In last month’s column we began an introspective series on what we learned from investing during the technology bubble. We have since received many comments from limited partners and general partners regarding this important topic. Foremost, readers were grateful for our initiative in tackling this subject. Most were as surprised as we were at the lack of prior contemplation on the topic.
So far, we discussed the following:
* The investment pyramid. This deals with minimizing portfolio risk via carefully controlled cash infusions. The key lesson is that venture firms need to limit their initial cash investments and only follow their winners-in an inverse pyramid form.
* CEO selection. This includes the hiring and firing process, which has a fundamental relationship to overall deal success. The old adage of “you can’t fire a CEO too soon” has proven itself again and again over the last cycle.
* Syndication and goal alignment between investors. The key lesson here is that co-investors need to have an early and honest discussion regarding their financial expectations from a deal. Deals whose venture firms have widely diverging return objectives are likely to lead to dysfunction and possible loss of capital. (For more, see “Lessons Learned in the Bubble – Part 1,” page 58, March VCJ.)
This month we continue to explore the deal syndication process with a particular focus on boards of directors. Next, we look at capital efficiency, a fundamental driver of the next wave of venture success.
Do the Math
A VC-backed board is a unique structure. Board members must forge a solid level of chemistry and trust with each other and the management team. Creating trust requires open communication, time and interest. Many VCs have found that working with 15 company boards prevents them from building the relationships required for each one. The takeaway here is simple: For early-stage investing, manage no more than five or six early-stage boards, build a trusting corporate governance, facilitate introductions and manage exits. Very smart people still only have 24 hours in each day.
Even during the bubble period, our seven-board-seats-per-partner guideline did not serve us well. It was still too much. We now believe that five to six companies per person is about the right number. Andy Grove once said that a manager should not have more than five to six direct reports because he will otherwise fail in his or her attempt to keep up and manage each one. The same logic applies to early-stage startups and the venture capitalists who manage them. Lesson: Every game has limitations.
Once the “bandwidth” equation is created, a personal relationship can be built. This forms the basis of board success over the four- to seven-year gestation period of a startup. The personal relationship between venture board members and founders could be the subject of an entire column. It speaks plainly of the value equation of early-stage VCs. Founders and company executives need advice and introductions made by their venture board members. They seek relationships and doors which may not otherwise be open. They seek help recruiting executives.
Typically, startup CEOs do not seek help in running their companies. That’s their job. The range of anecdotal evidence that speaks to the violation of this rule is outstanding. In one of our prior investments, one of our co-investors arranged for “weekly” reviews that brought company executives to the venture firm’s office for an entire afternoon. During the scheduled meeting, the newly funded company would need to report and account for its progress with a junior professional of the venture firm.
This extreme example demonstrates what we call the “screwdriver syndrome.” Many newer venture professionals with deep and senior operating histories have trouble letting go of their company-building screwdriver. They view their role on a board as providing interim management and supervision. Nothing can be more frustrating or demeaning to a senior operating team. Even with the recent departure of many operating executives from the venture ranks, many VCs continue to alienate and disrupt their operating companies by not understanding their roles on the board. Lesson: Coach your team, but do not play.
Get In Sync
Finally, a good board is complementary: strong finance, technology, industry and operational experience can come from different people. These skills can be used to synergistically support portfolio companies. On a current Blueprint portfolio company board, these complementary skills have proven helpful to executing an executive recruiting campaign. Each of the venture board members focused on recruiting an executive to the company based on his or her experience and affinity. One member focused on a CFO hire, another on a VP of Engineering and the third on the VP of Marketing. By “dividing and conquering” these tasks, the board proved itself very effective at supporting its portfolio company. Lesson: Your team benefits from synchronized coaching.
Feel the Burn
In this era of “capital overhang” why even care about capital efficiency? Simple: We believe that exits for successful venture-backed companies in the next few years will be capped in the $100 million to $200 million range. This outcome, with very few Google-like exceptions, will not be influenced by the amount of venture money raised by a startup. Stated differently, since the outcome is capped, the only way to make venture-style returns in the next cycle is by backing companies that can achieve successful exits in the expected range and provide venture-style returns. The intersection of these two objectives requires companies that can successfully gain customer and exit traction with less than $15 million to $20 million in lifetime capital. Lesson: Early-stage investors know their ratios.
Dot-coms took the heat for creating unreasonable spending habits, but every company jumped in. This led to a fundamental lesson learned: Companies go out of business when they spend all their money. Successful companies don’t spend their way to the top-not on compensation or on fancy office space. In many cases during the last few years, we as an industry forgot that. We forgot that fancy office space is irrelevant and that connecting flights cost a lot less. The company with the lowest cash burn and highest productivity wins.
Don’t Get Lost in Space
One of our portfolio companies successfully received a $15 million round of follow-on financing in 2001. At the first board meeting after the close, the question of office space was raised. The CEO proposed that the company move into a larger space, with about $200,000 in additional annual expense. A discussion ensued regarding the merits of the space (there were none) but the new investor dismissed it as irrelevant to the $15 million sitting in the company’s coffers. The CEO got his wish and two years later the company shut down. Was it because of the extra expense? Probably not, but boards that aren’t thrifty with every dollar are not doing their job. Lesson: Every dollar counts.
The answer to capital efficiency comes back to role modeling: From Hewlett Packard to Amazon, scrappy entrepreneurs built companies by treating every dollar like it was their own. Bill Hewlett and Dave Packard brought food from home to feed their engineers. Jeff Bezos built desks using wood planks from Home Depot. Somehow, this ethic was largely ignored during the last cycle. With unending sources of venture capital available, entrepreneurs (and their boards) forgot to focus on capital efficiency and entrepreneurial creativity. This doesn’t need to be the case. As one Blueprint entrepreneur recently remarked, the environment today is more inviting to low-cost operating expenses than it was 15 years ago. Office space is cheaper, flights are cheaper, communications are cheaper and even equipment is cheaper. While the cost of building a semiconductor company has risen, the cost of furnishing that company has dropped dramatically. Engineers can buy test benches and equipment on eBay. All of this should lead to greater productivity in the knowledge economy, but that productivity is only possible from capital efficient cultures.
Managing board dynamics and capital efficiency should be one of our foremost priorities and another of our key lessons from the bubble.
Next time: We’ll discuss managing the exit process, building a venture firm, aligning general partner interests and the ethic 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. Email George at