Lessons Learned in the Bubble – Part 1 –

It was with surprise, perhaps even irony, that we developed this month’s column on “Lessons Learned.” We began by searching past issues of VCJ, assuming that a handful of prior stories would have tackled this important subject. It is, after all, widely accepted that most limited partners, tourniquets still tightly wrapped around their substantial private equity losses, are looking hard at their GPs hoping to hear that, as a small consolation to the billions of dollars lost in the last cycle, their managers have spent months if not years in introspective analysis to identify and apply those lessons to the next cycle. Ironically, that was not the case, at least not in this publication. This is not to say that GPs have learned nothing from the past cycle or that many are not undergoing expiation therapy with the goal of awakening as better venture capitalists.

Still, we were not able to find any definitive pieces on the subject. At conferences and on panels, LPs speak frequently of their mistakes over the past period. And GPs sometimes join in the choir, many times by rebuking the LPs for giving them all that money to begin with. “If LPs hadn’t given us all this money, we couldn’t have funded startups to advertise Internet pet food on the Super Bowl.” Things would have been much different if only LPs hadn’t given us all that money.

To set out and describe our own lessons learned at Blueprint Ventures, we spent a day reviewing each of the 50-plus deals the partners had managed over a seven-year investment period. The results were fascinating and patterns quickly emerged. While not a scientific survey, our findings include lessons learned about financings, management teams, market conditions, co-investors and staffing a venture firm. This is Part 1 of a three-column series (maybe more).

The Investment Pyramid

Our most obvious observation pointed to losses of our larger dollar investments vs. the success of our smaller ones. Instead of identifying winners and losers early, it appeared that the losers swallowed a disproportionate amount of the fund’s capital. More notably, we found that the majority of the casualties raised large Series A rounds and only smaller B and C rounds. Example: MobileStar. We helped back the company, which literally invented the “hotspot,” or public access Wi-Fi network at Starbucks and elsewhere. MobileStar’s Series A round raised $40 million. By the time its assets were acquired by VoiceStream, it had raised an additional $15 million. In other words, the majority of the loss was on the first check written by each of the syndicate partners.

Historical VC investment was predicated on a pyramid that simply said, “Put a small amount of risk capital to work, and follow your winners.” (See Figure A.) However, on the MobileStar deal and many others, syndicate pressures led to gargantuan Series A rounds with little room for evaluation or course correction later. Even today, many groups still point to “fully funded syndicates.” Daily announcements of $20 million-plus Series A deals indicate that a lot of firms are still ignoring the rule of thumb. Lesson: Make sure your pyramid is pointed in the right direction, that is, upside down.

Exit Valuations

One of the things we’ve learned (the hard way) over the last few years is that exit valuations are not generally correlated to invested capital. In the current market, which we expect to persist for the foreseeable future, exits will be capped in the $100 million to $200 million range, regardless of the cost of building the company.

This is an empirical finding based on 18 months of exit data. Understanding this fact several years ago would have made a big difference. Here is an example across several companies: NewCo has just received an acquisition offer from a large, public company for $50 million. To date, NewCo has raised $35 million of capital and needs to raise money again. Take the money and run!

The alternative is to raise another $20 million, suffer 50% dilution and hope that a $100 million will come later. If it does, you have broken even. If it doesn’t, you are broke. This happened many times over during the bubble as VCs overestimated the value of their holdings. It is happening again as many groups refuse to face the valuation reality and ignore business 101: sunk costs are sunk costs. The value of a company will not change in the future, unless a major breakthrough is imminent. More often than not, the breakthrough never comes. Lesson: Take the deal when you can!

Hiring the CEO

CEO selection figured prominently in a majority of our successes and failures during the last cycle. The process of recruiting a CEO was related. No one will deny that a good CEO is a key success factor and a bad CEO is frequently the fall guy for a deal gone sour. But how is a CEO recruited and un-recruited? Our most prevalent failure involved “incomplete management teams.” The syndicate would agree to fund a deal and set out to recruit a CEO. For the most part, this strategy was a recipe for disaster. First, the process takes six to nine months, including three months where different board members attempt to agree on which executive recruiter to use, not a trivial task when “favor” piggy banks are counted and compared among VCs. Next is the challenge of agreeing on a candidate profile. GPs reading this will appreciate this point as they reflect on the hundreds of hours spent on free-ranging syndicate discussions on what would make the “ideal CEO.”

Finally, there is the recruitment process itself. For the most part, executive searches are lengthy, expensive and frequently unsuccessful. They sometimes produce candidates who the VC themselves already know but did not want to introduce directly for fear of upsetting the “process.” In the last cycle, the trusty Rolodex gave way to executive recruiters who minted search fees on the basis of this trend. Lesson: Nothing works better than a thick Rolodex.

On a related note, there is the issue of “organ rejection.” Unless a complete management team is in place (or is installed in place) prior to a term sheet, founding teams will often reject the organ (CEO) transplanted for them by their VC board. We have had this happen more than once. Many founders are living a dream of control and domination and view the VC’s insistence on “professional management” as an affront to their character. Before the money is wired, they may play along. But after the money is in the bank, all bets are off. Lesson: VCs need to build management teams (“implant organs”) before making an investment.

Firing the CEO

There is a premise in the venture business that you can never fire an operating manager too early, and we certainly agree. That said, many syndicates refused and continue to refuse to make this tough decision. In one-third of our portfolio companies where management was replaced, it was driven by a Blueprint partner and often done in spite of opposition from syndicate partners. This phenomenon is difficult to understand considering the truism of the premise. One explanation is reputation.

Many VCs might be loathe to orchestrate change because (1) it’s not pretty and (2) they’re worried that it will hurt deal flow, since some entrepreneurs or CEOs may avoid a VC who they think may later fire them. Our opinion is clear but not widely shared: Activism is a key requirement for early-stage company building. Lesson: When it is clear that management needs to change, pull the trigger as soon as possible.

Syndication

Many deals failed because of poor syndication. Syndication is a misused term. Everybody wants to syndicate (again), but with whom? Our experience has shown that lack of alignment, focus, philosophy and timing can make even the greatest sounding syndicate fail. Here is how: Company boards are like startups themselves. They are made up of people who need to work together to get something done. They need to communicate, meet, align, focus, work very hard and agree on objectives. That becomes hard when one of the team members is on a different page.

For example, we syndicated an early Blueprint I deal with a well-known venture group. What we didn’t know was that the particular partner wouldn’t be participating in that firm’s next fund. In many ways he was “done,” and a success in our mutual investment was irrelevant for him. At board meetings, between his visits to exotic islands, we slowly understood that while we were working desperately to create a successful portfolio company, his incentives were different.

In fact, with a shrinking number of portfolio companies, he had no incentive to bring any to liquidity, which would have reduced his total number of boards. Lesson: Make sure you do as much due diligence on a prospective syndicate partner as you do on a deal itself.

In another example, lack of alignment of syndicate fund sizes resulted in a complete write-off. Back in 2000, we syndicated a deal with a very large fund. When were presented with an M&A opportunity, we were pleased because it would have salvaged a modest part of an investment to bring a 1.5X return. However, the large fund we syndicated with refused to support the deal, arguing that 1.5X return on their $5 million investment would not “move the needle” in their billion-dollar fund. Ultimately, the company shut down. Lesson: Syndicate with like-minded people and agree upfront on the objectives of the investment.

Next time: Board/management dynamics, capital efficiency, managing the exit process, building a venture firm, aligning general partner interests, and the ethics of venture capital. Stay tuned.

George Hoyem and Bart Schachter are managing partners with Blueprint Ventures. Blueprint is an early- stage venture firm with two funds under management. Hoyem’s investment focus is software, wireless, security, and other IT and communications infrastructure companies. George may be reached at george@blueprintventures.com. Schachter focuses on communications and IT infrastructure, wireless technologies, nanoelectronics, software, and communications semiconductors. Bart may be reached at bart@blueprintventures.com.