Morgan Stanley’s Mary Meeker delivered an interesting speech at the Web 2.0 Summit on current market trends in the broad consumer internet/Digital Media space. Ordinarily, a talk on this subject from a banker/analyst would not move the news-worthiness needle enough for me to make it into a blog post, but Meeker has had a unique voice in the space for some time and the content-rich 18-minute clip gives a good overview on where the sector is and what macro trends are most in evidence.
Bill Reichert, a partner at early stage venture fund Garage Technology Ventures, gave a talk recently at Dublin SmartCamp 2010 in which he offered some thoughts on how entrepreneurs often get themselves into trouble with investors with ten lies that they often tell in pitch meetings. Personally, I would say “lies” is a strong term. More accurately, these are statements that are either unknowable or that lack foundation or sufficient evidence to support them.
While the statements are largely self-explanatory, I thought it helpful to provide some additional commentary in the interest of helping entrepreneurs understand why investors have a difficult hard time finding these arguments credible and why, in most cases, it’s best to simply avoid making them altogether.
1. Our projections are conservative
This kind of argument typically lacks foundation. What is a conservative estimate in a new industry where much is unknown about the growth path of companies in this space? Are there reasonable comps to reference? A better approach is to build sensible, data-driven financial assumptions and make sure they are supportable.
To be clear, making aggressive growth forecasts in a financial model is not a deal-killer. Indeed, venture investors want to see the potential for explosive growth in the business and will likely not invest if they are not convinced that the business can become a juggernaut. That said, whatever growth assumptions are made should be grounded in some logic and consistent with how the industry functions.
2. Our target market is $56 billion
Are there $56 billion markets? Of course there are. That’s not the issue. Having a large market is one of those necessary but not sufficient components to securing funding. An entrepreneur must also make a compelling case for what portion(s) of that large market are truly addressable, how the company intends to attack those addressable segments of the market, and, once a beach head has been secured and early validation has been achieved, how the company intends to roll out its solution more broadly.
3. We have a world-class team.
Sounds terrific. Based upon what, exactly? How are we defining world-class? This is just sloppy semantics. Like the word “genius”, “world-class” is one of those phrases that is bandied about cavalierly in the start-up community.
Let the investor be the one to judge how impressive the team is. Insisting that the team is world-class at the outset won’t impress investors to suddenly embrace it as gospel.
4. Our average sales cycle is 90 days.
There are few sales cycles this short, so insisting a company can enjoy that privilege will strain credibility. Entrepreneurs should shy away from making this kind of statement. As in #1 above, making this argument is not necessarily a deal-killer nor entirely wrong if it is indeed the case for this company and this market. However, if this argument is made then the entrepreneurs need to be prepared for a lot of collective eye-rolling and some pointed questions demanding data to support it.
5. We have no direct competitor.
This is perhaps the one comment that is most likely to persuade me to end a pitch meeting early and abruptly. There is always competition. Before pitching any investor, an entrepreneur should have thoroughly investigated the entire competitive landscape and identified not only current competitors (direct or tangential), but also developed an understanding of all the potential competitors that could enter the space at any moment. Like any good chess player, an entrepreneur must be thinking several moves ahead. She should ask, ‘Who could easily get into this space? Are there incumbents in tangential markets that could extend their reach into the market? How would our company compete with those better-financed, more established incumbents and their competitive solutions? What is defensible in our solution and our approach?’
If the start-up is fortunate enough to obtain funding and if the company executes well, one thing is sure to happen: if there wasn’t much competition previously, there will certainly be fierce competition now. A market entry plan should incorporate not only the thinking around how to enter the market but also how to stay competitive once new entrants emerge—both other start-ups and incumbents extending their reach.
6. No one else can do what we do.
This statement strains credibility because it assumes that the management team has hit upon something no one else has actively considered nor has the capabilities to successfully execute. In reality, this is very very rare.
7. All we need is 2% of the market.
Investors are not interested in a company that can be content with 2% of the market. As I like to say, “You are either in the lead, in the hunt, or in the way.” Venture investors aren’t just interested in backing potential market leaders; they must be backing potential market leaders. There is little room for ventures that can, at best, be a nice little business. There is nothing wrong with “nice little businesses,” mind you. Most small business in this country would fall into that category, but that does not make them appropriate venture investments.
8. We’ll be cash positive in 12 months.
This argument is problematic on a number of levels. First, it strains credibility. Few businesses can achieve cash flow positive one year after launch. Second, if the company hits this milestone this quickly it raises a lot of uncomfortable questions about whether this business is really that attractive, whether this market is that substantial, and whether the management team is being penny wise and pound foolish by focusing on achieving this at the expense of investing in growing the business.
While it may appear counter-intuitive, most investors are not primarily focused on getting a company to achieve cash flow positive in a narrow time frame. Their primary interest is in building a substantial company. This usually means embarking upon a torrid growth path which, in turn, often means that a great deal of capital will be necessary to fuel and sustain that growth which will, in turn, often push out the timeline of becoming cash flow positive.
9. I’ll be happy to hand over the reins to a new CEO
This is one of those ‘live by the sword, die by the sword’ dilemmas for entrepreneurs. Typically, one of things that influenced the investors to consider investing in the entrepreneur’s business was the entrepreneur’s sheer determination and tenacity. Investors love vigor and drive in a start-up CEO. However, that zeal also often comes in a personality not easily persuaded to step aside in the face of challenges and outside pressures. A CEO who is so invested in the business and considers it her baby is not likely to readily hand over the reins once investors feel a change is necessary at the top. That said, a good chief executive must grasp the effectiveness of everyone on the team and when that team member may no longer be the right fit for the company’s needs at that time. This is best communicated through actions over time, not through empty pronouncements.
10. Our contract with [Big Company] will be signed in two weeks.
Investors who have been involved in partnership agreements will agree that when it comes to large companies nothing takes two weeks.
The real danger in raising this argument, and many of the previous ones, is that it signals to the investor that the entrepreneur is naïve. This is, perhaps, the greatest risk to the entrepreneur. Investors are quite forgiving. They understand that there are many unknowables; that market conditions can change at any moment; that exogenous factors can creep in and fundamentally alter a business’ prospects. This is par for the course. However, what is critical for the investors is for them to feel supremely confident that the management team is capable enough to be nimble and to navigate through the speed bumps as they occur. What truly alarms investors is the sense that an entrepreneur is not savvy nor experienced enough to know how to react to these headwinds nor how to think about sales cycles, nor what typical growth expectations should be for a company in this market, etc. Gaffes such as these can effectively kill a financing because they can have the effect of undermining the investor’s faith in how the entrepreneur will manage the business post-financing.
Proving one man’s bubble is another man’s boom, venture capitalists John Doerr and Fred Wilson offered a refreshingly candid talk on the current venture market. Not surprisingly, given the focus of the event their perspectives were centered on the broad consumer/digital media space. That said, many of the insights — particularly around the health/attractiveness of public offerings for tech companies, the “nexus” of innovation (the NY vs. Silicon Valley debate), and other topics– apply easily across broad IT. The video runs about 37 mins, but is worth watching.
Many who came of age after 1980 might well remember the notion of the rock supergroup. [Asia anyone?] The idea sounded great: Why not assemble a band composed of all-star musicians from other groups? No filler, no mediocre musicians gumming up the works; just great players riffing off each other and making historic music for the ages.
However, like so many things concocted by committee—record company A&R departments being behind many of these supergroups—the reality rarely lived up to the hype. Despite some early commercial success these ventures rarely translated into significant musical contributions to the oeuvre. Honestly, can anyone name one song from a Bad English or Damn Yankees release? Me neither. Asia, for its part, is now a punch line in the 2004 comedy The 40-Year-Old Virgin.
In even the successful cases, most supergroups barely squeaked out one album and a follow-up tour before collapsing in a conflagration of clashing egos and battles over control, songwriting credits and, of course, over money. Rarely has a supergroup produced a follow-up record of any note, or at all. As a music fan myself, while I often wondered what a second Blind Faith or Temple of the Dog release might have sounded like I am comforted by the fact that, in most cases, the musicians behind such collaborations typically returned to their mother ships and produced other great works that can be enjoyed to this day.
I revisit this nostalgic musical past in part to both draw a parallel and to illustrate some of the silliness behind the notion of assembling fantasy VC teams. A recent blog post I came across posited the idea of assembling a “dream team” VC fund by identifying best-in-class investors and analyzing the implied return that a synthetic fund composed of those investors would generate. As a casual intellectual exercise, this analysis is fairly innocuous and hardly worth the time to mount a rebuttal. However, I sense there is something more harmful and even a bit disturbing in the notion—even the ephemeral notion—that venture returns and venture funds themselves can be cobbled together by component parts and put out on the road like some sort of inert machine designed to generate returns.
In a sense, I can appreciate the blogger’s fascination with the hypothetical exercise. While the venture industry has long been accused of being opaque, data is now increasingly available on venture industry returns and on fund performance and individual investor performance within those funds. Additionally, there are endless analytical tools at one’s disposal to run all manner of what-if and back-test scenarios. It’s only natural that one would be interested in running a few simulations. In short, I get it.
The problem I have with this kind of examination, however, is that it completely dismisses and discredits the role and value of the venture firm itself and that of what it takes organizationally to support a great investor to do his or her best work. In other words, it takes no account of the value of the partnership, the venture organization itself, nor how teamwork plays a role in generating great and consistent industry-leading returns.
The venture industry has long sought to codify ‘best practices’ and/or to identify the elements that separate venture firms that consistently post industry-leading returns from those that fall short. Appropriately, that is a topic for another post. That said, success leaves clues. Of the characteristics that great venture funds share I have found four that consistently appear, which I conveniently call the 4 Cs—a collaborative and collegial working environment; a consensus-driven deal selection and approval process; and, a cohesive team of investors that has a history of working together with minimal turnover. Sure, there are some top performing firms that do not possess all these characteristics, but I posit that an examination of firms that have consistently outperformed their peers over long stretches of time bears this out.
While few would argue that the venture industry is renown for having personalities lacking a healthy self-image, even the most immodest individual venture investors would rarely assert that they were solely responsible for their great personal track records. Indeed, when many prominent VCs left to invest for their own account independent of their prior firms few were able to repeat their earlier successes on their own. Returning to the music analogy for a moment, it is a rare frontman or guitarist able to mount a solo career equal to the glory and success achieved when just a member of the band that brought them their initial fame.
Venture team dynamics play a vital role in great returns. Moreover, having venture funds made up of investors that play off one another in sectors that counter-balance one another in booming and fallow cycles is a key ingredient to achieving consistent, industry-leading returns over time. No sector stays hot forever.
As such, the idea of assembling a “dream team” venture firm of discrete all-stars from other firms is no more appealing nor realistic in the real world than how supergroups of a generation ago fared. The connective tissue that binds a great rock band and a great start-up founding team and a top-tier venture firm are not all that dissimilar from one another. There are intangible qualities behind great partnerships that no spreadsheet or model can ever fully incorporate or capture, regardless of its complexity. Mick Jagger is Mick Jagger primarily because he came wrapped in a package with Keith Richards, Ronnie Wood, Charlie Watts and Bill Wyman. No self-respecting music journalist would argue that any of Mick’s bandmates were best-in-class at any of their instruments. However, those same journalists would likely stipulate that the combination of that merry entourage, as dysfunctional as it was at times, created something magical that the component parts could never pull off on their own. Mick Jagger’s less-than-stellar solo career in the 1980s is surely testament to that.