The Fein Line

Wee Willie Keeler - "Hit 'Em Where They Ain't" 

Whether it's in private company investing or public market investing, I have become more and more of a contrarian as time has gone on.  Certainly you can make money as a momentum investor following the herd, but you also have a big risk of crashing hard when the bubble bursts.  It took most VC firms years to dig themselves out of the tech bubble crash (and some are still digging).

As a contrarian, I look for opportunities where others aren't looking.  Sometimes you can be the first one to start a new trend.  Once the new trend becomes a tidal wave, it's time to get out...The beauty of being a contrarian is that competition is less, valuations are lower, and it's easier to build relationships as people are appreciative of the rare attention.

On the other hand, when you are part of the herd, you can more easily get caught up on group think, missing key issues.  Also, you have tons of competition and will definitely pay a higher price for a deal.  The upside can be high, but, as in musical chairs, when the music stops some people will be left out.

Being a contrarian brings up its own issues.  Other investors will wonder why you pursue out of favor opportunities.  You may have to wait for your target to come back into favor to have the best chance of an exit.  But, when it is time for an exit, there will likely be fewer competitors vying to be bought.  The scarcity factor can be significant.

As is the case with any type of investment strategy, the most important thing is to stick to your principles.  Don't let the market dynamics convince you to compromise your investment criteria.  Strategy drift is a big source of mistakes.

Also, I don't think I could be a day trader, moving in and out of positions very rapidly.  I focus on the long term and patience is required.  Since I'm investsing other people's money, I need them to be patient, too.

Convincing someone to go along with your contrarian strategy can be difficult, but when you turn out to be one of the only people who was right, it's all worth it.

Posted by Mike Feinstein at 12:35 PM | Permalink | Comments (0) | TrackBacks (0)

I recently caught up with a couple of CEOs I know.  Both are at companies that are about the same vintage and have spent about the same amount of money over that time.  They have different amounts of progress, but both companies are at least somewhat behind the plans that they had pitched to investors when they last raised money.

However, at one company, the Board is very supportive of the business and, although concerned about some of the progress issues, is sticking with the company and working hard to make it successful.  At the other company, at least one member of the Board has lost patience and is pushing for an exit at a pace that doesn't feel natural to the CEO.  Of course, there are always two sides to each of these stories, and I am just hearing from the CEO in each case.

The CEO of the company under pressure was wondering why their Board member had changed his attitude about the company so quickly.  I don't really know, but one issue that most entrepreneurs overlook is internal firm dynamics.  It can be hard to tell from the outside, but many times decisions at VC firms are influenced by the status of the particular fund the investment is in, the status of the partner at the firm, and partner-to-partner dynamics.

If a particular fund won't return all of its capital to investors, or the deal in question can't make a big difference one way or the other, the VC firm may be ready to give up on a deal just to free up the partner time.  This can happen with an older, small deal in a big fund.  The outcome just won't move the needle, and the VC firm is probably focused on newer funds that can generate carried interest income for them.

If a deal has lost its initial sponsor, or a partner at a firm sees some other deal as being the key for his or her ascendancy, it's possible that deals can get ignored by the partner on the Board.  Also, if partners are being tough on each other over deals in internal discussion, there may be retaliation where other deals are targeted to get even, rather than to maximize returns.

The fundamental issue is with deals that don't turn out to be as large as first thought.  However, these can still make some money for the firm and the entrepreneurs.  This kind of deal may not matter in some cases to the VC firm, but will matter a lot to the entrepreneur.  This misalignment of interest can cause problems.

What can an entrepreneur do about it?  First, do your best to know the people who will be involved in the deal, as well as to know the reputation of the firm.  Some people and firms can separate internal dynamics from how they manage deals.  Others can't.  Second, keep communications open so that if you sense these types of problems coming up, you can try to bring them into the open.  Most VCs won't acknowledge internal issues, but may be willing to minimize their time by appointing someone outside their firm to their Board seat.  This isn't ideal, but is better than getting pushed prematurely to the exit.

Also, you may be able to use other Board members and investors to keep each other honest.  No VC wants to look like the one who is the weak member of the syndicate.  Don't let a VC ringleader emerge if you can help it.  Instead, keep everyone engaged and have a lot of one on one conversations so that each person has to express their own opinion.

VC deals are like marriages, except that it is even more difficult to get out.  So, choose your partners very carefully!

Posted by Mike Feinstein at 01:43 PM | Permalink | Comments (0) | TrackBacks (0)

Today's Boston Globe has an article on the drop in VC funding both in the US and especially in New England in the first quarter of 2008.  We've been conditioned to think that when some number goes down, it must be a bad thing.  In this case, I don't agree.

Sure, it's nice when the number of start-ups and the amount of funding goes up and up.  But, that only works if the number of successful exits is also going up and up.  I've been concerned for some time that the amount of funding and the start-up valuations have been rising much faster than the number and size of the VC exits.  It's healthy if there is a breather.  It's a good thing for existing start-ups as they'll have to learn how to make less money go farther, a healthy dynamic.  And, it's a good thing for new entrepreneurs looking for money.  Having the bar a little higher means that entrepreneurs have to have a better story, a more refined plan, and a more compelling advantage in order to get funding.  Not every start-up and every entrepreneur deserves to get money.  In fact, when they do, it waters down the results for everyone.

Given the high levels of funding for the past year or so, we need a breather.  To really guage the health of the start-up world, you need to look at the health of the portfolio companies, not the amount of new money funding new start-ups.  I see more start-ups finding ways to stretch their cash and generate revenues from innovative business models and interesting partnerships.  That's the real health of start-ups.

After the dot com and telecom meltdowns, start-ups found it almost impossible to get anyone to buy anything.  That made a bad situation even worse.  Customers didn't want to bet on start-ups with uncertain futures.  These days, I am seeing a resurgence of start-ups being able to sell products and services to both consumers and enterprises.  And, with increasing capital efficiency, that revenue can go farther to help a start-up grow.  In fact, if start-ups find ways to be more efficient, they need less cash, which also puts downward pressure on the aggregate funding numbers.

So, unless there is a huge long-term drop-off and start-ups find it difficult to get customers to adopt their products and services, I'll continue to think that less funding is more.

Posted by Mike Feinstein at 10:52 AM | Permalink | Comments (0) | TrackBacks (0)

Fred Wilson wrote this morning about finding a "new path to liquidity" for start-ups.  He is fundamentally conflicted between being a VC and being a user of web services.

As a VC, Fred makes his money by either taking his companies public (harder and harder to do, particularly in the Internet sector) or by selling the company to some sort of acquirer who can pay cash or liquid securities.  Fred needs this liquidity to deliver a return to his investors.  By all accounts, he has done a great job at this.

But, since the IPO market is very tight, most companies get sold.  And, most acquirers don't realize the initial vision that the start-up had for its service.  Maybe they just want the technology and not really the product or service.  Maybe they lose focus and move onto the next corporate priority.  Or, perhaps they just can't execute well because of their size.  This doesn't always happen, but Fred reveals his frustration as a user of services that have been bought, and sub-optimized, by big acquirers.

Fred also mentions some new liquidy options for private companies, Goldman Sachs's GS True Market and Opus-5.  While I don't have any direct experience with these, the idea is that these are marketplaces where private company stock can be bought and sold between qualified investors.  Private equity firms can buy start-up positions from VCs, for example.

This type of exit can provide some liquidity and get a VC out of a position that they no longer want to hold.  But, I am skeptical that it will provide the high-multiple returns that VCs need to deliver the results that their investors expect.  Private equity firms like to value companies based on cash flow.  Most private companies that can't go public or be sold at a nice price to a strategic buyer probably don't have financials that will support a high exit price.  So, this may be liquidity, but it isn't a substitute exit that VCs really need.

And, the private equity buyers may allow the stand-alone services to grow on their own longer, perhaps realizing the vision that Fred the user is looking for.  But, if the company can't generate sufficient cash, it will go by the wayside.

On a cynical note, one point that Fred missed is that he needs the big strategic buyers to sub-optimize their acquisitions.  That creates gaps in the market that become opportunities for the next wave of start-ups to capitalize on.  If the big companies did a great job, then start-ups wouldn't thrive.  An example might be Cisco.  Although far from perfect, they did such a good job in the enterprise router market that there just wasn't much business left for anyone else.  Now, start-ups really struggle in that space and only a few get funded.  If Cisco screwed it up, there would be plenty of opportunity.

In the end, the only real exits that deliver VC returns are ones where the hype exceeds the reality, at least temporarily.  This would either be a nicely priced IPO, where the price is baking in a lot of future growth, or a sale to a strategic buyer who is willing to pay much more than what the financial statement justifies on its own.

Posted by Mike Feinstein at 10:00 AM | Permalink | Comments (2) | TrackBacks (0)

I really enjoyed Jeff Bussgang's post about American Idol in the Boardroom.  I think that he cleverly captured the personality types you need on a Board -- domain expert, cheerleader, and truth teller.  The truth teller is usually the person who the entrepreneur gets mad at the most.  But, they are the most valuable -- you need people on your Board who will bring objective input to the company from the outside and who will challenge assumptions.  You have to remember that investors and Board members are not your friends.  You want to have a good, open relationship with them, but you don't want them pulling any punches or worrying about your feelings.

I've often thought that investors tend to bring three types of skills to a company, each person with their own combination.  Note that this is different than the personality types that Jeff described.  In general, when you finalize outside investment and put your Board together, you want to get representation from all three personality types and all three types of skills below.

Skills from VCs:

1. Raw intellectual horsepower.  There are many VCs who are just super smart.  They can connect the dots faster than anyone else and think through the outcomes of various courses of action.  They often may be linked to the truth teller as you want the smartest person to not pull any punches.
2. Deep contact network.  Most VCs have deep rolodexes and close contacts with people in the industry -- potential partners, acquirers, other entrepreneurs, other investors, etc.  You should certanily expect to leverage these networks from your VC.  Make sure that the individual you bring on the Board has these connections directly, rather than representing connections that their firm has.  Most entrepreneurs will tell you that VCs are generally poor at leveraging relationships that their partners have.
3. Attention to detail.  You want to have an investor or Board member who will read everything and try to understand everything.  A lot of VCs are so busy that they don't have time for the details.  But, the management team needs to focus on the details, and, hopefully, one investor or Board member will be digging into these details to make sure that management stays on track.

As you put your Board together, make sure you have a good mixture of these skills and the personalities that Jeff Bussgang described.  Think about each prospective Board member along these dimensions and make sure you know how you score them on these scales.

These days, many entrepreneurs are raising angel money rather than VC money.  That's a good thing, but it doesn't mean you shouldn't think about your Board.  You can still put a Board together with some angel investors or industry people to give you an independent, outside perspective.  Too many times I see very early stage companies that don't put a real Board together.  These companies tend to 'breathe their own exhaust' for too long and lose site of where the real market opportunity really is.

Are there other styles or skills that you would like to see from Board members and VCs?

Posted by Mike Feinstein at 09:20 AM | Permalink | Comments (0) | TrackBacks (0)

Jeff Bussgang from IDG Ventures wrote recently about a breakfast sponsored by AlwaysOn to promote their upcoming AlwaysOn - East conference.  Jeff points out that many entrepreneurs play 'Blame the VC' when their business plans don't get funded.  It's true that some entrepreneurs are so enamored with their business plans that they feel that the VC who passes on the deal must be stupid.  And, if 50 VCs pass on the deal, they all must be stupid.  But, I haven't found this view to be very prevalent in the entrepreneur community.

I was at that breakfast, too (and had the pleasure of sitting next to Jeff).  My view of the entrepreneurs' tone was slightly different.  There were quite a few entrepreneurs who spoke up about the fact that their business plan had been funded, but not by Boston VCs.  Perhaps their plan was funded by angel investors, corporate investors, or the ever looming West Coast VCs.  I have some expereince helping out entrepreneurs whose plans I think deserve to be funded by VCs. Some of them have a lot of commercial traction.  Despite some introductions, Boston area VCs haven't moved ahead and funded these entrepreneurs.

But, these entrepreneurs aren't deterred.  They have raised money from angel groups and individual investors.  They are courting VCs that are out of town.  And, they have modified their plans to take less initial capital in order for them to prove some commercial viability before they go try to raise more money.

If these entrepreneurs succeed, it doesn't mean that Boston area VCs are dumb.  Maybe they are too conservative.  Maybe they don't understand the market segments that these entrepreneurs represent.  Maybe they are unwilling to back first time CEOs or willing to build out a team after they fund the company.  Maybe they can't justify a small initial investment.  The best entrepreneurs won't let this stop them.

Instead, these top entrepreneurs with their strong plans will let the marketplace show who is right.  There is a lot of capital out there from many sources.  A great entrepreneur has to be a great sales person.  If you can't sell your plan to anyone, then either you aren't good at sales or the plan really is flawed.  The whole world can't be dumb, can it?

Since we are raising money now for our new investment fund, I have a front row seat for these types of meetings.  Some of our target investors have strategies that don't line up with ours.  Others only look for funds with a certain profile that perhaps we don't meet.  It's our job to find investors who are the right match for our fund.  There seem to be more than enough out there of this type that we can get our fund off the ground.  We're very encouraged by the response and optimistic about our success.

But, if we aren't successful, it will be because of a shortcoming of our team or strategy, not the fault of our target investors.

Posted by Mike Feinstein at 07:37 AM | Permalink | Comments (0) | TrackBacks (1)

I've been in some negotiations like this:

Posted by Mike Feinstein at 01:49 PM | Permalink | Comments (0) | TrackBacks (0)

Posted by Mike Feinstein at 04:27 PM | Permalink | Comments (0) | TrackBacks (0)

I've been going through my track record as we put our diligence materials together for our new fund.

One stark fact is how the venture business has changed.  My last two operating jobs were at Shiva and New Oak Communications.  Shiva raised a bit more than $8M in four rounds of financing from 1989 through 1994.  That small amount of money came from two blue-chip investors -- Greylock and Kleiner Perkins.  In those days, you dripped the money into the companies (the biggest round was $4M).  Shiva went public in late 1994 with a $200M+ market cap and had a $2.4B market cap at it's peak in June 1996. 

New Oak raised just under $12M in two rounds (including seed capital) in 1996 and 1997.  When we sold the company in January 1998 for $156M, we still had $6M in the bank.  So, in about 15 months we spent almost as much capital as Shiva spent in 5 years.  Things were already accelerating, but no one complained about the outcome.

In looking at the venture deals I have been involved with since 1999 (14 deals), they have averaged $52M+ per deal!  Unfortunately, not all of these companies had a successful outcome, and some of them may require additional capital.  So, significantly more capital has gone into deals since 1999.  Now, that is not a big surprise, but it is still stark to see the contrast.

Of course, the problem is that with $12M of capital per deal, a $75-100M outcome is a very significant win.  With $50M of capital per deal, you need a $300-400M outcome to achieve the same multiple.  I think that there were proportionally many more $75-100M exits in the early to mid 90s than there are $300-400M exits today.  So, it's much tougher for VCs to make the same type of returns now than it was before.  And, that's a good reason why my new firm will be doing something different!

PS - Inflation is a small factor here.  According to my quick check, there has been about 31% inflation in the past 10 years.  So, it does make a difference on capital per deal, but not that big of a difference.

Posted by Mike Feinstein at 03:21 PM | Permalink | Comments (0) | TrackBacks (0)

This week got away from me as we were on the road raising money for our new fund, Sempre Management.  Meetings with prospective limited partners went very well, and we have many weeks and months of fund-raising ahead of us.  It's very exciting, especially when we continue to get such positive feedback on our strategy.

One LP told us that he expects a lot of money to shift from buyouts to venture capital in 2008.  This may be good for funds like ours that have a VC-like strategy, applied to a different market.  But, it also means that there will be a lot of investors looking to raise their exposure to more typical venture capital.  Although this may sound good for VCs, I think that it actually isn't.

Too much money in the VC segment means that investors will 1) overfund existing companies, 2) fund more marginal opportunities in order to put more money to work, and 3) be more content to live off of their larger fee base rather than focus solely on making strong returns for their investors.  This also, in the long-term, is bad for entrepreneurs.

Entrepreneurs may have more VCs willing to fund their companies, but those companies are more likely 1) to face increased competition from more well-funded start-ups and 2) to be over-funded themselves, leaving less room on the upside for the entrepreneurs, except in the cases of the largest outcomes.  Entrepreneurs don't start companies for the salary -- they start them for the equity upside which only comes from great exits.

In general, I think that over-funding the VC segment flattens out the distribution curve representing the outcomes of start-ups.  With increased capital, there will be some even bigger wins that could only happen with a lot of capital available.  There will be fewer mid-level outcomes and just a broader range of outcomes, including bigger, more spectacular losses.  If you happen to be at a company that ends up a the high-end of the curve, this is a good thing.  But, the curve probably also shifts to the left, meaning that the average return drops significantly.

I have long felt that the venture capital segment can only productively absorb a fixed amount of capital.  That amount slowly grows over time, perhaps just a bit faster than GDP growth (this is my guess -- no numbers to back this up!).  Like most investment segments, over-funding the segment leads to lower returns for everyone.  The only saving grace for VC is that most other investment segments are over-funded, leading to lower returns across the board.  This is why the big institutions are looking for more alternative investments in segments that are less well-funded, hoping for bigger returns.  At least until everyone else follows them and over-funds these segments, too.

Luckily, we feel that our strategy is unique, at least for now.  It seems like our prospective investors agree.

Posted by Mike Feinstein at 10:39 AM | Permalink | Comments (3) | TrackBacks (0)

Alot of people are talking about whether the potential acquisition of Yahoo! by Microsoft will be good for the start-up world or not.  Some say it's bad.  Others say it's good.

I'm in the latter camp.  I think that these types of big combinations are much more likely to produce opportunity than to shrink the number of buyers that start-ups can sell to.

In fact, I think that this will increase the number of buyers for start-ups in the online space.  Google is already a big media company.  So is Yahoo.  Microsoft wiould become an even bigger media company if it is able to buy Yahoo.  But, there are plenty of other media companies that are smaller players or almost non-existent players in the online world that we think of as Google and Yahoo -- IAC, News Corp., Disney, NBC-Universal, Viacom. 

I think that all these media types will continue to converge, meaning that these big media companies need to bulk up their online offerings.  So, there will be at least as many acquirers out there, if not more, as there are today.

Second, a big merger like Microsoft/Yahoo will take a long time to complete and optimize.  Development will slow down in these two big companies as everyone worries more about their job than their product or service.  After the dust settles, there will be gaps in their offering that will have to be filled in order to catch back up.  Again, start-ups are likely to fulfill these needs.

Last, the convergence of all this media is bound to create more new opportunities.  Start-ups are more likely to identify these and capitalize on them quickly than big companies.

If Microsoft/Yahoo created a real monopoly, that would be bad for start-ups.  But, then again, everyone thought search was 'over' when Google started.  In technology, things are never done, you just have to look a bit further ahead.

Posted by Mike Feinstein at 11:01 AM | Permalink | Comments (0) | TrackBacks (0)

If you enjoyed the adventures of Gary Snoman last year, you'll be glad to know that this year's holiday card from Blueprint Ventures answers the question "What about India and China?"  Happy Holidays!

Posted by Mike Feinstein at 11:37 AM | Permalink | Comments (0) | TrackBacks (0)

The National Venture Capital Association released the 2008 Predictions Survey recently (powerpoint slides here).

There were some interesting tidbits in here:

• VCs think that cleantech will be the fastest growing sector in 2008 for new investment, but will also be the most overpriced.
• Semiconductors and software will be undervalued in 2008 (good fodder for my fellow contrarians).
• VCs are optimistic about their returns in the future (or at least think that they will be better than they have been recently).  Given the amount of capital out there, I think that this is overoptimism.
• However, returns in the past 12 months are ahead of historical 10 and 20 year returns.
• Early stage venture capital, historically the strongest investment category, still has not recovered from the bursting of the bubble.
• VCs think that Hillary Clinton will be elected President!

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There has been a flurry of activity in some blogs about whether it is worthwhile for employers to require employees to sign non-compete clauses as a condition of employment.  Bijan Sabet, a VC at Spark Capital in Boston, had written about this a couple of times before.  Over the weekend he said that he didn't believe in these clauses and said that Spark would not longer require companies to have these in place for their employees.  I wonder if Spark's co-investors in future deals with agree.

Fred Wilson from Union Square Ventures disagrees.  Both posts have lively comments which are worth reading.

Having been an operating guy and a VC, I've seen both sides of this issue.  Also, I was once personally sued under a non-compete clause as one employer tried to keep me from taking a job at another company.  It's nice to be wanted, but that wasn't a lot of fun.

In my case, the non-compete clause of the first employer was very broad, making it almost impossible to enforce, even in Massachusetts.  And, my new employer, although in the same industry as my first employer, was also a partner that we had a cooperative relationship with.  So, it was tough to make the case that it was a pure competitive issue.  The case didn't last long in court (15 minutes on a hearing for a temporary restraining order), but I did have to reaffirm my commitment to the confidentiality of the information I had from my first employer.  I'm a strong believer in that.

Clearly, a non-compete clause, if well crafted and enforceable, protects the interest of a company.  VCs have a responsibility to protect the interests of their companies, so they should ask for such clauses.  But, these clauses should be narrow and fair.  If someone leaves voluntarily, they should be able to be restrained from joining a direct competitor of the products they worked on.  This can apply to big companies and small. 

Since these laws don't apply in California, investors there can't get such protection.  I agree with Bijan that this hasn't hurt entrepreneurship in California, but it has probably spawned more lawsuits from companies that may have started with or benefited from information gleaned from someone hired from a competitor.  I know that these are really issues of confidentiality, but they start from the fact that the there is no non-compete clause which is restraining job transfers.

I don't agree with Bijan that the presence of a non-compete clause has significantly impacted the development of start-ups in Massachusetts.  It may be a small factor, but I think that the issue is more of the overall attitude about starting companies.  Here's a comparison:

In Silicon Valley, when you tell your boss that you are leaving your job to start a company, they say "Great, I want to invest!"  In Massachusetts, they say "You can't', we'll sue you!"  This story works even if the start-up isn't a direct competitor.  No one wants to go to court, so the threat of the lawsuit is a big issue.

In summary, I'd like to see the courts require that non-compete clauses be narrow and fair.  If you really do restrain someone from working, you should pay them for their time.  But, these clauses have to be narrow enough to give the employee freedom without harming the company's interest.  I also think that it matters how you leave the company.  If you leave voluntarily, then you should be more constrained.  If you are fired, laid off, or forced to leave for "good reason", then you should have fewer shackles.  If you are so valuable, then they shouldn't want to see you go.

Posted by Mike Feinstein at 10:16 AM | Permalink | Comments (0) | TrackBacks (1)

Brad Feld wrote a post entitled "Don't Ask for a Referral If I Say No."  Good insight there into the mindset of a VC who tries to do an entrepreneur a favor by giving them a rapid 'No', but is then conflicted when asked to give the entrepreneur some additional help with VC introductions.

Too many VCs are hesitant to say No to an entrepreneur.  They prefer to preserve the option to invest later if the deal starts to look better (or if others get interested).  It's much tougher, but better for the entrepreneur, to give a No once you have decided to pass.  This saves the entrepreneur time.  I always tried to give feedback when I gave a No to a deal.  Maybe the target market wasn't interesting to me.  Maybe the deal didn't meet my firm's investment targets.  Maybe I didn't believe some of the assumptions behind the plan.  I try to be as open and direct as possible, probably only holding back when it was the entrepreneur themself who is the problem.  Maybe I'd say -- the team needs strengthening...

All of this feedback is my opinion.  Maybe I'm wrong.  But, if a VC says No, they have made up their mind.  It's not productive to try to change their mind through lots of follow-up.  If you want to keep me posted via an occasional email about your progress, that's fine.  Maybe we can meet again in six months or so.  But, don't try to overcome my feedback as if they were sales objections.  That's not the dynamic that is in play.

Also, as Brad says, asking for an introduction to another VC is a bad idea.  Unless the deal just isn't in a sector where my firm invests, I have to tell the VC that I passed and why.  I need to be honest with them as it's part of my relationship with them on sharing deals.  Instead, try to improve your plan and presentation first, and then get a trusted introduction to other VCs from their own non-VC contact network.  That's much more valuable.

You can get a lot out of a No from a VC.  Just not introductions to other VCs.

Posted by Mike Feinstein at 09:53 AM | Permalink | Comments (0) | TrackBacks (0)

Scott Kirsner from the Globe has done a great job writing about the start-up and VC scene in Boston for the Globe.  I always enjoy talking to him.

Although I haven't mentioned it here, I am in the process of getting a new investment firm off the ground.  But, we are still in stealth mode for a variety of reasons.  Today, Scott wrote a blog post about our activities that is directionally correct, but not totally accurate.  I very much appreciate the interest, Scott, but can't comment further until we are ready to be more public in our activities.

In the meantime, how about making a donation to Globe Santa?

Posted by Mike Feinstein at 04:00 PM | Permalink | Comments (0) | TrackBacks (0)

The Boston Globe writes today about the local venture capital market and the impact of angel investors and organized angel groups.  As the recent numbers show, VC activity in New England is on the upswing in terms of dollars invested, but this is skewed by larger, later-stage investing.  It's still pretty challenging for early-stage companies, and particularly first-time entrepreneurs to raise venture capital dollars.  The angel groups have filled the gap here somewhat, but there is still a mismatch between the appetite of angel groups and the number of early-stage companies seeking funding.  As the Globe reports, the amount of angel funding has stayed steady, which indicates that they are fully deploying the dollars available even though there is a growing market opportunity.

One way that this gap gets filled is with smaller VC funds that are willing to fund early-stage companies.  As I have been advising some early stage start-ups, I have found that three newer funds in town have been receptive to early-stage companies.  If you are an entrepreneur with an idea in the IT sector, it's worth getting introduced to these firms.  In alphabetical order:

.406 Ventures

Dace Ventures

Kepha Partners

Check out their web sites to see the backgrounds of the partners and their areas of interest.

Posted by Mike Feinstein at 10:21 AM | Permalink | Comments (0) | TrackBacks (0)

When I wrote recently about Backing into 20%, or why big VC funds face challenges in getting big returns while they want to own as much of a company as possible, I missed one obvious point.

When I compared the kind of returns that a smaller fund, like Fred Wilson's Union Square Ventures, needs to have versus those that a bigger fund needs, I skipped over another solution.  Why can't the bigger fund just do what the smaller fund does many times over?  A $750M fund can just do what a $125M fund does six times.  That means that the bigger fund needs to have six times the partners finding six times the number of great opportunitites.  Each of those opportunites can have the profile of the returns that I described for the smaller fund.

Mathematically, that all works.  But, the math doesn't map to reality.  The scarce resource is the entrepreneur who can build a company that delivers the great returns.  It's a competitve market out there for these entrepreneurs, and if your firm has to find 6x as many of them as a smaller firm does in order to have a similar return, your firm is bound to lower the quality bar in the name of putting the money to work.  And, you need to put the money to work in order to justify taking a management fee on the big fund.  And, that's the dirty little secret of today's large venture funds.  It's almost impossible for a big fund to repeat the success that smaller funds can have with early stage deals.

Posted by Mike Feinstein at 08:54 AM | Permalink | Comments (0) | TrackBacks (0)

Business Week's Sarah Lacy has an article that reinforces some of the structural VC issues that have been discussed here regularly.

There's simply no big overall tech movement getting Wall Street revved up, and among entrepreneurs, the feeling is mutual. Sarbanes Oxley and other regulations have made the prospect of going public far less appealing.

The picture looks worse among acquisitions. Sure, the usually sleepy third quarter saw $10 billion come in acquisition proceeds, but that was spread among 90 deals. Companies like TellMe, the voice recognition software company founded in the late 1990s that snagged $800 million from Microsoft (MSFT), are in the minority this year. Far more common is the tech company that plodded along for more than six years, chewing through some $30 million in venture cash to eventually get bought for $50 million or so. Indeed, the median length of time it took companies to get bought was the longest Dow Jones VentureOne has seen since it started measuring the industry 20 years ago. Meanwhile, valuations keep rising, as billions of dollars in VCs’ coffers fight to get in what few great companies are out there.

And

Internally, many investors are worried that only a handful of firms will break even on the current crop of funds, much less post stellar returns. In hushed conversations over breakfasts at Buck's and lunches at the Sundeck, VC veterans are wondering aloud whether they should get out, or, after years of playing boardroom quarterback, whether they've still got the chops to actually build a startup.

However you slice it, unless something changes, venture capital is in for upheaval. Some venture capitalists are going to find themselves out of a job. Overall, the industry may become more the font of outsourced research and development for big firms and less the breeding ground for the next great tech powerhouse. And returns will be lackluster for the majority of firms left out of the best deals.

Yikes.  That's pretty pessimistic.  I don't think that it is quite that bad, but I do think that LPs are resigned to the fact that returns won't be as strong as in the past and great returns will be even more concentrated in fewer firms than in the past.

If I could wave a magic wand, I would make at least half of the committed funds to venture capital go away.  Even though that would lead to there being many fewer VC firms and VC partners, it would also mean that funds were smaller, investment decisions were more disciplined, and capital would be doled out much more parsimoniously.  That's good for entrepreneurs who can get funded and very good for ultimate returns.  There might be fewer start-ups, but I also think that there would be more small scale financings to give company concepts a try.

Posted by Mike Feinstein at 12:26 PM | Permalink | Comments (0) | TrackBacks (0)

Fred wrote today about the mytical 20% ownership threshold that most VCs have when they make early-stage investments.  As he points out, there is no investment reason why a VC needs to own 20%+ of a start-up.  The reason they want to own this much is that they want to put more money to work and have significant large dollar volume returns that are significant to their large funds.

The fundamental problem is the large size of early-stage VC funds.  It makes it difficult for a VC to do a small early-stage deals.  Each deal takes more or less the same amount of time.  So, if you have to put in the time, you might as well put more money to work to try to get a bigger volume return.

The problem with this is that VCs should be in the business of generating a significant multiple on an investment.  But, with a large fund, you tend to focus on the total dollar return so that it 'moves the pile', or makes a difference in a fund.  Putting $2M to work and getting $20M back (10x return) doesn't matter that much to an $800M fund.  It would be more significant to put $25M to work and getting $75M back (3x). 

Take a look at the numbers at the end of Fred's post:

Don't get me wrong, I would love to own 25% of a company or more. But we don't make it a requirement. Our requirement is being able to get into the best deals, work with the best entrepreneurs, and be able to generate $40-50mm in proceeds when a deal works and return the fund, $125mm in our case, on the very best deal in the fund.

If Fred gets a $40M return on a company that they own 15% of, that implies (more or less, depending on deal terms)  a $267M exit value.  That's a pretty successful company, and I'm sure that Fred has had a bunch of those.  If they get $125M (their fund size) on a 15% ownership, that's a $833M exit, which doesn't come along too often.  If you change these exit values to be the same percentage of an $800M fund, that would imply a $256M return and a $800M return.  Even with 25% ownership, these imply $1B+ and $3B+ exits.  Don't hold your breath waiting for those.

You can see from this example that a smaller fund has a much better chance of generating a significant multiple than a big fund.

The fundamental problem is that there is much more money being put to work in the early stage space then there are great entrepreneurs that need that volume of money.  This leads to three problems -- 1) too many copycat deals get funded as the money burns a hole in the VCs pocket, 2) VCs end up pushing more money onto entrepreneurs to raise their ownership and put more money to work and 3) smaller, very early stage deals have a hard time raising money because no VC wants to make a $1M investment.

The big funds force those investors to back into the 20% requirement, instead of making it a 'nice too have'.

Posted by Mike Feinstein at 02:27 PM | Permalink | Comments (1) | TrackBacks (0)

Scott Kirsner of the Globe has a great column today on VC blogging.  He also has a blog post and video.  The video includes interviews with VCs and entrepreneurs, including me.

Scott's column does a good job capturing all sides of this discussion -- the views of VCs who blog, those who don't, and the view of the entrepreneur.  In the end, I think that a VC has to do what fits with their personal style.  Blogging doesn't necessarily give you an advantage over those who don't.  But, if you don't blog, you need to figure out what other means you will use to stay connected to the Web community.  One thing is for sure -- the market is changing and historical methods for marketing a venture firm and connecting with entrepreneurs won't continue to work in the future.

Posted by Mike Feinstein at 04:37 PM | Permalink | Comments (0) | TrackBacks (1)

I wrote recently about the small number of Boston VC Bloggers.  I received some comments from some Boston VCs (who preferred to remain anonymous and to respond to me directly).  The consensus I heard from them was that they weren't comfortable blogging or posting public comments.  They preferred to communicate one on one to control their communications.  There was also a theme that many blogs (not mine, I hope!) included a lot of personal ranting which wasn't that useful.

I don't agree with this, but my view is shaped by the positive feedback I get from entrepreneurs who discover me through my blog (or from a friend who reads my blog).

Another form of participating in the Boston entrepreneurial community is to attend some of the networking events which happen regularly around town.

Some events are sponsored, like Web Innovators Group (sponsored by Venrock).  Although this event is open to all, perhaps some VCs stay away because they feel it is Venrock's event.  Other events become associated with a firm, perhaps because a partner at that firm started it or promotes it.  An example here is OpenCoffee Cambridge, with Bijan Sabet of Spark as one of the founders.  Although Bijan is welcoming, perhaps some VCs stay away because they want to do their own thing.

There are even big, occasional events like Tech Cocktail, where North Bridge was one of the sponsors.  I've gotten a lot out of attending all of these events, so thanks to all the sponsors!

Like blogging, I don't see enough of the senior people at the big Boston VC firms at events like these.  Now, maybe I'm going to the wrong events.  But, in general, I see a lot of the more junior VC people at these events that are primarily aimed at the emerging Web 2.0 world.  I like the junior people, so don't get me wrong.  They are smart and high-energy.  But, you can't delegate your interest in a new market to your junior VC staff.  Many of the firms around town which claim to invest in Web 2.0 companies don't have senior partners who show up at many of these events.

If you want to understand a new market, you have to participate directly.  So, I hope to see more of my senior VC friends at some future events.

Posted by Mike Feinstein at 04:18 PM | Permalink | Comments (0) | TrackBacks (0)

As entrepreneurs give me feedback on my blog, they often ask me why more Boston VCs don't blog.  Of course, there are quite a few who do (these are the ones I read most often and is not a complete list):

Jeff Bussgang

David Aronoff

Mike Hirschland

David Beisel

Bijan Sabet

I wish there were more.  There are some firms that have no one who blogs, but they still claim to invest in the Web 2.0 market.  I don't get it.  I don't see how you can do that without being part of the community.  Without that, you just won't be able to understand these deals.

Some possible reasons why many VCs (particularly more of the 'older' ones, like me) don't blog:

1) They are very busy.  Hey, who isn't.  That's not a good excuse.  If you thought it was important, you'd find the time to do it.  This reasons is really 'I don't think that it's important.'

2) They don't want to be wrong.  I think it is risky putting opinions out there.  You may be wrong, or someone important may disagree with you.  So what.  As long as you are not confrontational, it's just a discussion.

3) They don't want their LPs to find anything that isn't totally buttoned up when they do their diligence.  Smart LPs will know that you can't invest in this space if you don't participate.  Just keep your sick hobbies out of your work blog...

4) They don't want to share their opinions with the rest of the world and lose their competitive advantage.  Come on.  Most VCs are pretty smart, but there are very few unique thoughts in this world.  By participating in the conversation, you'll have better opinions.  Of course, you have to be careful in talking about new spaces and companies you are looking at, but I think that blogging helps your deal flow so that you'll see more new things anyway.  And, we need to collaborate more in the Boston market anyway.

5) They have nothing to say.  I don't think that this is true, but if they really don't understand the space, then maybe they'd learn by trying.  See #2.

It took me a while to commit to doing a regular blog.  And, it's hard to carve out the time to write something sometimes.  But, I get so much great feedback from people who read The Fein Line that it's addictive.  I'd like to not be Boston's oldest VC blogger much longer...If there is someone else out there who deserves that title, let me know.

Posted by Mike Feinstein at 04:44 PM | Permalink | Comments (0) | TrackBacks (0)

I was getting an update on a company I know recently when I realized that the investors owned too much of the company for their own good.

Now, as an investor, you might think that you want to own as much as possible.  And, of course, the entreprenur wants to hold on to as much ownership as they can.  If the VCs do own too much, you can run into several problems:

• The more commonly known issue is that if the investor owns too much of a company, there isn't enough equity left to properly motivate the entrepreneurial management.  If you are asking management to work start-up hours and forego market rate salaries and compensation, you probably have to offer them reasonable equity stakes so that they can share in the upside that they help create.  If the investors own too much of the company (maybe more than 80%), there is no way to have enough equity left to motivate the team except in very rare situations (companies that have raised huge amounts of cash where everyone agrees that the outcome is also very huge).
• A separate issue has to do with large investor ownership getting in the way of follow-on financing.  A mature company (in terms of investment and age) that is a bit behind in terms of company development (maybe because a business model was switched one time along the way) may be in the situation where the investors own too much.  In this case, the investors own enough of the company (and probably at too high of a valuation) that it is hard to attract outside capital.  If there is investment interest, it may be at a lower valuation than the previous round.  The existing investors won't be happy about that.  However, if the investors do an 'inside round' and invest in the company without a new investor coming in, their ownership may not go up a commensurate amount because they hit the ceiling where they dilute management's upside too much.  Nothing is worse than doing an inside round at a company and, due to option pool expansion, owning less after the round than you owned before.

These types of situations often lead to companies being sold 'before their time.'  As a VC, you may prefer to sell the company rather than do one of those inside rounds where your ownership drops.  The only thing which may keep you from this is if you believe that the future upside is so big that it is worth the short term hit on ownership.  But, you have to convince your skeptical partners of this as well.

Posted by Mike Feinstein at 01:45 PM | Permalink | Comments (1) | TrackBacks (0)

Once again, Ask The VC has a great post on the VC business.  This one is Why are Venture Capitalists So Hard to Deal With?  I direct people to Ask The VC all the time as I think it is a great resource.  I also like the model of submitting questions to be answered by the authors.  If you have a question about venture capital, ask them!

One additional comment I have on the content of this post is that VCs often behave badly because entrepreneurs let them get away with it.  If you behave like a jerk and entrepreneurs continue to come see you with new business ideas, then you get positive reinforcement on behaving like a jerk.  So, check the reputations of the VCs you want to approach and avoid those that are hard to deal with.  Check out The Funded for more (probably biased) feedback on how VCs treat entrepreneurs.

Posted by Mike Feinstein at 01:31 PM | Permalink | Comments (0) | TrackBacks (0)

Marc Andreessen has written a great series of blog posts about startups.  But, his most recent about How to Hire a Professional CEO is too cute or just wrong.  To save you the trouble of clicking, here is what Marc says about How to Hire a Professional CEO for your startup:

Don't.

If you don't have anyone on your founding team who is capable of being CEO, then sell your company -- now.

I don't agree, although I will concede that it is far better to already have a great CEO than to have to go hire one.

I think that most start-ups are in a more nuanced situation than this.  Here are the most common scenarios:

1. There is an experienced CEO with the right market experience on the founding team.  You are done and can pass Go and collect your first VC investment check.  Maybe.
2. There is a strong manager on the founding team who can run things for a while as you get the company off the ground.  For many high-tech startups, this can be someone who ends up being a strong CTO, VP of Engineering, or VP of Marketing.  The risk is that, as an investor, you know you'll have to remove this person from the job of running the company at some point.  Even if the Founder agrees up front, when the moment of truth comes for them to help hire a true CEO, they may resist or, even worse, become obstructionist.
3. You have a great technical founder but no business person to get things going.  Usually, as a VC, I'd try to match up this great technical founder with a start-up CEO from category 1 above.  If you can't get one of 3 or 4 qualified CEOs to bite on the opportunity, perhaps there is some fatal flaw with the idea or the founder.  Think very, very hard before you go ahead and fund this kind of company without the CEO in place.
4. Even scarier is the situation where you have a person with the CEO title on the founding team, but you don't think that this person is qualified for the job or should even have a role at the company.  There is no way you should fund this opportunity until you get the right person in the CEO slot.  Anything else is just asking for trouble.

In some of these scenarios, you may need to hire a CEO, either at the beginning of the company's life, or after it has grown and matured a bit.  It is very, very common for start-ups to outgrow the initial management and have to add more experienced management as it progresses.  In these cases, you'll have to hire a 'professional' CEO, as Marc calls it.

I've had some luck finding CEOs through my own network of contacts.  It is definitely worth doing this at the start of a search, but don't delay for too long.  I'd recommend trying up to 4 people from your network that you think would be a good fit.  Beyond that, hire a recruiter.

I've had good success with professional search firms.  I prefer smaller, boutique firms that focus on particular market segments.  The partners at these firms are hungrier and tend to do all the work themselves, rather than delegating it to less experienced associates.  Although the best search firms do a good job on referencing checking and thinking about fit within the organization, I think you have to really do that job yourself.  Make sure you spend hours and hours with the candidate, in both business and social settings.  Make sure you do many, many reference calls (at least 20), including many people not on their formal list. 

I always go out of my way to talk to what I know will be negative (or less positive) references to hear their perspective.  We all have people that we have crossed at some point who won't be glowing in their feedback on us.  They may be biased, but I want to hear what the biased people say.  Find someone who decided not to promote the potential CEO sometime in their career.  Find someone whom the CEO had to fire.  Find the investor who passed on their previous deal because of concerns about the CEO's experience.

You have to have the management team be part of the CEO interview process, but don't let them be obstructionist.  In the end, the Board hires the CEO.  You want the new CEO to fit in with the company.  But, I have seen situations where the existing management, which may be weak, fears the new CEO being brought in because they know that some or all of them will soon be out of a job.  In addition to just hiring the wrong person, this is probably the kind of situation that Marc is wary of.  And, rightfully so.  But, as an investor, you have play the cards you are dealt.  And, sometimes there is some breakage in these management changes.

It's definitely possible to hire an experienced CEO later in a company's life.  It is an element of risk.  But, you also need to match the CEO to the stage of the company.  A boot-strapping start-up won't be able to attract the CEO who can run a $50-100M business.  As you go from one phase to the next, you'll have to make changes.  Proceed with caution.

Posted by Mike Feinstein at 09:12 AM | Permalink | Comments (0) | TrackBacks (0)

Bruno Langlais interviewed me recently in intruders.tv, a video blog. 

They've had a recent theme about the Boston VC scene and the differences between Boston and Silicon Valley.  Given my 'years of experience', I tried to give a bit of a historical perspective.  I also highlighted two of the start-ups I work with in the Web 2.0 space, Geezeo and Good2gether.  You may have figured out that I am an unabashed shill for the companies I work with!

I like the video blog concept.  You get a lot out of watching the video versus reading an article or even hearing a podcast.  I've never been comfortable watching myself speak, but I've reluctantly gotten used to it.  I hope you like the content, and I'd appreciate seeing your comments here.

Posted by Mike Feinstein at 07:49 PM | Permalink | Comments (1) | TrackBacks (0)

I've written regularly about how Boston-area VCs need to step up and take some risks in order to foster some market segments, such as Web 2.0 (posts here and here).  Many entrepreneurs have told me that VCs in the area aren't willing to back them unless they have a team that has done it before with a site that has a lot of traction and already generating revenue.  That doesn't sound like real early stage investing to me.  And, I hope to see it change.

But, entrepreneurs have to be willing to take some big risks, too.  There are other ways to fund a start-up besides a VC.  Maybe venture capital is the only way to raise millions at once, and that kind of investment can only be justified in something that has a chance to scale rapidly and build significant value.  But, plenty of start-ups have gotten going with other forms of financing:

• Angel investors -- in Boston, the angel groups are very active.  They don't move any faster than VCs, but they are willing to fund riskier ventures than typical 'early stage' VCs.  Also, there are many entrepreneurs who can find individual angels from their industry who are willing to back their ideas.  Geezeo and Good2gether are examples of this.
• Friends and family -- this is probably the most common way that start-ups get going.  Who knows the entrepreneur better than their family and friends?  While not every entrepreneur has friends and family with the resources to back them, a scrappy entrepreneur can do a lot with a modest amount of capital.  Earlier in my career, Cayman Systems started this way.  Also, CircleLending has formalized many business loans between friends and families to get businesses off the ground.
• Do some other work for funding -- a lot of companies get started with the team doing related work for pay (consulting work, licensing software, selling something related, etc.).  This may divert some attention from the core business, but it does keep people paid.  This will require extra effort on the team's part to do the revenue generating work as well as the 'new business.'  But, it gets you going.  Not many people know that one of my former companies, Shiva, was originally funded by doing driver work for a hard disk company.
• Fund out of your own pocket.  This is the riskiest form of financing for the entrepreneur, but it is done.  Some people have some resources from previous success that can provide them a financial cushion.  Others are willing to make a big bet on themselves and their idea.  GateRocket and MyDesignIn are examples of this.  GateRocket went on to raise formal angel funding afterwards.

Many times when I meet with entrepreneurs, they won't get going unless a VC gives them money.  Now, for certain businesses, this is wise.  A business that has to compete with venture-backed direct competitors who are ahead of it, or one that will need millions of dollars for R&D (like a semiconductor start-up) may very well have to raise venture capital to get going.  But, most Web businesses don't need large amounts of capital to get going.  Some money is needed, but a lot of work can be done on more of a bootstrap basis.

Although the most committed entrepreneurs are willing to do whatever it takes to get their business off the ground, others are too willing to accept a 'No' from a VC.  This is a good test of commitment.  I am always impressed by entrepreneurs who have pulled off amazing things on modest amounts of capital because they were determined to get it done.  So, don't let a VC's 'No' slow you down.  Find another way to fund your business and prove the VC wrong.

If you don't have the guts and determination to do this, maybe the VC was right after all...

Posted by Mike Feinstein at 09:04 AM | Permalink | Comments (2) | TrackBacks (0)