As most venture capital general partners know, for several years and until very recently, new limited partner investments in the venture asset class had come to a grinding halt. Instead, buyouts became the sexiest game in town and limited partners focused their energy and dollars into buyout managers. Many entrepreneurial VC firms reacted accordingly by repositioning themselves via “opportunistic,” “multi-stage,” or “stage-agnostic” strategies. In several cases, reputable early stage VCs left reputable early-stage firms to create new “venture buyout” firms that were designed to attract limited partner dollars earmarked for the buyout end of the private equity spectrum.
While the emergence of buyout firms has spurred the interest of limited partners, many VCs-ourselves included -continue to believe that venture capital and buyouts are only cousins and not identical twins. Like hockey and basketball, venture and buyouts both share the same stadium, target a similar audience, and require physically and mentally-adept athletes, yet they are not the same sport.
To continue the analogy, athletes can often learn from and emulate each other, even as they acknowledge the similarities and differences between their sports. And so it is with venture capitalists and buyout managers. We don’t profess to be buyout experts nor do we believe the two professions are readily interchangeable.
Still, there is a great deal venture managers can learn from their counterparts in the buyout world. In a 2002 Harvard Business Review article entitled “Value Acceleration: Lessons from Private-Equity Masters,” several Bain Capital partners outline their views regarding value creation by leading buyout managers. They compare the “value-add” of buyout investors with that of public company managers. In reading their article and many others, we observed a number of similarities (and differences) between buyout and venture managers.
Caveat: We are not buyout managers and there is much we don’t know about that art. However, as spectators of the buyout world, there are many things we can learn from our cousins.
According to the HBR article, successful buyout managers add value to their investments through a few core principles, such as fast action, transformation, managerial discipline, exit thesis and timing, management replacement and incentives, cash management, and a general sense of unsentimental analysis when it comes to effectuating change. They are also highly disciplined about exiting their investment when the price is right, being directly involved in high-level hiring (and firing), and fostering close GP relationships with the CEO.
In theory, venture managers follow many of these same principles with their portfolio companies. But practice reveals something else entirely. Take fast action, for example. Can anybody reading this column think of cases where obvious changes, such as cash burn reductions, management changes, or founder replacements took months to implement? Of course we can.
In many venture boards, pomp takes precedence over circumstance. After months of debating an issue, many experienced venture boards agree to resolve the issue … at the next board meeting. For many VCs, fast action is not a requirement of corporate governance in private companies. In fact another word for venture capital is “patient capital.” Some venture groups market themselves on this basis to entrepreneurs. Relative to other asset classes, certainly early-stage venture is a long-term game. However, many have come to confuse the duration of an investment with the need to effectuate change quickly.
Don’t Spare the Rod
Exit thesis and timing is another area where VCs simply lack the discipline of their buyout cousins. Certainly, most VCs can recite the “IPO or M&A” exit strategy for each of their companies. But how many VCs agree, inside their partnerships and inside their investment syndicates, on an acceptable exit value of their investment? In many cases we know, venture investors many years into an investment will continue to politely disagree on the ideal exit amount for the company. In some cases, it’s due to greed (which is defensible).
In others, it’s indifference. In almost all cases, no formal upfront discussion takes place among the investment syndicate regarding timing and valuation of exits. In a recent case, we considered participating in a first- round venture investment. As is always our process, we asked each of the two other investors what their exit thesis was. Both were unable to “predict” the value the company would build over time.
Considering the months of due diligence, it is ironic that an exit thesis and valuation is not part of every venture investment recommendation. Inevitably, lack of clarity and consensus on an appropriate exit strategy hinders the company’s exit later down the road.
Unsentimental management replacement is another area where many (though certainly not all) venture investors fail to heed their buyout cousins. How many venture boards fail to unanimously agree on the swift replacement of a CEO or VP? How many “second chances” and “leash-shortening” exercises can venture managers recall within their portfolios? For reasons hard to understand, unsentimental decision-making around management replacement is abundant. Perhaps again, pomp takes precedence over circumstance.
In an industry where reputation is everything, many VCs don’t want to harm their reputations by alienating management. After all, their very next deal might be sourced by a friend of the CEO whose job is now on the line. In a recent situation, one of our partners drove a management change and gained consensus in the syndicate (after many months).
A lunch was scheduled with himself, the CEO, and our co-investor in the deal. En route to the meeting, the two investors coordinated their message and meeting strategy by mobile phone. They agreed that after some small talk and before the salad was served, our co-investor was to broach the topic of change. As dessert was served, he stayed silent, forcing the Blueprint partner to broach the sensitive topic. Sentimentalism and reputation drive VC actions perhaps more forcefully than they do those of our buyout cousins.
Follow the Money
Cash management used to be the key measure for venture boards. Unlike large companies focused on ROI, ROE, or more recently EVA, venture companies should care primarily about cash. Yet many entrepreneurs over the last few years have found creative ways to disguise poor cash performance under metrics that replace the Internet “eyeballs” of yesteryear with other non-cash metrics. Many software startups have taken to reporting revenues, bookings, and other success metrics. Cash reporting sometimes takes a back seat to bookings growth.
VCs (perhaps unlike their cousins) are an optimistic and visionary bunch. Cash waterfalls are much less interesting than bookings and sales pipelines. As a result, many a venture-backed software startups will evolve sophisticated dashboards to show their boards a snapshot of their business. But cash is often an afterthought, perhaps because, over the past few years, venture boards silently pledged additional capital by way of insider rounds of “fully funded syndicates.” All an entrepreneur must do to gain the keys to the coffers is to demonstrate “traction” in the business. More often than not, traction comes from visionary presentation slides, and not spreadsheet cash waterfalls.
Don’t get us wrong; VCs care a lot about cash. But in many cases they get sentimental about reducing cash burn for fear of killing the business.
Many in the venture community describe themselves as “company builders” and show disdain for words such as investor or venture capitalist. Here lies perhaps the most fundamental difference between the two branches of the private equity tree.
Buyout masters describe themselves as crackerjack investors, whose professional mission is to raise capital, invest in promising opportunities, and focus incessantly on returning a capital multiple to their investors.
Venture investors speak a different language: Their professional mission is to raise capital, build reputation and deal flow, and focus their energy on company-building. Build it and they shall come. For an industry investing billions of dollars each year, it seems strange that so many VCs would consider themselves anything but investors. VCs would be well advised to borrow a chapter from the buyout world by focusing on delivering a solid ROI, lest the returns of the last few years shorten their “company-building” careers.
Bart Schachter and George Hoyem are managing partners with Blueprint Ventures, a San Francisco Bay Area early-stage IT venture firm. Schachter focuses on communications. and IT infrastructure, Hoyem focuses on software infrastructure. They may be reached at email@example.com or firstname.lastname@example.org.