the other side of that process is a leadership moment for all managers. Don’t delegate it away.

2. Act with All Deliberate Speed. Whatever your company’s circumstances, make a plan quickly and begin acting on that plan. If a capital raise is being contemplated, get to market as quickly as you can.  Capital markets can soften almost daily and time lost can never be recovered. If staff cuts are needed, cut quickly and deeply. Don’t drag it out (see point #3). Your company and staff will need time to recover and move forward.

3. Cut Deeper Than You Think. As counter-intuitive as it may sound, it is often easier to re-hire laid off workers if and when things rebound than trying to keep on idle resources. Moreover, making lots of little staff cuts is a company killer. It wrecks morale. Employees are constantly looking over their shoulder at when the next round of layoffs is coming and can lose sight of the broader objective. An “every man for himself” energy begins to pervade the culture and, when that happens, the company is usually toast. To borrow a sloppy metaphor from the recent presidential campaign, it’s the ax versus the scalpel. In this case, the ax wins hands down. Ideally, you should get out the ax once, cut hard and deep, give the company time to recover from the surgery, and get back to rebuilding the organization.

4. Sweat Every Expense. Yes, I know you’re already doing that anyway; but, this time, insist that every expenditure be directly linked to revenue in some way, however indirectly. Defer everything you can that is not directly revenue producing. No high-end furniture upgrades. No office expansions unless you are literally on top on one another (and even then…). No technology upgrades unless the old laptops/servers are directly impacting performance and, hence, revenue.  Also– and this should go without saying — dump all the expenses that you took on when things were crazed and you convinced yourself you did not have time to handle them. An example?  Fire the guy that comes every other day and waters the office plants. Do it yourself.

5. Back to Basics. As I’ve discussed in prior posts, entrepreneurs have a tendency to want to boil the ocean, particularly in frothy markets. This is not altogether a bad thing: it can emphasize all the leverageable opportunities for the company and its concept down the road. The key here, however, is down the road. Not now. As such, in a tight market, the company much focus first and foremost on its core business. What is it known for? What do customers immediately associate the company with? What is the company’s key value proposition? Everything else must be tabled.

When I think of companies that recovered from significant past market corrections and deep layoffs to become market leaders in their defined arenas, almost all of them persevered because they did one thing above all else: they focused entirely upon delivering massive value to a core group of customers (even just a handful of customers) and eschewed all other distractions. Their ideas were usually the simplest ones, but these companies stayed on target with their core business proposition and were the beneficiaries when the market pulled out of recession and there was a healthy spike in IT spending and other expenditures as pent-up demand from all the belt-tightening got released back into the system.

Part II (tips 6-10) coming soon…

Start-up teams are staying together longer. Make sure you like the people you work with.

Look no further than the current US presidential campaigns and you will see how the power of personal or business ‘associations’ can be leveraged, fairly or unfairly, to boost or damage a person’s career prospects or a company’s fortunes. A Barack Obama, for example, might be able to rattle off a litany of well-respected names to boost his candidacy, but he will also have his William Ayers’ and Reverend Wrights to contend with. A John McCain might be able to offer a similarly impressive list of supporters, but he will have to shoulder the burden of his Charles Keatings and Phil Gramms as well. I will leave it to the political pundits to determine the wisdom of pursuing an opponent’s associations as a political strategy, but the weight of associations and the decisions around who you surround yourself with in business and in life does have impact; more so now than ever.

In the start-up and venture capital world, there is the well-worn maxim that “A-list people hire other A-list people, while B-level people hire C-level people.” The idea is that truly exceptional people are not threatened by others of high analytical horsepower and competency and want to be surrounded by people of such caliber, while mediocre managers are more prone to be nervous about maintaining their station and, as such, don’t want to be challenged or threatened for their jobs. Hence, they ostensibly hire beneath them to preserve their position and authority.

To be sure, the issue of high caliber and competency within an organization’s ranks should be paramount regardless of market environment. In the current market swoon and anxiety that that brings, however, it bears even closer examination and discussion.

As I alluded to in an earlier post, the laws of good business practices were certainly not repealed in the somewhat frothy market we are just now leaving; it just seemed that way some of the time. To be sure, there were a lot of excesses that now bear serious re-examination.  As we are painfully coming to realize across our economy, easy credit and cheap, readily available capital can pervert incentives and can blur what should be clear lines between good, fiscal discipline and fast-and-loose management practices. In a frothy environment, however, strategic mistakes can be easily covered up and bad employees have places to hide. Not so in the market we now inhabit.

With few exceptions, venture-backed companies are becoming leaner. Those companies who were not fortunate enough to have raised their venture rounds before the financial crisis took center stage will now have to contend with lower valuations, less competition for their deals, and with venture investors more distracted with challenges in their current portfolio and less apt to dive into new deals as they were just a few short months ago. Yes, deals are getting done, but they are taking longer to do and are coming in at much lower valuations.

Whenever there is a downturn of any magnitude affecting the start-up environment, all venture investors begin re-thinking how they are evaluating new and existing opportunities. What items that were once “let’s see what develops” are now mission-critical? What questions that we could wait on for an answer do we now need real clarity on before proceeding with a new or follow-on investment? In short, what is acceptable risk and what, in the current marketplace, is no longer acceptable?

Arguably, the top item on anyone’s list of “fundability measurements” and criteria is going to be the team. Furthermore, I would venture a guess that team dynamics, competency, experience, integrity and demeanor has only increased in importance as a factor in determining for venture investors what deals get done and which companies fall by the wayside. In a heated market, more investors are willing to ‘wing it’ with a less seasoned CEO or VP Engineering hoping that once the company gains traction with its product or service and hits certain milestones, the exercise of bringing on a more seasoned pro will be a formality; not so today. In a tough environment, experienced CEOs who have actually navigated a company through a downturn are worth their weight in gold. Moreover, every investor wants one for his or her companies. This, ironically enough, also occurs at a time when experienced CEOs are more reluctant than ever to leave the relative calm and security of their current roles as Sr. VPs, CEOs, or heir-apparents elsewhere to take on the challenge of a venture-backed company in the midst of a market swoon.

Many venture investors will undoubtedly agree with the Darwinian sentiment that market downturns tend to force a somewhat healthy attrition upon the start-up landscape. Weaker companies find themselves unable to raise follow-on capital and quietly (or not so quietly) shut their doors, leaving more breathing room for their more able competitors to achieve their destiny and become eventual market leaders. Dilettante angel investors stop investing and retreat to the shopping mall or tanning salon businesses from whence their fortunes came, thereby pulling capital from the market and bringing deal competition and valuations back to a more healthy equilibrium. And, finally, inexperienced entrepreneurs who wanted to take a swag at a mediocre start-up idea decide to table their dreams in favor of holding onto their day jobs, hence leaving the highways and byways of I-280 and Rte 128 to more serious, purposeful entrepreneurial teams. And, thank goodness for that….especially now.

Therefore, some points to keep in mind:

Teams will need to be intact longer:If there is one thing I am detecting among colleagues at other funds it is the sense that a start-up team is going to need to be intact longer than in the recent past. The notion of swapping out key players later in the game has fallen out of vogue to an extent as the reality of how difficult it will be to find top-notch management available, interested, and affordable down the road is sinking in. This puts added pressure on start-up CEOs to button down their senior management teams now. Make sure you have as complete a team as possible before seeking funding.

Tie up the right people, and pay up if you have to:Take a hard look at your team and do the right things now. If the CEO is being too stingy with comp and options packages, correct that now by making sure the top guys (and gals) are properly incented to stick around and build the company through this tough cycle. Don’t expect to be able to get the rock star VPs later on. Pay up if you have to, but do it now.

Have a State-Of-The-Union type conversation about what to expect: Make sure everyone on the senior team has got religion about what is expected, what is required, and what is coming. People sleep-walking around the office waiting for options to vest might have been OK when venture rounds were easy to raise and no one was sweating their jobs (really), but it is not permissible anymore. That guy that everyone likes, tells good jokes at the office beer bashes, but no one really knows what it is he does? You know, that guy? Fire him.

Don’t Pre-Hire:On the other hand, don’t overhire or pre-hire. In other words, be conscious that everyone’s talents are leverageable now, not at some point down the road when the organization is much further along. It might never get there. Some CEOs make the mistake of hiring a perceived hot talent before that person can actually do their magic on the mistaken belief that it’s more important to have them on the team now before they can really do anything to help the company – like a talented CFO when a Controller would suffice, or a VP Sales that only knows how to manage large sales teams and can’t be scrappy. Everyone has to have a clear function and everyone’s talents need to be leverageable now.

Practice good Investor management relations:It’s too often said that CEOs need to manage their boards more effectively and that their venture investors are really long-term partners. This is no longer stuff on the VC firm’s website you can ignore: it’s the new new reality. So, expect that if everything goes in your favor, you will be a venture-backed company for the next 4-7 years and you will be meeting with (and occasionally arguing with) your investors at least every month for the next 4-7 years. This is not a process you can wing; it needs to be managed properly. Build good relationships now with all your investors, board members, and significant stakeholders. This is a big topic not suitable to getting into in great detail in this post, so do some homework. There are tons of good resources on best practices for managing BoDs and other matters, particularly the white papers by Pascal Levensohn , his venture firm, LVP, and/or some of the stuff I have written on the subject over the years, available widely online. Make them your new mantra. You’ll be glad you did, because tense board meetings when bad news has not been communicated properly will make your worst and most awkward family Thanksgiving dinner look like a day in the park. Ask me how I know.

The 'Don't Panic' wing counter-punches

As sure as the sun will rise tomorrow morning (and, given the market’s recent collapse, word has it there is a line going in Vegas against the sun rising, but I’m not taking that action) those ’sky is falling’ prognostications of last week by all manner of tech observers, investors and — yes — even some entrepreneurs has been met with a ferocious retort. This is a great thing; not so much because I conveniently find myself in the ‘buckle up, but don’t panic’ camp (see here, here and here) but because this is a very healthy–some might say cathartic–debate and it’s been a long time coming.

So, if you have not already done so, take a moment and review some of the superb contributions of others on this subject, not the least of which are Brad Feld’s OK Entrepreneurs, Time to Step Up, Fred Wilson’s Capital Efficiency Finds Its Moment, Alan Patricof’s Memo, John Borthwick’s Don’t Panic, Profit letter and, finally, Dave McClure’s brilliant and profane blogpost on the crippling nature of fear. Sure, you might still need that martini pictured at the end of Sequoia’s RIP presentation, but perhaps do without the Colt .45 chaser.

More later.

Hold off on desperate measures for now...

In perhaps one of the venture community’s worst kept secrets in quite some time, seminal venture capital firm, Sequoia Capital, recently convened its portfolio companies for a State of The Union-type conversation about the current market environment for venture-backed companies. The PowerPoint deck that was presented at that meeting, which has since been passed around like an hors d’oeuvres tray by the venture community at large in the days since, (and available here for the two of you who have yet to see it) was, to put it mildly, apocalyptic. Indeed, the final slide in the deck is a photo of a white jacketed bartender doing the long pour on what can only be imagined is a very strong vodka martini — stirred, I suspect, and very, very shaken if current market gyrations are any indication.

Sequoia Capital is a great venture firm, for a reason. The presentation, as a work product, is impressive. Chock full of relevant, startling, and overwhelming data on the current environment, how we got here, and what the future likely holds for venture-backed companies, it drives to one unequivocal conclusion if you are a portfolio company CEO – buckle up: this is going to be a rough ride. Predictably, for a firm of Sequoia’s stature, almost identical sentiments were issued by other members of the community in short order. Within days, if not hours, Benchmark Capital, Norwest Venture Partners, renowned angel investor Ron Conway, and a host of other firms and their principals began issuing pronouncements (or previously confidential letters) of their own saying many of the same things articulated in the Sequoia presentation. [Whether these opinions were issued directly from the firms themselves or subsequently leaked by some other method is unknown and I am not suggesting I have any better info on this than anyone else.]

Now, these are all eminent names in the business, by any standard. The smart money might say to just echo these sentiments and find a shelter for the coming storm. That said, let me offer a different perspective on this if I may. But first, it might help to stop, take a breath, make a stiff drink if that’s your thing, and calm down. We’re going to be here a while.

First, Sequoia, NVP and the rest make excellent points. Many of these points are valid even in flush times – being disciplined over costs, focusing on your core market, etc. Second, it’s pointless arguing with the supporting data because it is available elsewhere and can be quickly corroborated. What is open to debate, however, is how to interpret that data and what decisions should be made going forward as a start-up CEO and as a venture investor.

For the CEOs of venture-backed companies, this will be a challenging environment, but not an impossible one. As I have posited in recent posts (here and here) while there are obvious drawbacks to launching and growing a new enterprise in a rough economic cycle, there are also clear advantages that the rest of the economy generally cannot enjoy in quite the same way — i.e. less competition for talent, more flexible terms on leases and equipment, more time to develop your product without worrying constantly about new competitors entering your space, and so on and so forth. As I learned during the tech slump earlier this decade, fortunes are made and lost during times of transition. While many companies (and more than a few venture firms) will undoubtedly shutter their doors in the next 12-24 months as we work through this market cycle, other companies and investors will see their growth and their financial fortunes explode. In short, you want to be in the latter category and, yes, it is still possible.

Warren Buffett has been attributed many quotes that are bandied about frequently but perhaps the most cited over the past two weeks has been his pronouncement years ago that the secret to his success was that he “tended to be fearful while others were greedy, and tended to be greedy while others were fearful.” This somewhat contrarian view has certainly served Buffett well and may even save some of us, if we approach it pragmatically and without undue emotion.

First, this is the time to take stock of where you are. The concept of sound, conservative business management practices have been around decades. They are not, and shouldn’t be, new concepts for venture-backed company CEOs. If they are, then a lot of people (from the investors to the managers) have not been doing their jobs. A company CEO should always be concerned with capital efficiency, containing costs, hiring slowly and firing quickly, and so forth. This market downtown or correction or whatever-you-want-to-call-it-this-week is going to drive this point home like nothing else because everyone will be focused on it now. This does not mean that it is a new phenomenon — just that now you do not have the luxury of playing with the idea: you need to push it down into the very being of your organization. There is no place to hide now.

Second, don’t be seduced by the idea that you can just cut down expenses to the core, retract your head back into your shell like a frightened turtle until the storm passes, and simply re-emerge once things calm down. The only real issue I take with Sequoia’s deck has to do with slide 46 which features a linear spectrum with Preserve Capital on the left side and, opposite on the right side, Gain Share. The slide infers that the two concepts are in opposition to one another and, hence, are incompatible and cannot be pursued simultaneously. I reject that notion. Indeed, I can scarcely think of any technology sub-sector where one can ‘wait it out’ by focusing on controlling costs and simply expect to re-establish itself in the market later on as if it were a chess game that all players decided to suspend for a bit for the purposes of a pee break and would simply resume at the same point where they left off. Tech markets move too quickly, even in a downdraft. Simply put, if you are an early stage company with a commercial product and you are not gaining share, you are losing share. Your competitors will be the ones gaining share– in good markets or bad. Like the theory of capital flows, market share is neither lost nor gained; it is merely transferred. As such, the only viable strategy is focusing on costs but continuing to gain share; perhaps not at the same rate or with the same intensity, but one most always be focused on gaining share.

Finally, returning to the subject of pithy quotes applicable to this market crisis, being a weekend auto racer, I am reminded of a quote from the 1966 James Garner film, Grand Prix, in which the antagonist, a fiercely competitive driver played by Yves Montand, is asked for the secret to his success on the track. He replies, “when I come up upon an accident – a really horrific accident – I put my foot down HARD….because I know everyone else is lifting theirs.”

Opportunities abound, regardless of the market. As I write this, on Monday, October 13, 12:30 PM Pacific time, the Dow is up a record 956 points. This follows the worst week in Wall Street history. Go figure. Some of these gains may very well be given back tomorrow, but volatility will clearly be with us for a while. Those companies that will emerge from this cycle in pole position for the rebound will be those that not only survived through prudent cost controls but prospered by using this market cycle while their competitors were scared and distracted to build their businesses and lock up customers that will ensure their longevity once markets return to a healthier equilibrium.

Upon launch, sometimes good enough needs to be

Incrementalism has gotten a bad rap. I am not sure where this all began. I suspect the blame can be spread fairly broadly across academia, business book publishers (often one and the same), and the mainstream business press. This comes from the notion that ‘Go Big or Go Home’ is not simply a hackneyed bumper sticker slogan but an actual business philosophy that drives a lot of the decision-making by countless CEOs and founding teams.

That age-old ’strive for excellence, not perfection’ axiom has been turned around (literally) to the point where perfection can often be the only thing that leaders and their teams are interested in striving for. Like so many things, this is a powerfully romantic notion — swing-for-the-fences, go it alone, and all that.  Sounds great. Has a certain puffy-shirt-wearing Errol Flynn-swinging-on a rope-saber-in-mouth je ne sais quoi, right? Problem is, too often this is disastrous as a business strategy if you want your company to still be around two or more years from now and actually become one of the technology juggernauts. This is especially the case in the current market environment where caution, capital efficiency, and cost controls are the order of the day for start-ups.

First, let’s set some ground rules. Context is critical in this discussion, as is semantics. It might be easier to explain what it is I am getting at by first explaining what it is I am NOT saying. This is not a treatise on eschewing innovation…or large markets…or big, hairy, audacious goals (BHAGs to those in the know). No, pursuing those things is a matter of survival in any market, but most especially in the market we are in currently and in the one to follow which will almost assuredly be a recessionary one. Not being innovative? Not pursuing a big enough market? Not willing to challenge long-held assumptions about the market you inhabit and how it functions? Thanks, but good luck getting a meeting with any venture investor worth his or her salt. These are givens. I am not seeking to challenge the laws of physics here, people. Small, interesting business ideas abound but they usually make for lousy venture investments.

My point is that I have been sensing recently a pre-occupation on the part of founders and management teams with the notion of (1) holding out for perfection; and (2) to get noticed in the environment one needs to be bold in all things. This needs to stop.

That said, I get it. Look around at where the culture has gone in recent years — both the macro culture reflected by mainstream media and the micro-culture of where we work, live and interact — and you will find that little heed is paid to those people or companies that do excellent work quietly without flash, controversy or over-exposure. To be heard above the din, too often the common strategy is to say, do or propose something outrageous whether you can ever execute it or not. While the mainstream media can be (fairly) accused of over-weighting interest in things salacious and controversial, the business community (and their investors) can too often be pre-occupied with companies that offer a ‘great story’ rather than whether the company is addressing a key problem that may not be terribly sexy, or bold, or likely to be featured in the next issue of Wired.

This entire topic grew out of a heated series of discussions I had recently over the proposed business strategy of a company my fund was (briefly) interested in backing. The core elements were there: a solid team; a track record of previous success; a market ripe for a novel solution and a team uniquely positioned to deliver that solution; sleepy, entrenched competitors more concerned with preserving their cushy franchises than being innovative; fat and predictable margins; and on and on. Where talks broke down was around approach.  I found myself in the fairly uncommon position (at least for a venture capitalist) of advising a cautious, measured approach in how the first product should look, what functionality it should have, how it should be priced and marketed, how fast to ramp things up, etc. Much of this came from the knowledge that — in this particular market, anyway — there were too many unknowns. The team, for their part, clung assiduously to the notion that they could only be successful if they launched with their idealized version of their product, no expense spared, with a full (perfectly hand-selected) team in place, a sizable first institutional round (at a lofty valuation), a high-priced PR campaign, the boldest possible strategy and approach, and on and on. Granted, a venture investor expects (and often insists) that their entrepreneurs be driven, optimistic and self-assured. Where this can run into problems is around embracing the notion that every journey begins with a first step — often, a baby step — and that what assumptions a company has at launch rarely reconcile with market realities in the ‘fog of war’ of a given marketplace once competing in that marketplace. Additionally, many companies often end up two or three years down the road in an entirely different business with an entirely different product from what they originally intended or conceived — assuming, of course, that the company is lucky enough to still be around in two or three years after initial launch. Welcome to the jungle. 

This all plays, at least to my mind, directly to the belief that most great companies grow through an iterative process that often involves product and strategy mis-steps, course corrections, and management changes. Years ago, while seeking counsel as a first time CEO, I was told by an early mentor, “There are 100 ways a start-up company can fail, Jonathan; if you can think of 50 of them, you’re a genius.” He did not need to add the rejoinder that I was no genius, but I got his drift. No truer words on the subject of start-up failures have ever been uttered, to my mind.

Which brings me to title of this post. Sometimes good enough needs to be good enough — at least for now. Most great companies (just make a list; you’ll find it fairly accurate) were built not through blistering technology or innovation, but through execution. The clearest and oft cited example of this is Microsoft. For all its gifts and qualities, Microsoft will never be feasibly considered by many knowledgeable observers as a great technology company; but, on the matter of strategy and execution, there is none better.

Products (and services) need, first and foremost, to hit squarely on a market need in a market seeking to fill that need. A version 1.0 of anything is expected to have flaws and leave customers lacking — at least to a point. Having a great team in place may be a pipe dream at this stage. You don’t have a great CEO in place, but perhaps you have a decent biz dev guy that can pinch hit, knows his way around a P&L, and has done a partnership or two in his day? Great, that might be all we have to work with. You don’t have the resources to bring on all the salespeople you’d like on Day One? Well, you’ll need to figure it out; and, by the way, who better to sell your product or service that you, the CEO? Make it happen. The bottom line is that if you can execute on your most humble vision and actually prove that your business is viable and you have a clear path to profitability, you will have plenty of resources to execute on ‘bolder’ initiatives and have no problem recruiting almost anyone you want — and that includes venture investors.

The credit crisis is racking private equity but venture capital might dodge this bullet

“To repay summer, they’re closing winter down…” Ask any frustrated writer and they’ll admit that they’ve got witty lines that they have been carrying around for years searching for a way to use them in print or polite conversation. With the dizzying news coming out of Washington and Wall Street on a daily basis, I got the rare chance to actually hit the trifecta in being able to deploy that obscure lyric from equally obscure ’90s-era pop band XTC in two news outlet interviews and in venture industry mixer cocktail banter in one 24-hour period. For a journeyman writer, that’s gold, Jerry. GOLD!

To me, the line is evocative: witty due to its illogic but also a bit sad and sobering. The notion of canceling winter due to the excesses of the previous summer is a clever turn of phrase. But, as we all know, winter is coming, regardless. It cannot be cancelled, nor postponed, nor have its length or ferocity negotiated away. Sunday was the first day of fall and that point was brought home to me vividly that afternoon as I enjoyed a spirited drive through Sonoma wine country and witnessed the amber hues amidst the rows and rows of grape vines that blanketed the valley hillsides. The metaphors of the season’s obvious change evident that afternoon juxtaposed with the steady stream of dour financial news and doomsday prognostications for our economy were not lost on me.

In the weeks to come we will no doubt hear every hackneyed and overwrought phrase or adjective used to describe the woes that currently face this country’s financial system. “Apocalyptic” and “catharsis” are my current favorites. That said, I don’t want to minimize or trivialize what is happening to US financial markets. Indeed, as exciting or terrifying as it sounds history is occurring before our very eyes, hundreds of books will be written on this subject in the months to come, and we will have many more years to divine what happened, how we all got here, and what kind of country and economy we will become in its aftermath. While I have been known to say that pendulums swing but one way — too much this way; too much the other; forever – I may have cause to reconsider that maxim when it comes to the changes afoot in how the US government and the financial system work and play together. For one thing, I doubt we will ever see the kind of deregulation free-for-all of the past 25 years again–certainly not in our lifetimes.

The venture markets, however, have thus far been spared the carnage and dislocation evident in other sectors of private equity. Some market participants will no doubt argue that point. However, while our financial markets are inextricably linked on many levels and while a long and deep recession will eventually extract its pound of flesh from all private equity market practitioners, the day-to-day functions of a typical, traditional venture capital firm have not changed all that much in the past year. More cautious investment philosophies? To be sure. Less froth and competition for most early stage deals? Most definitely. However, investing moves apace, certain fundamentals idiosyncratic to early stage venture capital remain sound, and most firms report strong deal flow and relatively consistent interest from existing and prospective limited partners. So, why the seeming contrast? Let me posit a few ideas.

1. Venture capital learned (some of) the lessons of the tech bust and did not “re-load.”  If you accept the axiom that what goes up must come down, then you must also accept that the fact that venture has been spared the carnage visited on other sectors of private equity has a lot to do with the notion that venture capital never really recovered from the tech bust earlier this decade. As such, while our hedge fund and buyout/LBO firm brethren were raking in massive remuneration over the last seven years (and getting a bit sloppy regarding overcompensation and managing LP relationships) most venture firms were relatively hunkered down. Additionally, there were few meaningful liquidity events sufficient to re-ignite the cash spigots from distributions of circa 1998-2000. (A lot of this has to do with the seized IPO market and dwindling M&A appetite, but more on that later. ) Even venture firms that went “all in” on the latest consumer internet/Web 2.0 boomlet beginning in 2004 still did not typically bring on platoons of new partners to chase and manage new deal flow; they typically elevated their own — many of whom were around during the tech bust and had the scar tissue to not repeat certain ill-conceived practices. If there is doubt on this last point, please ask any venture partner recruiter. Sad as it sounds, throw a rock through Palo Alto’s Il Fornaio on any given Friday happy hour and you will hit six former General Partners at marquee Sand Hill Road venture firms still “on the beach” all these years after the tech investing bubble burst.

2. Better teams, better ideas, less journeymen. This point has been echoed elsewhere. This is also probably because it’s accurate. Soft markets do a lot of wacky things. One of things they do is weed out a lot of mediocre folks with mediocre ideas who really should stay at their jobs at Big Tech Company or Impressive Consulting Firm and leave the funding landscape to talented people who actually have a technology or a compelling business idea that has real potential. In frothy markets, everyone feels emboldened to go for that brass ring and try out their crazy ideas. That’s great. It’s part of what makes the industry so rewarding in many ways. However, when markets soften those same people are more concerned about keeping their jobs, thus clearing the way for people who need to start exciting new companies because, frankly, they have no other choice. Those are the kinds of people I like to meet with.

3. Soft markets allow start-ups more time to get it right.The day-to-day blocking and tackling of building a company has little to do with exogenous economic factors. Whether markets are heated or cooled, the mechanics of building a product, recruiting partners and employees, sealing partnership deals, and taking a product to market remain unaltered. Frothy markets are often a negative because they distract founding teams and force them to spend much more time competing with other companies for talent, trying to get the attention of their over-worked attorneys and advisors, cutting partnership deals, locking up building and equipment leases, etc. There is also the annoyance of having to continually reassure early investors and employees about the company’s prospects each time a new market entrant raises a venture round and carpet-bombs the community with press releases. A softer market slows things down, re-establishes more stable equilibrium for costs and expectations, and reduces the likelihood that other would-be founding teams will get funded. The upshot? More time for you and your team to focus on building a great company.

4. The Last Man Standing concept. OK, this is a bit controversial but here goes. To many limited partner investors, venture capital was the ugly girl at the Ball in the aftermath of the tech bust. The star for Hedge funds and private equity firms was ascendant once venture capital fell on difficult times. For complex reasons too involved to go into on this forum, hedge and buyout firms were able to attract enormous amounts of money and, for a time at least, brought some impressive returns for that money. The venture capital model could not really compete with those returns. In short order, LP allocations for traditional venture capital funds were cut. Poorly performing venture firms closed shop, fund sizes were cut, and new realities were beginning to become adopted in the community to cope with longer hold times, a dry IPO window and intermittent M&A cycles. Now that hedge funds and buyout firms are struggling with their own challenges in the current financial crisis, venture firms have become more palatable for limited partners again.

In short, the venture capital story is a compelling one. Kleiner Perkins’ Ted Schlein has been an impassioned ambassador for the industry and has worked tirelessly to distinguish for the limited partner community what it is venture capitalists do and how they differ from the activities of buyout and hedge fund professionals. As terms like “financial engineering” and “complex derivatives” become derogatory in the current credit crisis, the notions of building great companies and innovating ideas that can change the world and how we live in it will continue to gain power. That allure will continue to draw in new investors from the institutional class who wish to play a part in this next chapter. Venture capital is ideally positioned to leverage that renewed interest better than any other asset class. While there remain myriad problems — the lack of an IPO window is a serious problem and the dwindling numbers of M&A acquirers is an increasing concern — venture investors seem unified and motivated to address these issues and implement viable long term solutions.

Tough times at hedge funds could be helpful to VC firms raising capital

As if the old adage about Main Street coughing and Wall Street catching pneumonia wasn’t tired enough already, new kindling was added to the fire in recent days in the form of abysmal performance numbers put up by some of the industry’s best known hedge funds as well as word that certain marquee portfolio managers were packing it in. Dan Benton, who made his name at Pequot and Andor Capital Management, announced he would be shutting down his fund in October. Former CNBC financial news commentator Ron Insana’s advisory fund-of-fund vehicle told it’s investors that it would cease operations shortly as well.

Predictably, the schadenfreude has already begun. There are some within the venture ranks that have maintained that hedge funds and private equity groups had effectively sucked all the oxygen out of the room for venture firms these past six years in terms of attracting limited partner capital. While there is anecdotal evidence that one could argue supports that claim, I remain unconvinced. The principal rationale for venture firms imploding, at least as far as I have witnessed, has had very little to do with competition for investor dollars by hedge and private equity funds and has been largely the result of mediocre returns from mediocre venture outfits, persistent legacy issues, partner infighting, a dreadful dot-com/tech meltdown that took longer than anyone expected to work its way through the system, and a host of other ills. In almost all the cases that I have heard of, blaming hedge funds and private equity groups for draining the capital flows from venture groups has really been about sour grapes and about finding a convenient straw man to punch. Add to that the caricature that the popular media has provided of hedge fund and private equity players throwing themselves lavish birthday parties, buying robber baron-esque country estates, and indulging in over-the-top spending sprees, and you have a convenient whipping boy that is begging for a pile-on and a great story line for glossy magazines about the imminent bursting of the hedge fund bubble.

Sure, it makes for great copy, but not so fast. In its own Oscar Wilde-ian way, the demise of the hedge fund is being greatly exaggerated.

I don’t pretend that my crystal ball is any clearer than most in these matters, but I have been wondering aloud for years how the mathematically unsustainable lofty hedge fund returns could be, well, sustained. The hedge fund industry did not grow inasmuch as it exploded. From 800 active firms to 6,000 firms a few years later, to some 20,000 funds some time after that. If one accepts the premise that markets are efficient, it becomes pretty clear very quickly that returns must normalize over time as the market becomes ever more crowded with hedge funds all trying to beat the market. The inelegant image it conjures up is that of Miami Beach retirees all walking a small sandy beach with their metal detector wands in hand looking for that lost Rolex or wedding band. One guy will probably make a bundle. If there are 10 retirees out there, perhaps two will enjoy “outsize returns” for their time investment while the remaining 8 will cover costs and eke out a living. What we have come to — to push this metaphor to its logical conclusion — is 500 people on the beach…and it’s bedlam.

Ok, perhaps not a great analogy, but you get my point. Everyone in venture (and, I suspect, in the hedge fund business) loves to talk about finding the “white spaces” — those elusive regions no one has discovered yet. [i.e. That patch of sand no one has yet tilled with their metal finder.] Raw, exciting areas of opportunity where other investors aren’t breathing down your neck (yet) and there is time to roll up one’s sleeves and make a go of things. As more and more people pile into these sectors, incentives get perverted, valuations go haywire, and it’s almost impossible to get to a positive outcome. Typically, only a handful of smart investors find a way to eke out a couple good deal exits and everyone else licks their wounds and moans about the sector getting “overfunded.”

As tough as this is in venture, it’s just dreadful in the hedge fund world because of the mechanics of that business. Like in a sailing regatta, everyone is tacking off everyone else. Show a little success and you will find entire platoons of me-too copycat hedge funds mimicking your every trade. Pretty soon, you need to go further out on the risk profile to chase that elusive outsize return and then, like Icarus and his wings of wax, things don’t turn out so well. Now I know why there are almost always empty bottles of Tums strewn on every desk I walk by on the times I find myself at a hedge fund’s offices – especially lately. 

While I do not cheer at the knowledge that some of my friends on the hedge fund/buyout fund side of things are in crisis right now, such a development could be good news for venture. Pendulums swing in only one way — too much this way, and then too much the other. Forever.

As for the hedge fund business, it will survive and prosper. Of that, let there be no doubt. But it will be leaner and more differentiated that it has become in recent years. This is in large part because in order to provide “outsize returns” hedge funds really need to get back to their entrepreneurial roots and eschew the temptation to raise excess capital and become like the bloated, glorified asset managers that they seek to best in terms of market returns. As the saying goes, one starts out in both life and business trying to break the mold; pretty soon, you are the mold.